One thing that distinguishes Austrian economics from more orthodox views influenced by the Chicago school is that, in principle at least, it allows for the possibility of generating what quantitative financial types like to call “alpha”.Â Best known as a variable in the Capital Asset Pricing Model equation, alphaÂ represents the return on an asset that cannot be explained by the risk being assumed in holding that asset. Simply put, to earn alpha is to beat the market.Â
The Efficient Markets Hypothesis, based on the assumptions of the Chicago school, famously argues that investors cannotÂ systematically outperformÂ the market.Â In the main, they can only generate returns thatÂ compensate them for the risks they’ve taken. Â This is supposedly because the financial markets are populated by enough rational investors competing for profits to ensure that all available information is immediately reflected intoÂ prices.Â As a result, investors always pay for what they get. By contesting the notion that individuals are perfectlyÂ rational and that equilibrium is the normal market condition, the Austrian tradition holds that prices can deviate from correct values for sustainedÂ periods of time. An informational equilibrium is neither immediate nor automatic. So this gives well-informed investors — those, of course,Â whoÂ comprehend Austrian economics — a chance to beat the market.
NotÂ surprisingly, then, there are a number of investors whose strategies are based on the postulates of Austrian economics. Peter Schiff is the most famous among them.Â A less famous — indeed, I’d never heard ofÂ Â this individual until today — is Jack Sparrow who contributes to Mercenary Trader.Â Sparrow nicely outlines the sequence of events by which traders and investors can both recognize a credit induced mania-crash dynamic as wellÂ its current stage. Â He calls it the Von Mises Prophecy:
- The economy has an upswing.
- The upwsing starts to falter, as is natural to the business cycle.
- Politicians say â€œHey, letâ€™s keep this thing going.â€
- The system is juiced with leverage-enhancing liquidity.
- Via stimulative reinforcements, a boom mentality takes hold.
- The boom continues, now in an unnatural state.
- The â€œcanâ€™t loseâ€ mentality sets in. Greed and hubris run amok.
- Via risky marginal investments, unproductive debt accumulates.
- After a period of years (or even decades), cracks reappear.
- The â€œmountain of debtâ€ now casts a long cold shadow.
- That same mountain threatens to topple and collapse.
- The authorities panic. They know the debt will crush them.
- To circumvent the avalanche, the debt is monetized.
- Via monetization, the economy experiences temporary relief.
- But the relief is not enoughâ€¦ the problems persistâ€¦
- â€¦and so more monetization is applied.
- As alternative to full collapse, the currency is destroyed.
Sparrow goes on to say that, “The pattern as described above is now in full swing in the United States and Europe, and coming to potentially spectacular fruition in Japan.”
A noteworthyÂ aspect of Sparrow’s exposition of the Von Mises Prophecy is his acceptance of the Keynesian idea that psychological forces, the so-called “animal spirits”, are what specificallyÂ create the temporary deviations from rationally informed values. But it is not all psychology. For as Sparrow explains, the objective factsÂ do eventually pull the market back to reason.Â
This is exactly the position argued by L.A. Hahn, an almost forgotten Austrian economist (and a big favorite of Jeffrey Tucker’s at LvMI USAÂ ), inÂ Part 5 of Common Sense EconomicsÂ Â