U.S. stocks fell hard last week.  The Dow finished off the week by plunging more than 500 points on Friday.  The Dow ended up below 16,500.  The S&P 500 finished below 2,000.  The Nasdaq finished well below 5,000.

This is after quite an extended period of stocks bouncing around in a fairly narrow range.  Some say this is a needed correction that can set the stage for another run.  Others worry that this may be a signal that an economic downturn is beginning.  So which is it?

We should turn to Austrian school economics.  This is basically free market economics.  It doesn’t matter what you call it, but it is important to understand how government interference and central bank interference in the marketplace affects the economy.

As a side note, it must be frustrating for someone trying to study the economy in Austria.  I can imagine someone “googling” the term Austrian economics and wondering why he keeps getting results for some guy named Mises who was born in 1881.

We have to distinguish between real and sustainable economic growth, versus false prosperity that is unsustainable.

Real and sustainable economic growth comes about because of savings and investment.  This leads to higher and more efficient production.  It leads to increasing technology.  This adds real wealth to our economy and increases our standard of living.

False prosperity comes about due to government intervention and central bank intervention.  These policies distort the marketplace and lead to resource misallocation.  Government taxes, spending, and regulation all contribute to this.  Even more, central bank tampering of the money supply and interest rates distorts the marketplace.

When the major economic downturn showed up in 2008, the government and Federal Reserve took unprecedented action in the form of increased spending, bailouts, increased debt, massive monetary inflation, and lower interest rates.

The Fed increased the monetary base approximately five-fold from late 2008 to late 2014.  Most of this newly created money went into bank reserves, which prevented the multiplication of the money supply via fractional reserve lending.

However, we must understand that the new money that went into excess reserves is not really the banks’ money.  It can help make them more stable, but they do not “own” this money.  It still represents deposits for individuals or companies.

Meanwhile, price inflation has stayed relatively low (not including health insurance premiums).  This is in reference to consumer prices as calculated by the CPI.  The price inflation has been low due to the huge increase in excess reserves, as well as a higher demand for money.  The sense of fear has never completely left, and many people still are not as anxious to spend as they were prior to 2008.

There has been asset price inflation, particularly in stocks, and to a much lesser extent in real estate.  In terms of housing prices, it depends on the location.  But in most places, it is still nothing like the previous housing bubble.

Interestingly, in the late 1920s, in a prelude to the beginning of the Great Depression, consumer prices were not rising rapidly then either.  It was asset prices – stocks in particular – that were going up.

The rush into U.S. stocks over the last 6 years is largely due to the easy money policies of the Fed.  In addition, the low interest rates have driven some investors into stocks in search of yield.  It is a situation where investors are virtually forced to engage in excessive risk just for the chance of a positive return above price inflation.

When there is bubble activity (false prosperity) due to an easy money policy, it is unsustainable.  Some people may feel like they are doing better for a while.  Think of a guy who gets a temporary raise at work, but he doesn’t know it is temporary.  He takes his family on a nice vacation.  But they don’t realize that their new lifestyle is unsustainable.

In the case of bubble activity, it eventually has to stop.  In order to continue the bubble activity, the economy requires an ever-increasing dose of monetary stimulus.  If it keeps coming in bigger doses, you will eventually get runaway inflation.  If the central bank does not keep increasing the dose of stimulus, you will eventually get a correction.

Note that you don’t even have to stop the money creation to get a downturn.  You just need for it not to keep increasing.  But in the case of the United States, the Fed actually stopped QE3 in late 2014.  It has kept the monetary base stable since that time.  Due to this reduction, we should expect to see a major correction, assuming the Fed does not intervene again in a significant way in the short term.

There is always a lag effect.  It takes time for the liquidity to dry up and expose the malinvestment.  Perhaps this is what is starting to take place now.  It is certainly taking place in China, where they are going to get a hard lesson in the Austrian Business Cycle Theory.  I don’t know if they will learn it, but they will certainly experience the major correction of the unsustainable boom in both stocks and real estate.

Not all of the growth of the past 7 years in the U.S. is false.  Technology continues to increase in the face of government intervention.  Computers and other electronics continue to advance.

But we can’t ignore that there has also been significant malinvestment in the U.S. over the last 7 years.  It may not be as bad as China, but it is still significant.

I don’t know if the stock market will rally again before the inevitable correction or if this will continue in the weeks ahead.

I advocate a permanent portfolio setup, which consists of 25% stocks.  You definitely don’t want any more than that right now.  In addition, your bond portion is quite important right now, as a downturn in the economy could lead to even lower interest rates than what we currently have.

The fall in stocks should not be surprising for anyone who understands Austrian economics and the artificial boom/ bust cycle that happens because of government and central bank intervention.

Be prepared for some rough times ahead.  Keeping your main source of income is the most important thing.  Your investments come after that.