It Might Be Time to Hear the Austrians

The latest Keynesian spending and money-printing initiatives are exploding. It's time to listen to what Austria has to say.

While behavioral economics is sometimes portrayed as a meaningless collection of anecdotes and weird or incorrect experiments, when stripped of its exaggeration and correctly contextualized, it can provide insights to Austrians looking to improve their own outcomes.

At its most basic level, behavioral economics asserts that while people strive to achieve their goals, they are occasionally confronted with a choice architecture that leads to systemic error. Prospect theory—the tendency of individuals to overestimate the likelihood of extremely rare events, underestimate the occurrence of more likely events under certain conditions, and make suboptimal economic decisions as a result—is a well-known example that has been confirmed in dozens of studies around the world over the last fifty years.

Another well-documented cognitive bias, framing, plays a significant role in such situations. Individuals who were presented larger numbers than another group, for example, were more prone to overestimate the price of a certain item—a phenomenon known as the anchoring effect. Participants in a fixed group game in which all other participants secretly but purposely chose incorrect answers also demonstrated a tendency to choose knowingly inaccurate answers—the herd effect—in the process actually beginning to rewire their own brains, proving the lie real!

These are only a few of the heuristics and biases identified by behavioral economics and psychologists. Neoclassical modeling assumes that errors will be distributed randomly in a typical bell shape, and that any errors in asset pricing, for example, will naturally tend to revert to the mean. This discovery has far-reaching implications.

For example, during the Great Financial Crisis, most major market actors assigned their own position a systemically incorrect level of systematic risk: it turned out that combining a lot of bad investments, dividing them into pieces, and then dividing them into tranches did not change the fundamental fact that these had all been bad investments. Aggregation produced overleveraged monstrosities that stalled and eventually ruined much of the developed global economy in the instance of the value at risk model and the subprime mortgage-backed securities markets.

However, despite the fact that the entire subprime mortgage industry was riddled with bad incentives from top to bottom—from ultimate government backstopping to the originate-to-distribute model of mortgage lending, from the opaque nature of the synthesized derivatives being traded to the obvious conflicts of interest between ratings agencies and their clients who demanded investment-grade ratings for bonds that even they someti Prior to the catastrophe, these mortgage-backed securities were the most rewarding investment available.

A story fueled this sentiment: US property prices have always risen in the past. This larger fool assumption was confirmed in the real estate market by multiple cases of buyers purchasing with the aim of flipping six months later. Flipping houses had become a cottage industry across the country by 2007.

Conceptualized game theoretically, the situation facing the prospective Austrian investor looked like this:

Whether to participate in an “irrational” market

Post-Keynesian/neoclassical market actors


Don’t participate

Austrian market actors


100, 100

100, 0

Don’t participate

0, 100

0, 0

In this usual game scenario, it is obvious that the only rational option for anyone seeking a profit is to participate—or, in the case of Austrians, to imitate the irrationality of the majority of market participants. Of course, this is only true if you have a certain amount of risk tolerance. Even if one prefers risk, the Nash equilibrium might shift dramatically—as it did when enough market participants became aware of their holdings' actual values and risk levels.

In retrospect, it is clear that the crisis was fueled by a strange but familiar recursive loop: increased demand for mortgage-backed securities prompted a search for more supply, which prompted a search for more supply until mortgage originators ran out of prime and even reasonable subprime lending candidates. However, as house prices soared, numerous famous economists openly warned of an imminent disaster, and several individual and institutional investors used credit default swaps to take large positions against the mortgage-backed securities market. Those who were astute and bold were rewarded, while the remainder were penalized.

This example can be taken more widely for the Austrian: What should one do when the overwhelming majority of market players, in their opinion, are making systematic mistakes not only in asset pricing but also in their assumptions about money, interest rates, and even value?

Because, from an Austrian perspective, to engage in modern financial markets at all, one must act irrationally from beginning to end. However, Austrians must participate if they are to realize optimal gains—at least, until they feel that the risk of continuing to ape the irrational behavior of the post-Keynesian financial landscape outweighs the likely payoff of continuing to ape the irrational behavior of the post-Keynesian financial landscape. Knowing, or rather probabilistically assuming, that most market participants will act irrationally by going along with the status quo of modern monetary

Consider Menger's thought experiment, which demonstrates the force of the subjective theory of value: shipwrecked on a desert island in the middle of the ocean, one values a glass of water more than a diamond, but only in that or a few other severely confined situations.

Austrians are better at understanding actual value, profit, than any other economic school, but that doesn't imply they're immune to tasteful design or crowd frenzy. While actual value usually wins out in the long run, prices are influenced by market emotion, momentum, and a variety of other factors, making all prices "always erroneous in retrospect," as Eugene Fama, theorist of the efficient market hypothesis, conceded. This is due to the fact that entire information is difficult to gain in retrospect and impossible in the present.

Behavioral economics provides Austrians with clear frameworks for identifying and analyzing the numerous types of financial market misbehavior that can and have occurred. Austrians can better avoid being pulled into risky investing fads like memes or nonfungible coins if they have this understanding. Furthermore, because behavioral economics can disclose when and how market actors are likely to be systematically wrong about the worth of something, informed Austrians can profit from price arbitrage possibilities over time by focusing on consumer wants and business responses.

Austrian business cycle theory provides a matrix for behavioralists seeking a more predictable macroenvironment for their choice architecture. After all, how can a world interest rate determined by a few unelected members of a private monopoly be predicted? Isn't it better to have pure market forces and a less elastic medium?

Yes, without a doubt, from the standpoint of risk reduction.

To avoid any behavioralist objections to ABCT's apparent contradiction that lenders would continue to lend despite the fact that the economy was becoming too hot, as Joseph Salerno has demonstrated, this is not at all a contradiction. "As long as the music is still playing, we have to get up and dance, and the music is still playing," said one investment manager on CNBC a few months ago.

Client desire for returns may create bubbles, but it is bad monetary policy that permits them to reach truly disastrous levels. Everyone should now realize that the Federal Reserve kept the recent celebration going for far too long.

The only question now is how far down you can go.


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