Weekender: The Von Mises Prophecy Explained

December 12, 2010
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In Keynesian Psychology With Austrian Tails, I detailed a personal trading transition above and beyond Austrian economics.

In short, while believing the Austrian school to be more or less correct — especially in respect to human nature — when it comes to real world implications (and trading decisions), there is a human psychology standoff that involves a time element.

The Keynesian approach — which advocates government stepping into the breach — essentially overlooks the corrupt, inefficient nature of public policy, and also promises something for nothing.

But people like promises of something for nothing… that’s practically a foundational principle of politics… and persistent delusions can go on for a very long time.

To put it another way, the market can be like an emotional spouse: For extended periods of time, “facts” don’t matter so much as “feelings.”

Keynesians call these feelings “animal spirits,” and there have been entire books (written by Keynesian acolytes) on how important it is to revive animal spirits for the sake of the economy.

In capturing the tendency of markets to doggedly embrace Keynesianism — even when such a track seems delusional — Emanuel Derman nails it in his book My Life as a Quant:

In physics you’re playing against God, and he doesn’t change his laws very often. In finance you’re playing against God’s creatures, agents who value assets based on their ephemeral opinions. They don’t know when they’ve lost, so they keep trying.

To wit: In the same way that you can’t “win” an argument with your overly emotional wife (or husband), nor can you “win” an argument with a persistently delusion-embracing market.

Except, of course, by 1) going with the flow in the near term, and 2) waiting for the longer-term “facts” to actually pan out…

The Von Mises Prophecy

Despite very long interims, reality (and gravity) tends to eventually reassert itself. This is why the Austrian school will always have relevance.

In that respect, there is something I think of as “the Von Mises prophecy,” which is a sort of one paragraph summation of Austrian thought — anchored to a prediction — as put forth by Ludwig Von Mises himself:

There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

The Von Mises prophecy can further be understood in the context of “exploding debt dynamics” (a highly useful term coined by an IMF staffer).

To wit, your debt dynamics become explosive when debt service costs overtake your ability to arrange new financing. “A rolling loan gathers no loss,” as the Wall Street wags say, but once that loan stops rolling? Game over man.

The “boom expansion brought about by credit expansion” Von Mises refers to sits atop a mass pyramid scheme of leverage and debt.

As credit expands, more and more unproductive debt is taken on in pursuit of marginal return investments. This process can play out over years, or even decades (as we have seen in the U.S. via a 25-year leverage and debt supercycle).

The prophecy’s “final and total catastrophe of the currency system” comes from last ditch emergency measures in the face of a debt avalanche.

An economy that is lightly (reasonably) leveraged can handle a slowdown without imploding. An economy that is leveraged to its eyeballs cannot. A catch-22 is thus created, in which the taking on of excess leverage requires the application of even more leverage (via the authorities) to save the system from itself. This feedback loop is, of course, unsustainable, barring the economy’s ability to “grow its way out” of the problem.

So the process by which the Von Mises prophecy is fulfilled can be generalized like this:

  • The economy has an upswing.
  • The upswing starts to falter, as is natural to the business cycle.
  • Politicians say “Hey, let’s keep this thing going.”
  • The system is juiced with leverage-enhancing liquidity.
  • Via stimulative reinforcements, a boom mentality takes hold.
  • The boom continues, now in an unnatural state.
  • The “can’t lose” mentality sets in. Greed and hubris run amok.
  • Via risky marginal investments, unproductive debt accumulates.
  • After a period of years (or even decades), cracks reappear.
  • The “mountain of debt” now casts a long cold shadow.
  • That same mountain threatens to topple and collapse.
  • The authorities panic. They know the debt will crush them.
  • To circumvent the avalanche, the debt is monetized.
  • Via monetization, the economy experiences temporary relief.
  • But the relief is not enough… the problems persist…
  • …and so more monetization is applied.
  • As alternative to full collapse, the currency is destroyed.

The pattern as described above is now in full swing in the United States and Europe, and coming to potentially spectacular fruition in Japan.


While there is heavy emphasis on the Fed and the $USD, the eurozone’s sovereign debt crisis is perhaps an even clearer example of the “mountain of debt” phenomenon. Over a period of many years the peripheral eurozone countries were allowed to spend borrowed funds (on a borrowed credit rating) they could never pay back.

Now there will likely prove no final option in saving the eurozone, other than monetizing the non-serviceable debt (i.e. the ECB will eventually have to disavow its Bundesbank roots and print, taking up local debt issuances with fiat paper and massively devaluing the euro).

The United States too, of course, is on a similar path. This is why U.S. yields have been rising, not falling, even as the Bernanke Fed has promised to keep rates low. As we wrote in the 12-2 Global Macro Notes:

In short, the Federal Reserve has made clear its intentions to utterly trash America’s finances, as it seeks to paper over the excess leverage and debt sins of the entire planet.

Delayed Payback

The dynamics of the Von Mises prophecy also help clarify why we have rough waters ahead. The problems of the “debt mountain” have not been dealt with — which means they will continue to press in future.

Understand that the majority of market participants (as represented by CNBC and the like) do not actually understand economics. Worse still, they do not actually CARE about understanding economics.

This is what makes it all too easy for misplaced optimism to take hold (with talking heads and banking house strategists cheering it on). When one’s entire focus is on straining to see “green shoots,” and one’s psychological orientation is towards justifying optimism whenever possible (rather than developing as realistic a worldview as possible), every extended period of temporary Keynesian relief becomes reason to believe that all is coming up roses and the worst has passed.

Are the Bond Vigilantes Returning?

Above is a chart of 30 year t-bond interest rates, dating back to the mid-1990s.

Though the actual trend goes back farther, you can see the key point illustrated here — interest rates have been falling for decades. The aberrational low point came at the height of the 2008 financial crisis, when seemingly the whole world piled into USTs.

In respect to this long, long trend, Fall 2010 represents a potential inflection point of great magnitude. Why? Because this is when two things happened:

  • The Federal Reserve made an unprecedented “QE2″ commitment.
  • The explicit goal of this commitment: To keep U.S. interest rates low.
  • Interest rates rose, not fell, in response to the Fed’s actions!

In short: The bond vigilantes, long in Rip Van Winkle slumber, may now be waking up.

The Von Mises prophecy, remember, involves panic fears of being crushed under a mountain of long-accumulated debt. As the authorities seek to alleviate presssure by monetizing that debt (turning it into paper currency), faith in the system on the whole (currency and debt) is eroded, and investor preference for holding said debt (or currency) shifts at the margins in favor of something else.

There are, of course, other explanations for why bonds are falling (and rates rising) in the face of the Fed. Optimistic bulls will argue that rising rates are a function of a U.S. economy returning to health, and may go even further in arguing that rising rates will not derail a sustainable recovery.

That is one possible interpretation of the future path. Another is that:

  • The bond market is repudiating the actions of the Fed;
  • Rising interest rates will put a stranglehold on anemic recovery;
  • Recovery failure (new signs of sickness) will beget more QE;
  • More QE will erode faith in the system further;
  • Repeat cycle from step 1 until the currency is toast.

Of course, with all three of the major currencies ($USD, euro, yen) in various stages of this same cycle — just wait until Japan hits a loss of faith patch! — it’s little wonder that forex forecasters are calling for “Super Volatility” in 2011.

It’s a great time to be a trader…

JS

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30 Responses to Weekender: The Von Mises Prophecy Explained

  1. Adam on December 14, 2010 at 5:51 pm

    how do save yourself from this

  2. Econophile on December 14, 2010 at 5:51 pm

    What books have you read about Austrian theory?

    • Jack Sparrow on December 14, 2010 at 5:58 pm

      Hayek, Rothbard, Mises, Friedman… many of the names and titles featured on your reading list actually. Any particular thoughts or recommendations?

  3. Econophile on December 14, 2010 at 6:46 pm

    It is always nice to find Austrian theory compatriots. I just wanted to know if you were for real. I see a lot of folks talk about Austrian theory but know nothing about it. I would quibble with your assessment of the essence of the theory. To me the damage occurs on the upside of monetary stimulus. Fiat money expansion is the mother's milk of the boom-bust cycle.

    • Jack Sparrow on December 14, 2010 at 7:12 pm

      Well, we could certainly hash out some of the finer details — but ultimately I suspect our differences would be small. My sense of essence focuses on endgame consequences, but that is not to dismiss the long-run build-up that brings the endgame about.

  4. Econophile on December 15, 2010 at 12:10 am

    But then you are a trader and I'm just a dilettante. Good work and I look forward to your analysis.

    • Jack Sparrow on December 15, 2010 at 12:21 am

      Some might say just the reverse in respect to more formal grounding (simple caveman trader here)… at any rate, thanks for the visit and the kind words!

  5. JJTV on December 15, 2010 at 2:16 pm

    This article is comparing apples to oranges. The Euro Zone countries are facing debt issues because they have no money sovereignty and are essentially in the same position as US states. Japan, US, etc. don't face the same kind of constraints as their debt does not finance spending. It is not possible to "monetize" the debt because the Federal Reserve does not even have that policy option. As long as the Fed has a mandate to maintain a target fed funds rate, the size of its purchases and the sales of its government debt are not discretionary. The Fed has no control over the quantity of reserves and any action that would "monetize" the debt causes the federal funds rate to fall to zero. The definition of "monetize" means to convert to money and the statement itself is a relic of the gold standard. Quantative Easing is not monetizing. I suggest the author follow the works of Minsky as most Austrian theories are useless. I will also plan on betting against this author's suggestions. Japan will collapse? Really? Sovereign governments do not need people to buy their bonds to purchase goods for sale in their own currency.

    • Jack Sparrow on December 15, 2010 at 2:29 pm

      Hey, a Modern Monetary Theorist! Regards to Mosler and the gang…

      In all seriousness, thanks for your comments. I understand (I believe) the technical assertions of MMT, but also believe that MMT as a theory is essentially tautological, history blind, and quaintly self-referencing in the same manner that elegant quant equations related to the housing bubble — which supposedly didn't exist — were doomed by their own myopically closed loop. "The math adds up, so we can't be wrong…" Not taking into account that the internal consistency of the math is not the point, but rather the quality of first assumptions that matters most.

      The ability for America and Japan to fund themselves does not extend to infinite issuance capacity, as many MMT'ers seem to implicitly assume. While true that a country which borrows in its own fiat currency need never technically default (because debt can always be retired with currency), the action of investors in shifting their holding preferences under an increasingly monetized regime can amount to a de facto default. In a world where meaningful holding alternatives to $USD and JPY denominated investments exist, one does not have to sit around and watch as congress blows money on stimulus programs that do not work and the Fed turns it into paper. The much-vaunted closed-loop aspect of self funding does not take into account external investor preferences — nor does it address the impact of ever mounting levels of unproductive debt (as compared to the real producing assets of the economy in question). At root, the simplistic assumption of MMT seems to be that the US (and now Japan I suppose) are "too big to fail," i.e. too big to ever exhaust their capacity for debasement. History may prove this a myopic assumption, as with the quants of the housing bubble.

  6. JJTV on December 15, 2010 at 4:08 pm

    Your above assumptions imply that you're not practicing balance sheet discipline. You also assume that firms and individuals will not sell or buy goods in Japanese Yen and US dollars, which is beyond implausible. You also further assume that the value of money is determined by a market which is incorrect. Fiat currency such as the dollar and yen are "creatures of the state" and history has proven this point time and time again. If you assume that Post-Keynesian PhD’s operating out of an MMT framework advocate spending at an operationally infinite level then you haven't read much of the empirical work. If the government spends at a level that consumes all goods and services then you will get a "real resource constraint" form of inflation. Not everything will be for sale in your currency either.

    • Jack Sparrow on December 15, 2010 at 4:22 pm

      Well, I personally don't assume that the $USD and JPY are at risk of going to zero. I think it's clear that Von Mises was making a point by stating the case in extreme terms. The productive capacities of the U.S. and Japan would not be utterly wiped out by a currency debacle, and I'm not aware of anyone saying otherwise. After all, even post-Weimar survived. This in fact gets to the heart of much of my issue with MMT, namely, its tendency to ignore powerful effects at the margins (such as the potential for certain actions to seriously damage the purchasing power of a currency without necessarily obliterating it completely).

      • JJTV on December 15, 2010 at 4:50 pm

        The Weimar republic lost WWII. They were on a gold standard and had no gold post-WWII because the winning nations took it. Their war repariations were required to be paid in a foreign currency and not their own. The currency was destroyed because the debts were being paid in someone else's money for which they could only get by creating their own to purchase it. MMT does not ignore Weimar but it is clear to distinguish between monetary systems. If the US issued Euro debt then there is a "real" possibility that it could default on those obligations but there is no possibility of default if the debt is denominated in its own currency . A monetary regime that operates a gold standard, currency board, or fixed exchange rate can default but one with a free-floating, non-convertible system cannot. There are no examples of this happening.

        • Jack Sparrow on December 15, 2010 at 5:00 pm

          Yes, I don't believe this point was ever in dispute. Of course it's axiomatic that a country that issues debt in its own currency cannot technically default — there is simply no need.

          With that said, I believe Russia surprised a number of global macro investors in the 1990s by electing to default and devalue at the same time, a maneuver that made no sense.

          Anyway yes — a sovereign who borrows and pays in its own paper cannot default. But the issue is one of investor preference under conditions of slow degradation and "de facto" default, by means of which a preference for holding the currency (or the debt, or both) steadily diminishes. Uncle Sam could issue $50 trillion worth of USTs if he chose, and the Fed could conduct super-QE operations to support the whole lot, but I rather doubt investors would be keen on sticking around for the experience.

          • JJTV on December 15, 2010 at 5:38 pm

            Russia was on a fixed exchange rate and could not defend its pegged. In an effort to defend the outflow of dollars GKO rates went through the roof but it wasn't enough to stop the speculative attack. Russia defaulted in dollar denominated assets and had to devalue the ruble against the dollar. This type of event is common for countries operating under a fixed exchange rate system.

            The debt issue goes back to the point that governments do not issue debt to spend. If no one wanted to hold our debt then overnight lending rates would fall to zero and it would be a "de facto" tax on banks. If the fed pays interest on reserves, which it started to recently, then the government does not need to issue debt at all.

            From a functional finance point of view the government should only issue debt if it wishes its citizens to hold more debt and less money.

            Currency will always be in demand (have value) because the government imposes a tax liability, forces banks to lend in dollars, etc. Traders who take this short-term view will get burned.

            • Jack Sparrow on December 15, 2010 at 5:52 pm

              And the statement that governments "do not need to issue debt at all" points out that unproductive spending via direct debasement of the currency is a form of tax in itself.

              You are correct that the government need issue no taxes, but if, under this no tax scenario, all politicians chose to grant themselves and their lobbyists million dollar salaries, the productivity cost would still have to be extracted from somewhere, as the non-productive cannot magically live off the productive (in terms of real goods and services being consumed) with no exchange taking place.

              A regime in which the government simply spends what it wants, regardless of mechanisms in use, is not unlike the old systems of seignorage and coin clipping dating back to ancient Rome. In fact this is what we have to some degree, and I suspect part of the reason that goverments DO collect tax is to disguise the fact that debasement is a hidden form of tax that the less fortunate pay. (The more fortunate are able to gain more in paper asset appreciation than they lose via general cost of living increase.)

              And no, currency will not necessarily "always" be in demand, as that statement implicitly depends on supply. Again I say, let the United States issue $50 trillion worth of bonds, supported by QE operations, and then see how in demand the currency is.

              MMT continues to confuse "large capacity" with "infinite capacity," thus making important theoretical errors at the margins in result. This confusion is underscored repeatedly with all the use of unqualified superlatives — "never," "always," etcetera.

  7. JJTV on December 15, 2010 at 4:08 pm

    This framework understands that there are real constraints to fiat currency, however, they are not the ones outlined in the above article. Comparing the housing bubble to Modern Money, which I'm not a devout follower of, is highly incorrect. 4,000+ years of state created money is hard to ignore. The Post-Keynesian discipline is broken into lots of different forms: structuralists, circuitists, modern money, etc. The first assumptions are correct, namely, what is money? Where does its value come from?…then you can move onto larger problems. The issue with the above piece is that it is making incorrect comparisons, ignoring historical fact, and is largely missing key concepts happening at the "balance sheet" level. It is my opinion that you should reevaluate your position on the Japanese Yen and sovereign debt. The market will not be able to “defeat” the types of monetary regimes that these countries operate under.

    Cheers!

    • Jack Sparrow on December 15, 2010 at 4:25 pm

      Funny that you should speak of "positions," as at the end of the day we are humble traders here… re, rethinking a stance on the Japanese situation, I would refer you to brighter bulbs than I such as Kyle Bass of Hayman Capital, John Burbank of Passport Capital, and David Einhorn of Greenlight Capital. They and others collectively can and have made the "Japan case" far better than I, and appear to be backing their theories with tens to hundreds of millions (for what it is worth).

      • JJTV on December 15, 2010 at 4:55 pm

        There are men who have put more money on the line, and lost it, than these gentleman. I think there are assuming this will be like the asian currency crisis in which countries were forced to defend their peg, however, Japan is not on a peg. If you have deep enough pockets, i.e. George Soros, then you can see this type of currency peg attack through. A market, however, cannot beat a federal reserve bank. They might see a currency depreciation as the market moves to more riskier investments but it will not be a 'black swan" event like they think. There is no magic "debt level" if your debts are owed in the currency you create.

        • Jack Sparrow on December 15, 2010 at 5:04 pm

          And here again you illustrate one of my beefs with MMT precisely — in saying there is no magic debt level as a defense of "unbeatable" reserve banks, you imply that the capacity for a modern central bank to issue debt without consequence is infinite. ("Very large" capacity and "infinite" capacity being a mildly important distinction!)

          • JJTV on December 15, 2010 at 5:44 pm

            I never said there are not consequences. If the US government gave everyone $1M tomorrow there would be rampant inflation but not because of money creation. The inflation occurs when demand outstrips available supply. Spending $2 Tril on another stimulus package would most likely not be inflationary as US economic capacity is somewhere around 60% and unemployment, depending on how your measure it, is 10-20%. The inflation occurs when an economy reaches full-employment. There is a difference between operational and real constraints and this paradigm identifies those realities. An ELR program and other policies this theory advocates seem to be inline with the real economic constraints that are in place. The magic debt level doesn't exist because debt is a measure of net financial assets (bonds) that entities hold.

            • Jack Sparrow on December 15, 2010 at 7:26 pm

              Ok, now you're losing me… you said:

              "If the US government gave everyone $1M tomorrow there would be rampant inflation but not because of money creation."

              Not sure how that computes.

              Then you said: "The inflation occurs when demand outstrips available supply."

              That's actually backwards. A deflationary situation is present when there is excessively high demand for cash relative to supply — think hoarding in times of panic a la Q42008.

              But going back to the first statement… there is a grand canyon leap in there somewhere. Fiat money creation — or debt issuance, another form of liability creation — is in fact a government orchestrated increase of supply, which, when occurring in the face of non-correspondingly increased demand at a non-dampening rate of velocity, is inflationary.

              Re, other stuff, too many small elements to address… I think we are reaching the point where it is best to shake hands and amicably part ways.

            • Laban Tall on December 16, 2010 at 6:24 am

              "Spending $2 Tril on another stimulus package would most likely not be inflationary as US economic capacity is somewhere around 60% and unemployment, depending on how your measure it, is 10-20%. The inflation occurs when an economy reaches full-employment. "

              Does it matter if there's 'spare capacity' if the eventual recipients of the $2trn decide to spend it on things the US doesn't make any more ?

              In the UK, the Bank of England has printed money (QE), sterling has devalued so imports are more expensive, inflation is 5% and rising, unemployment is rising AND the balance of payments is worse than ever. Because the things people want to buy are no longer made in the UK – and with rising UK energy costs (to satify a green agenda) and regulatory costs, they won't be any time soon.

              You haven't quite exported all your industry like we have – but the trend is there.

  8. JJTV on December 15, 2010 at 8:02 pm

    " I think we are reaching the point where it is best to shake hands and amicably part ways." …point well taken. We will let the Japan trade prove one or the other wrong.

    Cheers!

    • MrV on December 20, 2010 at 11:32 pm

      Thanks for the interesting MMT/Austrian debate.

      My question is, how much debasement is enough? We've already seen the considerable loss of purchasing power of money. This is what I believe is responsible for much of todays poor, i.e those on fixed incomes feel the effects of debasement first.

      Sure entrepreneurs/technology have been able to provide many goods/services at lower costs in real terms, but is this process infinite? Especially with growing populations putting pressure on resource availability etc, I'm concearned that we can no longer afford to slow technology development-wise, otherwise the continual debasement of money will become more exposed

      • Jack Sparrow on December 21, 2010 at 9:45 am

        Unfortunately the debasement process is more likely to speed up than slow down. The "graying of the west" (retiring baby boomers) is coming at a most inopportune time, with already excessive debt levels set to build further even as the emerging world produces and consumes more aggressively (which in turn compresses wages and increases the cost of food and energy).

        To a significant degree the upper income classes will be okay with this debasement acceleration, because they have the ability to 1) better exploit the profit-producing aspects of globalization and 2) combat wealth erosion via cost of living increase by participating in paper asset booms.

        Bottom line: For those on the bottom rung of the income and education ladder in the Western world, life was already hard — and it's only going to get harder…

  9. Tom_Hickey on December 16, 2010 at 1:30 pm

    The von MIses prediction sounds pretty much like a capsule summary of what Post Keynesian Hyman Minksy elaborated in his financial instability hypothesis and which has been developed by subsequent Post Keynesians, notably L. Randall Wray, Michael Hudson, and Steve Keen.

    • Jack Sparrow on December 17, 2010 at 9:35 am

      Love Minsky. "Stability itself is destabilizing"… great stuff.

  10. Anonymous on December 17, 2010 at 6:33 pm

    Wow, this is the longest comment chain I have seen between an Austrian and a real economist. It is interesting because I’ve never really seen or understood the Austrian thought process. Now I have seen it, and it is not pretty.

  11. Fooled ya... on January 3, 2011 at 8:03 am

    I once heard someone (whom i thought was very intelligent for the short time I knew him) ask another someone if they thought the market was “faking, or acting.” The “other someone” dismissed this thought and stated that the market was clearly in a delusional and manic depressive state. But what was interesting was that no matter how bad it got, the market held it’s ground, and to me, in my mind, it wasn’t going to give. It’s as if it knew the troubles, and began working on it’s plan to stay informed. It’s really very simple when you think about it. Based on fundamentals, I think the market made moves by watching what overconfident (yet naive) traders were willing to give it, then take that data to use and stay one step ahead. In this instance, I think the market played the players based on many knowledgable experiences. Whether the market is extremely smart, or a quick recovering idiot, you know what they say, “Never argue with a top rated idiot due to the fact that he’s smart enough drag you down to his level, just so he can beat you with experience. Also, the market has a sick sense of humor, when you happen to disrespect it, it has a tendency to turn on you.

    H

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