To Predict the Next Bust, Ask An Austrian

Revising The Mantra

It’s long been the mantra of the Psy-Fi Blog that no one can successfully predict anything about anything to do with finance; or anything much else, to be honest. To this, though, we probably ought to add a corollary – no one can successfully predict anything about anything to do with finance except when they do, but when they do everyone will ignore them. Tough business, this crystal ball gazing lark.

Although the history of the recent crash is too close to analyse, it is possible to look at what happened in the turn of the century debacle. It turns out that there are two groups of people who successfully predicted the market collapse – a bunch of value based investors and an obscure group of economists hailing originally from central Europe. In difficult times we must take our heroes where we can find them.

Dotcom Predictions

In Who Predicted The Bubble? Who Predicted the Crash? Mark Thornton looks at the record of prediction in the run-up to the dotcom crash of 2000. What we can say with certainty is that virtually all the people we most associate with these predictions pretty much got it wrong – equity analysts from blue chip firms and the U.S. government’s own analysts seem to have formed their predictions by looking at what happened in the previous year and doing a cut and paste – and were thus inevitably wrong-footed by changes in market direction.

However, Thornton points out that quite a wide range of people and institutions did warn that the bubble was unsustainable. Part of the problem, though, is that such negative views are never popular. The publicity provided to these people was negligible while the airwaves and print media were filled with ever-optimistic gurus predicting ever rising stockmarkets. Dow 36,000 anyone? Yet a basic grasp of maths was sufficient to show that many of the predictions were ridiculous.

When All Else Fails Be Lucky

However, even the most successful predictor of a crash may simply be lucky. In a world in which everyone is predicting something, someone is bound to predict everything. Just because they randomly settle on the correct result doesn’t mean we should invest our trust and capital in their future prognostications. No, we need something more: we need to understand why they were right.

Leaving aside outliers, stray individuals and perma-bears, we can roughly identify two groupings of people espousing broadly similar approaches who correctly discerned the name of the game in the tech stock run-up of the late nineties. Firstly there were the value based analysts, who based their predictions on the brutal nature of reversion to a historical mean. These people had simply learned from history that there are no monetary miracles when it comes to the basics of corporations growing earnings – the productivity revolution engendered by the Internet simply wasn’t going to drive corporate growth to anywhere near the extent being predicted.

Austrian Angst

The second group of generally successful sayers of soothes turned out to be a bunch of economists from the so-called Austrian school (named after where it originated, not an odd predilection of its practitioners for wearing leather shorts and funny hats with feathers in them). In popular economic terms comparing mainstream economics with the Austrian school with is like comparing a Ferrari with a Trabant, although as far as I know a pig’s never tried to eat a Tyrolean economist. If that’s not very clear: this approach to economics is not very mainstream, most practitioners being treated like Prince Philip at a convention of anarchist animal rights activists.

As its heart Austrian style economics disparages the attempts to quantify economic matters, regarding such approaches as hopeless in what is a fundamentally non-deterministic world. In essence the Austrians believe that the complexity of human economic systems is such that it’s basically impossible to predict anything very much and certainly that you’re not likely to learn a lot by sticking people in a laboratory and probing their responses to arbitrary economic tests.

A Viennese Whirl

You might note that there’s a bit of a contradiction here. Austrian school economists – who generally don’t think you can predict anything about economies – suddenly decided, en-masse, in the late nineties to huddle together and start making wild and unsubstantiated predictions about the likely course of the dotcom bubble – which then turned out to come true. Even better, from the perspective of reviewers of crystal ball gazers, most of their predictions came in the latter stages of the boom. There’s something a bit odd going on here.

To provide a summary of what lies behind this would require an even longer dissertation than normal but roughly we can point to a single facet of Austrian thought behind this peculiar polarisation of predictions. Essentially they believe that most wide scale economic events can be explained by increases in the amount of money sloshing about in the system and at the heart of this is the money creation capability of the central banks.

From an Austrian viewpoint as central banks pump money into the economy this feeds into asset prices – stuff like stocks and housing – leading to valuation increases and the reduction in nominal value of the money created – i.e. there’s more money about but it buys you less assets. More money can also lead to more credit, which feeds forward into more money and further asset price rises. Eventually assets reach unsustainable prices, the money runs out, the dumb saps holding overpriced assets realise they’re in trouble and everything comes tumbling down.

Procyclicality

A secondary implication of this way of thinking is that if governments and central banks intervene to ameliorate the outcome of downturns they’ll simply be storing up problems for the future. This issue, known as procyclicality, is increasingly a concern for central bankers. As William R. White wrote in August of 2009:

“Not surprisingly in current circumstances, the possibility that liberalized financial systems might be inherently “procyclical” is already receiving increasing attention. Similarly, the possibility that accumulated imbalances might significantly reduce the effectiveness of stimulative monetary policy is being increasingly accepted. In particular, it cannot be denied that the period of financial market turmoil, which began almost two years ago, has been met with an extraordinary and creative response on the part of central banks. Nevertheless, the financial turmoil has continued unabated and the real side of the global economy looks increasingly vulnerable.”

Basically every bust is met with counteraction from central banks, which feeds forward into more instability which requires even greater interventions and so on and so forth. Given this viewpoint you can imagine what Austrian school economists think of the current bout of central pump-priming of the financial system.

Cheap Money Leads to Bad Behaviour

From this perspective the predictions of the Austrian economists at the back end of the nineteen nineties become easily explicable. The successive and successful attempts by the Federal Reserve to bail out investors through the decade, along with gradual expansion of the money supply simply led investors to believe that they were living in a period without risk. Simple behavioural biases did the rest.

Naturally, Austrian economists would have argued that the massive monetary easing that the Fed embarked on in the wake of the dotcom crash was simply sowing the seeds of an even worse crisis to come. They would have suggested that the expanded money supply would start flowing through the economy, leading to all sorts of unexpected booms in all sorts of dodgy assets. They would also have suggested that procyclicality would indicate that the next bust would be far worse and would require even more massive government intervention.

The End of the Line?

Of course, mainstream economists wouldn’t have agreed. Now we know who was right. Whether the ever pessimistic Austrian school was simply correct in the same way that a stopped clock is right twice a day we don’t know but it increasingly seems like their time has come. With the world economic system on its knees we probably don’t have another chance: if the Austrians are right then we’re almost at the end of a succession of booms and busts: even if we survive this crisis, what ammunition do governments have left for the next one?

To believe this is inevitable isn’t acceptable, and the monetary expansionist ideas of the Austrian school and the behavioural biases that these engender are finally being grudgingly accepted by central bankers. Let’s hope they learn the lessons fast.


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