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Real-World Economics: An Interview with Frank Shostak

Austrian Economics Newsletter

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07/30/2014Frank Shostak

Volume 19, Number 3 (Fall 1999)


An Interview with Frank Shostak


Frank Shostak is chief economist at Ord Minnett Jardine Fleming, Sydney, Australia, one of the largest brokerage houses in that country, and serves on the editorial board of The Quarterly Journal of Austrian Economics. He received his bachelor's degree from Hebrew University, master's degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University. He is a frequent contributor to the Asian Wall Street Journal, among many other popular and scholarly venues. His email address is


AEN: Do you find Austrian economics useful in your day-to-day work?

SHOSTAK: I think it's important that clients understand the rationale behind your thinking. The Austrian School makes that possible. Clients relate to it very easily, and there's plenty of available literature with which they can follow up. On the other hand, most businessmen cannot understand econometrics, even if they sometimes pretend to because they don't want to appear stupid. But the really smart ones want to know why you think the way you do. You can't just say: "that's what the model says." Serious businessmen won't buy that. Neither will they be tricked into thinking their advisers are oracles. I never pretend to predict the future but only to suggest possibilities based on real events and realistic theory.

AEN: The job of chief economist for a major investment firm usually involves mathematical wizardry.

SHOSTAK: I was trained as a mathematical economist. My dissertation topic was "An Econometric Inquiry into the Monetary Transmission Mechanism in South Africa." After my PhD, I went to work as the head of the econometrics department for the major Johannesburg bank. While there, I built one of the first large macroeconomic models in South Africa. I visited the Wharton School of Business, showing it off and impressing all the math jocks. After working ten years on the project, I began to have doubts, and those doubts grew.

At some point, I decided to throw myself back into thinking about the basis of economic theory. I eventually read Murray Rothbard's Man, Economy, and State, and it permanently changed the way I thought about economics. He began with human beings as they are and as they act and as they choose-points that macroeconomic models cannot take account of. It became clear to me that most of what I was doing was based on the wrong foundation.

The big problem in economics is not that it lacks technical sophistication; the problem is that it lacks philosophical sophistication. When economists do attempt to give the science a philosophical justification, the results are unimpressive. It usually comes down to a defense of patently incorrect assumptions about the world.

But why should we assume things that are incorrect? The answer used to be that you can know good models by their predictive power. Today, few believe that, so the defense of implausible assumptions now comes down to this: they are necessary to create models. This is just a vicious circle, when the starting point and the ending point are the same. This is just a con-job.

From a Rothbardian point of view, economic theory must stand on its own. It doesn't require a mathematical proof but a logical one. It is valid in all space and time because it deals with unchanging laws of cause and effect that emanate from choice.

This is not captured in mathematical functions. If you say y is a function of x, you are trying to dispense with causality and you imply that relations between facts are brought about apart from choice. But in the end, human beings decide how much to spend, whether and how much to invest, and so on. If you throw this idea out, you can create elegant models of anything you want, but they have no bearing on reality.

AEN: While in South Africa, did you know Ludwig Lachmann?

SHOSTAK: I attended his private seminar, which he ran out of his house. What aroused my attention was his attack on quantitative economics. I remember thinking: there must be something wrong with this guy. But he invited me to join his seminar, and I always found him interesting. He lectured and we heard papers by others, and I presented some.

Even in those days, Lachmann emphasized uncertainty and the unknowability of the future. Much of it was sound, but he tended toward nihilism, the assertion that we can never know anything. I must say it wasn't until Hans Hoppe's article on that subject in the old Review of Austrian Economics that these issues were clarified for me.

In any case, in one seminar, he mentioned the debate between Keynes and Mises. I wondered who this Mises guy was, and I became very curious. Lachmann let me photocopy his copy of the first edition of Human Action, and I read the whole thing. I must admit that I couldn't understand a word of it. I was very upset because I thought of myself as a top economist, a member of an elite corps of econometricians. For my own sake, I remember hoping that Mises was just writing rubbish.

After that, I read Henry Hazlitt, whose work I found comprehensible but childish, intriguing but not rigorous-or so I thought. Later I changed my mind. In any case, Hazlitt footnoted Rothbard, and finally I found the economist who could, for me, make the case for the Austrian School.

In my opinion, Man, Economy, and State is better organized, more precise, and more focused than Human Action. Rothbard writes for the mainstream economist and in a language he can understand. Part of the difficulty of becoming an Austrian economist is that it requires a different vocabulary. Rothbard makes the transition much easier.

In fact, I attribute the rise of the Austrian School in our times, whether in academia or the financial world, to Rothbard's writings. They have had far more influence than is usually admitted, even by Austrians themselves. That so many claim that their primary influence is Lachmann or Mises or Hayek is due to the natural tendency to rally around thinkers who speak more obscurely as a way of congratulating oneself on one's interpretive capacities. It is Rothbard who has taught the world of today Austrian economics.

AEN: Was Lachmann a classical liberal?

SHOSTAK: Yes, he was, but he also had a great deal of admiration for Keynes. I asked him about Mises, and he said that Mises was a very stubborn person who didn't make enough of an effort to understand Keynes. If he had made more of an effort, he wouldn't be as negative toward Keynes. He also regarded Mises as arrogant, abrasive, and uncompromising.

I didn't tell him this at the time, but it is clear why Mises didn't compromise. He had strong disagreements with his colleagues. He wasn't interested in making incorrect assumptions about the world. He wanted to describe reality. Of course this led him to be an outcast after the entire profession had decided that it is perfectly fine to assume such things as all people are identical, knowledge is perfect, and output is given.

AEN: What about Lachmann's influence in the Austrian movement?

SHOSTAK: There is a long-running tendency among Austrians who have discovered the fallacies of mainstream thought to reject not just bad theory, but theory altogether. They conclude from the failure of one formal system of thought that all formal systems of thought must go. They rally around the work of Lachmann and G.L.S. Shackle and end up rejecting the existence of the law of demand, for example.

This is an enormous error. The problem with mainstream economics is not that it is theoretical and formal but that it is based on the wrong foundation and therefore generates crazy conclusions. The right response is to start from the right foundations. If a bridge collapses, you shouldn't reject the possibility of scientific geometry; you should try to figure out what went wrong with the bridge engineering plan.

Lachmann's key contribution to Austrian theory was said to be his theory of expectations. He said we live in a kaleidic world that is shaped mainly by what we believe about it and what others believe about our beliefs, etc. But Mises pointed out in the 1940s that expectations are a black box to an economist; they belong in the category, not of praxeology, but of thymology: knowledge concerning internal human valuations. We cannot make any fixed assumptions about such valuations. We cannot say they are perfect or that they are never correct about the future. We just do not know. Praxeology provides certain knowledge about unchanging facts.

AEN: How does this apply in the context of business cycle theory?

SHOSTAK: Writing in Economica in 1943, Lachmann criticized Mises's theory of the business cycle on grounds that expectations could prevent it from taking place. The idea is that businesses expect the bust and refrain from investment expansion, thereby muting the impact of new money coming into the economy. Hence, the business cycle is recast as an information- coordination problem rather than a theory about cause and effect.

The incorrect assumption here is that bad expectations are somehow the cause of the business cycle. The actual cause is the introduction of counterfeit money, which redistributes wealth and leads businesses to make calculation errors. You can have any kind of expectations you want but they will not and cannot obviate past events. This new money is an economic error which must work itself through the economy in some way.

You cannot use psychology to explain the consequence of real events. What people believe about the future cannot change the reality of cause and effect. The business cycle is a consequence of a real act of damage that, once set in motion, cannot be undone. Guido Hlsmann prefers to recast the business cycle theory into a general theory of error cycles, which gets to the core of the issue at hand: government intervention leading to bad decisions.

AEN: Which aggregate money supply statistic do you think is the most reliable?

SHOSTAK: I like the one spelled out by Rothbard in the late 1970s: money that permits instant conversion at no loss. Today this is covered by such aggregates as M2 and Money of Zero Maturity, or MZM. You need to make small modifications-removing short-term savings deposits-and you need to make allowance for institutional money.

Using this measure, it's clear that the money supply has been bouncing back since about 1992, and in the first quarter of 1999, money growth reached as high as eleven percent. This suggests to me that America's economy is very unbalanced. When and how it will tip the other way can't be known, but it will happen. Most people, including people at the Fed, are focusing on whether inflation will return. But that is not the issue. The issue is exaggerated levels of investment, particularly in the stock market, that cannot be sustained.

When the bust hits, you can bet that there will be more cries for the Fed to inflate. This will be a direct result of Milton Friedman's claim that the depression in the 1930s would have been prevented if the Fed had inflated. But he has it exactly backwards: it was the early credit expansion that created the conditions that led first to the boom and then to the bust. It was the first round of money printing that destroyed the pool of funding.

AEN: What do you mean by pool of funding?

SHOSTAK: Essentially, the pool of funding is the quantity of goods available in an economy to support future production. In the simplest of terms: a lone man on an island is able to pick 25 apples an hour. With the aid of a picking tool, he is able to raise his output to 50 apples an hour.

Making the tool, however, takes time. During the time he is busy making the tool, the man will not be able to pick any apples. In order to have the tool, therefore, he must first have enough apples to sustain himself while he is busy making it. His pool of funding is his means of sustenance for this period-the quantity of apples he has saved for this purpose.

The size of this pool determines whether or not more sophisticated means of production can be introduced. If it requires one year of work, for instance, for the man to build his tool, but he has only enough apples saved to sustain him for one month, then the tool will not be built-and the man will not be able to increase his productivity.

The island scenario is complicated by the introduction of multiple individuals who trade with each other and use money. The essence, however, remains the same: the size of the pool of funding sets a brake on the implementation of more productive-but longer-stages of production.

Trouble erupts whenever the banking system makes it appear the pool of funding is larger than it is in reality. When a central bank expands the money stock, it does not enlarge the pool of funding. It gives rise to the consumption of goods which is not preceded by production. It leads to less means of sustenance for the production structure.

As long as the pool of funding continues to expand, loose monetary policies give the impression of boosting economic activity. That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downward plunge. At this point, the central bank's monetary policy becomes ineffective. The most aggressive loosening of money will not reverse the plunge. Paper money cannot replace apples.

AEN: What do you make of the many companies that are attracting funding without actually showing profits or earnings?

SHOSTAK: In a free market with sound money, stock prices would function very much like other prices on the market. They would change relative to each other and pay an average return tending toward the normal rate of profit, with due qualifications owing to the good judgment of investors. What we see today, however, is roughly akin to a hyperinflation in financial assets. This is no different from the debasement we see in the value of money in a normal inflation.

Most economists believe that if the stock market is going up, the economy is being revived. But altering the valuation of stocks does not change reality. It is only a manifestation of what people think about the real world. And if you print money, you corrupt the signals that lead people to make rational decisions. Right now, people are being led to form false perceptions about reality. That doesn't mean that people cannot make money in stocks, but it does mean that the present rise of the stock market cannot be sustained.

In the real world, there is no way a company with no earnings can be properly valued at half a trillion dollars. And yet that is what we are seeing. Someone may say: but these companies may produce something someday. Sure, but there are limits. A new Volkswagen is a good car, and it may have a surprisingly high price due to popularity. But when the car sells for a million dollars, something has gone very wrong. It doesn't matter how spectacular the new technology is. Resources are being misallocated.

Even aside from these absurd prices, you can know that malinvestment is taking place by looking at the money-supply figures. They have been growing for years, and every time a crash or a recession is threatened, the Federal Reserve intervenes to save the day. When will all this end? There is no way to know. But the fund is not unlimited, and when the means of sustenance are not there, the growth cannot continue. The music will stop at some point, and, when it does, all the new credit in the world will not revive the economy. The new money can pour in but people will not use it to invest.

AEN: This sounds something like a Keynesian liquidity trap.

SHOSTAK: There is a superficial commonality. There is such a thing as pushing on string. What Keynes describes, however, he does not explain. Only the Austrian cycle theory can do that. A good example can be found in the Asian crisis. Paul Krugman says that Japan fell into a liquidity trap. Why? He doesn't know. He just describes it as an unfortunate state of mind adopted by the citizens, one that can only be cured by printing money.

But there is no need to resort to psychological explanations for why the Japanese are reluctant to borrow. It is clear that the pool of funding was unable to support the level of investment that had been subsidized by excess credit creation, averaging 9 percent per year prior to the crisis. When the central bank raised interest rates, the bubble burst and all the misallocation-which is to say the robbery-was revealed.

How do you recover from a crisis? The Japanese government continues to inflate and spend money. This is incredibly wrongheaded. To create more money is merely to replicate the error that brought about the problem in the first place. And yet, virtually every economist, from Keynesian to monetarist, recommends this disastrous path as the way out of recessions. The only path to recovery is to allow the bad investments to wash out of the economic structure and allow the pool of funding to be replenished.

AEN: Why is inflation still considered the preferred path of economic recovery?

SHOSTAK: It represents a complete misunderstanding of the purpose of money. The purpose of money is to facilitate exchange. It cannot create or sustain economic growth. It is no substitute for productivity. No matter how powerful a central bank is, it cannot revive an economy that is suffering from a credit-generated bust.

Also, mainstream economists have a hard time understanding the theoretical basis of a misallocation of resources. This is due to their economic method. Misallocation cannot be put on a graph and it cannot be represented in a mathematical equation. It has to be understood in light of market theory, which mainstream economists only embrace to the extent it can be modeled.

Think about the statistic Gross Domestic Product (GDP), from which most all economic indicators are derived. What is it? The value of goods and services produced expressed in terms of money, with the real GDP arrived at by dividing it by some meaningless deflator. If you print more money, you spend more money and GDP goes up.

But this does not reflect economic reality. Neither does the GDP deal with stages of production. It should be clear, then, that the GDP is not a reliable indicator of economic growth. It does not reflect malinvestment and, moreover, it is subject to manipulation depending on monetary policy.

AEN: Austrians are sometimes said to regard recessions as the "good" part of the cycle.

SHOSTAK: This is because recessions reveal an underlying reality. They expose a lie that has been generated by credit creation. In Malaysia, for example, the government had been trying to build an Asian version of Silicon Valley, to compete with the US. They had massive structures and companies and plans. But none of it amounted to anything. It was no more valuable than an Egyptian pyramid. The virtue of a recession is that it reveals the truth.

But this truth is difficult for people to face. Economists spend an enormous amount of energy inventing policies to keep the truth from being revealed in recessions. This is what accounts for the hysterical fear of deflation, which is considered to be the worst thing an economy can face. Instead they recommend more inflation. In fact, in an inflated economy, a deflation is exactly what is needed.

The International Monetary Fund (IMF) has improved its understanding of the importance of recessions. In Japan, for example, its economists said that banking and the industrial sector need to be cleaned up. At the same time, the IMF is still pro-credit creation. In Indonesia, with the IMF's blessing, money expansions were running 60 percent and more. In South Korea, the rates were at 35 percent.

What does this accomplish? Nothing but further economic destruction. You cannot eat money. To get the economy back on a sound footing, you need to store up a new pool of funding-the real stuff-so the capital stock can be replenished. That requires sacrifice in the short term.

I fully expect Asia to crumble again. Last year's major crisis was a result of bad fiscal and monetary policies, and those haven't changed. Neither has the economy adjusted.

AEN: What about the currency board option?

SHOSTAK: It produces a better result than the present system because it defangs the central bank. To that extent, it is a good step. But it creates problems of its own. The currency board must choose some existing currency on which to base its system. Doing so makes the currency-board country monetarily and politically beholden to the host country, whether it be Germany or the United States.

The best solution in these countries is to stop printing money and adopt a pure gold standard, defining their own currency in terms of gold. No country is too small to make this feasible. Such a country might be opposed by the US, but it would become a magnet for investment. It would not be vulnerable to outside shocks or outside political manipulation. A country with a gold standard wouldn't have to pay any attention to Alan Greenspan. Most importantly, its productive sector would be built on a solid financial foundation.

Of course central banks are working to undermine gold right now, just as they have for most of this century. Their recent sales of gold suggest that they would like to get rid of gold completely. Even from their own point of view, this is crazy. The current monetary system is completely unstable, and unloading gold can only destabilize the system further.

AEN: How regulated is the financial sector in Australia?

SHOSTAK: About as regulated as the US, which is to say partially so. In the early 1980s, we had what is called financial deregulation, but this phrase is a misnomer. Because money is unsound and the central bank still has the power to inflate and provide guarantees against financial failure, deregulation unleashes financial institutions to conduct business unchecked by genuine market forces.

This is what happened in the savings and loan crisis, an experience that foreshadowed the financial crisis throughout Asia. It was this very deregulation that opened the spigots, and brought about the huge boom-bust cycle.

The lesson is that you cannot have financial deregulation and also have a central bank. The two are incompatible. The whole point of a central bank is to make the banking system unaccountable to market forces. Whenever the banks are in trouble, there is a lender of last resort. No other business entity enjoys such a privilege.

AEN: How powerful is the Fed in your part of the world?

SHOSTAK: Its power to do evil is enormous. Its bureaucrats exercise the dominant influence at all G7 meetings, as well as the Organization for Economic Cooperation and Development (OECD) and the World Bank. It works to coordinate world policies to prevent anyone from getting out of line. The Fed's ideal is a world monetary system that it manages completely, but, for political reasons, it is unable to achieve this.

So in the meantime, its main goal now is what it has always been: to provide a safe and profitable working environment for its member banks via monetary policy, which is to say, credit expansion. This is what is behind the Fed's attempted bailouts of Mexico and Asia. It was acting to protect the assets of its member banks' portfolios.

More generally, the Fed's actions generate inflation and the business cycle, and create artificial uncertainty in the market. It cannot be known in advance what policies the Fed will adopt, and neither can you know the precise timing of the effects. Just speculating on the Fed's actions swings markets in wild and unpredictable ways. I have to laugh every time the Fed demands that the portfolios of foreign central banks become more "transparent." No institution is more clouded in secrecy and obfuscation than the Fed. We can only guess at what it has done or is doing.

AEN: This is one reason you don't accept the Efficient Markets Hypothesis (EMH).

SHOSTAK: It's not only the Fed; uncertainty is built into the core of the market itself. The whole theory of the EMH is ridiculous. They are saying there is no reason for market analysis. All that can be known is known and reflected in the market price. If this were true, there would be no profits. There would be no business cycle.

EMH is another error that stems from a misapplication of mathematical techniques to human action. They examine past behaviors and develop probability distributions based on them, as if past behavior can somehow be a guide to future behavior. But the science of probability breaks down insofar as human choice is involved. There is no normal distribution in human affairs. In some ways, the EMH represents the opposite error of Lachmann. It goes from believing that nothing about the future can be known to assuming that everything about the future can be known. The whole question is mistaken. It is not a question of whether or how much knowledge is out there. It is a question of whether people have understood the information and acted upon it. Plenty of knowledge that is available may not be reflected in the price. The price only reflects knowledge that market participants believe is relevant to market conditions and have thereby acted upon. The market does not have a life of its own and it is not a god; neither is the market random, blind, and aimless.

The market is made up of human beings who are radically different from each other. We have different goals, different kinds and levels of information, and face different environments. Discovering how this works itself out in voluntary exchange is the task of market analysis. Economics is a qualitative, not quantitative, science. It's amazing how many errors in economic theory stem from the failure to understand this.

AEN: You don't find the recent critics of the Austrian School very compelling?

SHOSTAK: Take a look at Brian Caplan's article in the Southern Economic Journal. It is an apologia for fudging one's scientific standards. It's true, he says, that utility is not cardinal but ordinal, but there's nothing wrong with indifference curves even though they assume cardinality. Why? Because it's easy and nothing important is compromised. But he's wrong. The assumption that people's utility functions can be compared mathematically opens up a Pandora's Box of economic and social planning.

He further defends the idea of indifference on grounds that such a state of mind is actually possible. But economists don't care about psychology; they care about action and choice. Indifference is not an economic category. The whole point of economic theory is to explain the implications of choice. People must set priorities and act on them. Economic theory consists of elucidating causal relations between actions and events, not speculating on states of mind or weaving tales through graphs and equations.

Caplan further notes that Rothbard criticizes the continuous function assumption behind smooth curves, preferring to deal only in discreet units. He then claims that Rothbard himself dispensed with his critique in order to draw demand and supply curves. In the first place, Rothbard was merely using the curves for illustrative and not theoretical purposes, and he put them in context in a way which neoclassicals do not. Rothbard's graphs illustrate but do not determine the theory, and there's a huge difference.

But there's a more fundamental point: Caplan never rebuts Rothbard's criticism of the continuous function assumption. Again, Caplan seems to be suggesting that he might have been correct, but then claims it doesn't matter. But of course it matters, if we care about getting the theory right. As scientists, we should not adhere to theoretical assumptions about the world that are false.

But mainstream economists do this all the time, just so they can use mathematics. If some point doesn't fit into a graph or equation, it is just thrown out. That is why most economists today end up doing nothing but analyzing various nonsensical states of equilibrium. Their priorities are wrong. Our purpose should not be to do math but to arrive at true theory.

AEN: Apart from business cycle theory, what aspects of Austrian economics are useful to you?

SHOSTAK: I use the foundational issues of choice and human action on a daily basis. But the great gift that Austrian economics gives practitioners is the ability to think logically about all aspects of economic life. There are so many investment fads out there. They come and go every season. With Austrian economics, you can easily spot the fallacies in these new theories and stay rooted in reality. Over the long-term, this is the best survival mechanism I know.


Contact Frank Shostak

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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