An Introduction To The Sound Principles Of Austrian Economics

This article is based on a Q&A with Ronald Stoeferle, editor of the master pieces “In Gold We Trust” (click for the 2012 edition).

The Austrian view on economics – many know it from the surface, but a minority has studied the principles. The Austrian way of thinking could have saved us from a lot of pain in the past … and from suffering that is inevitably coming.

The Austrian School of Economics is not some educational institution in Vienna, nor is it related to the economy of Austria. Rather, the term refers to a particular approach to economics, and to the economists around the world who subscribe to it.

To understand the Austrian School there is one quote from Ludwig von Mises which says it all (source: his master piece “Human Action”): ‘Economics must not be relegated to classrooms and statistical offices and must not be left to esoteric circles. It is the philosophy of human life and action and concerns everybody and everything. It is the pith of civilization and of mans human existence.

The fundamental principle of the Austrian School of Economics is that you have to take into account human action; you basically cannot calculate the economy, you cannot put men into statistical models, people are no machines. Amazingly, that is exactly the opposite of what is unfolding today. Politicians and economists at central banks try to forecast their desired economic outcome, making use of sophisticated models that simply do not work in real life.

Key pillars of the Austrian view on the world

One the most powerful ideas of the Austrians that applies to today’s environment is that every act of consumption has to be preceded by production first. “Debt is nothing but consumption brought forward which will then not take place in the future.” Looking at the actions of central banks, you will very fast understand the power of this idea … but also recognize the fundamental difference with the mainstream way of thinking. Odds are high that the current establishment will be forced to learn this idea the hard way, sooner rather than later! It is a matter of being open to look at it, and willing to understand it. Nothing more, nothing less.

The major points of the argument the Austrian school of economics is making:

  • Money is not neutral
  • Inflation is the increase in the supply of money and credit
  • Inflation is a harmful policy and causes a transfer of wealth (Cantillon Effect)
  • Private ownership and property rights are essential
  • Economics is all about individuals Actions have consequences – good and bad
  • Bailout policies lead to moral hazards
  • Prices signal scarcity and abundance are essential for allocating resources efficiently
  • Erroneous price signals set by central banks are the cause of boom and bust cycles
  • Lowering interest rates leads to distortions in the economy by altering relative prices, which results in an artificial boom. Eventually, misallocations and malinvestment can no longer be supported, and a ‘bust’ ensues working out the misallocations
  • A return to sound money is necessary and advocated

Referring to the last point, gold’s role is crucial. As Murray Rothbard put it once: “Gold was not selected arbitrarily by governments to be the monetary standard. Gold had developed for many centuries on the free market as the best money; as the commodity providing the most stable and desirable monetary medium.”

The creation of money and value of gold

Ronald Stoeferle refers to the so called regression theorem which explains the theory of money and credit, and it is absolutely crucial to understand the monetary character of gold. The regression theorem by Ludwig von Mises in his book “The Theory of Money and Credit.” It says that the expectation with regard the future purchase power of money depends crucially on the knowledge about today’s purchase power of money. Today’s evaluation of purchase power in turn is derived from yesterday’s purchase power. If we continue this regression, we find that at the beginning of the process there has to be a good that was generally needed and had an industrial use. This means that money has emerged from a tangible good. This also includes the demand for jewellery and thus gold. According to Mises only those goods that have a generally accepted utility value can turn into generally accepted, natural money. Gold and silver were already used as jewellery before they assumed their monetary functions. According to Mises, past experience is the decisive factor for the future trust in monetary stability. The trust in the stability and the future purchase power is essential for the value measurement of money.

Central banks are not concerned about high inflation but deflation. The world, with Japan in the front seat, is moving towards nominal GDP targeting. As soon as monetary velocity picks up, there will be growth in the broader money supplies like M2. That will be the inflection point of the so called credit boom that Mises once mentioned.

Because of the abuse of governments, gold is some sort of cheap option against the monetary inflation. It has an asymmetric profile because the downside at the moment is very limited (the ongoing correction could go on for a while, perhaps lower prices are in the cards), but the upside is enormous (covering the total monetary base M0, the shadow gold price would stand at $12,000). From a risk rewards point of view gold is still the best trade going forward.

From the Austrian school point of view, the interventions in the past decade made the economic situation just worse. 2008 should have had massive deflation, with major unemployment. If that were the case we would be better off in 2013. Iceland is a very good example; they did nothing. They did not bail out any bank in their country. Now they are already recovering.

Steady vs out-of-control inflation

In his 2011 report, Ronald Stoeferle made the comparison between the regression theorem and gold’s stock-to-flow ratio. People “know” there is some sort of natural inflation which is some 1.5% per year. That percentage is exactly the 2500 tons of yearly gold production (compared to the 170,000 tons above the ground). “People only trust in money as long as it offers a certain degree of safety with regard to the future money supply. The very low yearly inflation of only 1.5% probably explains our trust in the future purchase of gold. I think that the highest stock-to-flow ratio of gold must play and very important role in this context.”

Now compare this with the highly inflationary policies conducted in the West. There is no monetary stability, only major inflation brought forward by excessive creation of EUROS and US Dollars. It is very important to distinguish between inflation and rising prices. Inflation describes the expansion of the uncovered money supply, whereas rising prices denote the increase in the general price level. Inflation is the root cause of the devaluation of money, whereas price increases are just the result of inflation. Nowadays these two terms are used interchangeably. That is the root cause for mixing up the cause-effect relationship and, as a result, keeps us from solving the problem. Instead, unsuitable measures such as price regulations and nationalisations have been demanded in order to fight the wave of rising prices, while in the background inflation continues to be fuelled.

The combined base money supply of the four most important central banks has been growing by 15.2% per year since 2000. According to the Austrian School of Economics, this means inflation. Rising prices are only a logical consequence. From 2007 to April 2012, the balance sheets of the four most important central banks were growing from USD 3,500bn to almost USD 9,000bn. Last year alone, the increase amounted to USD 1,500bn.

Therefore, Austrian economists clearly distinguish between monetary inflation and price inflation. As von Mises stated, there is a causal relationship between the two. Monetary inflation begets price inflation. It is worthwhile to be able to track the development of the money supply correctly. This task, however, is not that trivial. Due to the characteristics of our monetary system (i.e. fractional reserve banking) one can calculate several different monetary aggregates. It is critical to note that the total money supply consists partly of base money and partly of credit (uncovered money substitutes) which is created by commercial banks (for instance expressed by M2 minus the monetary base).

About Ronald Stoeferle

This article is based on a Q&A with Ronald Stoeferle. Born in 1980 in Vienna (Austria), he is a Chartered Market Technician (CMT) and a Certified Financial Technician (CFTe). After graduating from University, Stoeferle joined Vienna based Erste Group Bank, covering International Equities, especially Asia. In 2006, he began writing reports on gold. His six benchmark reports called “In GOLD we TRUST” drew international coverage on CNBC, Bloomberg, the Wall Street Journal, Economist and the Financial Times. He was awarded “2nd most accurate gold analyst” by Bloomberg in 2011.

As of December 2012, Stoeferle became a partner of Liechtenstein based Incrementum AG, an asset management company. The company is one hundred percent owned by its partners. There are no affiliations to any banking institution, which enables the company to implement the investment strategies autonomously and respond to market conditions in a flexible way. The partners of Incrementum AG are highly qualified and have over 140 years of combined banking experience.

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