God is a Capitalist

Wednesday, September 24, 2014

Swedes help with timing

Anyone not a mainstream economist has recognized the awesome blindness of the profession to the approach of the latest financial crisis and its impotent policies afterwards. I recently finished a book published last year that not only explains why mainstream economics failed but promotes good economics, the Austrian kind, and provides another tool for telling the future.

Thomas Aubrey, the author of Profiting from Monetary Policy and founder of Credit Capital Advisory in the U.K., consults businesses on how credit creation affects global asset prices. Aubrey begins by detailing the devastation of the crisis on pension funds. Not only did many funds lose money in the crisis, but the low interest rate monetary policies intended to restore the economy have inflicted more damage and will lead to many failing in the future. Aubrey doesn’t mention the life insurance industry, but it and millions of retired people are suffering for the same reasons.

Many maladies afflict mainstream economics, including its expulsion of entrepreneurs, time and capital theory. Aubrey focuses on the lack of credit and the fixation on equilibrium:
 The omission of credit from macroeconomic models is both unsurprising, given the intellectual heritage of the new neoclassical synthesis, and shocking, given credit is the life blood of modern capitalism. As two leading monetary economists have pointed out, “there are by construction no banks, no borrowing constraints, and no risks if default, the risk free short term interest suffices to model the monetary side of the economy. As a consequence money or credit aggregates and asset prices play no role in standard versions of these models.” 
Aubrey draws from a lot of sources, one of which is the Bank for International Settlements. Claudio Borio and William White have positioned the BIS to lead international institutions in promoting the credit theory of financial crises. Much of their work agrees with the Austrian business-cycle theory and they occasionally quote Mises and Hayek. But the bulk of Aubrey’s book traces the credit theory of crises created by the Swedish economist Knut Wicksell. Ludwig von Mises distilled Wicksell’s ideas into the Austrian business-cycle theory. Hayek studied the theory under Mises and introduced it to the London School of Economics in the early 1930s. Aubrey thinks another Swedish economist, Gunnar Myrdal, co-winner of the Nobel Prize in economics with Hayek, improved on the theory, but I’m not so sure. He concludes with contributions from another Swede, Axel Leijonhufvud who taught at UCLA.

Aubrey gets a few details of the ABCT wrong and makes some factual errors on Mises’ and Hayek’s theories because he took critics seriously, especially the works of Piero Sraffa and Tyler Cowen. I have read both critics and have found them attacking straw men versions of Mises and Hayek, not the real theories. It’s true that the ABCT is much more difficult than the simplistic theories of mainstream economics, but that is no excuse for smart people like Sraffa and Cowen. Anyone who has casually read Hayek and Mises will understand that Sraffa and Cowen did not. Otherwise they would not have made such obviously false claims.
The errors about Mises and Hayek make me suspicious about how correct Aubrey got Wicksell and Myrdal whom I haven’t read. But I think those errors are a small problem. Don’t them stop you from reading this otherwise excellent book.

My favorite anecdote from the book relates Keynes’ visit to Stockholm in 1936. Keynes titled his speech “My grounds for departure from orthodox economic traditions.” Aubrey wrote, “Unexpectedly for Keynes it was not well received, mainly because the young Swedes thought he was too classical and had not departed much from orthodox economics at all. During the speech the audience struggled to understand what was in fact new, which made Keynes very irritable. According to one of the Swedish economists present:
 It was certainly a remarkable event when the great prophet came to Stockholm pretending that he had seen a new light only to be taken down by the Swedish youngsters – who told him that he was rather old fashioned, that Swedish economists had gone much further and that his, Keynes’ very method, the equilibrium method was unsuitable for the treatment of dynamic problems.
 If only American and British young economists had been so well educated!

Near the end of the book Aubrey introduces his tool for seeing crises coming and using it to guide the investor’s timing of entries into and exits from the stock market. He calls it the Wicksellian differential because Wicksell had argued that when the market rate of interest is lower than the natural rate, credit will expand as people invest in capital goods. Much of that is poorly invested and eventually leads to the crisis. Wicksell theorized that the economy would stay in equilibrium if central banks could keep the market rate close to the natural rate. But Wicksell, Mises, Hayek and most Austrian economists found it difficult to measure the natural rate.

Aubrey makes some simplifying assumptions and determines that he can get reasonably close to the natural rate of interest with the return on the corporate sector’s invested capital. For the market rate, he uses a five-year moving average of government bond yields.

When the gap between the two rates expands and the market rate is lower, the Wicksellian differential signals the launch of an artificial boom. Investors should get into the stock market because much of the new credit will end up there and stock prices will rise. Rising prices will inflate profits, adding to the demand for stocks.

Investors should get out and invest in bonds when the differential shrinks. Such timing would have earned investors an average 8.2% annual return between 1986 and 2011 even though the model would have caused investors to abandon the stock market for bonds between 1996 and 1999 during the blowing of the dot.com bubble. But it would have switched investors to bonds in 2007 before the latest stock market disaster and back into the stock market in 2009 in time for a magnificent rally. Over the same period equities returned just 6.8%. Also, the standard deviation of returns fell from 2.72 for equities and 2.1 for bonds to 1.73 by following the differential.

Aubrey’s Wicksellian differential may not be perfect, but it’s the best effort anyone I know of has made at measuring the natural rate. It’s definitely another tool investors can use to profit from the Fed’s policies instead of being crushed by them as has happened to pension funds.
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