Same Foundations, Different Perspectives

If you have been reading my blog recently then you know my economic view of the world is based on Money Realism. While this provides a good foundation for understanding the monetary system, predictions may vary among its adherents. Simply put, I am slightly more bearish on the US economy than Cullen is.

Cullen points to three improving macro indicators: retail sales, initial jobless claims and manufacturing production. The problem with looking at these indicators is that they are all lagging and only offer the historical trend. One must look at forward looking markets or leading indicators. I asked Cullen if he looks at forward indicators and if they are showing any divergence from the lagging indicators to which he responded:

"My general view is that the macro picture in the USA has not changed in recent weeks and that Mister Market was just having an Ebola and Europe scare…"

It appears Cullen has a sanguine outlook for the US economy but let me tell you what I am seeing...

The bond market is one forward looking indicator and it is predicting low inflation. Lower inflation usually means a lack of demand in the economy and entails an extension of the accommodative monetary policy set by the Fed. In other words this lowers the probability of interest rate increases in the future.

Note the sharp drop in the back end of the US inflation curve over recent months

Another forward looking indicator is US residential construction investment which is slowing:

dynamics in housing not posive, in UK as well as in US ...hope for the best, but https://t.co/GYvmQXlxaV pic.twitter.com/OcWNIDndvf
— Aurelija Augulyte (@auaurelija) October 8, 2014

Finally, the collapse in oil prices is telling you that the global economy is stagnating and that inflation is not likely to be a concern in the short to medium term (lower inflation = economy not operating at full capacity):

The other reason the US economy will slow in the short-medium term is that a significant part of the US economic recovery has been driven by fixed capital investment in the oil and gas industry. With oil prices falling, we are likely to see less investment activity. It depends how much further oil prices fall, but WTI would need to fall below $80 before we start seeing projects suspended.

Of course falling oil prices are also beneficial to US consumers who will be paying less to fill up their cars. It is often remarked that a falling oil price is like a tax cut for consumers who will now have higher discretionary incomes. The falling oil price is a mixed bag for growth but inflation is definitely less of a problem in the short-term.

There are other macro risks including geopolitics and further strength in the USD, which would slow down the US recovery. Until those risk scenarios materialise, the US economy should continue to heal albeit at a slower pace. The Fed is unlikely to increase rates until wages begin to rise and inflation becomes a clear problem. Given the perception of a fragile recovery, the Fed will be reluctant to raise the Fed Funds Rate/IOER early. I do not see the Fed increasing interest rates in the first half of 2015 and are now less likely to hike rates in the second half of 2015.

To summarise:

• Forward looking indicators are warning that the US economy's momentum is slowing along with the global economy
• Inflation less of a concern given market expectations and falling oil prices
• Deflationary forces will prevent the Fed from increasing interest rates in the first half of 2015

EDIT: In April 2015, Cullen Roche agrees that the US economy "appears to be softening" and it "would be wise to wait on rate increases".

Review of Past Predictions

In my previous post, Mea Cupla, I discussed my new economic framework built on Money Realism with influences of Behavioural Economics, Post-Keynesian economics, some Austrian Economics (malinvestments) and a few others. Now it is time to review ALL my past prediction and make forecasts on what lies ahead using my new economic framework.

Anyway let's go back and review my posts:

First we have "Downfall of the US Empire". In this post I rebuke the debt incurred by the US in addition to "printing money" and QE. The error made in this post was to only focus only on the liability side of the US balance sheet and not the asset side. The US is the most productive and innovative economy in the world. Additionally, the US government has trillions of dollars worth of land and natural resource assets. When this is considered, the debt can easily be repaid. On a more technical note, the US government can avoid bankruptcy or default by monetising its debt. Therefore the debt is not a problem and neither is QE. The main limitation on endless government borrowing is inflation not the debt itself.

The next economic article I wrote was one entitled "Asset Bubbles" in February 2010. I recognised that asset bubbles are driven by irrationality, which aligns well with my current view of understanding behavioural biases when analysing the economy. I then write about property bubbles and predict Sydney's property market will crash. While I still think the Australian property market is prone to a correction. I no longer think a crash is likely given the government imposed supply constraints and because the RBA can still cut interest rates or even purchase RMBS to ease the supply of credit for mortgages. But what is the difference between a correction and a crash? I'm going to use the same loose definitions of both as they apply to the stock market. A correction is a decline of 10% and a crash is a rapid decline in a short period of time. Let's say a crash is 20% or more.

I then go on to identify China as a bubble, which I still think is true given the enormous expansion of credit used to fund unproductive investments. The main lesson to learn from this post is that when price deviates from its long-term average, it cannot be said that there is a bubble. There may be legitimate fundamental factors driving prices and as long as that does not change, prices will remain elevated. This is not true for China because even though they will be a powerhouse economy of the future, no economy is immune to a bust following a massive credit boom. You can read about my dire predictions on the Chinese economy here.

2012 Articles

The next post I wrote is in February 2012 on fiscal policy. I criticise government borrowing and cite a few reasons why. The primary claim I make is government borrowing crowds out private sector borrowing. This is only true when the economy is booming, bond yields are rising and inflation is a problem. More government borrowing in this scenario would put upward pressure on interest rates economy wide. My original claim was wrong in normal times but correct when inflation is high.

In July 2012, I wrote about why we want a stronger currency. Ultimately we should not want a strong or a weak currency but one that reflects the fundamentals. Now obviously that is as ambiguous as it comes in economics. But the main point is that a strong currency will hurt domestic exporters while consumers will benefit from cheaper imports. Conversely, a weak currency will boost exports but foreign imports will be expensive. Central banks are conflicted on this topic because a strong currency will reduce imported inflation while reducing employment in export industries and vice-versa with a weak currency. Trying to stimulate the economy by purposely weakening the currency is ineffective as Japan has recently found out (research from GS).

In August 2012, I wrote about how banks feed off inflation. This is probably the best example of my incorrect understanding of the monetary system. I explicitly reference the money multiplier when talking about fractional reserve banking. What's funny is that the conclusions about banks needing inflation to generate increasing profits are correct. If the money supply contracts because people are repaying loans, then the interest income banks receive decline, which will impact their profits. The main point is that we have a credit based monetary system that requires inflation or else the system implodes in a deflationary spiral. Hence why central banks are terrified by the prospect of deflation.

2013 Articles

Moving along to March 2013 when I wrote an article gloomily entitled, "The Keynesian Endgame". But wait till you read the first sentence: "I absolutely despite the Keynesian school of economic thought." I can only shake my head at this ridiculous diatribe. Having actually read Keynes, he's not as bad as the Austrians portray him to be. While the vilification of Keynes was gratuitous, I still believe the crux of the article. The main message is - the current debt-laden world is unsustainable. I'll address this point in the months ahead.

In June 2013 I wrote an article provocatively titled, "Apocalypse Now", in which I outline the main risks I see for the Australian economy. This article was light on theory so there's not much revision here except for my comments on Japan. Obviously QE is not inflationary for the general price level in the economy. It could be said that QE results in asset price inflation but that's not inflation in the traditional sense of the word. I still retain my bearish bias on the Chinese economy which you can read about here. I later mention the main risks to the global economy which is still 100% valid today:

"There are also known unknowns (as Donald Rumsfeld likes to say), which include terrorism, global health pandemic (watch the movie Contagion), natural disasters, wars, government policies (QE, protectionist trade and capital policies)."

This year we've seen the war in Ukraine and in Iraq with ISIS. Then there's the global health pandemic of 2014 - ebola. Thus far the markets seems to be shrugging off these risks. But it only takes a slight escalation in the spread of ebola for example, before the market rapidly reprices risk to the detriment of asset valuations. I still believe the following prediction made in June 2013 will eventuate:

"My predictions: base case rates go lower in Australia to 2% and in combination with the lower AUD (70c-80c) causes the economy to re-leverage. Worst case scenario is an implosion in Asia due to any of the factors mentioned above, will cause rates to go to zero in Australia and the AUD to go sub 50c as commodity prices collapse and the high unemployment prevents credit growth from occurring.  It’s difficult to see any bullish scenario simply because “we’ve been there and done that” for a few years now."

The next post I want to look at is one entitled "Escape is Impossible" in December 2013. Back then I realised that QE from the Fed was largely ineffective, albeit for the wrong reasons. This is the post where I start getting more things right than wrong.


There you have it. A  quick review of my past posts and what I missed or got right. It's difficult to believe that for years I had been operating under a flawed economic model, leading to erroneous conclusions. While I have updated my knowledge, most economists still don't understand the monetary system an in particular the concept of endogenous money. It will only be a matter of time before they change their views (I hope) because their predictions will be consistently wrong.

Updated Predictions and Forecasts

As promised, here is a summary of my updated forecasts and theories:

• US does not have a debt crisis due to enormous asset side of balance sheet
• Australian property market likely to fall at least 10% as economy enters recession by 2016 (same as before)
• China will crash by 2016 (same as before)
• Government borrowing does not reduce business borrowing (most of the time)
• Engineering a weaker currency through monetary policy is not a path to sustainable economic growth
• Keynesian policies such as deficit expanding tax cuts or infrastructure investments are beneficial during a recession 
• The reason why high inflation won't occur is because credit growth is demand driven (as MR states) and as we've seen over the years in the US, Europe and Japan, lower interest rates have not engendered credit growth
• Basically more debt in the system results in less growth because interest must be paid from income (Post-Keynesian theory of financialisation of the economy), which means less disposable income
• Deflation is occurring across the world but could be one or a combination of many reasons including: the accumulation of private sector debt, demographic trends, globalisation or income/wealth inequality (Post-Keynesian reason)

Mea Culpa

"When the facts change, I change my mind. What do you do, sir?" - Unknown quote

Rebuilding the model

Part of the learning process is acknowledging the limitations of your understandings and when a better theory or model of the world is developed then one must reject any contradictory models or theories. I say this because a year ago you could have described my economics views as Austrian, with little tolerance for government intervention. Whether it be regulations, taxes or spending - the less the better.

That changed towards the end of 2013 after I learned that the Austrian model of banking and money is inaccurate when applied to the current monetary system (it may have been accurate decades ago). Further doubts arose as I learned more about cognitive bias and behavioural economics/finance. These realisations invalidated my economic view of the world and I began to question everything including: if free markets were really the best way to allocate resources? and does government have a role to play during recessions? But I first had to address how I came to be so wrong in the first place.

I looked at my economic education sources: Mises.org, ZeroHedge, Peter Schiff etc. What do they all have in common? All have a strong libertarian political bias and hence also share a pro-free market or Austrian economic view. I couldn't believe it, I had fallen for confirmation bias. My own libertarian political bias had guided me to embrace an economic school of thought which supported absolutely free markets with little room for government intervention. I knew that any cognitive bias distorts one's perception of reality and if I wanted to know how the economy really operates, I would need to research other economic theories and schools of thoughts objectively.

Like a phoenix rising from the ashes, a new model is born.

I started my post-Austrian economic journey when I discovered Modern Monetary Theory (MMT) and Money Realism (MR). At first their theories sounded heretical. They were saying things like the government can never default and that bank loans create bank deposits. Like any objective critical thinker, I learned more about it and found their monetary model to be a more accurate portrayal of the current monetary and banking system than any Austrian model.

Earlier this year, the Bank of England released a paper (highly recommended reading to understand money creation and QE) explaining the monetary system, which matched the model portrayed in MMT and MR. It also means that it punches holes in Austrian theory with conclusions such as:

• Banks don't rely on deposits to create loans
• Savings that are deposited in a bank do nothing for the economy. Hence savings deposited at a bank or what Keynes described as "liquid assets", results in less economic activity
• A central bank conducting QE is not the same as the "money printing" in Zimbabwe or Weimar Germany

I still think the Austrians have a lot right about high levels of government intervention harming the economy and their theory of malinvestment has some merit. But their monetary model (loanable funds model) needs to be discarded to reflect the current reality. In response to these claims, Austrians retort that they describe the real economy and not the fiat/nominal/accounting economy. This may be true, but at least acknowledge that the loanable funds model (people save and then banks lend those savings out) embedded in Austrian Capital Theory is utterly wrong.

So what are my general beliefs and views now? After being intellectually burned on Austrian theory, I've become a strong proponent of objectivity and observation rather than developing a theory and then imposing it on the world. In Nassim Taleb's book Antifragile, he discusses this thought process and classifies it as phenomenology. Simply put: don't worry about the theory, just know what works.

Much of mainstream economics is influenced by political bias and therefore any accurate economic school of thought must be apolitical. Given this premise, I was forced to reject MMT because they are tainted by a strong left-wing political ideology which favours pervasive government intervention. This leaves MR which explicitly states its focus on the "operational realities of the current monetary system". Political decisions are left to others and have no place in MR. As nerdy as this sounds, I fell in love with this principle.

You can learn about Money Realism at pragcap.com run by the wonderful and erudite Cullen Roche.

What are my current economic thoughts?

I think everything that MR claims is true when compared to all other economic schools of thought. Cullen does a fantastic job of comparing the other economic schools here and here.

One of the important tenets of MR is that we are all irrational and thus, markets are not as efficient as we believe (you probably already knew that). This does not imply free market capitalism should be rejected. It just means pure capitalism is not the ideal outcome for the economy.

Government intervention can be a net benefit to the economy in a recession if done correctly. There is a fine line between allowing an unsustainable boom or bubble to deflate and preventing a potential depression. Policy makers must not prop up inefficient businesses if they are the by-product of poor decisions by investors (similar to the Austrian malinvestment theory).

I also place a lot of value on cognitive bias and behavioural economics/finance. It explains everything from booms/busts (herd mentality and loss aversion) to people claiming the data is manipulated to show no inflation (confirmation bias and just batshit crazy).

I also have incorporated the main idea of Antifragile by Nassim Taleb, describing things that become stronger (antifragile) not weaker (fragile) after being temporarily exposed to a stressor.

Cannot recommend this book highly enough!

An economy is just the aggregate of people's spending decisions and because of behavioural biases like overconfidence and the herd mentality, excesses can accumulate in the system. Without the full impact of a recession, risk taking will become irrational as investors expect fiscal and monetary stimulus to limit their losses (moral hazard). This is similar to Minsky's Financial Instability Hypothesis which states stability creates instability. In layman's terms, the more stable the economy, the more risk taking which results in future instability. Again you can see the influences of behavioural economics with overconfidence etc.

This is the main reason I strongly believe a recession should be allowed to run its course. After a recession, the system becomes stronger as the weakest businesses are liquidated and the factors of production that were previously used inefficiently are now reallocated to the strongest and more efficient businesses. The government can support unemployed people through welfare and can stimulate economic activity but cutting taxes and allowing the deficit to increase. These measures must be taken ONLY after the unsustainable excesses and malinvestments of the boom are liquidated.

What lies ahead...

Now that I have a better understanding of the reality of the banking system, it's time to update my predictions. My own view is that all developed economies are sinking into Japanese style debt deflation. The conventional monetary policy is that lowering interest rates encourages more borrowing which is then spent on investment by businesses and consumption by households. Implicit in this theory is that we can reduce the severity of recessions and the economy will grow forever. Is that possible? Can we just always lower interest rates and the economy keeps on chugging along to new heights? Remember that old phrase when someone tries to convince you that some form of government intervention makes everyone a winner, there's no free lunch in economics. There are other confounding factors such as demographic trends, inequality and technological progress fuelling the deflationary trend which I will discuss in future posts.

But that's it for now. In the next post I will be reviewing my past predictions and updating my forecasts for the future using my current and more accurate understanding of economics and finance.