Sterling Terrell

Is There Such a Thing as Austrian Investing?

[An audio version of this article, read by Dr. Floy Lilley, is available as a free MP3 download.]

What is Austrian investing? Is the way an Austrian invests different than any other? Can Austrian principles be formed into an investing method? As one who is profoundly interested in the financial markets, I believe these are questions worth asking.

Equity markets have collapsed in value, bond yields are off, real-estate markets are (in many places) in a state of disarray, monetary devaluation through government inflation is a constant dilemma, bailouts occur weekly, and wars and rumors of wars seem to lurk in the distance. Investing of any sort is enough to make one’s stomach turn in times such as these. The hole in the backyard and that spot between the mattresses keeps looking better and better.

Given all this, we can say one thing for sure: there is a lot of uncertainty in the world around us. And given enough time in investment and finance classes, you learn that in the end all an asset manager is really good for is managing that uncertainty — managing risk. The appropriate mix of assets in your portfolio will depend on your level or tolerance for risk. An endowment fund, a 35-year-old attorney, a pension plan, and a 65 year old retired professor do not share the same level of risk tolerance; consequently, they will have very different looking portfolios.

Conventional investing today falls into two categories. The first group says it is best to be as diversified as possible (passive investing). One should buy into an index fund (or some other broadly diversified fund) and hold on for the long term. Coupon payments, dividends, interest, and the passing of time will do the job for you. The second group thinks that the best strategy is to outsmart the market (value or growth investing): find out where the market is going to go by forecasting it, and constantly position your portfolio to profit from it.

Problematically, both of these methods address risk from the same perspective. Under each, there is a high probability that on a given day the portfolio will see a small return and a very small probability that the portfolio will show a large return — due to the unexpected.

Austrians know that the future is uncertain and the uncertain is just that — not known or knowable (i.e. unforecastable). Rather than just diversifying (and hoping for the best) or trying to predict the future (with a crystal ball, or a regression), why not use the fact that the future is uncertain as an investing strategy in and of itself? Develop an investing strategy that has, on any given day, a high probability of a small negative return, and a small probability of a very large positive return.

Rather typically, this idea is not original and Nassim Nicholas Taleb of Empirica Lab is already doing exactly this. More famously, Dr. Taleb is the author of Fooled by Randomness and, more recently, Black Swan — both New York Times bestsellers.

For an excellent bit of background information and a better description of his views, see the Mises Daily Article “Fools Put Faith in Data Alone” by James Sheehan. In addition, Dr. Gary North also has a well written (and scathing) critique, “How Mr. Taleb Got Utterly Fooled by Randomness,” available at LewRockwell.com. (The latter article is more theological in nature.)

More specifically, Dr. Taleb advocates putting the majority of a portfolio in less-risky-to-riskless assets, and a much smaller portion of the portfolio in extremely risky assets that have a limited downside.

Simply put, Dr. Taleb makes money by only buying options. On most days, the options expire worthless. On a few days, an unexpected shock is realized, the market moves wildly, and large amounts of money are made. This is identical to finding a volatile industry (or equity) and doing a “long straddle” with it: within a narrow trading range, maximum losses are known in advance and fixed, while a large price movement (positive or negative) can show a virtually unlimited profit.

To further explore Austrian investing, one might look at the nature of Austrian Business Cycle Theory: how can the role of the Federal Reserve in setting interest rates, causing shortages and surpluses in the market for loanable funds, the nature of malinvestment, and the inevitable boom and bust that follow, be formulated into a successful investment process?

But as for Dr. Taleb and the nature of risk, what can be more Austrian than an investment strategy that is based entirely in the notion that the future is uncertain and accurately forecasting it is impossible?

This article was first published by the Mises Institute.

The cover story of the June 17, 2008 issue of the Wall Street Journal was, “Obama Plans Spending Boost, Possible Cut in Business Tax.” The story indicates that (then) presidential hopeful Barack Obama would consider lowering the corporate tax rate if tax breaks and loopholes were eliminated. It reads,

He stressed the idea was not a broad move toward Sen. McCain’s broader tax-cutting philosophy. While Sen. McCain has argued that tax cuts — particularly on business — spur growth, Sen. Obama dismissed that as flawed economics. “I’ve seen no evidence that … would actually boost the economic growth and productivity.”

No evidence? Really? Maybe I can help.

The historical and current belief is that taxes in America are low, compared to the world in general. America is the model of free markets, low regulation, and economic freedom. Right? This is simply not the case. The United States has high taxes in general and higher corporate taxes in particular.

In the 2008 Index of Economic Freedom, assembled by the Heritage Foundation, personal income taxes and corporate tax rates are compared across the globe — along with many other economic measures. In regard to personal income taxes, the United States ranks 87th out of 156 nations. And in corporate rates, it ranks 125th out of 156. In other words, 86 nations have lower tax rates on personal income than the United States, and 124 nations have lower corporate tax rates.[2]

Venezuela, India, Finland, Haiti, Burma, Canada, Mexico, Egypt, Cambodia, and Russia are among the many nations whose top personal income tax rate is lower than the rate in America.

The only nations who have a higher corporate tax rate than America are Suriname, Pakistan, Togo, Benin, Republic of Congo, Cameroon, Chad, Libya, and Vietnam. No information was available for The Democratic Republic of Congo, Iraq, North Korea, Montenegro, Serbia, or Sudan. I cannot imagine why.

Lower corporate taxes are associated with economic growth. This can be shown a priori and empirically.

A Priori

Corporate taxes reduce the profits of business owners. This is true because net income is reduced by the tax rate. For example, Firm X, with a $100 investment, earning a 7% return has an income — before taxes — of $7. With a 10% corporate tax rate, net income — after taxes — is $6.30. Firm X now has earned a 6.3% return. In contrast, a corporate tax rate of 40% reduces net income after taxes by $2.80 to $4.20, or a 4.2% after-tax return. This rise in taxes, on the margin, reduces the profit-seeking incentive to take business risks. Why risk starting a biotech company when inflation-protected T-bill’s will give you the same return? Entrepreneurs and venture capitalists less willing to take risk means less innovation and fewer innovative ideas being economically viable. This results in less economic growth. Conversely, higher returns on invested capital encourage investment and savings. All of this leads to more capital savings, more innovation, better technology, and higher wages.

Further, the above example of Firm X is true if the firm does not have the pricing ability to transfer the tax to its customers. If the ability does exist, an increase in the corporate tax rate is really a tax on customers of the firm. In this case, consumers now have less to spend and save and the end result is the same.

Finally, a firm unable to pass on a tax increase or bear the reduced profit will either attempt to cut costs by reducing wages (among other costs) or be forced to go out of business.

The main point is this: by definition, corporations do not pay taxes — people pay taxes. A corporate tax is either a tax on shareholders of the firm, customers of the firm, or employees of the firm. Less corporate tax means more innovation, capital savings, and spending by these groups — also known as economic growth.

Empirically

After theory and logic tell us what is true, empiricism can confirm our result.

Thankfully, Professors Young Lee (Hanyang University) and Rodger Gordon (UC — San Diego) have done the work for us. In a 2005 journal article they concluded,

This paper finds that the corporate tax rate is significantly negatively correlated with economic growth in a cross-section data set of 70 countries during 1970–1997, controlling for many other determinants/covariates of economic growth.

More specifically, they continue, “The estimates suggest that cutting the corporate tax rate by 10 percentage points can increase the annual growth rate by around 1.1%.”

Using these figures, Andrew Chamberlain of the Tax Foundation opines, by cutting the U.S.’s combined federal and average state corporate tax rate from roughly 40 percent to 30 percent we could boost U.S. economic growth by around 1.1 percent per year — enough to double our nation’s wealth every 63 years.

Even better, a cut from the actual corporate tax rate of 35% to a rate of 10% would double our nation’s wealth every 30 years.

Life Savers moved production to Canada. Nabor Industries and Tyco International moved to Bermuda. Halliburton has announced a move to Dubai. In a globalizing economy, is it really a puzzle that firms prefer to operate in lower-taxing, less-regulated environments?

These are examples of what can be seen. As Frédéric Bastiat reminds us, however, it is imperative to also account for what cannot be seen. What would the wealth of our nation be today if the corporate tax rate had always been 10% or less? What creature comforts would have been innovated? What new technologies brought to market? What diseases cured?

Due to a history of high corporate taxes, these answers are not known, and we are worse off because of it.

First published by the Mises Institute.

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