“The fateful errors of popular monetary doctrines which have led astray the monetary policies of almost all governments would hardly have come into existence if many economists had not themselves committed blunders in dealing with monetary issues and did not stubbornly cling to them.
There is first of all the spurious idea of the supposed neutrality of money. An outgrowth of this doctrine was the notion of the “level” of prices that rises or falls proportionately with the increase or decrease in the quantity of money in circulation. It was not realized that changes in the quantity of money can never affect the prices of all goods and services at the same time and to the same extent. Nor was it realized that changes in the purchasing power of the monetary unit are necessarily linked with changes in the mutual relations between those buying and selling” (Ludwig Von Mises, “Human Action”, Chapter XVII, 1949)
Please, click here to read this article in pdf format: may-19-2009
The S&P 500 reached the 900pts and analysts are predicting lower lows in equities and wider wides in credit. The fundamentals are simply not there for the market to continue rallying. (We have been discussing this issue since March). It is true, fundamentals have not improved, and they are only less bad. However, good scientists don’t argue with reality; but try to explain it. If economics is a science and economists cannot explain a fact, they should at least not criticize or ignore it. In the past weeks, we have read economists call “ironic” the fact that Treasuries were sold off and equities rallied or “anomalous” the fact that the USD weakened as yields rose, etc. Now, these same analysts tell us that: 1) In the near term, equities will fall (S&P 500 back to 600s) and 2) In the long-term, we should expect inflation. How can these happen? What is behind this line of reasoning? Should we believe? Let’s see:
a) How we can have short-term sell-off in equities and credit and long-term inflation
The assumption here is that equities have rallied with “not-so-bad” fundamentals, earnings. But once earnings for the 2nd half of 2009 are disclosed and show that the picture remains ugly, equities will sell. In the meantime, there is no short-term inflation. Analysts acknowledge the colossal amounts of money being printed but indicate that there is still a low velocity of circulation. A low velocity means that lending is still minimal and that there is overcapacity in the global economy.
b) What is behind this line of reasoning
Perhaps Paul Krugman, 2008 Nobel Prize in Economics, best summarizes these linkages. On February 4, 2009, Mr. Krugman published this chart in his New York Times blog (http://krugman.blogs.nytimes.com/2009/02/04/about-that-deflation-risk ):
As the chart shows, the higher the inflation rate, the lower the output gap (Tincho’s letter of April 27th). For the sake of intellectual honesty, I reviewed the equations behind this model (see Krugman’s: www.pkarchive.org/economy/spiral.html). In equation (1), we see that: Output = a – b * (Interest rate – Inflation rate). As you can see, Krugman takes for granted (equation 1 is his axiom) that output grows if the inflation rate is higher than the interest rate. In equation (2) Demand for liquidity – Price level = c + d* output – e* Interest rate. Here, the demand for real liquidity is directly proportional to the output level (=if the economy grows, more liquidity is demanded) and indirectly proportional to the interest rate (= if interest rates are high, people take liquidity off the system). But, what determines the price level? Expectations and output! (See equation 3). This model is interesting, but is beyond the scope of our letter. (If you read it from the link, ask yourself a) how valid this model is, if in the 1930s the economy eventually found a bottom; b) why there is no further analysis on an exit strategy, if central banks use Mr. Krugman’s window of opportunity)
c) Should we believe?
You may think I am crazy criticizing a Nobel Prize. Well, at least I am not alone. Someone else did it too, 70 years ago. Why is this important? If you think I am just writing about a theoretical debate, I failed to send the message: IDEAS ARE NOT AT STAKE HERE: YOUR SAVINGS ARE! If Mr. Krugman is right, you should sell your long risk asset positions now, and buy in October. If Mr. Krugman is wrong, you should stay put and perhaps start buying commodities.
Krugman’s model fails to explain the transmission mechanism of monetary policy. If in the long-term there is inflation, then in the short-term the money that is printed has to go somewhere. Since March 18th, we have compelling evidence that the newly printed money pushed the stocks and commodities markets. How much are we talking about? About $100bn in Treasuries purchases plus $172Bn in Agency debt in April only! And there is at least $200bn more in Treasuries purchases waiting. So….how can stocks fall? How can credit go wider?
In my view, for this to happen, one of the two events have to take place: 1) The Fed does not keep up with the programmed purchases or, once it is done with them, it does not size them up 2) Banks are faced with a high and devastating rate of defaults, negating the latest wave of debt restructurings
In 1949, an economist called Ludwig Von Mises, wrote exactly why a model like Mr. Krugman’s is a fallacy. I will not speak for Mr. Von Mises. His views are very simple to read. He wrote them in a book called “Human Action”, Chapter XVII, 2: “Observations on Some Widespread Errors”. Here is the link: http://mises.org/humanaction/chap17sec2.asp . You should read this, because understanding Mises’ view will eventually help you preserve your capital.
The problem these mathematical models have is that when the equations cannot prove anything, economists blame people’s expectations. It is people’s expectations that screw our recovery plan! You immediately see the political implications of this: You have inflation because people expect it. Ergo, manage people’s expectations and inflation will stop…Manage = Regulate…Regulation = Socialism. And regulation indeed is what we are going to see more and more often. The latest one was announced for the derivatives markets.
Finally, let me say that the aforementioned model is not just one of Krugman’s curiosities. To be fair, it is very old. It is based on the Quantity Theory of Money, which can be traced back to the ideas of David Hume. It has attracted serious attention from the Fed. One of the main beliefs is that there is an “optimal” growth rate of money supply, which the Fed must come up with. The problem is to find out whom it is optimal for! (The Fed? The Treasury? Taxpayers?)
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