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The Answer to DragonLZ is as Easy as ABCT

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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

19 Comments – Post Your Own

#1) On June 01, 2010 at 8:06 AM, mhy729 (33.20) wrote:

Thanks for this well-written post.

Sort of a random question, but what do you do in Qatar?  You always seem to sign off your postings with "David in Qatar" and I'm curious as to what kind of work you are doing over there.

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#2) On June 01, 2010 at 8:26 AM, dragonLZ (99.46) wrote:

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.

For your information, I was born and grew up just a few hours of slow drive from Austria so don't tell me I'm not familiar with Austrian School.

Just kidding, but the fact that I was born close to Austria is as relevant to your post just as your Austrian School is relevant to my question...

p.s. I have to admit, my question maybe was too confusing so that's why everybody is telling me how bad 2003-2007 and 2009-2010 were (based on ABCT in part), when I know, for a fact, the market returned 85% from 2003-2007 and 60+% from 2009-2010.

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#3) On June 01, 2010 at 8:41 AM, dragonLZ (99.46) wrote:

To help you understand here is the argument we are having in a more simplified form:

DragonLZ: "It's a beautiful day out. Let's enjoy the sun while we can. Let's go to the beach and have some fun."

David in Quatar: "Don't you know the rain will come after the sun. That's how it works. Always. Haven't you heard of Austrian School of Meteorology? They predicted rain last time we had 4.5 sunny days, and guess what? It poured."

DragonLZ: "Yeah, it sounds scary, and in the may of May, there is a good chance it will rain soon, but let's take the advantage of this sunny day while it lasts."

D in Q: "No thanks. Everything good must come to an end. If I never start it, there will be no end..." (D in Q then continues with a 60 min. story about the nice weather / bad weather cycles based on his knowledge of Austrian School of Metrology... 

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#4) On June 01, 2010 at 8:50 AM, russiangambit (29.29) wrote:

> Just kidding, but the fact that I was born close to Austria is as relevant to your post just as your Austrian School is relevant to my question...

DragonLZ, you got plenty of answers, but they were not the answers you wanted, I guess. It seems you are not looking for an answer but for a confirmation of your thesis that the market will go up because another bubble will be found. Perhaps, but it has little to do with the underlying state of the economy. The next bubble if allowed to develop will collapse even sooner because the foundation is shakier than in 2003. 

We discussed many time already in these blogs that FED is trying to reinflate all financial assets and it is the next bubble. But it has to inflate despite the free market immense deflationary pressure. It is free market vs. FED  here and the outcome is still open for debate. Since FED started winding down some liquidity programs the deflationary pressures are gaining on them. Will there be political will for FED to resume QE on time to rein in deflation? We don't know right now.

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#5) On June 01, 2010 at 8:55 AM, binve (< 20) wrote:

David, another great post. Thanks!

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#6) On June 01, 2010 at 9:35 AM, whereaminow (22.35) wrote:

Thanks guys.

I wasn't planning on blogging so soon, but this was an opportunity to explain an important concept, and it took me like 5 minutes to write :)

myh, I work in IT

I remember the debate I had with GMX last year.  I told him that in 2007, there was a Zimbabwean version of him predicting a market collapse and looking foolish too.  If you can see the fundamentals, that's great. But you need to understand the business cycle too. 

Back then there was a kid named Alex1963 that used to troll on my blogs and write 10,000 word diatribes that said absolutely nothing except "I disagree."  I brought up to GMX that the Fed was going to reinflate and boy did he ever think I was crazy.  Well, I stand by my record.

David in Qatar

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#7) On June 01, 2010 at 9:42 AM, dragonLZ (99.46) wrote:

DragonLZ, you got plenty of answers, but they were not the answers you wanted, I guess. It seems you are not looking for an answer but for a confirmation of your thesis that the market will go up because another bubble will be found.

russiangambit, I don't think that's correct.

See, Tasty gave me an answer, and even though his answer was completely different from my thesis, I still said he answered my question (and he proved me wrong in thinking it was equally hard to figure out a new bull market was starting in 2003, just as it was in 2009). 

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#8) On June 01, 2010 at 9:53 AM, whereaminow (22.35) wrote:

DragonLZ,

What economically justified the 1200% rise in the Zimbabwean stock market in 2007?

I ask because it is such a clear example of a central bank creating a bubble that I think anyone can see it.

David in Qatar

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#9) On June 01, 2010 at 11:39 AM, ChrisGraley (29.80) wrote:

DragonLZ I think the difference between you and the bears is the perception of sustainability.

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#10) On June 01, 2010 at 1:06 PM, dragonLZ (99.46) wrote:

What economically justified the 1200% rise in the Zimbabwean stock market in 2007?

whereaminow, I guess you didn't read all of my comments in my post.

I'm a wrong guy to ask that question as I'm the guy who keeps saying bull markets are not "economically justified".

I'm more of a "Who waits for economical justification misses the train" kinda guy.

I think the problem is that we are debating two differet things here.

Your argument is that after each bubble comes a crash. Nothing wrong with that. Nowhere did I say that's not correct.

But my argument is What's wrong with being on the right side of a 1200% run? Or 60%?

These posts "I don't care I missed this once-in-a-life-time market because I know it'll crash EVENTUALLY" are funny (and dishonest) to me... 

p.s.

Let's go back to our Meteorology example to show you what I mean when I say bull markets are not "economically justified".

DLZ: Let's go to the beach. I think it's gonna be a gorgeous day.

DinQ: Haven't you watched the weather forecast? It's supposed to rain with a high of only 60 degrees. Also, 7 out of 10 last years, it had rained on June 1st.

DLZ: They said that yesterday, and we had 98 degrees all day long. (Btw. you stayed home, and I got this nice tan...)   :)  

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#11) On June 01, 2010 at 1:49 PM, dragonLZ (99.46) wrote:

DragonLZ I think the difference between you and the bears is the perception of sustainability.

Cris, what do you mean exactly?

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#12) On June 01, 2010 at 1:50 PM, dragonLZ (99.46) wrote:

Chris (Sorry)

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#13) On June 01, 2010 at 10:24 PM, whereaminow (22.35) wrote:

dragonLZ,

What's wrong with being on the right side of a 1200% run? Or 60%?

Certainly nothing, if you can unwind when the crash comes.  If you've lost 60% of your investment capital, it makes buying at the bottom a lot more difficult.

The only other problem I see with it is something binve and I have both talked about at length: it turns ordinary investors into excessive risk takers.  I'm not talking about career investors like many who frequent CAPS. I'm talking about people like me, who have another profession and try to spend some time every week working on our investments.  Many of them don't know what a bubble is.  Many don't know that a crash is inevitable if you inflate with the printing press.  And if you think about the impact that a Bubble Economy (our term for the current state of affairs) has on the average working couple, well you can see that the psychological and by extension, political outcome can be devastating.

On the other hand, those that felt deflationary forces were too strong advised people to move to dollars.  That was a terrible play.  There was a brief bounce in the dollar, but then it sank like a stone while the market took off.  The deflationary position was not the Austrian position.  We said hold on to gold, as it will rise, for a safe play.  We also said that inflation would drive up stock prices, but be careful, that's a risky play.

DLZ: They said that yesterday, and we had 98 degrees all day long. (Btw. you stayed home, and I got this nice tan...)   :)  

So now, we didn't stay home.  We just brought an umbrella in case it rained.  (Gold, silver, and mining stocks did very well in 2009 in case you didn't notice. In fact, isn't that one of portefeuille's most successful sectors?)

David in Qatar

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#14) On June 02, 2010 at 5:22 AM, MGDG (34.96) wrote:

I liked the video David and oh, yea the blog was good too.

+1 Rec

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#15) On June 02, 2010 at 10:58 AM, nzsvz9 (< 20) wrote:

All,

A bull market is an abberation of the free money being pumped into the market, today by the government by the mechanism whereaminow discusses. By the Zimbabwe example he correctly illustrates the effects of "stimulation" or "quantitative easing" - it exacerbates the boom. Investors and others can cause a boom as well but their effects tend to be in a company or sector, or an industry, as opposed to what an influx of money in general does to the market as a whole.

Think pet rock. Pokemon cards. Webkinz. Squishies. Silly Bands. The influx of buyers and related price increases is a natural market boom - but in a very narrow segment. The bust always follows.

But, what do you do when you come into unexpected money?

The balance is out of whack between the real increase in goods and services produced in a growing economy and the amount of money out there chasing the total available goods and services. If the fiat money supply grew at the same pace as the growth in real goods and services the price level would remain the same - ceretis paribus (all other things being equal - a fallacy over time, but useful for illustration here at any moment in the economy).

Real sustainable growth only happens during periods of monetary stability - and by no means do we have that now! The money supply has grown to 80% of GDP from 60% in the last 40 years ... and that's inflationary. A big, long term bubble.

Known as bubble-popping nzsvz9

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#16) On June 02, 2010 at 4:03 PM, dragonLZ (99.46) wrote:

So now, we didn't stay home.  We just brought an umbrella in case it rained.  (Gold, silver, and mining stocks did very well in 2009 in case you didn't notice. In fact, isn't that one of portefeuille's most successful sectors?)

D in Q, this is just brilliant. I can't argue with that.

Even though we disagreed (at first), I'm glad I got my point across, and you got yours. 

Good Luck in the future. 

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#17) On June 03, 2010 at 1:18 AM, whereaminow (22.35) wrote:

Same to you dragon. 

nzsvz9,

Thanks for the follow up and great comment!  Another mini-bubble was video games in the early 80's.  There was a big run up and crash in games and gaming companies, but just like the others demand-induced bubbles you mentioned, we can't blame the Fed for something like that!

David in Qatar

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#18) On June 04, 2010 at 2:02 PM, MichaelMolenaar (< 20) wrote:

"Little does dragonLZ know that he is at the start of journey that leads to Mises, Hayek, and the Austrian School of Economics"

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#19) On June 09, 2010 at 10:11 AM, MichaelMolenaar (< 20) wrote:

oops, sorry for the spammy looking image, the picture that I was using must have been taken down. It was a guy smiling.

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