At its core, Austrian school economics is free market economics.
Often, many people who say they favor free markets don’t in reality. Because of this, I tend to distinguish myself and others as advocates of Austrian economics just so there is no mistake.
Most advocates of Austrianism are libertarians, but it is technically possible to believe in Austrian economics without being a strong advocate of liberty. Since Austrian economics generally teaches that a free market with strong property rights is the key to peace, prosperity, and greater wealth for society, it is natural for people to push this philosophy once they understand it. But it is also possible someone may not want to see a prosperous society or may simply want to advance his or her own individual goals, while understanding the truth of Austrian economics.
Austrian economics is not named as such because the country of Austria adopts this philosophy — rather, the founders credited with the philosophy happened to be from Austria. The face of Austrian economics is Ludwig von Mises, who lived from 1881 to 1973.
Mises promoted the study of what he called praxeology — the study of human action. He used this as a starting point for his economic philosophy. While Mises wrote many books and essays, his most famous is called Human Action. It is not light reading, and I wouldn’t really recommend it for most people, especially those starting out.
But for whatever Mises lacked in writing for the average person, he more than made up for in his excellent economic analysis over his long lifetime.
And we have to consider that he did not have the benefit of the Internet or a long list of Austrian economists that came before him. While he certainly built upon the work of others, he had a lot of unique insights during his time.
Austrian Economics and Predicting the Future
Some people will ask me if libertarians/Austrian economists will invest their money differently than others. My short answer is yes, that is often the case. However, just because you follow Austrian school economics doesn’t automatically mean you will be a great investor. You could be the worst investor in the world and still be a legitimate advocate of free markets.
One thing Austrianism teaches is that the future is unpredictable. The economy is made up of the billions of people in the world, with each person making transactions almost every day. Each decision is an individual’s choice, and each decision — even the decision not to spend your money — has some effect on the economy, no matter how small.
Since human action determines what will happen in the economy, you can’t predict with any certainty what will happen and when.
However, we can use the study of human action to make rational guesses about likely outcomes.
For example, if there is a law passed that says you can’t charge more than one dollar for a pound of bananas, we can take a good guess at what is likely to happen and how rational human beings will act.
In this case, we will likely see a shortage of bananas. People will likely buy more because of the mandated lower price. Meanwhile, supplies will diminish as sellers of bananas find it less profitable or perhaps not profitable at all.
This doesn’t mean shortages have to happen. Perhaps another factor will offset this new law, such as minimal demand for bananas regardless of price. Or perhaps someone will find a way to grow bananas at a lower cost.
In economics, a common phrase to go with these guesses is “if everything else stays the same.” In the case of the bananas, supplies would shrink if everything else stays the same. This means we can take a good guess that supplies will diminish — but they don't have to if other things don’t stay the same.
Of course, in the real world, nothing stays the same. There are all kinds of variables, precisely because we live in a changing world with individual human action. For this reason, it is always important to remember the phrase “if everything else stays the same.” We often have to guess at what the other important variables are, what they will do, and what effect they will have.
Monetary Inflation and Consumer Price Inflation
The last six years serve as a great example, and I think they taught this important lesson to many people, including Austrian school followers.
When we hit the fall of 2008 with the financial crisis, the Federal Reserve started creating money out of thin air at a staggering pace. It was like nothing Americans had ever seen in modern times. In a matter of five years, the Fed quadrupled the adjusted monetary base.
As this was occurring, some Austrians were predicting massive price inflation. It is understandable how they could come to this conclusion. With the money supply being increased so dramatically by the Fed, it is reasonable to think that consumer prices would follow in a rather short period of time.
That is, if everything else stayed the same. But the people who predicted massive price inflation learned this is rarely the case.
It was also during this time that the Fed started paying interest on excess reserves. It was only one-quarter of a percent, but it was still something. This, coupled with a lack of borrowers and fear by the banks, meant banks were piling up this new money as excess reserves. They weren’t lending out most of the new money.
This meant the new money was not being multiplied through the system through the process of fractional reserve lending, as had typically happened in the past. The supply of money circulating through the economy was less than expected.
In addition to that, this period has been filled with continued fear over unemployment and an overall uncertainty about the economy. This has kept the demand for money high, which means consumers are spending less. It means prices are not being bid up as high, and this has helped keep a lid on consumer price inflation.
Instead of significantly rising consumer prices, we saw rising asset prices. Real estate bounced back in most areas, although it didn't return to its all-time highs from the bubble phase. Meanwhile, stocks really seemed to benefit from the Fed’s easy money policies, as they soared to all-time nominal highs, even after the bad beating they took in 2008 and early 2009.
So while it seemed like a reasonable guess that high consumer price inflation would result from the high monetary inflation, it didn’t happen. It may still happen, but this would just demonstrate how difficult it can be to time things in the market.
Austrian Economics and the Permanent Portfolio
It is for this reason that I take a somewhat conservative approach in investing, at least for a portion of investments. Since the world is unpredictable, with billions of humans acting every day, we have to have the humility to admit that we can’t predict the future with any absolute certainty.
And this is why I recommend that you keep at least half of your investments (in most situations) in a setup called the permanent portfolio. It is designed to protect your assets in any economic environment, while still providing some long-term growth.
But I also understand most investors are looking for some investments that have a potential to provide huge returns. For this, I think knowing and understanding Austrian economics can be beneficial for taking good guesses at where the economy is going and what is likely to pay off in such an environment.
The key here is that we limit our speculations, while keeping at least half of our portfolio in a safe and stable environment — or at least as safe as we can get in our world today.
Our speculative investments can be based on guesses of how humans — particularly politicians and central bankers — will act and how this will affect the economy and our investments.
While I would love to live in a world with much smaller government, no central bank, and a free market in money (and everything else), I understand that is not the reality we live in.
Given our circumstances, we have to invest accordingly. Politics has a great effect on the economy in almost every way, and the economy, in turn, affects our investments in almost every way. For that reason, we do have to understand politics and its effects so we can choose our investments more wisely.
Austrian Business Cycle Theory
Perhaps one of the most important theories to know and understand with Austrian economics is the Austrian Business Cycle Theory (ABCT). This explains the business cycle that occurs because of central bank manipulation.
To be clear, you can have ups and downs in a free market economy, but you are unlikely to have widespread miscalculations or bubbles and busts as we see in today’s world. You will see business failures, but they will tend to be spread out, not happening in a widespread manner at the same time as we see in our modern-day recessions.
The ABCT teaches that when the Fed (or any central bank) artificially lowers interest rates and creates money out of thin air, it distorts the economy. It misallocates resources, which are sometimes referred to as malinvestments.
The artificially low interest rates and new money send false signals in the economy, particularly to entrepreneurs. They signal that there is more savings than there really is. This will cause businesses to think there is more demand for particular products and services — or perhaps there is great demand, but that demand is unsustainable once reality sets in.
When there is monetary inflation, the new money does not spread out equally across the economy. It is not as if every person gets the same amount of new money in his pocket. New money created by the Fed causes a redistribution of wealth, benefiting those who see the money first (government contractors, borrowers, lobbyists — just to name a few) at the expense of others.
The new money will also flow into certain sectors or hot spots. This could be anything from stocks to housing to stamp collections. These are usually unsustainable bubbles that eventually go bust when reality sets in.
At some point, the Fed has to cut back on its monetary stimulus or risk the chance of runaway inflation. Even if the Fed simply reduces the rate of its monetary inflation, this can be enough to expose the malinvestments, as businesses and individuals find themselves unable to meet their financial obligations.
This will eventually lead to a correction or recession. If the market is allowed to reassert itself, then the previously misallocated resources will try to realign with actual consumer demand. This causes pain in the form of unemployment, bursting asset bubbles, business losses, and even bankruptcies. Unfortunately, this is the necessary process to correct the previous distortions.
Some people will blame followers of Austrian economics for being pessimistic or even for wanting recessions. But this is not the case; Austrians are simply facing reality. When the Fed causes a huge artificial boom, it is simply unsustainable, and the market must be allowed to correct it. The longer the Fed tries to keep the artificial boom going, the more painful the correction will be down the road.
It is better to face a problem and deal with it than to pretend it doesn’t exist and experience even more pain later.
Since the Austrian Business Cycle Theory deals with the overall economy and is especially applicable to our world today of central banking and inflation, it is essential to understand its implications. This is the number one thing that will affect the economy and our investments.
We can’t always guess what the Fed will do and how the market will react. We also can’t always determine an accurate time frame, as some Austrians were predicting a housing crash a couple of years before it actually happened. But we can use our knowledge of the ABCT in helping us protect our wealth, giving us a good chance at successful speculation.
Overall, understanding Austrian economics is important in knowing that we can’t predict the future with any absolute certainty. This is why the permanent portfolio is so important.
At the same time, Austrian economics can also give us some guidelines in our speculations, giving us good chances for profit based on our best guesses of how human action will affect the economy and the markets.