Austrian Energy Cycle Theory: Beware the Green Bubble

Austrian Energy Cycle Theory: Beware the Green Bubble

Should you invest in the green bubble? It’s not just a green energy bubble anymore. Everything else is set to go through the same transition; which could completely upend the economy.

The EU wants to extend its carbon credits program to other parts of the economy, as Germany already has. Not only will power plants be subject to paying for their emissions but, eventually, all of us will, in all parts of our life.

But it isn’t the green campaign itself I’m worried about. It’s the side effects and unintended consequences. The externalities of a green bubble, you might say, if you were being cheeky…

After all, if the campaign to cut CO2 emissions simply left its investors out of pocket, if it turns out to be a bad idea, that’d be fine. But they want to drag the rest of us with them, kicking and screaming if need be.

So, what are the consequences?

A familiar story

Back in 2001, American Politician Ron Paul was busy explaining how the Federal Reserve’s interest rate policy would inflate a housing bubble, eventually triggering the bust of government-sponsored entities like Fannie Mae and Freddie Mac. In other words, that housing bubble and bust were perfectly foreseeable, predictable and…profitable.

So, would you have invested in that housing bubble back then, knowing it was a bubble? It had another five years to run. A vast amount of wealth was created during that time.

Rumours are that American college students bought houses by lying on mortgage applications and, by the time they defaulted when interest rates had ratcheted up, the value of the house had spiked enough to pay off their college debt by selling the house.

So, perhaps the ability to spot a bubble suggests an investment incentive, not just doom-mongering.

But what allowed a politician and medical doctor like Ron Paul to diagnose what would happen — the US housing bubble’s inflation and subsequent bust — so accurately? And what does that have to do with the green bubble?

I believe the two are very closely linked by…Austria. More specifically…

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The Austrian School of Economics

Ron Paul is a believer in the Austrian School of Economics — Keynesians’ worst nightmare.

The Austrian Business Cycle Theory, which Paul used in 2001 to anticipate the housing bubble, argues that central bank manipulation of the economy creates the boom and bust cycle. (According to central bankers, they mitigate the boom and bust cycle, so this is precisely the opposite of conventional wisdom.)

In the early 2000s, central banks inflated the housing bubble with low interest rates, for example. Just as Paul Krugman argued they should in 2002:

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

And the Fed went on to do just that.

These days, the central bankers are back, creating both a tech and a housing bubble at the same time. But that’s another story.

We can apply the same Austrian Business Cycle thinking to energy, given how energy is almost as influential in the economy as money itself.

Sure enough, central banks are busy inflating the green bubble directly, too. They’ve made climate change a central part of their mandates. They’re backing green bonds in their QE, for example.

Austrians would argue this would lead to a bubble, just as it led to a housing bubble in the early 2000s and a government debt bubble since the housing bubble popped.

The green movement reminded me of Krugman and Paul McCulley in 2002. They’re cheering on the boom, supposedly for a good cause, forgetting about what follows such a boom…

As governments and central banks intervene in energy, I predict a boom and bust cycle not just in energy prices but the entire economy. Because just like money and interest rates, energy and its price underpin everything.

That means vast amounts of money will be made and lost, just as during the tech and housing bubble.

We’ve already seen this play out in the past with the EU’s diesel subsidy shemozzle, which fuelled German car company booms and busts, solar power companies like Solyndra booming and going bust, the EU’s carbon credit trading program, and US ethanol subsidies.

Each program created vast misallocations of capital. But it’s important to note that a lot of money was also made in the boom each time.

What of the bust, though?

Why bubbles are bubbles and why they burst

According to Austrian Business Cycle Theory, it’s important to understand that a bubble’s bust is inevitable. Or, in this case, Austrian Energy Cycle Theory, if I might call it that.

But to explain why, we must also understand the concept of misallocation of capital.

You see, to a Keynesian, all GDP is created equal. You might as well dig a hole in the ground and dig it back up again — as long as someone pays you for it, you’re creating GDP. Under the Keynesian worldview, the only person dumb enough to pay someone to dig holes and fill them back up again is a government official. And so they should do just that.

I prefer the practice of mowing your neighbour’s lawn for $10 and them mowing your lawn for $10, thereby creating $20 of GDP, as opposed to none if you both mow your lawn. But that’s also another story and not one to tell the ATO about.

To the Austrian School of Economics, the quality of GDP matters too. And mistakes happen — investments in the wrong things can be made, leading to poor quality GDP. A misallocation of capital, Austrians call it.

A recession is when such investments are liquidated and reallocated to more productive uses, which makes a recession a good thing. (One reason Austrian economics isn’t very popular is that it’s not very palatable, politically speaking. Paul Keating’s ‘the recession we had to have’ is a good example, though.)

If you prevent a recession, you get falling productivity growth and zombie companies because the mistakes and misallocation of capital aren’t fixed, and the resources are not reallocated to better uses. More on that another time. Or you can just read the news, where economists puzzle about falling productivity and zombie companies all the time…

Central bank intervention in an economy creates misallocation of capital by fiddling with price signals. Specifically, the most important price signal there is — the price of money, the interest rate.

That’s why central bank fiddling tends to show up in house prices, banking and sovereign debt bubbles — the three things that blew up in 2008 and the three things most sensitive to interest rates.

Coincidence? I think not.

If the government set the price of orange juice and the orange juice industry had a crisis, who would you blame?

Well, central banks set the interest rate and banks, houses, and sovereign debt had a crisis in 2009 and 2010. Who do you blame?

The Austrian Business Cycle Theory says, ‘blame central banks’. And you can apply this thinking to energy too. Just like money, everything is connected to energy…

If energy goes green, it affects the entire economy

Every economic activity today is energy-related. So, if you mess with energy prices, you mess with everything.

Government policies related to green energy, like carbon taxes, green subsidies and approvals for energy developments, have created incentives that diverged from the free market’s prices.

Not that energy has been much of a free market historically…but the added intervention motivated by green policies added divergence from what is most beneficial and efficient.

In other words, my problem with the environmental movement is that it is reminding me a lot of the Austrian Business Cycle Theory’s misgivings about central banking. Just as central planning of an economy causes havoc for an economy, central banking creates problems for banks, and green energy policy creates problems for energy.

But banks and energy are central to the rest of the economy too.

If the government’s interpretation of climate science drives economic activity and not consumer preferences and costs, more and more of that economic activity is likely to cease making sense. Because the calculations of costs and demand will become misleading, prices will misdirect consumption and production into less productive uses.

Our energy will be green, but the economy simply won’t make sense. Just as it didn’t in 2006. And that portends a reckoning like 2008 to come.

The green bubble is like the housing bubble. It has put everything out of whack.

Until next time,

Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

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