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.
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.
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…