multi-asset
What the Austrian school of economics got wrong
This week, Simply put focuses on the Austrian school of economics to ask: should its theories inform today’s monetary policy?
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Closing the book on the Austrian school of economics
At the dawn or dusk of every recession, the time comes for some to reopen the Austrian economic textbooks (well, grimoire might be more appropriate). And on such occasions, the time to close them arises promptly.
A century of economic research has accumulated since the 1930s, producing in economics the effect that Albert Einstein's physics produced in Newtonian physics: a revolution. The Austrian school of economics brought together economists whose names are often overlooked – Ludwig Von Mises, Friedrich Hayek and Carl Menger – and whose thinking played a major role in the development of economic theory, the same theory guiding the actions of central banks today. While their theories may have generated debates in the past, when economists could not test their hypotheses on actual data, those days are over.
This week’s Simply put examine key elements underlying theories from this school of thought and refutes them, both in past and present situations. The Austrian theories are no more applicable today than they were historically, in our view, and we highlight two areas to dispel any lingering doubts.
How do rates impact borrowing and investment?
The Austrian school of economics mainly explored the role of interest rates on borrowing and investment as triggers of the real cycle (or the business cycle). The argument is that a natural rate of interest allows the supply of loans to match the need to borrow. This rate is adjusted in such a way as to motivate consumers to prefer tomorrow to today, in order to save and thus create financing capacity for the economy.
On the other hand, this same interest rate also makes it possible to differentiate between profitable and unprofitable investment projects. When altering this pivotal variable, central banks generate phases of economic expansion or contraction: market rates that are lower than their natural equivalent encourage over-investment and over-consumption, while rates that are too high have the opposite effect. The conclusion is that central banks – those great manipulators of interest rates – should have no role in economic life since they play sorcerer's apprentice with policy rates.
Worse still – and this is one of the criticisms that has resurfaced recently – by keeping real rates artificially low, central banks introduce distortions in investment: low rates push economic agents to implement investment plans that would not otherwise be profitable. Thus, when rates are low, agents will prefer to invest in real estate rather than in productive projects. In doing so, a property bubble will develop and its explosion will have a significant economic cost.
While the Austrians never observed negative real interest-rate policy in action, the low-to-negative rates in the aftermath of the Global Financial Crisis in 2008 give us the benefit of being able to test their hypothesis with actual data. If their theory was correct, then the growth of property investment should dominate that of business investment.
Figure 1 shows that this has not been the case. Instead, the low interest-rate policy since 2008 has led to US business investment dominating property investment in all periods. Periods of low and declining real rates have benefited both types of investment. This invalidates the school’s conclusions and challenges its theory; we believe it illustrates the Austrian school of economics fails to predict the distorting effect of artificially low real rates.
Figure 1: Growth in US business and property investment 1998-2023 and real rates
Source : Bloomberg, LOIM
Growth of money supply = inflation
The second proposition of the Austrian school is that any growth in money supply that does not reflect growth in output can only generate inflation. In their models, inflation and money supply in excess of real transactions are perfectly linked: money that is not issued to finance trade inevitably leads to price increases, which are also distorting. The underlying logic is that if money is issued for a reason other than the growth of trade, the quantity of money in circulation being greater, it follows that the value of each unit of this money must decrease. If nothing is done, this excess money is simply worth less – and price growth is the symptom of this.
The opposite conclusion can also be derived: from this perspective, to reduce inflation, production must increase by as much as money supply – in short, to invest without delay in a world where everything occurs instantaneously – an interesting but clearly unfeasible conclusion.
Again, we have the benefit of a decade's experience of activist money issuance by central banks. As Figure 2 clearly shows, until recently there was no historical link between US money supply growth and inflation. This debunks another premise of Austrian theories.
Figure 2: US money supply growth in excess of economic growth vs US inflation (1982-2019)
Source : Bloomberg, LOIM
And yet inflation is running hot
What about the current situation?
Of course, today’s environment sheds a completely different light on the issue of monetary inflation. Between 2020 and 2023, the size of central bank balance sheets literally exploded, and with it the money supply in circulation experienced unprecedented growth. In the second quarter of 2020, the US money supply grew by an extraordinary 300%. A few quarters later, a wave of inflation surfaced not seen since the 1970s: a happy coincidence or a return to the Austrian school of economics? None of the above, in our view.
Years of quantitative easing did not cause inflation to surge, and the situation is no different today. The distinction currently lies in the reasons for the growth of this money supply: the financing by central banks of government debt without a budgetary financing plan.
During the first weeks of the pandemic, many states unleashed emergency fiscal stimulus of Herculean strength: the first Trump plan was around 10% of GDP. This growth in the money supply thus reflected an explosion of debt that never seemed likely to give rise to future tax increases. This heavily stimulated demand in the context of an upheaval in world production and supply chains. The US has thus accumulated a budget deficit of 27% of GDP between 2020 and 2021, amounting to 10 times the Maastricht criteria and equivalent to more than 15 years of real growth.
Figure 3 shows the average increase in US inflation when the government issues debt that is indirectly financed by the Federal Reserve (Fed), and the same figure when it is not. On average, central bank financing leads to an increase in inflation of close to 1% after four quarters, which is reminiscent of a familiar situation. In 1981, Thomas Sargent and Neil Wallace (in a paper entitled "Some Unpleasant Monetarist Arithmetic") mentioned how debt financing with money supply could be a source of inflation, recalling in passing the essential role of the central bank in imposing fiscal orthodoxy in its economic zone.1
The appeal of the Austrian school of economics today is understandable and its views are not completely obsolete. Artificially low real interest rates have contributed to the results of growth companies by supporting the profitability of part of their investments; it is the rise in real interest rates that will eventually eliminate this abnormal situation.
However, current inflation is due to the collaboration between the major developed governments and central banks, not because of the growth of the money supply alone or because real rates have been too low for too long. The neo-Keynesian models used at the European Central Bank and the Fed have been updated and no one in those institutions is oblivious to this situation. Still, we have all been surprised by the scale of it, clearly. It may also cost dearly to correct this anomaly, and here Keynesians and Hayekians are singing from the same hymnsheet to offer an explaination – watch out for the credit crunch concertina effect, or the moment when higher rates lead to a collapse in investment.
Figure 3: US inflation in excess of trend when debt grows by more than 1% per quarter (1990-2023)
Source : Bloomberg, LOIM
| Simply put, theory from the Austrian school of economics should be left to rest in peace. Many of its ideas do not stand the test of time, failing to hold up in current rates, investment, money supply and inflation scenarios. We believe history will keep this school of thought in check. |
Sources
1 We are thankful to Philippe Bernard, Professor of economics at Dauphine University in Paris, France, for pointing us towards that paper.
Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Our growth indicator declined again this week. It did so essentially because the US indicator declined, but our Chinese growth nowcaster rose to leave the recessionary zone
- Our US inflation nowcaster increased marginally over the week, mainly because of US data. Inflation remains set to decline for now
- Our monetary policy indicator remained stable this week. The US and Eurozone indicator increased lightly, in line with the evolution of the inflation indicator. It does not change the message from them: central bank moderation should the theme of Q2
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM's nowcasting indicators gather economic indicators in a point-in-time fashion to measure the probability of a given macroeconomic risk - growth, inflation and monetary policy surprises. The Nowcaster ranges from 0% (low growth, low inflation and dovish monetary policy) to 100% (high growth, high inflation and hawkish monetary policy).
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