The Answer to DragonLZ is as Easy as ABCT
June 01, 2010
– Comments (19)
In this post, DragonLZ asks a very important question:
What was so much better back in 2003 that justified the incredible bull market that lasted four and a half years, from March of 2003 until October of 2007?
A related question that DragonLZ could have asked is what was so great about Zimbabwe in 2007 that caused it to have the best performing stock market in the world? But we'll get back to that.
This post is an explanation, not meant to disparage, but to enlighten. If you are only interested in hurling insults, leave now. Thank you.
Little does dragonLZ know that he is at the start of journey that leads to Mises, Hayek, and the Austrian School of Economics, for it is that very question that only the Austrian School can answer. As he pointed out, there isn't a very good economic reason why the market kept going up and up. We agree. So what did happen? Here is the Austrian School answer, known as the Austrian Business Cycle Theory (ABCT):
Excessively low interest rates excarbate the boom and bust cycle
These low interest rates cause an increase in the available funds (business capital.) From these funds, malinvestment occurs as companies take on projects that would not be justifiable under a system of free market interest rates. (Rates higher than the prevailing rate.) This expansion can occur because the Fed (or any central bank) holds rates too low for too long, or through unchecked fractional reserve banking. If it persists long enough, economic activity can BOOM, but it is an illusion. Many of the projects are unsustainable, excessively risky, and pull resources away from more efficient alternative uses. In other words, economic activity gets distorted. The result is a predictable crash.
Do you think the Fed's rates don't have an impact on economic activity? Then why do they bother manipulating them? Ask Krugman
From this most recent boom/bust to the dot.com boom/bust all the way back to the late 1920's boom/bust.... and guess what.... the panic of 1819, the inflationary boom/bust of John Law's Mississippi System and the Tulip Bubble before them...
Every single one has the same characteristics. Easy money at the beginning, resources drawn into sectors that wouldn't normally justify it, unsustainable development due to scarcity, and it all comes crashing down as entrepreneurs miscalculate risk. The lyrics from the famous Hayek-Keynes Rap Video explain it better than I can:
The place you should study isn’t the bust
It’s the boom that should make you feel leery, that’s the thrust
Of my theory, the capital structure is key.
Malinvestments wreck the economy
The boom gets started with an expansion of credit
The Fed sets rates low, are you starting to get it?
That new money is confused for real loanable funds
But it’s just inflation that’s driving the ones
Who invest in new projects like housing construction
The boom plants the seeds for its future destruction
The savings aren’t real, consumption’s up too
And the grasping for resources reveals there’s too few
So the boom turns to bust as the interest rates rise
With the costs of production, price signals were lies
The boom was a binge that’s a matter of fact
Now its devalued capital that makes up the slack.
Whether it’s the late twenties or two thousand and five
Booming bad investments, seems like they’d thrive
You must save to invest, don’t use the printing press
Or a bust will surely follow, an economy depressed
And that's how the Austrian School knew that we were headed for trouble. The Fed had merely reinflated with cheap credit, which Austran scholars knew was unsustainable. Another bust was sure to follow, worse than the bust which preceeded it.
So the story continues, and this is why we urge caution once again.
However, it is foolish to view the Austrian School as anti-stock market. Nothing could be further from the truth as the following quote shows:
One time, during Mises's seminar at New York University, I asked him whether, considering the broad spectrum of economies from a purely free market economy to pure totalitarianism, he could single out one criterion according to which he could say that an economy was essentially "socialist" or whether it was a market economy. Somewhat to my surprise, he replied readily: "Yes, the key is whether the economy has a stock market." That is, if the economy has a full-scale market in titles to land and capital goods. In short: Is the allocation of capital basically determined by government or by private owners? - Murray Rothbard
Now look at this Austrian School examination of the Fed and the stock market in May 2009. Pretty consistent with what I have been saying all along. This rally is built on cheap money.
This is very dangerous. Consider that the best performing stock market in the world in 2007 was Zimbabwe. I'm surprised dragonLZ didn't ask us why that was justified. You can see now that it was for the same reason.
While I don't want to disparage other CAPS bloggers that may have libertarian leanings and an affinity for sound money, without an Austrian School perspective on the boom/bust cycle they may sound like PermaBears to the untrained ear. But just like me, they want economic growth. We all however would just prefer it to be sustainable.
Neither 2003-2007, as dragonLZ pointed out, nor 2009 was sustainable.
David in Qatar
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