Could the Next Crash Happen This Month?

In late August of this year, Federal Reserve chair Janet Yellen began hinting that the Fed might raise interest rates some time in September. Speaking at the annual meeting of central bankers in Jackson Hole, Wyoming, Ms Yellen said that “in light of the continued solid performance of the labour market and our outlook for economic activity and inflation, I believe that the case for an increase in the federal funds rate has strengthened in recent months.”

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Fed chair Janet Yellen recently hinted that the Fed Funds Rate might be raised in September.

While there was a stock market reaction to the announcement, it was fairly mild, with the S&P 500 falling by just 0.16%. Tellingly however, the bond market was much more severely hit, with yields on two-year US government bonds rising by 6.8%, and on 10-year US government bonds rising by 3.6%. This speaks to the way in which the easy money policy which the Fed has been pursuing since the last crash, has inflated a bubble in the value of government debt, particularly in the current low-rates climate, where it’s seen as one of the few safe ways to see a return on your savings. (For more about how central banks have been inflating a dangerous government debt bubble, see my recent article for the Mises Institute.)

So why might a Fed rates hike start the next crash? Essentially, the low interest rates, quantitative easing, and general “money-printing” which central banks have been pursuing since the last crash, has allowed investors to bid asset prices higher than they otherwise would have been, and governments to borrow at lower cost. As illustrated by the Austrian Business Cycle Theory, not only does the cheap cost of borrowing enabled by artificially low interest rates allow for the inflation of unsustainable asset bubbles, but it also encourages businesses to borrow money to invest in more risky projects. The problem with this is that it gives the illusion of profitability to projects which would not have appeared profitable if interest rates had been allowed to naturally reflect the state of real resources in the economy.

When a central bank, such as the Federal Reserve, forces interest rates lower than they otherwise would have been, it distorts the signals businesses have available to them, concerning the state of real resources the economy has at its disposal. An artificially low interest rate signals that the economy has more saved up resources than it actually does. This makes certain, long-term investments appear as though they’re going to be profitable, when actually there aren’t enough real resources in the economy to see them all through to completion. Eventually, in order to avoid hyperinflation, the central bank will have to cease its money printing and allow interest rates to rise again, at which point a whole host of these projects across the economy are suddenly revealed to have been unprofitable all along, with the resources invested in them having been wasted. Bankruptcies ensue, and the crash begins.

Furthermore, to illustrate the way in which central bank money printing has created a bubble in the stock market, I have stolen this graph from Lara-Murphy.com, which shows a clear correlation between the rate at which the Fed has been increasing the money supply, and the value of the S&P 500.

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The blue line approximates the total amount of money in the US economy, as controlled by the Fed, and the red line shows the value of the S&P 500.

The graph shows quite a striking correlation. Whenever the Fed has stepped on the gas and ramped up its quantitative easing – such as can be seen here between late-2012 and late-2014 – the stock market has boomed with it, and whenever it has hung fire the stock market has stuttered, as can be seen on the graph in late-2011. The extraordinary thing about this is that throughout almost this entire time period, Fed interest rates were close to 0%. The fact that, even during a time when borrowing was forced to be so cheap, so much of the stock market growth still seems to have been nothing more than a result of inflation, hints at just how little the US economy really has recovered from the Great Recession, even to this day.

A taste of the calamity we have in store for when this bubble finally bursts, was provided in December of 2015, when the Fed raised interest rates for the first time since 2006. Even that interest hike of a mere 0.25%, caused a dramatic downturn in the stock market, as can be seen on the graph above, and widespread speculation in January of this year that we were about to plunge into another recession. The massive downturn caused by such a modest rates hike then, gives an insight into the enormous degree of malinvestment which must be lurking under the surface of the economy, a bubble teetering precariously on the edge of bursting, kept there by low interest rates alone. When the Fed finally does have to raise rates more, and this stock market bubble finally bursts, I suspect that the similar bubbles throughout the economy – government debt, house prices, auto-loans, etc – which will come crashing down with it.

Even the mere suggestion of another possible rates hike has already caused a wobble in the economic house of cards the Fed’s easy money has propped up. The S&P 500 fell by 2.45% on Friday, its biggest decline since the Brexit shock, whilst the Dow Jones Industrial Average fell by 2.13% and the Nasdaq fell by 2.54%. The fact that these key economic indicators were so bludgeoned by even the faintest hint of a rates rise, lays bare the unstable, low rates fuelled bubbles which have been the source of so much of their apparent recent “growth”, and which now appear close to bursting.

So will the rates hike and crash really arrive this September?

While Ms Yellen’s remarks did initially spark concerns that this could be the case, prediction markets have now quieted down somewhat about the possibility of a September rates hike. According to the CME Group fed funds futures, the likelihood of a rates rise in September has fallen to just 27%. The consensus at this point is that the Fed will wait until after this year’s election before contemplating any further action, with the likelihood that a Fed Funds Rate hike will be agreed upon at the Fed’s final meeting of the year placed at 46%.

However, as much as I suspect a crash will follow any rates hike they do pursue, this delay is actually not necessarily good news. The longer interest rates are held low, the more malinvestments will be made before the crash comes, and consequently the worse the crash will eventually be. With interest rates having been at extraordinary lows since the start of the Great Recession, there’s no way of completely avoiding the fact that such a long period of low rates means malinvestments have already been made, the bubble has already been inflated, and so the crash is inevitably coming. It’s not within our power at this point to avoid the next crash altogether, because the mistakes which will cause it have already been made. But an early rates hike would at least get the recession out of the way before the bubble could inflate any further.

Sadly though, high rates in 2016 are scarcely more popular at the Fed than they are at the Bank of England. The likelihood that policymakers will be bold enough to raise rates enough to give us the short, sharp shock needed to rid us of this bubble and get the inevitable recession out of the way quickly, are rather slim.

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Could post-Brexit Credit Downgrades save Britain from the next Crash?

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After last Thursday’s decision by the British public to leave the European Union (a decision which I endorsed and stand by), reports emerged in the press almost immediately of the imminence of a downgrade in the UK government’s perceived creditworthiness. And sure enough, several downgrades have occurred in the days since the referendum. First to act was ratings agency Moody’s, who assigned a negative outlook to Britain’s Aa1 rating on government debt the day after the referendum. Shortly afterwards, Standard & Poor’s downgraded the British government’s creditworthiness from AAA to AA+, while Fitch went even further, downgrading the government’s credit rating to AA. Significantly, S&P has also, in the past few hours, downgraded the credit rating of the EU itself from AA+ to AA.

Grim sounding stuff, upon a cursory glance, and certainly perfect headline content for the many doomsayers and pro-EU commies of the fourth estate. However, the long-term implications of such downgrades might not be as negative as we’re all being led to believe. Indeed, increasing doubtfulness of the government’s creditworthiness could help to cushion the blow for Britain somewhat, when the next crash inevitably arrives.

First of all, these downgrades theoretically make it more difficult for the British government to sell bonds to private investors, and hence more difficult for it to borrow money, which to me at least makes the downgrades a positive, almost regardless of their other consequences. With UK public sector debt at over 80% of GDP and Osbourne still failing to achieve even his own lax targets for reducing the deficit, I’m pretty sure that if fire rained from the sky and Beelzebub ascended from hell to eat Mark Carney’s legs, I would still hail the event as a positive if it made it more difficult for the government to borrow money. One might argue that the downgrades actually won’t affect the total amount that the government can borrow, because even if they dissuade private investors from buying government bonds, the Bank of England can theoretically pick up the slack by simply buying government bonds with money created out of thin air. However, with interest rates at record lows since 2009, the threat of high inflation might prevent the bank from completely offsetting a reduction in demand for government bonds, and so it’s possible that the total amount of money the government can borrow may indeed decrease.

However, far more important is the fact that these downgrades may help to deflate the government debt bubble which we are currently living through, and which will in all likelihood be the cause of the next crash. In the aftermath of the Dot-com crash of 2000-2001, central bankers’ pursuit of artificially low-interest rates encouraged speculation and a scramble to borrow and invest, during a time in which the economy should have been allowed to readjust and learn the lessons of the crisis it had just been through. Instead of allowing the Dot-com bubble to fully deflate so that the economy could start building on a solid foundation again, they merely rolled the bubble over into another section of the economy: housing. The reason why housing became the area of the next bubble was because it was seen as an extremely safe area of the economy, with  relatively predictable rates of expected return, and only a small chance of failure. When the housing bubble finally did burst, central bankers made all the same mistakes again that they had in 2000, sledgehammering interest rates into the earth’s mantle and consequently causing a scramble to invest in the area that had replaced housing as the universally accepted “safest” investment in town: government debt. However, with Puerto Rico facing an historic debt default just this very week, and many other countries not far behind, the signs are beginning to emerge that the government debt market of today is just as “safe” as the housing market of 2006 was.

If the above is true, and if we really are on the verge of a government debt crash that will dwarf the housing crash just as much as the housing crash dwarfed the dot-com crash, then we should all be thanking the ratings agencies for trying to steer UK investors away from becoming more heavily invested in government debt. Will it completely shield us from the effects of the crash? Absolutely not. But we can at least assume that, come the crash, the British public and its institutions will likely find themselves at least somewhat less heavily invested in the failing government bonds than they would have been, had they retained their unimpeachable AAA ratings.

So thank you again to the British public for voting for Brexit, and thank you to Moody’s, Fitch, and S&P for downgrading your assessment of our government’s creditworthiness; in exchange for a little short-term uneasiness, you may have put Britain in a stronger position to weather the coming storm, perhaps without even having realised it.

Why Austrian Economics?

The other day someone sent me a question over on my Tumblr blog: “Why Austrian economist? I thought you were English. Aren’t you a British national?”

The question highlights the fact that, despite its resurgence and speedy growth in recent years, the “Austrian School” of economics is still seen by many as part of what Keynes would have called the economic “underground”. Indeed, the Austrian tradition lies so firmly outside the mainstream of economic thought that, for the inaugural post on this blog, perhaps I should repeat here a somewhat expanded version of the answer I gave to that confused Tumblr follower. What is “Austrian” economics? Why is it unique? And why is it so vital that it’s message be understood in these troubled economic times?

As I highlighted in the “About” page of this blog, I’m still a relative newcomer to Austrian ideas, and my hope is that the level of understanding displayed on this blog will increase as time goes on. So the reader should temper their expectations somewhat for this very first post, as it likely won’t be the most exhaustive or masterful exposition of Austrianism ever. Nevertheless, it should still serve to single out some of the most fundamental ideas in the Austrian tradition, as well as those which strike me as most important to the state of economics today.

So first thing’s first, forget about the “Austrian” part. Austrian economics doesn’t refer to supply and demand in Vienna, or inflation in Salzberg, and too many people get confused thinking it must have something to do with the actual country of Austria itself. In fact, most “Austrian” economists today live and work in North America and, as the great economist Murray Rothbard quipped, “there are very few ‘Austrians’ left in Austria.”  Austrian Economics is rather a school of thought, a body of ideas and theories, which were first explored by Carl Menger in the 1860s.

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Carl Menger (1840-1921)

During his time as a financial journalist in central-Europe, Menger noticed that the received wisdom of Classical Economics did not match-up with how he observed prices being formed on real-world markets. This prompted him to write his Principles of Economics (1871) which demolished the archaic “labour theory of value” favoured by Adam Smith, David Ricardo, and Karl Marx, and ushered in the “Marginal Revolution” of the 1870s. (Incidentally, its genesis in Menger’s 1871 work makes Austrian Economics the oldest continuously-existing school of economic thought in the world.) For about a decade after the publication of the Principles, there was no “Austrian school”, there was only Menger. However, in the mid-1880s Menger came under attack by the dominant school of economic thought in the area at that time, the so-called “German Historical school”. The Germans disdained Menger’s abstract theorising, instead favouring pragmatism and reference to historical knowledge as the correct approach to the economy. At this point in history, Germany was considered the cultural and intellectual centre of Europe, and so adherents to the German Historical school began referring to Menger and his ideas as mere “Austrian economics”, in an attempt to brush them aside as unrefined and parochial. Despite being intended as an insult, the name stuck and, as Menger’s ideas gained an increasing following throughout the 1880s, including brothers-in-law Eugen von Böhm-Bawerk (1851-1914) and Friedrich von Wieser (1851-1926), the “Austrian school” of economics was born.

From that time until this the Austrian school, despite its ostracism from most of academia, has nevertheless developed a host of key economic ideas, some of which have even been accepted into the corpus of acceptable mainstream opinion. These include Menger’s subjective marginal utility theory of value, Böhm-Bawerk’s positive time-preference theory of interest, and Wieser’s concept of opportunity cost. Other adherents to the Austrian tradition, whose names might be more familiar to the lay reader, include: the extremely eminent economist Friedrich von Hayek (1899-1992), whose political writings, such as the famous Road to Serfdom, influenced British Prime Minister Margaret Thatcher; Murray Rothbard (1926-1995), economist and founding father of the political ideology now known as anarcho-capitalism; and three-time US Presidential candidate Ron Paul (1935- ).

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Ludwig von Mises (1881 – 1973)

However, I’m many ways, the central figure to the modern Austrian tradition was the brilliant economist Ludwig von Mises (1881-1973). Although he made extraordinarily important and extensive contributions to the theories of money and credit, the problem of economic calculation in planned economies, and our understanding of the business cycle, perhaps Mises’s most important contribution to economic thought was in the rarely-traversed field of methodology. Mises devoted a large part of his career to explicating and systematising the method which had been implicitly used by previous Austrian economists, as well as by proto-Austrian figures such as J.B. Say and A.R.J. Turgot.

Looking at the academic world around him in the early- to mid-20th century, Mises became increasingly concerned by what he saw as the grave methodological bankruptcy of modern economics. Ever greater numbers of economists, particularly those in the penumbra of the logical positivist movement, were beginning to believe that the best way to gain insights into the economy was simply by  measuring and gathering its empirical data, and then discerning the mathematical relations between the various variables. While this is undoubtedly a fruitful way to approach the natural sciences, such as Physics, Mises believed that its use in the distinctly human science of economics introduced an unacceptable element of error, in particular due to its inability to account for two factors which he called “finality” and “ideas”.

What he means by “finality” is the understanding that human action, unlike the movement of atoms or the reaction of chemicals, takes place in the pursuit of individually chosen goals. Because people chose the outcomes they would like to achieve, this means the range of different behaviours they exhibit in the face of external forces is much wider and less predictable. Not only are the goals people aim at as numerous and varied as the human race itself, but any person or number of people in the economy could change the goals they’re aiming at at any time, in any way, and any number of times, and could do so for reasons completely unknown to anyone but themselves, least of all to the economist and his calculator. This peccadillo of human nature and (apparent) free will, leads to a potentially infinite number and variety of future changes in the economic system, which severely restricts the predictive power of mere data-gathering and mathematical methods.

What he means by “ideas” is the fact that different people have very different ways of looking at the world, which cannot be empirically measured or modelled for. These different world-views, beliefs, and constellations of abstract concepts which exist within each individual mind, cause different people to react in unforeseeably different ways when confronted with the same external circumstances.

Mises argued that the failure of (what is now) the mainstream economic method to account for these two human factors, finality and ideas, as well as the impossibility of truly controlled experiments in economics, renders the empirical/mathematical method useful only as tools of economic history, able to blandly state what happened in the past, but little more. For the purposes of devising economic theories, on the other hand, to actually explain the past and predict the results of future changes, Mises had to create an entirely new field of study: Praxeology.

Praxeology is the value-free, objective science of human action, of which Economics is the most well-developed branch. In order to overcome the extreme variety and unpredictability of human action, Mises sought a few core statements about it which are undeniably true under all circumstances: axioms. The most important praxeological axiom is the Action Axiom: the statement that human beings select particular outcomes which they would like to achieve, and then pursue those outcomes by chosen means. In a word, humans “act.” This is axiomatically true, because any attempt to disprove it would be to select a preferred outcome, and then to pursue it by chosen means. That might seem banal, but because these axioms are undeniably true under all circumstances, that must mean that any statement that can be correctly deduced from them logically must also be true under all circumstances. Any economic statement correctly deduced in this way, would therefore also be universally true, and hence would have overcome the obstacles of finality, ideas, and the sheer complexity of the economy.

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Six key “Austrian” Economists, and some of their notable ideas and works.

Therefore, Mises argued that a priori logical deduction from axioms about human action was the only method by which undeniable economic truths could be discovered. Misesian Austrians argue that this method equips the economist with the ability to make a narrower range of predictions, but to do so with absolute certainty. An Austrian economist doesn’t believe they can predict what the price of crude oil will be in a year, or by how much a certain tax hike will raise government revenue. Rather they believe their system allows the economist to make absolutely certain statements, like “Other things being equal, people will always value acquiring the ‘n’-th unit of a good, more than they value the ‘n+1′-th unit of the same good”,  or “Other things being equal, a rise in the price of a particular good will always cause people to prefer buying a smaller amount of that good than they otherwise would have.”

Mises further understood that, if an economic law really is true under all circumstances, as a result of having been correctly deduced from praxeological axioms, that law would therefore be invulnerable to supposed empirical evidence against it. Indeed, if economic laws can be deduced aprioristically in this way, asking to prove or disprove them with empirical evidence wouldn’t even make sense; to compare economics to another purely aprioristic science, it would be like asking a mathematician to go out into the real world and gather empirical evidence to prove that the 2 is never the same number as 7. Naturally, their complete rejection of supposed empirical evidence, as well as their increasingly unfashionable lack of interest in mathematical analysis, has made the Austrians extremely unpopular in academic circles, and they have consequently been relegated to well outside the mainstream since at least the Keynesian devolution of 1936 onward.

However, there has been a somewhat increasing level of interest in the Austrian school in recent decades, and certainly since the Great Recession. It didn’t go unnoticed that a disproportionate number of the people who accurately predicted the 2008 financial crash in advance were Austrians, and this has led to growing interest in perhaps the most important Austrian theory for our times: the Austrian Theory of the Business Cycle.

I’m conscious that this post is already so long that it could easily be mistaken for the average modern-day cinematic release, and with a roughly equivalent proportion of the audience proffering unanswered pleas to God for mercy at this point. Furthermore, I’m sure I’ll have many other chances to relay this elegant theory in future posts, so I won’t go into it in any great depth here. But basically, the absolute bare bones of the Austrian business cycle theory, which was first outlined by Mises and then fleshed out by Hayek, is the idea that interest rates coordinate production across time. If the interest rate is high, it will be more expensive to borrow money for a long time, so businesses will tend to invest more in enterprises which will yield profits quickly, i.e. consumers’ goods. Conversely, if the rate is low, it will appear more profitable for businesses to invest in producers’ goods and other projects which won’t yield profits for a long time. On a free market, the rate is determined by supply and demand of credit, i.e. how much people are saving. This coordinates things beautifully, because banks will offer high rates (and hence stimulate investment in consumers’ goods) when people are saving least (and hence demonstrating their desire to consume now), and banks will offer low rates (and hence stimulate long-run investment) precisely when people are saving most (and hence demonstrating their preference for spending in the future.) However, the Austrian theory shows that the business cycle is kicked-off when the interest rate is pushed artificially low, usually by a government central bank. The artificially low rate incentivises consumers to save less and spend more in the present, while at the same time incentivising businesses to produce less in the present and invest more in long-term projects. This disco-ordination leads to lots of spending, lots of construction, lots of investment, and outwardly that all looks great, but under the hood it’s merely the boom or “bubble” that precedes the crash. When the government eventually has to raise interest rates again, to avoid severe inflation, all these long-term projects which had the illusion of profitability at the artificially low rate, will be revealed to have actually been unprofitable all along. Therefore all the resources businesses sunk into such projects are shown to have been wasted, resulting in economy-wide losses, the bursting of the bubble, and the resulting inevitable crash.

I understand that that’s an extremely oversimplified version of the Austrian theory, which is actually quite a lot more complex and nuanced than most other explanations of the business cycle, but hopefully I’ll be able to do it a little more justice in future posts.

Anyway, I should probably finish this utter behemoth of a first post here. Hopefully though that will have given pretty good outline of why I think the Austrian school stands so far apart from the crowd, and why I consider its method and business cycle theory so important to the current state of economics today. If you’d like to learn more, I’d heartily encourage you to check out the absolute wealth of educational materials that the Mises Institute puts out, both on their website and on YouTube. They, in their extraordinary generosity, have made practically every major work of Austrian economics available as free PDFs, and sometimes even as free audiobooks, alongside all sorts of other goodies they offer on their website, so you’ll do yourself an immense favour by checking them out. In general though, if you want to learn more I hope you’ll continue to follow the output on this blog in the future, as I certainly look forward to writing more on this fascinating subject, as well as on libertarianism and current events in general.