The Great Gatsby and the Fed Mises, by Louis Rouanet

Even the most innocent novel can give its reader a fresh perspective on the economy during the author’s time. Economic writings and economic conditions often inspired great writers who, in turn, allowed us to contemplate either a glimpse or a detailed picture of economic reality. Stendhal was influenced by Malthus, Flaubert by Bastiat, and Ayn Rand by Mises. Other novelists faithfully described the economic times of their lives. Émile Zola, for instance, brilliantly accounts for the French 1882 financial crisis in his novel L’Argent (1891) and unconsciously exhibits the evils of fractional reserve banking.

Just as Zola’s L’Argent, so too F. Scott Fitzgerald’s The Great Gatsby (1925) is a product of the business cycle. Some have interpreted Fitzgerald’s novel as an indictment against capitalism. It is not. It has been said that Gatsby is a product of alcohol prohibition, but Gatsby is also the unfortunate product of the Federal Reserve’s expansionist monetary policy. The “constant flicker” of the American life described by Fitzgerald in his celebrated novel is no less than the artificial boom driven by the Fed during the roaring twenties.

Inequality and the Fed during the Twenties

The Franco-Irish economist Richard Cantillon was among the first to notice the redistributive effects of monetary creation. Cantillon observed that the first to receive the newly created money saw their incomes rise whereas the last to receive the newly created money saw their purchasing power decline as consumer price inflation came about.

Under modern central banking, money is created and injected into the economy through credit on financial markets. Thus, the economics of Cantillon effects tells us that financial institutions benefit disproportionately from money creation, since they can purchase more goods, services, and assets for still relatively low prices.

One of the most visible consequences of this growth of financial markets triggered by monetary expansion is asset price inflation. Increases in asset prices will mainly benefit the wealthy for several reasons. First, the wealthy tend to own more financial assets than the poor in proportion to income. As the wealthy’s net worth increases, securities with continuously rising prices can be used as collateral for new loan requests. Second, it is easier for the richest individuals to contract debt in order to buy financial assets that can be sold later at a profit. Since credit-easing lowers the interest rate and therefore funding costs, the profits made by selling inflated assets bought on credit will be even greater. Finally, asset price inflation coming with the growth of financial markets will benefit the workers, managers, traders, etc., in the financial sector.

Not surprisingly, the development of ostentatious wealth and extreme inequality is one of the main themes in The Great Gatsby — which was published and written during the boom that would finally lead to the Great Depression. In his bestseller on the causes of the “Great Crash” of 1929 and the subsequent Great Depression in the United States, John K. Galbraith mentions “the bad distribution of income” as the first of “five weaknesses which seem to have had an especially intimate bearing on the ensuing disaster.” The cause of this rising inequality is to be found in asset price inflation.

The responsibility of the Fed in the asset price bubble of the 1920s cannot be doubted. Indeed, as late as 1927, Benjamin Strong, who was then governor of the Fed, told the French economist Charles Rist that he was going to give “a little coup de whiskey to the stock market.” Similarly, the former chairman of the Fed, Marriner S. Eccles, points to the rising inequality financed by credit expansion during the 1920s, when, “as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.”


 Money in The Great Gatsby is either inherited or derives from the mysteries of high finance or comes from crime or is made on the sports field. Involuntarily, Fitzgerald unfolds the Cantillon effect before our eyes. Indeed, the artificially stimulated financial sector, Fitzgerald shows, creates a distinctive geography and urban space. Whereas Manhattan and Long Island benefit from the redistributive effects of money production by the Fed and the Wall Street banks, the rest of America suffers from them. Thus, in the first chapter of the book, Nick Carraway explains that “Instead of being the warm center of the world, the Middle West now seemed like the ragged edge of the universe — so I decided to go East and learn the bond business.” Under central banking, money is first of all where it is artificially produced rather than in the hands of the most talented entrepreneurs. Nick followed the money.

Easy Money and Consumerism

The Great Gatsby describes a society that had gone beyond industrialism to become driven by leisure and consumption. But this too was at least partially caused by the Fed’s policies. As Dr. Guido Hülsmann writes in The Ethics of Money Production (p.187): “The spiritual dimension of these inflation-induced habits seems obvious. Money and financial questions come to play an exaggerated role in the life of man. Inflation makes society materialistic.”

No surprise then that the romance between Gatsby and Daisy is fashioned by materialistic concerns. Daisy’s love for Gatsby is conditioned by his great wealth. Daisy’s emotions are “materialistic”:

Suddenly, with a strained sound, Daisy bent her head into the shirts and began to cry stormily.

“They’re such beautiful shirts,” she sobbed, her voice muffled in the thick folds. “It makes me sad because I’ve never seen such — such beautiful shirts before.”

Consumerism is a function of monetary inflation because easy money policies create the illusion of wealth and thus lead individuals to consume more than they would otherwise. Because consumption increases, the capital stock will decline and society will ultimately be poorer than it would have been. This naturally leads us to depict the cultural consequences of easy money which are so visible in The Great Gatsby.

The Cultural Consequences of Inflation

The cultural effects of inflation have perhaps never been clearer than during the 1920s. As H.L. Mencken writes in 1925 in his review of The Great Gatsby, “To find a parallel for the grossness and debauchery that now reign in New York one must go back to the Constantinople of Basil I.” Mencken then adds with typical wit and gusto:

The thing that chiefly interests the basic Fitzgerald is still the florid show of modern American life — and especially the devil’s dance that goes on at the top. He is unconcerned about the sweatings and sufferings of the nether herd; what engrosses him is the high carnival of those who have too much money to spend, and too much time for the spending of it. Their idiotic pursuit of sensation, their almost incredible stupidity and triviality, their glittering swinishness — these are the things that go into his notebook.

By meddling with money, the Fed created an illusion of wealth and contributed to the creation of an all-pervasive world of illusion. It is Paul Cantor, that patron saint of Austrian literary criticism, who has noticed the link between inflation and the distortion of reality. Under fiat money, reality is confused with illusion and inauthenticity becomes a prevalent trait among the people. As Paul Cantor writes:

In a paper money economy, one does not see gold anymore, but the currency gives the illusion of the presence of wealth. The increasingly mediated character of the modern economy, especially the development of sophisticated financial instruments, allows the government to deceive its people about the nature of its monetary policy. When a government tries to clip coins or debase a metal currency, the results are readily apparent to most people. By contrast, the financial inter-mediation involved in modern central banking systems helps to shroud monetary conditions in mystery.

This inauthenticity of the characters in The Great Gatsby is obvious. From the beginning, everyone is speculating about Gatsby’s true identity. “Somebody told me they thought he killed a man once” says one; “it’s more that he was a German spy during the war” answers another. Gatsby himself lies about the fact that he was educated at Oxford. Worse, Daisy’s love for Gatsby is revealed to be phony as she finally realizes that her allegiance is with her husband Tom.

For the reader who knows his monetary history, nothing is clearer in The Great Gatsby than the cultural decline for which the artificial inflation of the money supply is responsible. Central banking, today as in the 1920s, led formerly good Americans to lie, commit fraud, and desert hard work. As Nick Carraway narrates the first night he goes to Gatsby’s mansion:

I was immediately struck by the number of young Englishmen dotted about, all well dressed, all looking a little hungry, and all talking in low, earnest voices to solid and prosperous Americans. I was sure that they were selling something: bonds or insurance or automobiles. They were at least agonizingly aware of the easy money in the vicinity and convinced that it was theirs for a few words in the right key.

In an inflationary environment, one must dream of becoming an overnight success because the slow steady way of amassing a fortune by working hard simply will not work. Hard-working people are systematically screwed. George Wilson, the garage owner and the figure of the hard-working American is, with Gatsby himself, the great loser of the novel. Not only is his wife Tom Buchanan’s mistress but she ends up dead. In The Great Gatsby, the Cantillon effect holds true even for love and women. Fitzgerald, however, somehow anticipated the bust that inevitably follows the boom. Gatsby dies. Nick returns to the Middle West.

One disappointing aspect of The Great Gatsby is the lack of contrast between the nouveaux riches who got wealthy thanks to fraud and financial speculation and the entrepreneurially talented bourgeoisie. This contrast, for instance, was made much clearer in Émile Zola’s book L’Argent. In Fitzgerald’s world, on the other hand, all the rich people are immoral and disgusting creatures. To this extent, Zola was much more successful, more than 30 years before Fitzgerald, in accounting for the corruption of entrepreneurial values and the debauchery caused by modern finance under fractional reserve banking and central banking.

One reason why Fitzgerald was incapable of elucidating different categories of rich was his insensitive ignorance of the financial sector itself. Contrary to Garet Garett’s novel The Driver (1922) which precisely describes the inner workings of the financial sector, Fitzgerald is sloppy and particularly unknowledgeable when it comes to describing the stock market. Thus, there probably is a germ of truth when Mencken writes that The Great Gatsby is “no more than a glorified anecdote, and not too probable at that.” Nonetheless, the moral decay on display in Fitzgerald’s novel serves, not merely as titillation for the reader, but as an object lesson in the evils of both central banking and prohibition.

Inequality vs Inequality. NASSIM N TALEB

There is inequality and inequality.

The first is the inequality people tolerate, such as one’s understanding compared to that of people deemed heroes, say Einstein, Michelangelo, or the recluse mathematician Grisha Perelman, in comparison to whom one has no difficulty acknowledging a large surplus. This applies to entrepreneurs, artists, soldiers, heroes, the singer Bob Dylan, Socrates, the current local celebrity chef, some Roman Emperor of good repute, say Marcus Aurelius; in short those for whom one can naturally be a “fan”. You may like to imitate them, you may aspire to be like them; but you don’t resent them.

The second is the inequality people find intolerable because the subject appears to be just a person like you, except that he has been playing the system, and getting himself into rent seeking, acquiring privileges that are not warranted –and although he has something you would not mind having (which may include his Russian girlfriend), he is exactly the type of whom you cannot possibly become a fan. The latter category includes bankers, bureaucrats who get rich, former senators shilling for the evil firm Monsanto, clean-shaven chief executives who wear ties, and talking heads on television making outsized bonuses. You don’t just envy them; you take umbrage at their fame, and the sight of their expensive or even semi-expensive car trigger some feeling of bitterness. They make you feel smaller.

There may be something dissonant in the spectacle of a rich slave.

The author Joan Williams, in an insightful article, explains that the working class is impressed by the rich, as role models. Michèle Lamont, the author of The Dignity of Working Men, whom she cites, did a systematic interview of blue collar Americans and found present a resentment of professionals but, unexpectedly, not of the rich.

It is safe to accept that the American public –actually all public –despise people who make a lot of money on a salary, or, rather, salarymen who make a lot of money. This is indeed generalized to other countries: a few years ago the Swiss, of all people almost voted a law capping salaries of managers . But the same Swiss hold rich entrepreneurs, and people who have derived their celebrity by other means, in some respect.[ii]

Further, in countries where wealth comes from rent seeking, political patronage, or what is called regulatory capture (by which the powerful uses regulation to scam the public, or red tape to slow down competition), wealth is seen as zero-sum. What Peter gets is extracted from Paul. Someone getting rich is doing so at other people’s expense. In countries such as the U.S. where wealth can come from destruction, people can easily see that someone getting rich is not taking dollars from your pocket; perhaps even putting some in yours. On the other hand, inequality, by definition, is zero sum.

In this chapter I will propose that effectively what people resent –or should resent –is the person at the top who has no skin in the game, that is, because he doesn’t bear his allotted risk, is immune to the possibility of falling from his pedestal, exiting the income or wealth bracket, and getting to the soup kitchen. Again, on that account, the detractors of Donald Trump, when he was a candidate, failed to realize that, by advertising his episode of bankruptcy and his personal losses of close to a billion dollars, they removed the resentment (the second type of inequality) one may have towards him. There is something respectable in losing a billion dollars, provided it is your own money.

In addition, someone without skin in the game –say a corporate executive with upside and no financial downside (the type to speak clearly in meetings) –is paid according to some metrics that do not necessarily reflect the health of the company; these (as we saw in Chapter x) he can manipulate, hide risks, get the bonus, then retire (or go to another company) and blame his successor for the subsequent results.

We will also, in the process, redefine inequality and put the notion on more rigorous grounds. But we first need to introduce the difference between two types of approaches, the static and the dynamic, as skin in the game can transform one type of inequality into another.

Take also the two following remarks:

True equality is equality in probability


Skin in the game prevents systems from rotting

The Static and the Dynamic

Visibly, a problem with economists (particularly those who never really worked in the real world) is that they have mental difficulties with things that move and are unable to consider that things that move have different attributes from things that don’t –it may be trivial but reread Chapter [3] on IYIs if you are not convinced. That’s the reason complexity theory and fat tails are foreign to most of them; they also have (severe) difficulties with the mathematical and conceptual intuitions required for deeper probability theory. Blindness to ergodicity which we will define a few paragraphs down, is indeed in my opinion the best marker separating a genuine scholar who understands something about the world, from an academic hack who partakes of a ritualistic paper writing.

Let us make a few definitions:

Static inequality is a snapshot view of inequality; it does not reflect what will happen to you in the course of your life

Consider that about ten percent of Americans will spend at least a year in the top one percent and more than half of all Americans will spent a year in the top ten percent[1]. This is visibly not the same for the more static –but nominally more equal –Europe. For instance, only ten percent of the wealthiest five hundred American people or dynasties were so thirty years ago; more than sixty percent of those on the French list were heirs and a third of the richest Europeans were the richest centuries ago. In Florence, it was just revealed that things are really even worse: the same handful of families have kept the wealth for five centuries.[iii]

Dynamic (ergodic) inequality takes into account the entire future and past life

You do not create dynamic equality just by raising the level of those at the bottom, but rather by making the rich rotate –or by forcing people to incur the possibility of creating an opening.

The way to make society more equal is by forcing (through skin in the game) the rich to be subjected to the risk of exiting from the one percent

Or, more mathematically

Dynamic equality assumes Markov chain with no absorbing states

Our condition here is stronger than mere income mobility. Mobility means that someone can become rich. The no absorbing barrier condition means that someone who is rich should never be certain to stay rich.

Now, even more mathematically

Dynamic equality is what restores ergodicity, making time and ensemble probabilities substitutable

Let me explain ergodicity –something that we said is foreign to the intelligentsia; we will devote an entire section as we will see it cancels most crucial psychological experiments related to probability and rationality. Take a cross sectional picture of the U.S. population. You have, say, a minority of millionaires in the one percent, some overweight, some tall, some humorous. You also have a high majority of people in the lower middle class, school yoga instructors, baking experts, gardening consultants, spreadsheet theoreticians, dancing advisors, and piano repairpersons. Take the percentages of each income or wealth bracket (note that income inequality is flatter than that of wealth). Perfect ergodicity means that each one of us, should he live forever, would spend the proportion of time in the economic conditions of segments of that entire cross-section: out of, say, a century, an average of sixty years in the lower middle class, ten years in the upper middle class, twenty years in the blue collar class, and perhaps one single year in the one percent. (Technical comment: what we can call here imperfect ergodicity means that each one of us has long term, ergodic probabilities that have some variation among individuals: your probability of ending in the one percent may be higher than mine; nevertheless no state will have a probability of zero for me and no state will have a transition probability of one for you).

The exact opposite of perfect ergodicity is an absorbing state. The term absorption is derived from particles that, when they hit an obstacle, get absorbed or stick to it. An absorbing barrier is like a trap, once in, you can’t get out, good or bad. A person gets rich by some process, then having arrived, as they say, he stays rich. And if someone enters the lower middle class (from above); he will never have the chance to exit from it and become rich should he want to, of course –hence will be justified to resent the rich. You will notice that where the state is large, people at the top tend to have little downward mobility –in such places as France, the state is chummy with large corporations and protects their executives and shareholders from experiencing such descent; it even encourages their ascent.

And no downside for some means no upside for the rest.

Take for now that an absorbing state –staying rich –causes path dependence, the topic of Part X.

Pikketism and the Revolt of the Mandarin Class

There is a class often called the Mandarins, after the fictional memoirs of the French author Simone de Beauvoir, named after the scholars of the Ming dynasty that gave their name to the high Chinese language. I have always been aware of its existence, but its salient –and pernicious –attribute came to me while observing the reactions to the works by the French economist Thomas Pikkety.

Pikkety followed Karl Marx by writing an ambitious book on Capital. I received the book as a gift when it was still in French (and unknown outside France) because I found it commendable that people publish their original, nonmathematical work in social science in book format. The book, Capital in the 21st Century, made aggressive claims about the alarming rise of inequality, added to a theory of why capital tended to command too much return in relation to labor and how absence of redistribution and dispossession would make the world collapse. The theory about the increase in the return of capital in relation to labor was patently wrong, as anyone who has witnessed the rise of what is called the “knowledge economy” (or anyone who has had investments in general) knows. But there was something far, far more severe than a scholar being wrong.

Soon, I discovered that the methods he used were flawed: Picketty’s tools did not show what he purported about the rise in inequality. I soon wrote two articles, one in collaboration with Raphael Douady that we published in Physica A: Statistical Mechanics and Applications, about the measure of inequality that consists in taking the ownership of, say the top 1% and monitoring its variations. The flaw is that if you take the inequality thus measured in Europe as a whole, you will find it is higher than the average inequality across component countries; the bias increases in severity with extreme processes. The same defect applied to the way inequality researchers used a measure called Gini coefficient, and I wrote another paper on that. All in all, the papers had enough theorems and proofs, to make them about as ironclad a piece of work one can have in science; I insisted on putting the results in theorem form because someone cannot contest a formally proved theorem without putting in question his own understanding of mathematics.

The reason these errors were not known was because economists who worked with inequality were not familiar with… inequality. Inequality is the disproportion of the role of the tail –rich people were in the tails of the distribution.[2] The more inequality in the system, the more the winner-take-all effect, the more we depart from the methods of tin-tailed Mediocristan in which economists were trained. Recall that the wealth process is dominated by winner-take-all effects, the type described in The Black Swan. Any form of control of the wealth process –typically instigated by bureaucrats –tended to lock people with privileges in their state of entitlement. So the solution was to allow the system to destroy the strong, something that worked best in the United States.

The problem is never the problem; it is how people handle it. What was worse than the Piketty flaws was the discovery of how that Mandarin class operates. They got so excited by the rise of inequality that their actions were like fake news. Economists got so excited they praised Piketty for his “erudition” from his discussing Balzac and Jane Austen, the equivalent to hailing as a weightlifter someone seen carrying a briefcase. And they completely ignored my results –and when they didn’t, it was to declare that I was “arrogant” (recall that the strategy of using theorems is that they can’t say I was wrong, so they resorted to “arrogant” which is a form of scientific compliment). Even Paul Krugman who had written “if you think you’ve found an obvious hole, empirical or logical, in Piketty, you’re very probably wrong. He’s done his homework!”[iv], when I pointed out the flaw to him, when I met him in person, evaded it –not necessarily by meanness but most likely because probability and combinatorics eluded him, by his own admission.

Now consider that the likes of Krugman and Piketty have no downside in their existence –lowering inequality brings them up in the ladder of life. Unless the university system or the French state go bust, they will continue receiving their paycheck. Donald Trump is exposed to the risk of ending having his meals in a soup kitchen; not them.

Cobbler Envies Cobbler

Envy does not travel long distance, or across so many social classes. The envy-driven feelings that usually –as we saw in the works of Williams and Lamont –do not originate from the impoverished classes, concerned with the betterment of their condition, but with that of the clerical class. Simply, it looks like it is the university professors (who have arrived) and people who have permanent stability of income, in the form of tenure, governmental or academic, who bought heavily in the argument. From the conversations, I became convinced that these people who counterfactual upwards (i.e. compare themselves to those richer) wanted to actively dispossess the rich. As will all communist movements, it is often the bourgeois or clerical classes that buy first into the argument.[1]

Aristotle, in his Rhetoric postulated that envy is something you are more likely to encounter in your own kin: lower classes are more likely to experience envy towards their cousins or the middle class than towards the very rich. The expression Nobody is a prophet in his own land making envy a geographical thing (mistakenly thought to originate with Jesusουδείς προφήτης στον τόπο του in Luke and a similar expression in Mark) originates with that passage in the Rhetoric. Aristotle himself was building on Hesiod’s: cobbler envies cobbler, carpenter envies carpenter. Later, La Bruyere wrote jealousy is found within the same art, talent and condition.

So I doubt Piketty bothered to ask blue-collar Frenchmen what they want, as Lamont did. I am certain that they would ask for a new dishwasher, or faster train for their commute, not to bring down some rich businessman invisible to them. But, again, people can frame questions and portray enrichment as theft, as it was before the French Revolution, in which case the blue-collar class would ask, once again, for heads to roll.[2]

[1] “τὸ συγγενὲς γὰρ καὶ φθονεῖν ἐπίσταται.”, Rhetoric 1388a, citing originally from Aeschylus, frag. 304.

[2] La Bruyere: L’émulation et la jalousie ne se rencontrent guère que dans les personnes du même art, de même talent et de même condition.

Data, Shmata

Another lesson from Piketty’s ambitious volume: it was loaded with charts and tables. But what we learn from professionals in the real world is that data is not necessarily rigor. One reason I –as a probability professional –left data out of The Black Swan (except for illustrative purposes) is that it seems to me that people flood their story with numbers and graphs in the absence of logical argument. Further, people mistake empiricism with flood of data. Just a little bit of significant data is needed when one is right, particularly when it is disconfirmatory empiricism, or counterexamples for rules: only one point is sufficient to show that Black Swans exist.

Probability, statistics, and data science are principally logic fed by observations –and absence of observations. For many environments, the relevant data points are those in the extremes; these are rare by definition; and it suffices to focus on those few but big to get an idea of the story. If you want to show that a person is richer than, say $10 million, all you need is show the $50 mil in his brokerage account, not, in addition, list every piece of furniture in his house, including the $500 painting he has in his study and a count of the silver spoons in his pantry. So I’ve discovered, with experience, that when you buy a thick book with tons of graphs and tables used to prove a point, something is alarmingly suspicious. It means something didn’t distil right! But for the general public and those untrained in statistics, such tables appear convincing –another way to substitute the true with the complicated. For instance, the science journalist Steven Pinker did that with his book, The Better Angels of Our Nature, concerning the decline of violence in modern human history. My collaborator Pasquale Cirillo and I, when we put his “data” under scrutiny, found out that that either he didn’t understand his own numbers (actually, he didn’t), or he had a story in mind and kept adding charts not realizing that statistics isn’t about data but distillation, rigor and avoiding being fooled by randomness –but no matter, the general public of IYI colleagues found it impressive for a while.

Ethics of Civil Service

People who like bureaucracies and the state have trouble understanding that having rich people in a public office is very different from having public people become rich –again it is the dynamics, the sequence that matters. Rich people in public office have shown some evidence of lack of total incompetence –success may come from randomness, of course, but we at least have a hint of some skill in the real world, some evidence that the person has dealt with reality. This is of course conditional of the person having had skin in the game –and it is better if the person felt a blowup, has experienced at least once the loss part of his or her fortune and the angst associated with it.

A good rule for society is to oblige those who start in public office to pledge never subsequently to earn from the private sector more than a set amount; the rest should go to the taxpayer. This will ensure sincerity in, literally, “service” — where employees are supposedly underpaid because of their emotional reward from serving society. It would prove that they are not in the public sector as an investment strategy: you do not become a Jesuit priest because it may help you get hired by Goldman Sachs later, after your eventual defrocking –given the erudition and the masterly control of casuistry generally associated with the Society of Jesus.

Currently, most civil servants tend to stay in civil service –except for those in delicate areas that industry controls: the agro-alimentary segment, finance, aerospace, anything related to Saudi Arabia…

Currently, a civil servant can make rules that are friendly to an industry such as banking — and then go off to J.P. Morgan and recoup a multiple of the difference between his or her current salary and the market rate. (Regulators, you may recall, have an incentive to make rules as complex as possible so their expertise can later be hired at a higher price.)

So there is an implicit bribe in civil service: you act as a servant to industry, say Monsanto, and they take care of you later on. They do not do it out of a sense of honor: simply, it is necessary to keep such a system going and encourage the next guy to play by the rules. The IYI cum scumbag Tim Geithner–with whom I share a Calabrese barber –was overtly rewarded by the industry he helped bail out.

Watch former heads of state such as Bill Clinton or Tony Blair use the fame that the general public gave them to make hundreds of million in speaking fees –indeed for these two sleek fellows, public service was the most effective step towards enrichment. The difference between a salesman and a charlatan is that the latter doesn’t deliver what he claims to be selling. Ironically the pair Clinton-Blair appeared less greedy than the typical ego-driven businessman who seeks elections.


[1] 39% of Americans will spend a year in the top 5 % of the income distribution, 56 % will find themselves in the top 10%, and 73% percent will spend a year in the top 20 %.

[2] The type of distributions –called fat tails –associated with it made the analyses more delicate, far more delicate and it had become my mathematical specialty. In Mediocristan changes over time are the result of the collective contributions of the center, the middle. In Extremistan these changes come from the tails. Sorry, if you don’t like it but that is purely mathematical.

Los límites de la economía psicológica

Adjunto la reseña al interesante libro de Richard Thaler Todo lo que aprendí con la psicología económica, editado por Deusto (2016). Se trata de una buena lectura que sirve para comprender la falla de la economía neoclásica y como la también llamada economía del comportamiento no plantea un método alternativo y conviene ser cautos a la hora de substituir el ‘homo economicus‘ por el ‘homo psicologicus’. Sin embargo, sí que los descubrimientos del Premio Nobel Daniel Kahneman y Cía. arrojan interesantes insights sobre algunos de los sesgos y mecanismos que configuran nuestra manera de pensar y de tomar decisiones.

9788423425549Reseña en PDF

David Gordon on Mervyn King: Central Bankers are Losing Faith in their own Alchemy. Cobden

Mervyn King is the British Ben Bernanke. An eminent academic economist, who now teaches both at New York University and the London School of Economics, King was from 2003 to 2013 Governor of the Bank of England. In short, he is a very big deal. Remarkably, in The End of Alchemy he frequently sounds like Murray Rothbard.

King identifies a basic problem in the banking system that has again and again led to financial crisis.

“The idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments came into its own with the Industrial Revolution in the eighteenth century. It was both revolutionary and immensely seductive. It was in fact financial alchemy — the creation of extraordinary financial powers that defy reality and common sense. Pursuit of this monetary elixir has brought a series of economic disasters — from hyperinflation to banking collapses.”

How exactly is this alchemy supposed to work?

“People believed in alchemy because, so it was argued, depositors would never all choose to withdraw their money at the same time. If depositors’ requirements to make payments or obtain liquidity were, when averaged over a large number of depositors, a predictable flow, then deposits could provide a reliable source of long-term funding. But if a sizable group of depositors were to withdraw funds at the same time, the bank would be forced either to demand immediate repayment of the loans it had made, … or to default on the claims of depositors.”

Readers of Rothbard’s What Has Government Done to Our Money? will recognize a familiar theme.

Many have sought to salvage the alchemy of banking by resorting to a central bank. By acting as a lender of last resort, a central bank can bail out banks in need of funds to satisfy anxious depositors and thus avert the danger of a bank run. The alchemy of transforming deposits into investments can now proceed.

Though he was one of the world’s leading central bankers, King finds fault with this “solution.” A local bank can be rescued by getting money from the central bank, but the process generates new problems. Thomas Hankey, a nineteenth-century Governor of the Bank of England, pointed out some of these in response to Walter Bagehot, the classic defender of the central bank as the lender of last resort:

[i]f banks came to rely on the Bank of England to bail them out when in difficulty, then they would take excessive risks and abandon “sound principles of banking.” They would run down their liquid assets, relying instead on cheap central bank insurance — and that is exactly what happened before the recent [2008] crisis. The provision of insurance without a proper charge is an incentive to take excessive risks — in modern jargon, it creates “moral hazard.”

Given the dangers of financial alchemy, what should we do about it? Again, King strikes a Rothbardian note. He writes with great sympathy for one hundred percent reserve banking.

Even though the degree of alchemy of the banking system was much less fifty or more years ago than it is today, it is interesting that many of the most distinguished  economists of the first half of the twentieth century believed in forcing banks to hold sufficient liquid assets to back 100 percent of their deposits. They recommended ending the system of “fractional reserve banking,” under which banks create deposits to finance risky lending and so have insufficient safe cash reserves to back their deposits.

Like Rothbard, King calls attention to the insights of the nineteenth-century Jacksonian William Leggett. King cites an article of 1834 in which Leggett said:

Let the [current] law be repealed; let a law be substituted, requiring simply that any person entering into banking business shall be required to lodge with some officer designated in the law, real estate, or other approved security, to the full amount of the notes which he might desire to issue.

King may to an extent resemble Rothbard; but unfortunately he is not Rothbard; and alert readers will have caught an important difference between King’s idea of one hundred percent reserve banking and Rothbard’s. King’s notion, unlike Rothbard’s, still allows banks to expand the money supply. The “liquid assets” need not be identical with the deposits: they need only be easily convertible into money should the need arise to do so.

King’s own plan to “end the alchemy” allows for substantial monetary expansion. He calls his idea the “pawnbroker for all seasons (PFAS)” approach. This is a form of “liquidity” insurance. Banks would have to put up in advance as collateral with the central bank some of their assets. This would act as a “form of mandatory insurance so that in the event of a crisis a central bank would be free to lend on terms already agreed.” So long as the insurance had been paid, though, the central bank would still bail the bank out in a crisis by giving it more money. Contrast this with the plan suggested in the quotation from Leggett, in which if a bank could not redeem its notes, depositors could proceed directly against the bank’s assets. This allows no monetary expansion; and Rothbard’s plan is of course more restrictive still.

Having come so close to Rothbard, why does King shrink from the final step? Why does he still allow room for monetary expansion? He fears deflation.

Sharp changes in the balance between the demand for and supply of liquidity can cause havoc in the economy. The key advantage of man-made money is that its supply can be increased or decreased rapidly in response to a sudden change in demand. Such an ability is a virtue, not a vice, of paper or electronic money. … The ability to expand the supply of money in times of crisis is essential to avoid a depression.

But if the demand for liquidity suddenly increases, when the monetary stock is constant, cannot falling prices for goods satisfy the demand? King, here following Keynes, is skeptical. “Wage and price flexibility does help to coordinate plans when all the markets relevant to future decisions exist. But in practice they do not, and in those circumstances cuts in wages and prices may lower incomes without stimulating current demand.” Prices may keep falling indefinitely.

Other possibilities of coordination failure also trouble King, and underlying them is an important argument. Following Frank Knight, he distinguishes between risk and uncertainty.

Risk concerns events, like your house catching fire, where it is possible to define precisely the nature of that future outcome and to assign a probability to the occurrence of the event based on past experience. … Uncertainty, by contrast, concerns events where it is not possible to define, or even imagine, all possible future outcomes, and to which probabilities cannot therefore be assigned.

We live in a world of radical uncertainty, and thus we cannot be sure that relying on market prices to adjust to changes in the demand to hold money suffices to avert catastrophe. It is for this reason that resort to monetary expansion sometimes is needed.

This argument moves altogether too fast. It does not follow from the fact that Knightian uncertainty prevails widely that one must take seriously the possibility that prices and wages would fall indefinitely. In a situation of uncertainty, we cannot, by hypothesis, calculate probabilities; but this does not require that we take outlandish possibilities as likely occurrences that must be averted by the government. Some reason needs to be given for supposing that prices will continue to fall indefinitely. Why would entrepreneurs not be able to correct the situation, without resorting to monetary expansion? We are not faced with a dichotomy between exact mathematical calculation, in the style of an Arrow-Debreu equilibrium, and blind groping in the dark.

King himself acknowledges that in the American depression of 1920 to 1921, no resort to the government was needed.

The striking fact is that throughout the episode there was no active stabilization policy by the government or central bank, and prices moved in a violent fashion. It was, in the words of James Grant, the Wall Street financial journalist and writer, “the depression that cured itself.”

It is encouraging that King cites the Austrian economist James Grant, but he draws from his work an insufficient message. “The key lesson from the experience of 1920–21 is that it is a mistake to think of all recessions as having similar causes and requiring similar remedies.” In view of the manifold invidious consequences, fully acknowledged by King, of government intervention, should we not rather emphasize the need to rely on the unhampered market? King nevertheless merits praise for coming close, in his own way, to many Austrian insights.

Venetians, Volcker and Value-at-Risk: 8 centuries of bond market reversals (Paul Schmelzing)

Paul Schmelzing is a visiting scholar at the Bank from Harvard University, where he concentrates on 20th century financial history. In this guest post, he looks at the current bond market through the lens of nearly 800 years of economic history. 

The economist Eugen von Böhm-Bawerk once opined that “the cultural level of a nation is mirrored by its interest rate: the higher a people’s intelligence and moral strength, the lower the rate of interest”. But as rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre”.

Bond “bull markets” since 1285

Chart 1: The Global risk free rate since 1285


As a contemporary of fin-de-siècle Vienna, Böhm-Bawerk witnessed a period of unprecedented internationalization, deepening trade relations, and technological innovation – associated with the parallel financial phenomena of the expansion of London-based merchant banks, and the growth in global capital mobility(triggering the heyday of the “cash nexus”). At this point, yields on the global “risk free bond” – then British consols – had fallen to an all-time low of 2.48% in 1898 (Chart 1). But not least his own enthusiasm should prove short-lived: soon after his writing, rates entered what Richard Sylla and Sidney Homer later defined as the “first bear bond market”.

Indeed, judging purely by historical precedent, at 36 years, the current bond bull market had been stretched. As chart 2 shows, over 800 years only two previous episodes – the rally at the height of Venetian commercial dominance in the 15th century, and the century following the Peace of Cateau-Cambrésis  in 1559 – recorded longer continued risk-free rate compressions. The same is true if we measure the period by average decline in yields per annum, from peak to trough. With 33 bps, only the rallies following the War of the Spanish Succession, and the election of Charles V as Holy Roman Emperor surpass the bond performance since Paul Volcker’s “war on inflation”.

Chart 2: Length and size of bull markets since 1285


Modern bear shock markets, 1925-2016

It thus appears timely to ask about the characteristics of bear bond markets. Since Homer and Sylla’s first bear market, on our count the United States (the current issuer of the global risk-free asset) experienced 12 modern “bond shock” years, during which selloff dynamics cost long-term sovereign bond creditors more than 15% in real price terms.

Aggregating these bear markets (chart 3), we find that, at 6.1% CPI year-on-year on average, “bond shock years” record inflation levels almost double the long-term trend, at 3.1%. Global growth equally is below average, though not in recession territory. Interestingly, during bond bear markets, US federal deficits, with 2.3% of GDP, actually fall slightly below the post-1945 average track record of 2.9%. An increase in the supply of bonds, therefore, seems not decisive to the weakening in price levels.

Chart 3: Macroeconomic outcomes in bear markets


Bond turbulence, however, has traditionally struck investors in different shapes – especially since the time of Homer/Sylla’s first bear market. Below we present three types of modern bear bond case studies to illustrate that – while historically inflation acceleration has been a solid predictor of sharp bond selloffs – some prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses.

Type 1: The inflation reversal, 1967-1971

The “inflation reversal” leaves bondholders particularly bruised, and is most clearly associated with fundamentals: namely a sharp turnaround in realized consumer price inflation (CPI).  This  scenario correctly weighs on the minds of today’s reflationists. US bonds lost 36% in real price terms during 1965-1970, slightly outstripping losses during the 20th century’s first bear market (Chart 4). Annual CPI more than tripled in the same timeframe, from 1.6%, to 5.9%. Looser fiscal policies seem to have played only a secondary role in the 1965-70 bond sell-off, though the Vietnam War put some unexpected pressure on the federal budget. The deficit widened from just 0.2% in 1965, to 2.8% three years later – but USTs continued to decline when public finances swung back into positive territory.

Chart 4: The bear market of 1967-71


Type 2: The Sharp Reversal, 1994

The 1994 “bond massacre” has attracted particular attention of late, and represents a second type of reversal, characterized by steep, but short-lived turbulence that is associated more with financial sector leverage and exogenous positioning – rather than macro fundamentals.

After bottoming in the autumn of 1993, US bond market yields started ascending quickly, even amid discount rates on a 30-year low. A rollercoaster performance followed, which saw bond volatility surge to levels not seen since the Volcker inflation fight. However, US bonds were firmly back in bull territory by 1995, adding 18.1% in prices after inflation.

Neither inflation expectations – which peaked at an unexciting 3.4%– nor fiscal policies, which remained on the steady Clinton consolidation path, offer satisfactory explanations for the rout. Though journalistic accounts link the sell-off with the Fed’s February 1994 decision to raise short-term rates, closer investigations suggest a loose correlation at best. As the data proves, volatility in US 10 year bonds started rising in Q3-1993, while official discount rates were only raised in May 1994 – at a time when volatility had almost peaked already (Chart 5).

Chart 5: The “Bond Massacre” of 1994


Evidence from the financial sector rather suggests that the dramatic increase in leveraged bond positions by both US hedge funds and mundane money managers set in motion self-reinforcing liquidations once uncertainty over emerging markets including Turkey, Venezuela, Mexico, and Malaysia – all of which experienced sharp capital flow volatility – put pressure on speculative positions. Against current predispositions, it seems unlikely a sell-off today would trigger only a brief spark in volatility, and soon revert to the secular post-1981 trajectory.

Type 3: The VaR shock, Japan 2003

But as our third type illustrates, bond turbulence can be highly discriminatory across maturities. Given the latest decision by the Bank of Japan to target long-term bond yields, after a period of unprecedented yield curve flattening, parallels emerge to the 2003 Japanese curve steepening episode, sometimes dubbed the ”Value at Risk Shock” (Chart 6). Back then, markets underwent a notable rollercoaster of the term structure against the backdrop of “tapering fears” over the BoJ’s bond buying program, the Iraq War, and domestic tax hikes.

Chart 6: The Japanese bear market of 2003


“VAR shocks” have especially deep impacts on the banking sector, whose profitability in the maturity transformation business tracks prevailing curve steepness. The dramatic flattening of the JGB term structure prior to March 2003 therefore went hand-in-hand with a sustained sell-off in the TOPIX bank index, which fell to multi year lows. Prominent financial institutions, such as Resona Group, had to be rescued through billion Dollar public bailouts.

Though the TOPIX recovered, and realized Japanese inflation only accelerated modestly, the sudden steepening of the JGB curve from the middle of 2003 posed a new set of challenges: calibrated risk management structures, known as “Value-at-Risk” models, required banks to shed JGB assets once their price started plummeting. Since most banks followed similar quantitative signals, and exerted a traditionally strong home bias in their fixed income portfolios, a concerted dumping of government bonds ensued.


What does the historical track record imply for current markets? A pessimistic reader could certainly identify gloomy ingredients for the “perfect storm”: the potential for a painful steepening of bond curves, after a sustained flattening as in 2003, coupled with monetary tightening; and a multi-year period of sustained losses due to a structural return of inflation as in 1967.

On the one hand, the anecdotal fear that a repeat of a 1994-type of bond crash is likely seems somewhat exaggerated, given progress on bank leverage regulations – while the current global capital flow cycle has already almost fully reversed from the cycle peak.

Type-1 and Type-3 bear markets warrant more attention. Global inflation dynamics are picking up, at a time when Central bankers voice more tolerance for “inflation overshoots”. Though currently bank equity investors are cheering the steepening of yield curves, meanwhile, the 2003 Japan episode should fix regulators’ attention on the growing home-bias in government bonds. Problematically, the IMF has warned that VAR risks have risen “significantly” in Japanese financial institutions after the financial crisis, given a continued build-up of JGB concentration in balance sheets. In Europe, the trend is equally one-directional: Italian monetary financial institutions, for instance, hold 18% of their assets in domestic government loans and securities, up from 12% in 2008. In most geographies, these bonds, despite efforts to the contrary, remain mainly held in “available-for-sale” portfolio buckets, where they have to be marked-to-market.

On balance, then, more than to a 1994-style meltdown, fixed income assets seem about to be confronted with dynamics similar to the second half of the 1960s, coupled with complications of a 2003-style curve steepening. By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias.

Paul Schmelzing is an academic visitor to the Bank from Harvard University’s History Department.


The Economic Risk of Ignoring Arithmetic by John P. Hussman

“Let us not, in the pride of our superior knowledge, turn with contempt from the follies of our predecessors. The study of errors into which great minds have fallen in the pursuit of truth can never be uninstructive… Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one… Truth, when discovered, comes upon most of us like an intruder, and meets the intruder’s welcome… Nations, like individuals, cannot become desperate gamblers with impunity. Punishment is sure to overtake them sooner or later.”

Charles MacKay, Extraordinary Popular Delusions and The Madness of Crowds, 1841 

When we observe the greatest follies of our predecessors, the episodes of speculative madness that come most immediately to mind are the pre-crash bubble peaks of 1929, 2000, and to a lesser extent, 2007. Unfortunately, we are in the midst of yet another episode of equivalent speculative madness, but one that will only be recognized in hindsight, and in the recollections of our children. They too are likely to take pride in a feeling of superior knowledge, forgetting the same lessons, and eventually creating another bubble and collapse of their own. The herd mentality is human nature. As in 2000-2002 and 2007-2009, when the S&P 500 collapsed by 50% and 55% respectively, we’ll likely see that herd mentality expressed on the downside soon enough. That also is human nature.

The stock market bubble that ended with the September 1929 peak began in August 1921, running just a few days beyond 8 years in duration. The bubble that ended with the March 2000 peak began in October 1990, running fully 9 years and 5 months in duration. Those two episodes represent the longest bull markets in U.S. history. The current half-cycle began at the March 2009 low, and has now run 7 years and 10 months in duration, making it the third-longest advance in history, placing it just 2 months short of the 1929 instance, but a full year and 7 months short of the 2000 instance.

What’s notable here is that by the time the bubbles that ended in 1929 and 2000 reached a duration similar to the present, they were already experiencing a significant increase in volatility and the frequency of corrections. From a time-perspective, for example, 7 years and 10 months into the bull market that began in October 1990, it was August 1998, about the point that the S&P 500 took a nearly 20% dive. By July 1999, the S&P 500 had eclipsed its mid-1998 high, followed by a correction of over -12% during the next 13 weeks (taking the net gain from mid-1998 to just 5%). The S&P 500 then rallied again into December 1999, followed by a nearly -10% correction over the next 8 weeks. Immediately after the final market high in March 2000, the S&P 500 quickly gave up more than 11% in the following month, wiping out a year of gains, and the bear market had hardly even started.

Likewise, by the time the bull market from the 1921 low extended into late-1928, the market became much more susceptible to corrections. Following a peak in November 1928, the Dow Jones Industrial Average lost nearly -13% in a month. The next peak in February 1929 was followed by a -8% correction over the following two weeks. A fresh high in May 1929 was followed by a -10% correction over the following four weeks. The final high in September 1929 was followed by an initial drop of nearly -15% over the next 6 weeks. Put simply, once the bull market was as mature as the present one has become, further market gains were not smooth. Nor were they ultimately durable.

From a valuation perspective, the current run is similarly mature. The most reliable market valuation measure we’ve identified across history (having the strongest correlation with actual subsequent market returns) is the ratio of nonfinancial market capitalization to corporate gross value-added (MarketCap/GVA), with Warren Buffet’s old favorite, the ratio of market capitalization to gross domestic product, just slightly behind, followed somewhat further by a variety of measures that normalize earnings in one way or another (by comparison, neither the ratio of price/forward operating earnings nor the Fed Model even come close). By the time valuations reached levels similar to recent extremes during the advances toward the 1929 and 2000 bubble peaks, it was already mid-1929 and late-1999, respectively.

The market losses over the subsequent 10-12 year periods directly reflected the extent of the corresponding overvaluation. At present, we estimate S&P 500 nominal total returns averaging just 0.8% annually over the coming 12-year horizon. If our measures of market internals were to improve materially, particularly across interest-sensitive sectors, we would be inclined to allow leeway for valuations to become even more extreme. But in the end, richer valuations would only imply steeper losses over the completion of the current market cycle, and even weaker returns on a 10-12 year horizon. For a review of current valuation extremes, see Economic Fancies and Basic Arithmetic.

As we enter 2017, the great risk for investors is not in missing out in an exhausted run that already rivals the 1929 and 2000 extremes, but in failing to contemplate a 50-60% market retreat over the completion of the current cycle. The chart below presents some of the most reliable valuation measures we follow, showing percentage deviations from their pre-bubble norms. S&P 500 forward earnings and revenues are imputed prior to 1980 based on their relationships with available data having a longer history. The measures below have correlations as high as 94% with actual subsequent S&P 500 total returns, particularly on a 10-12 year horizon. At present, they range between 120% and 150% above their respective historical norms. A run-of-the-mill cycle completion, even ruling out historically undervalued levels, would imply a 50-60% market loss.



In recent weeks, we’ve observed the single most extreme syndrome of overvalued, overbought, overbullish conditions that we define. I’ve noted before that with one exception, each instance of this syndrome has been associated with a major market peak (1929, 1972, 1987, 2000, 2007), though in a few cases an initial signal was followed by a secondary signal several weeks later that marked the final high. The sole exception was a set of extremes in late-2013 and early-2014 during the height of enthusiasm about zero interest rates and quantitative easing. Our excruciating lesson in the half-cycle since 2009 was that in the presence of zero interest rates, overvalued, overbought, overbullish extremes were not enough to generate risk-aversion among investors. One had to wait for market internals to deteriorate explicitly before taking a hard-negative market outlook. Given that the Federal Reserve is now in a tightening mode and our measures of market internals have turned negative, my impression is that investors are playing a dangerous game by ignoring present extremes in the belief that this is anything but a mature and vulnerable financial bubble.

We’re certainly open to the possibility that market internals will shift to a more favorable condition (when investors are inclined to speculate, they tend to be indiscriminate about it, so the uniformity of market action across a broad range of individual stocks, industries, sectors and security types is a useful measure of investor risk-preferences). Yet while a constructive shift would at least temporarily suspend our hard-negative market outlook, a strong safety-net would remain imperative. Even in a bullish world where the current advance might extend to match or surpass the duration and valuation extremes of the 1929 and 2000 bubbles, investors should brace themselves for amplified volatility in the near-term.

The economic risk of ignoring arithmetic

I’ve previously detailed why arithmetic of demographics and productivity suggests a likely central tendency of less than 2% annually for real GDP growth over the coming 8 years, with even 3% growth being both optimistic and rather implausible. Increased allocation of savings toward productive investment would certainly benefit the country over a period of decades, but is unlikely to materially alter the course of economic growth over the span of a few years. In my view, the primary economic risks here are clearly to the downside: years of Fed-induced yield-seeking speculation have already set the financial markets up for an equity market collapse on the order of 50-60% over the completion of the current market cycle, coupled with a secondary crisis in a mountain of covenant-lite debt, as the indebtedness of U.S. corporations (even after netting out cash holdings) has been driven to record levels relative to corporate gross value-added.

To understand our muted enthusiasm about the economy here, recall that GDP growth is driven by the sum of employment growth and productivity growth. While there may be some vicarious gratification in the idea of “getting tough” with companies about domestic jobs and imports, the fact is that even if we assume a 2% unemployment rate in 2024, built-in labor force demographics would still limit annual growth in U.S. employment to just 0.7% annually in the interim. That demographic fact will not be altered by the disturbing practice of singling individual companies out for intimidation, as a substitute for informed, uniform policies and equal treatment under the law. From an economic standpoint, the spectacle is little but a carnival sideshow, because the job numbers at issue are absurdly small relative to the ordinary turnover of the U.S. labor force. In 2016, for example, there were 5.2 million jobs created in an average month, with an average of 5 million job separations, for a net increase in payrolls averaging about 200,000 jobs per month (JOLTS data – yes, employment turnover is that high). Entertainment value aside, the likely contribution of employment growth to GDP growth in the coming years is likely to be in the range of 0.2-0.7% annually, barring an economic recession that could pull this figure to negative levels.

Aside from short-run outcomes, any durable and sustained acceleration in GDP growth will have to come from productivity growth. That, in turn, is highly dependent on gross domestic investment (broadly defined to include intangible investments such as education and job-training initiatives to boost labor productivity). This is the component of economic growth that faces the largest downside risk in the coming years. See, productivity growth is highly dependent on growth in gross domestic investment, and it’s here where the incoming administration seems to have little understanding of economic arithmetic.

Part of that arithmetic can be expressed as the “savings-investment identity,” which is not a theory but an accounting equality. We can state it as follows. U.S. gross domestic investment is always identical to the sum of: household savings, government savings, corporate savings, and savings acquired from foreigners.

The other bit of arithmetic has to do with trade. You can think of it this way. For every dollar of “stuff” we import from foreign countries, we have to pay for it by transferring an equal value of “stuff” in the other direction. That stuff can either be goods and services, or securities. We obtain the savings of foreigners by exporting securities to them, rather than goods and services. But here’s the accounting hitch. A net import of foreign savings is equivalent to running a trade deficit. By exporting more securities than we import, we obtain foreign savings to finance U.S. gross domestic investment, but it must then also be true that we’re exporting fewer goods and services than we import.

Here’s the problem: pursue a policy to reduce the trade deficit, and you automatically (and possibly unintentionally) pursue a policy to reduce the import of foreign savings. Now, that may be all well and good when domestic sectors are running surpluses. If the combined savings of households, businesses and the government are more than enough to finance our own gross domestic investment, the U.S. can run a trade surplus and can lend the excess savings to the rest of the world, becoming a net creditor. The problem is that’s not anything close to the position of the United States.

Our nation relies heavily on the import of foreign savings to finance our gross domestic investment. If the new administration pursues larger fiscal deficits, that financing gap will become greater, not smaller. If it pursues larger fiscal deficits (reducing government saving to even more negative levels) while also pursuing punitive trade policies and import restrictions (reducing the import of foreign saving), the net effect will be to crowd out and sharply restrain gross domestic investment. In theory, a boost to the sum of household and corporate savings could ease the gap, but in practice, the two are negatively correlated, because the corporate share of GDP is relatively high when wages and salaries are low as a share of GDP, and also because boosting household savings by refraining from consumption tends to depress corporate earnings and resulting saving.

The bottom line is that large and sustained increases in U.S. gross domestic investment have always been achieved by financing a substantial portion of the increase with foreign savings. Booms in U.S. gross domestic investment are systematically associated with “deterioration” in the trade balance. Conversely, declines in U.S. gross domestic investment are systematically associated with “improvement” in the trade balance. The chart below provides a good picture of how this relationship looks in practice, in data since 1947.



Outcomes are not independent of initial conditions. While there are certainly policy shifts that could encourage greater productive investment and raise the long-run trajectory of economic growth, no shift in economic policies is likely to produce rapid, sustained economic growth in the next few years because the underlying factors that drive rapid, sustained growth aren’t presently in a position to support it. GDP growth is the sum of employment growth plus productivity growth. Strong employment growth typically emerges when there is a relatively large pool of available and unemployed labor, because that pool of available labor provides the economy room to run. Strong productivity growth requires expansion in gross domestic investment, which in turn is enabled by deterioration in the trade deficit. As a result, rapid productivity growth typically begins from points where the trade deficit is relatively narrow or even in surplus. That’s why the economic booms following the 1982 and 1990 recessions were so strong – both expansions started from a high unemployment rate coupled with a trade surplus. At present, we’ve got a low unemployment rate and a rather deep and persistent trade deficit. Rapid growth will emerge from much different conditions than we observe at present, and one doesn’t want to be exposed to a great deal of economic risk in the interim, because the risk during that transition period is emphatically to the downside.

We are left, then, with a hypervalued and mature market advance that now rivals the two greatest speculative mistakes in U.S. history; with extreme overvalued, overbought, overbullish conditions coupled with a tightening Federal Reserve and dispersion across key measures of market internals; with an incoming administration that by all evidence values spectacle and coarse provocation over diplomacy and informed, dignified leadership; and with an economic agenda so lacking in the foundations of basic arithmetic that a needless retreat in U.S. gross domestic investment may be the unintended consequence.

As for stocks, last week, my friend Jesse Felder published a piece headed with a cartoon of Lucy snatching away a football while a trusting Charlie Brown tumbles upside-down after attempting a kick, imagining that this time might be different. This time will not be different. Look carefully at the advances that led to the 1929 and 2000 peaks, but look only backward, ignoring what was ultimately to come. Look at the 2007 peak, or the 1972 peak, or the 1987 peak, with the same backward-looking perspective. Overvalued bull markets lure investors to hold on precisely by convincing them that at every seemingly overvalued point in the recent past, prices have triumphed to achieve even higher levels. It’s important to recognize that during the majority of those preceding advances, extreme overvalued, overbought, overbullish syndromes were absent, and market internals typically demonstrated broadly positive uniformity, indicating that investors remained inclined to speculate despite rich valuations.

In contrast, in market cycles across history, by the time extreme valuations were joined by extreme overvalued, overbought, overbullish syndromes and deteriorating market internals, whatever potential gains remained were purely transient, and were overwhelmed by losses over the completion of the market cycle. The half-cycle since 2009 was different only in that the Federal Reserve’s deranged policy of zero interest rates and quantitative easing encouraged investors to continue speculating long after extreme overvalued, overbought, overbullish syndromes emerged. The extension of this speculation was admittedly frustrating for us. In the presence of zero interest rates, one had to wait for internals to deteriorate explicitly. Even after the adaptations we introduced in mid-2014, the combination of an extended top-formation and a performance-chasing rush toward passive indexing hasn’t created much opportunity to demonstrate the benefit of historically-informed, value-conscious investment discipline. Still, we’ve demonstrated the benefits of our integrated discipline nicely in previous complete market cycles, and we remain convinced that it is well-suited to navigate the completion of this cycle and those to come.

While we’re seeing persistent signs of dispersion, particularly across interest-sensitive sectors, my sense is that investors are mistaking the market gain in 2016 as a repudiation of the idea that extreme valuations, dispersion across market internals, and overextended conditions are of real concern. My own expectation is that even if there is a longer life to this bull market, the 2016 gain will be erased rather soon, in a quite ordinary late-stage correction, much like those that emerged with increasing frequency approaching other major market peaks. Our outlook will change with conditions, particularly with respect to valuations, market internals, and the presence or absence of overextended syndromes. For now, the stock market is now much like Wile E. Coyote temporarily hovering just past the edge of a cliff. The moment of descent isn’t clear, but I believe it would be a mistake to climb onto his shoulders.

Inflation Is Not About Price Increases, Frank Shostak (12/06/2016)

There is almost complete unanimity among economists and various commentators that inflation is about general increases in the prices of goods and services. From this it is established that anything that contributes to price increases sets in motion inflation.

A fall in unemployment or a rise in economic activity is seen as a potential inflationary trigger. Some other triggers, such as rises in commodity prices or workers’ wages, are also regarded as potential threats.

If inflation is just a general rise in prices as the popular thinking has it, then why is it regarded as bad news? What kind of damage does it do?

Mainstream economists maintain that inflation causes speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources. Inflation, it is argued, also undermines real economic growth.

Why should a general rise in prices hurt some groups of people and not others? Or how does inflation lead to the misallocation of resources? Why should a general rise in prices weaken real economic growth?

Also, if inflation is triggered by various factors such as unemployment or economic activity then surely it is just a symptom and therefore doesn’t cause anything as such.

To ascertain what inflation is all about we have to establish its definition. Now to establish the definition of inflation we have to establish how this phenomenon emerged. We have to trace it back to its historical origin.

The Essence of Inflation

Historically, inflation originated when a country’s ruler such as king would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this Rothbard wrote,

More characteristically, the mint melted and re-coined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks,” but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses. (Murray N. RothbardWhat Has Government Done to Our Money? (Auburn, Ala.: Mises Institute, Libertarian Publishers, 2010), p. 58.)

On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins and pocket for his own use the extra coins minted. (He could now divert real resources to himself.) What was now passing as a pure gold coin was in fact a diluted gold coin.

The increase in the number of coins brought about by the dilution of gold coins is what inflation is all about. As a result of the increase in the amount of coins that masquerade as pure gold coins, prices in terms of coins now go up (more coins are being exchanged for a given amount of goods).

Note that what we have here is an inflation of coins, i.e., an expansion of coins. As a result of inflation, the ruler can engage in an exchange of nothing for something (he can engage in an act of diverting resources from citizens to himself).

Also note that the increase in prices in terms of coins comes on account of the coin inflation. Observe however that it is the increase in coins brought about by the dilution of gold coins that enables the diversion of resources here to the ruler and not an increase in prices as such.

Under the gold standard, the technique of abusing the medium of the exchange became much more advanced through the issuance of paper money un-backed by gold.

Inflation therefore means an increase in the amount of receipts for gold on account of receipts that are not backed by gold yet masquerade as the true representatives of money proper, gold.

The holder of un-backed receipts can now engage in an exchange of nothing for something. As a result of the increase in the amount of receipts (inflation of receipts) we now also have a general increase in prices.

Observe that the increase in prices develops here on account of the increase in paper receipts that are not backed up by gold.

Also, what we have here is a situation where the issuers of the un-backed paper receipts divert real goods to themselves without making any contribution to the production of goods.

In the modern world, money proper is no longer gold but rather paper money; hence inflation in this case is an increase in the stock of paper money.

We don’t say that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

Inflation Is About Wealth Destruction 

Note that increases in the money supply set in motion an exchange of nothing for something. They divert real funding away from wealth generators toward the holders of the newly created money. This is what sets in motion the misallocation of resources, not price rises as such.

Real incomes of wealth generators fall, not because of general rises in prices, but because of increases in the money supply. When money is expanded (i.e., created out of “thin air”) the holders of the newly created money can divert goods to themselves without making any contribution to the production of goods.

As a result wealth generators who have contributed to the production of goods discover that the purchasing power of their money has fallen since there are now less goods left in the pool — they cannot fully exercise their claims over final goods since these goods are not there.

Once wealth generators have less real resources at their disposal this is obviously going to hurt the formation of real wealth. As a result real economic growth is going to come under pressure.

General increases in prices, which follow increases in money supply, only point to an erosion of real wealth. Price increases by themselves however do not cause this erosion.

Can Increases in Commodity Prices Cause Inflation?

According to most economists, an important factor behind a general increase in prices is increases in commodity prices.

We have seen that inflation is brought about by a deliberate act of currency debasement — on a gold standard by issuing un-backed by gold paper money, while on a paper standard an increase in the supply of paper money.

An increase in commodity prices as such is not related to an act of embezzlement. For instance, in a true market economy an increase in the price of oil versus the prices of other goods is just a reflection of changes in peoples’ demand. Obviously it has nothing to do with an act of currency debasement brought about by the increase in money supply out of “thin air.”

Also, if the price of oil goes up and if people continue to use the same amount of oil as before, people will be forced to allocate more money to oil. If peoples’ money stock remains unchanged, less money is available for other goods and services.

This of course implies that the average price of other goods and services must come down. Again, remember a price is the sum of money paid for a unit of a good. (The term “average” is used here in conceptual form. We are well aware that such an average cannot be computed.)

Note that the overall money spent on goods doesn’t change; only the composition of spending has altered, with more on oil and less on other goods. The average price of goods or money per unit of good remains unchanged.

Hence, the rate of increase in the prices of goods and services in general is going to be constrained by the rate of growth of money supply, all other things being equal, and not by the rate of growth of the price of oil.

It is not possible for increases in the price of oil to set in motion a general increase in the prices of goods and services without the corresponding support from money supply out of “thin air.”

We can then conclude that the so-called general increase in prices that seems to follow an increase in a commodity price such as oil, is in fact on account of an increase in the money supply out of “thin air.” (Note that since an injection of money doesn’t enter all the markets instantly, a general increase in prices ensues on account of previous increases in money supply.)

Most economists, when discussing the issue of general increases in prices, which they label inflation, never mention the word money. The reason for that is the lack of a good statistical correlation between changes in money and changes in various price indexes such as the CPI.

Whether changes in money supply cause changes in prices cannot be established by means of statistical correlation.

A statistical correlation, or a lack of it, between two variables shouldn’t be the determining factor in establishing causality. One must figure it out by means of reasoning as to the structure of causality.

Can Inflation Expectations Trigger a General Price Rise?

We have seen that, as a rule, a general increase in the prices of goods emerges on account of an increase in the amount of money paid for goods, all other things being equal.

The key then for general increases in prices, which is labeled by popular thinking as inflation, is increases in the money supply.

But what about the situation when increases in commodity prices ignite inflation expectations, which in turn strengthens a general increase in prices? Surely then inflation expectations must be also an important driving factor behind the general increase in prices?

According to most economists, inflation expectations are the key driving factor behind increases in general prices.

Once people start to anticipate higher inflation in the future they raise their demands for goods at present thus bidding the prices of goods higher.

Also, according to popular thinking, workers expectations for higher inflation prompt them to demand higher wages. Increases in wages in turn lift the cost of producing goods and services and force businesses to pass these increases on to consumers by raising prices.

It is true that businesses set prices and it is also true that businessmen while setting prices take into account various costs of production. However, businesses are ultimately at the mercy of the consumer who is the final arbiter. 

The consumer determines whether the price set is “right,” so to speak. Now, if the money stock did not increase then consumers wouldn’t have more money to support the general increase in prices of goods and services, all other things being equal.

Hence, on account of expectations for higher prices in the future, all other things being equal, consumers will not be able to raise their demand for goods at present and bid the prices of goods higher without having more money. Consequently, the amount of money spent per unit of goods will stay unchanged.

So irrespective of what peoples’ expectations are, if the money supply hasn’t increased then peoples’ monetary expenditure on goods cannot increase either. This means that no general strengthening in price increases can take place without an increase in the pace of monetary pumping.

Note that inflationary expectations as such don’t cause a currency debasement, so in this sense an increase in so-called inflation expectations has nothing to do with inflation — i.e., an increase in money out of “thin air.”

Imagine that somehow the Fed did manage to convince people that central bank policies are aimed at stopping inflation and maintaining price stability, yet at the same time the central bank also raises the rate of growth of money supply.

Even if inflationary expectations were stable the destructive process will be set in motion regardless of these expectations on account of the increase in the rate of growth of money. Note that people’ expectations and perceptions cannot offset this destructive process.

It is not possible to alter the facts of reality by means of expectations. The damage that was done cannot be undone by means of expectations and perceptions.

When inflation is seen as a general increase in prices, then anything that contributes to price increases is called inflationary. It is no longer the central bank and fractional-reserve banking that are the sources of inflation, but rather various other causes.

In this framework, not only does the central bank have nothing to do with inflation, but, on the contrary, the bank is regarded as an inflation fighter.

On this, Mises wrote,

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call “inflation” the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying “catch the thief.” The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices. (Ludwig von Mises, Economic Freedom and Interventionism, p. 94.)