Austrian Theory Alone Won't Do All the Investing Work

X
Story Stream
recent articles

Chad Nelson's September 25 piece on Realclearmarkets.com touches on an important debate among Austrian economists, on using economic theory to make financial predictions.

Nelson's critique misunderstands what economic theory itself can and cannot do. Critics seem to think theory should be a map, when theory itself is more like a compass: a compass that tells you where to go, not how to get there. Just as there are good and bad compasses, there are good and bad theories.

In the real world, prediction is a spectrum: we might predict the sun will rise tomorrow, that winter will be colder than summer, that money-creation leads to inflation. All of these predictions are subject to outside factors, therefore they all run on different probabilities and different magnitudes.

Reading Galileo alone won't tell you if winter will be mild. And it certainly won't tell you if a given day will be cold. Similarly, economic theory will not give you precise magnitudes nor will it give you precise timing. For that we need to supplement the theory with data. This proposition, that theory alone does not give you all the answers, is a part of "radical uncertainty" in Austrian economics, a concept admirably popularized by Nassim Taleb's best-seller The Black Swan.

To actually predict using an economic theory -- any theory -- you need data. A good theory will tell you what data you need. If you choose well, that data informs your magnitudes, and it's the magnitudes that give you your best timing.

To see why, consider walking backwards on an eastbound train. The train is pointed east, and you walk west. Which direction is your body moving? Well, are you walking fast? Is the train moving slow? Newtonian physics or human anatomy will only get you part-way. Closer than Aristotlian physics and octopus anatomy, to be sure. But you'll need to supplement the theory with data. The theory is necessary but insufficient.

The question becomes, then, whether Austrian economics is better theory. Does it give better answers about fundamental trends. After that, no matter what theory got you there, you'll have to plunge into the data.

One of my favorite examples is the role of consumption in economic growth. Consumption is taken by most non-Austrian economists as a positive indicator of economic health. Like a doctor's thermometer, consumption tells you the economy is "healthy" and likely to grow. Non-Austrians make this prediction largely via correlations: higher consumption is correlated with future growth.

An Austrian, on the other hand, starts with logical causation. And, logically, when an extra resource is consumed that means it was not invested and it was not saved. After all, you can only do three things with a resource -- consume it, invest it, or save it. So raise consumption and you necessarily lower either investment or savings.

So an Austrian doesn't naively celebrate consumption. Rather, our theory tells us which data to use next. Was the extra consumption siphoned out of investment? Or was it siphoned out of savings?

If it came out of savings, then consumption may well grow tomorrow's GDP, albeit "stolen" from the future by running down saved resources. If, on the other hand, it came from investment, then the mainstreamers are completely wrong - siphoning from investment to consumption will have no impact on current growth and will actually harm future growth. Simply because investment makes stuff in the future, while consumption does not.

The point here is that data alone doesn't tell you the whole story, a core proposition of the Austrian approach. Instead, you need to start with good theory that tells you which data you need. Where to look next. Guiding that process is the fundamental proposition of Austrian prediction, and to ask for more is to fundamentally misunderstand what theory can do. Just as Newton alone won't tell you who's walking west on a train, Austrian theory alone won't do all the work in investing.

 

Peter St. Onge is an assistant professor at Fengjia University College of Business, a former hedge fund manager, and was a 2014 summer fellow at the Ludwig von Mises Institute. He blogs at profitsofchaos.com.  

Comment
Show commentsHide Comments

Related Articles