What The Average Investor Doesn’t Know

If you’re an investor you’re most likely aware that if you don’t make decisions for yourself the market will make them for you.  The market is a unique universe of its own, one that acts – or better to say, it reacts – according to current factors, political and environmental.  In a completely free environment – one without outside interventions – the market would be based on the well known, supply and demand factors.

But investor beware, this has not been the case for at least one hundred years.  The average investor invests under the adage of a “free market”.  This is the real reason for which most investors lose money in the long term.  The above average investor invests based on the superior knowledge of a quasi free market.

So, if you find economics to be a boring subject you may want – or need – to re-evaluate.  The primary reason is the strong correlation between the economy and the investment field.  Whether you invest in real estate, the stock or commodity market, or other business ventures, understanding the fundamentals of the market economy would help you transition to a higher level position.  It would help you strategize better.  A successful investor is a good planner; and a good planner is an educated forecaster.

The other reason is that the government and the modern economists – to include Uncle Benny (Ben Bernanke) – have been consistently wrong about the economy, even if they act like they know what they’re doing.  They may claim they’re on top of things, by implementing various measures to save the collapsing financial institutions.  The bailouts, QE’s (Quantitative Easing), Bond Swaps, or Reverse Repo’s only added more damage to the economic and financial instability.  In short, you have to take care of yourself and your own investments, and realize that the government will not work in your best interest.

So, if you’re eager to start, know that you don’t have to have a degree in economics.  All you need is to use logic and common sense, and do a little reading on the subject.  Instead of reading the Wall Street Journal I would start with a few basic books such as Economics in One Lesson by Henry Hazlitt and What Has Government Done to Our Money by Murray Rothbard.

A website on free market economics I highly recommend is www.mises.org. Its name is from one of the most notable economists and social philosophers of the twentieth century, Ludwig Von Mises, who was also one of the founders of the Austrian School of Economics.  Once you explore articles published back during the early 2000’s, for example, you’ll notice how accurately the “Austrians” have predicted the real estate boom and bust of the past decade.  And if you care to know what’s in store for the future simply read a few more recent articles to get a glimpse; you’ll be better equipped to handle your investments!

In case you wonder what the Austrian School is known for the quick answer is: The Theory of the Business (Boom-Bust) Cycle.  It is not the only subject but it is the instrumental one that has been at the core of all panics, recessions, depressions, or whatever terms economists like to use for the same symptom.

So what is the Austrian business cycle? 

The following is a short and very simplified version.  Artificial expansion of money and credit (inflation) leads to suppression of the interest rate.  Such expansion is not the result of people’s savings but an artificial addition – by the central bank – to the already existing money supply.  It is created through the printing of paper money and electronic ledger input.  Creation of new money does not create a natural demand, instead it leads to creation of an artificial demand.

The low rates entice people and businesses into long term unsound investments, investments which would have not been undertaken if the money supply would have not been tampered with and the rates were dictated by the free market.  The newly created money and credit distributed via bank loans find their way into various sectors of the economy causing a rise in the price of certain assets.  Buyers of such assets ultimately bid up prices thus creating an artificial demand and inviting speculation from additional investors, many of which are unqualified.  Businesses engage in long term production as a direct result of the low rates and the newly created artificial demand.

But such monetary expansion cannot last indefinitely.  When the central bank stops the process the interest rate begins to rise while asset prices are brought to a halt.  The first round of investors and borrowers  – typically the weakest and most marginal ones – fail.  The assets in the artificially inflated economic sectors are now in larger supply than there is demand for.  There are no more buyers to bid up their prices.  As a matter of fact a reversal process is now triggered.  As more borrowers default there are more buyers/speculators looking to sell (discard) causing a deflationary event.  In the meantime, businesses that have engaged in long term production find themselves with goods for which there is little to no more demand for and loans which are now harder to be repaid.  These businesses are forced to restructure their activities with layoffs being among the first to occur.

What is the cure and can it be prevented?

In Austrian terms the cure to the boom is to allow market forces to freely adjust without government or central bank intervention.  Prices would adjust to natural levels, malinvestments would be discarded, unsuccessful businesses – that produce goods that are no longer in high demand – would be allowed to fail thus allowing resources to be used in sectors that are in higher demand.  Under such circumstance the depression – or recession – would be short-lived and the economy can get a fresh new start.

Of course, this is not exactly what happened with the most recent real estate boom-bust cycle.  The Keynesian formula was – and still is – to keep unsuccessful ventures alive, new resources still directed (squandered) in malinvestments, and asset prices still kept artificially at higher than market levels (stocks and real estate).  Newly created money – by the Federal Reserve – is being used to sustain such detrimental (to the people) activities at the taxpayer expense.  This is moral hazard, an event in which businesses are engaging in risky (and wasteful) ventures knowing that the government will be there to save them from collapsing.

Can such a calamity be prevented?  Absolutely, and all it takes is for the central bank to stop the expansion of the credit and money supply, for the government to not engage in moral hazard activities, and for the banking system to stop lending money they don’t have (full reserve banking system).  May I recommend Thomas Woods’s excellent easy to read Meltdown?  “Austrians” understand that economies have seasons.  There are seasons when people save and their consumption is minimal at which times businesses engage in long term production.  And there are seasons when people engage in high consumption while savings are minimized, a trend that the free market reverses via the natural rise in the interest rate.  All it takes is for the government and the central bank (Federal Reserve) to not interfere.

During the mini-crises of the 1970′s America suffered a dark age stagflation.  While most Americans lost their shirts, a few farsighted ones made fortunes investing in the right kind of assets.  There is no doubt the market will experience another period of stagflation before the economy recovers.  Yet this time it will be more severe.  So don’t wait for the market to make the decisions on your behalf!  Be proactive!  Gain knowledge of the market fundamentals so you can make your own decisions and get relief knowing that your investments are well positioned.

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