Austrian economics might explain China's turmoil

There are still economists who publish papers in the Review of Austrian Economics, and there are still a bunch of people on the Internet who will tell you they subscribe to the "Austrian school." The Austrian school, for the uninitiated, is a hodgepodge of beliefs, usually holding that fiat currencies are doomed to fail, that a return to the gold standard is inevitable and that central banks are responsible for bubbles, market crashes and recessions. But this group has grown relatively quiet of late, and it isn't hard to see why.

First, there was the dramatic failure of the Federal Reserve's program of quantitative easing to cause even a hint, even the slightest whiff, of inflation. For a few years, the fears of inflation were kept on life support by Austrian claims that inflation was being hidden from the public eye, that asset price increases were actually a form of inflation, or -- my personal favorite -- that QE itself is inflation. Eventually, even the most diehard supporters of these silly backup arguments were forced to quiet down; reality can only be denied for so long.

Then there was the bursting of the gold bubble. Gold was the Austrians' big asset play - - the hedge against the end of the modern economy and the return of the 1500s. That hasn't worked out too well. If you followed Austrians' advice and bought gold at the peak, you have now lost more than a third of your money. I hope, for your sake, that you didn't need to retire or make any big purchases during that time -- or that you only gambled on Austrianism with a small fraction of your life's savings. At any rate, with the Fed preparing to hike interest rates, it seems doubtful that the Austrian gold bugs will be redeemed anytime soon.

So it's understandable why the Austrians have been maintaining radio silence, more or less. That isn't to say that they've changed their minds, of course -- Austrianism, like many economic schools of thought, is a "brain worm" that doesn't easily relinquish its host.

What's interesting to me, however, is that events in China are actually bearing out some of the classic predictions of Austrian thinking. Though most Austrians on the Internet spend their time flogging gold, hyperventilating about inflation and calling various people communists, the original "Austrian school" thinkers -- Ludwig von Mises and Friedrich Hayek -- had some other ideas as well. And some of these might be useful for thinking about China. One of these is "malinvestment." Austrian thinkers such as Mises contend that recessions happen because too many resources are funneled into assets that won't actually be productive in the future. By the time businesses realize that they have made a mistake, they are locked into bad lines of business, or bad business locations.

It has never been very clear exactly why malinvestment causes an economic hangover. Why don't businesses just cut their losses and immediately start investing in something more useful, as soon as they realize that they're doing the wrong thing? Austrian theory has never been particularly clear on that (and its notorious refusal to use precise mathematical models certainly doesn't help).

But at least Austrianism embraces the possibility that businesses might make big, systematic mistakes. That possibility is essentially ruled out by most modern mainstream models, which use "rational expectations" as their jumping-off point. It also requires that productive capital come in multiple forms, while mainstream macro usually assumes that all forms of capital are interchangeable. Over in China, it seems clear that there has been a lot wasted resources -- ghost cities and overcapacity in various manufacturing industries. That in turn seems to have led to a bubble in Chinese real estate prices, whose slow decline may in turn have caused the recent spectacular stock bubble and crash.

That brings us to another interesting Austrian notion -- the instability of financial markets. Mainstream macroeconomics is only just barely starting to deal with the idea that financial markets may have a natural tendency to boom and bust. Austrians have been saying this for almost a century.