Detlev Schlichter, a former City and Frankfurt investment professional-turned-writer, argues that "Austrian" economics can explain current crises, unlike other schools of thought. He says the era of paper money is over.

As gold prices flirt with a once-unthinkable $2,000 per ounce and inflation rears its ugly head, a question that comes as a shock to mainstream economists is whether paper money is doomed.

Paper or “fiat” money, which is money not exchangeable on demand for assets such as gold but simply decreed by the state to be legal tender, has been the norm for around half a century. (The US finally severed its dollar link to gold in 1971.) But recent events have shaken faith in paper money. The 2008 market crash and repeated quantitative easing rounds (i.e. credit creation) by central banks have not reignited Western economies, although defenders of “QE1” or “QE2” say this has avoided disaster.

According to one body of economists known as the “Austrian” school, this money printing, however, only postpones painful unwinding of mal-investments. This approach takes its name from thinkers of the late 19th Century based around the University of Vienna, such as Carl Menger. Two of the most famous Austrians were Ludwig Von Mises and FA Hayek, who both battled against the ideas of JM Keynes and advocates of once-fashionable state planning. Hayek achieved fame as winner of a Nobel Prize and for a widely read late 1940s book, The Road To Serfdom.

So what does the Austrian approach have to say about today’s problems?

Simply put, Austrians, who analyse human action exclusively from the perspective of an individual agent, don’t say business cycles are inevitable - as Keynesians might do - but caused almost entirely by credit expansion by fractional reserve banks. This credit growth is also bolstered by central banks like the Bank of England (FRBs issue more credit than is covered by deposits), leading to a boom and bust. Money, they say, is a claim on resources – both human and non-human – so if more credit is issued without it having been created by forgone consumption (i.e. savings) of resources, then the price of resources goes up – in other words, inflation. And later, unless credit keeps expanding, there is a bust. Also, Austrians say that trying to avoid a bust by creating yet more credit is like trying to avoid a hangover by drinking more alcohol.

Detlev Schlichter

One "Austrian" – in fact he comes from Germany – is Detlev Schlichter, a former JP Morgan and Merrill Lynch investment professional who has swapped the hurly-burly of the dealing room for the cut and thrust of economic debate. He has a new book out, Paper Money Collapse - The Folly of Elastic Money and the Coming Monetary Breakdown, published by John Wiley & Sons. This publication recently asked him about his outlook. (His website can be viewed here.)

“My book argues on a theoretical and conceptual level that paper money systems have no advantages over commodity money systems with an essentially inelastic money supply, but that they have many disadvantages. The book shows that elastic money systems must inevitably lead to economic instability and chaos. They must ultimately fail,” Schlichter said.

“These findings are true regardless of what happens over the coming years, and they would have been as true and relevant if I had written the book in 1985 or 1992. If there is growing acceptance of these ideas today it is because the present paper money experiment is approaching its endgame. This is now palpable. I think there is growing skepticism about the viability of paper money today, and growing acceptance of the need to go back to inflexible, apolitical commodity money. But this change in opinion is predominantly the result of the present crisis, not because of any books, whether mine or those of other writers. `Events, dear boy, events.’ Nothing changes public opinion more. This does not mean that books have no role to play. As the crisis intensifies, people look for explanations and for guidance. I am hopeful that my book can help in this regard. But the very same ideas would have been ignored in 1992 or 1999,” he said.

“Overall I am pessimistic. The dislocations are now so big that a crisis is inevitable, even if we stopped printing money now and went back to hard currency, as we should. But nobody in the policy establishment has the resolve to do this. Instead, more and more aggressive money creation will occur. As a result of this, we will suffer a much bigger crisis. Paper money systems collapse not because those in charge don't understand inflation. They collapse because at some stage they begin to fear the immediate consequences of stopping the printing press more than inflation. Ultimately, this is a mistake. It takes down the whole system,” he said.

Unwelcome messages

This is a message that wealth managers, never mind politicians, resist. Schlichter is not, however, the only commentator to have pointed to the follies of paper money. There is Jim Rogers, a regular media pundit, investment-focused travel writer, and the former business partner of hedge fund legend George Soros. The TV pundit and investor Peter Schiff has been warning about the dangers of paper currencies for years. Interest in gold-backed currencies was highlighted at a conference in London in January this year by Cheviot Asset Management. A number of wealth management houses have been advocates of gold as a safe haven asset, concerned about inflation of fiat money. 

It is interesting to know how a person holds the views he or she does. Schlichter is no ivory tower academic. After graduating in economics and business from Germany’s Ruhr Universität Bochum, he started as a derivatives trader at JP Morgan in Frankfurt in 1990, moving four years later to its asset management arm, running bond portfolios. He moved his young family to London in 1996, calling it home ever since. In 1998, Schlichter joined Mercury Asset Management, which was in the process of being acquired by Merrill Lynch (eventually becoming BlackRock). In 2001, he went to Western Asset Management, based in Pasadena, California, and oversaw its London investment team.

“I can honestly say that I feel very lucky having worked for the companies I have. I met and worked with some very interesting people, and also had some great clients. It was a fantastic experience. But by 2009 I was ready to quit the business and do something different. It was not only because of the crisis, which - naturally - was a dreadful time for anybody who had responsibility for client money and for staff. Physically and emotionally, these were tough times,” he continued.

“But there were two other factors for me: I had for some time wanted to do something that was intellectually more satisfying, and second, it had become, over the years, more and more clear to me that the financial system was fundamentally broken. Our financial system is not only sub-optimal, it is unsustainable. And I felt that we were approaching some kind of endgame. I wanted to work through this in my head. I quit the business in 2009, I rented a small office in St John's Wood in London, and locked myself in with my laptop and my books,” Schlichter said.

A gradual journey

He did not have a sudden flash of insight, however. “The conversion was gradual, although I was never a Keynesian, not even at university. Most of my university teachers - at least those who impressed me - had a free-market orientation, which from the start appealed to me, although none of them were "Austrians", as far as I know. Maybe there was indeed one key moment. In my final year at university I came across something written by Friedrich August von Hayek - and I was immediately hooked. His approach and philosophy impressed me greatly. When I went into financial markets in 1990 I already was a staunch free-marketeer and a Hayekian. The people who worked with me - even in those early days - certainly realized this,” he said. "I later discovered Ludwig von Mises and Murray Rothbard who became an even greater influence on me. I believe that Mises is still the towering figure of Austrian economics."

As his views developed, Schlichter said he increasingly doubted if modern financial systems were sustainable.

“And at the same time I also saw growing systemic instability first-hand in my daily work-life. As my intellectual position became firmer over the years, the "real" world around me seemed to confirm this position almost as if on cue. Since the late 1990s, the gaps between financial crises became shorter, and each crisis became more severe requiring - by the logic of the "mainstream" - more stimulus. The system was never allowed to contract, de-lever and cleanse itself. The addiction to low rates and cheap credit became ever more extreme,” he said.

Schlichter’s brand of economics is still, he says, far from the mainstream. “It tells you something about the intellectual bubble that exists in the financial markets community that I never met an `Austrian’-influenced economist in almost two decades in the industry. Only when I left the "mainstream" industry did I discover speculators and financial writers who had read and understood the Austrians, such as Doug Casey. Not surprisingly, these people were not to be found at the central banks or on Wall Street,” he said.

Eccentrics or visionaries?

“Among mainstream macro-economists, the Austrians are seen as slightly eccentric and quaint. Sometimes even as intellectual and political extremists. People who have not gone with the times. If you are an Austrian, your views are sometimes met with a knowing, pitiful and slightly condescending smile that seems to give you credit for your intellectual effort but also tells you that "in the real world" a different type of economic thinking matters,” he said.

“Most market professionals are not economists but the economic debate that they are part of is determined by the economists at the central banks, the World Bank and the IMF, and the economists at Wall Street and City firms who all started their careers at the central banks, the World Bank or the IMF. As I said, an intellectual bubble. The course of debate in financial markets is entirely determined by a certain set of generally accepted concepts - popularized versions of macroeconomic theory - that people accept because everybody around them does the same. Most of it is erroneous common wisdom. All this talk about "stimulus", for example, as if the economy were some organism suffering from fatigue and just in need of a kick in the backside.”

It is clear, whatever the views, that economics, like any other body of knowledge, cannot stand still. And at a time when many conventional economic policies seem to have failed, or are slow to act, different approaches are likely to achieve new respect and force wealth managers to re-examine old premises. Schlichter and his fellow “Austrians” may find themselves very busy people in the next few years if paper money ceases to be worth the material it is written on.