In 2002 I wrote a book about the economic stupidity of the euro. Titled Des Lions Menés Par Des Anes (Lions Led By Donkeys), it became a minor best-seller in France. Its modest success prompted a well-known economics professor to invite me to present my ideas to his PhD students. Commenting after the presentation, the professor asked, “Do you realise that your framework of analysis is totally Wicksellian?”
I didn’t, and for a good reason: I had never heard of Knut Wicksell before. But the question changed my life. Ever since, I have been trying to understand what the work of the “radical bourgeois” Knut Wicksell, who lived a quiet life in Sweden at the beginning of the 20th century, really means. And the more I researched, the more fascinated I became. Often I felt like a bloodhound trying to follow a very old scent. Once in a while I lost the trail, and then I had to retrace my steps and start over again.
To guide my research, I used the writings on Wicksell in The Age Of Science, the third volume of Joseph Schumpeter’s The History Of Economic Analysis. According to Schumpeter, for whom the Swede was one of the greatest economists ever, Wicksell was the first to realize that there is a difference between the “equilibrium level” of interest rates (at which savings equal investments), which he called “the natural rate”, and the actual level of interest rates, which he called “the market rate”. This realization led to the emergence of a whole new school of economists, who ever since have researched the relationship between the monetary side of interest rates and the economic side of interest rates.
Wicksell also understood that if there is a difference between the two—natural rate and market rate—it leads the economy into what he called a “cumulative process”, which does not stop naturally. Schumpeter was quick to see the implications:
“Let us assume that the banks at the end of an economic recovery or after a long period of stagnation are in a situation of abundant liquidity. Their interest will push them to increase the volume of their loans. To achieve such a result, they will have to lower the interest rate that they charge below the Wicksellian natural rate..., which as we know is equal to Böhm-Bawerk’s real rate. As a consequence, the companies will invest... at a higher level than they would have done if we had had a higher level of interest rate.
“As a result, we have a cumulative inflationary process and a distortion in the structure of production. However, this cumulative process has to stop when the banks reach their lending limits and/or when the market rate moves above the natural rate. We then have an untenable situation because all the investments that were made when the rates were artificially low are now unprofitable, and this leads to forced liquidations which announce the coming depression.”
Schumpeter noted that while John Keynes, Ludwig von Mises and—especially—Friedrich Hayek all picked up and elaborated upon Wicksell’s ideas, none of them gave the Swedish economist much credit. Their omission downplays the importance of Wicksell’s theories, which paved the way for the monetary analysis of the economic cycle, in which the most important variable is the spread between different interest rates.
I have spent much of the last ten years researching this relationship, and specifically trying to understand how in the real world to measure the natural rate and the market rate (for the fruits of this research, see Of Wicksell And Fed Fallacies). The next step was to “map” the cumulative process that is the unavoidable consequence of a divergence between the market rate and the natural rate. This is what I try to do in this paper.
Wicksell’s cumulative process
First, it is necessary to define the measurement tool. What matters for Wicksell is not the absolute level of interest rates, but the spread between the natural rate and the market rate. If the market rate is too high relative to the natural rate, growth falters. If the market rate is too low, the economy enters an explosive cumulative process. As regular readers will know from past research, I use the growth rate of gross domestic product as a proxy for the natural interest rate. And to get a view on the short term evolution of the economy, I usually take Baa bond yields as a proxy for the market rate. However, to get a longer term picture, in this study I use the yield on 30-year US treasuries, deflated by the inflation rate over the previous two years, as my proxy for the market rate. And since I am trying to identify a cumulative process, in this study I will not look at the Wicksellian spread itself, but at the two-year moving average of the Wicksellian spread. After all, if rates are too low for a month or two, it doesn’t greatly matter. But rates that are kept too low for years and years are a different thing entirely.
Since it takes time to destroy an economy like the US, in my charts I have pushed the Wicksellian spread forward by three years (a number I arrived at the old-fashioned way, through trial and error). Put simply, if the market rate is too low compared with the natural rate for too long, then the result is a Wicksellian boom and bust, in which the consequences of bad policy appear three years down the road. The beauty of this analysis is that it introduces a longer time frame into the reasoning. Instead of concentrating on the next quarter’s GDP, which was probably determined by events that happened years before, we are forced to focus on the “long wave”. As the chart above shows, this approach reveals three distinct Wicksellian periods over the last half-century:
1) From 1968 to 1982, market interest rates were far too low. The result was a succession of busts, such as the 1970 and 1974 recessions, together with the inflationary booms of 1973 and 1979-1980.
2) Then for most of the period from the early 1980s to 1998, the Wicksellian spread was largely where it should have been, and the economy prospered through what the economists of the day called “the great moderation”. Notably, very few economists were able to explain just why the economy went into this period of great moderation, but that didn’t stop central bankers from claiming the credit.
3) Finally, since 2002 policymakers have kept the market rate far too low versus the natural rate. The only exception has been when the natural rate collapsed because the economy sank into recession.
The volatility of growth
According to Wicksell, if market interest rates are too low for too long, the inevitable result must be a significant increase in the volatility of the growth rate of the underlying economy. This is easy enough to check with another chart.
In the chart above, the grey shaded area corresponds to the two-year moving average of the Wicksellian spread, pushed forward three years (i.e. the blue line in the first chart). When this indicator is above the zero line, capital is either at the right price or too expensive. When it is below zero, capital is too cheap, which will lead eventually to an “explosive” boom and bust scenario. The green shaded bands correspond to periods when rates were properly structured—i.e. not too low—three years earlier. During these green periods, the volatility of US GDP growth was half what it was during the light brown “Keynesian” periods in which rates were too low. This is exactly what Wicksell would have expected.
The Keynesians among our readers will immediately retort, “Yes, the volatility of growth was higher, but surely the rate of growth was also higher?” Not according to Wicksell. He made the point quite clearly that during boom phases a lot of capital is badly allocated, only to be destroyed in the subsequent busts. An economy which keeps market rates too low for too long will automatically find itself with less and less capital in cycle after cycle. Ultimately this capital destruction leads to a much lower structural growth rate, as the United Kingdom demonstrated between from 1966 and 1976, when London was forced to go cap in hand to the International Monetary Fund, and as we have seen in the US since 1998.
Once again, it is easy enough to verify this controversial proposition with a chart. Once again, the scoreline is clear: Wicksell 1, Keynes 0. As I have been saying non-stop for years now: low rates lead to low growth. This has nothing to do with a new normal, secular stagnation, or a structural downshift in the growth rate, and everything to do with the wrong level of short term interest rates.
The volatility of inflation
As we know, the price system is the only information tool that business managers use to reach their decisions. For them inflation is neither good nor bad. The only thing that matters is whether inflation changes abruptly. Put simply, what entrepreneurs abhor is a volatile inflation rate. So, what does the volatility of the US inflation rate (the second derivative of the US consumer price index) tell us?
So, when central bankers adopt Keynesian policies, not only is the economy afflicted with lower growth and a higher volatility of the growth rate, as the chart above illustrates, it also suffers from a much higher volatility of prices, which go up during the boom phase and collapse when the inevitable bust then arrives.
It’s hard to imagine a worse state of affairs for the entrepreneur. Not only does the poor chap have no idea how much stuff he should produce, he also has no idea at what price he will be able to sell that stuff. Rather than stimulating “animal spirits”, a Keynesian policy environment creates a world in which anyone rational scrambles for the air-raid shelter before the next bomb explodes.
Looking at this chart, you can tell that Keynes was a civil servant and never a businessman. He believed that entrepreneurs were like Pavlov’s dogs, and had nothing but contempt for them. Of course, he never had to meet a payroll...
As Schumpeter said in 1947, “The real reason behind the huge success of Keynes’s theory was that it allowed the politicians to intervene non-stop in the economy.”
How prescient he was!
Wicksell and the market
If Wicksell was right, and capital is well allocated in times when the market rate is close to the natural rate, then the price to earnings ratios of listed stocks should go up during these Wicksellian periods. Conversely, during Keynesian periods, when the market rate is maintained—deliberately or otherwise—below the natural rate, P/E ratios should go down. Another quick check...
I rest my case—except to mention that in the near future, US P/E ratios should start to fall. And since at the time of writing, profits are falling, it would be very surprising if the S&P 500 performed strongly, given that the addition of two negatives seldom equals a positive.
Now take a look at the relationship between the performance of the US stock market and the performance of a long bond issued by a country where the central bank more or less consistently followed a Wicksellian policy—Germany back in the days when the Bundesbank was independent. The chart below shows the total return of the S&P 500 and the total return of a long-dated German bund in common currency terms since 1966, which is roughly when all the silliness began in the US.
On a total return basis, over the last 50 years US shares have underperformed German bonds by a whopping 30%. So equities outperform bonds over the long term? Yeah, right.
The funniest thing is that the deepest underperformance of US equities versus German bunds occurred during the Keynesian periods when the US Federal Reserve was attempting to ignite entrepreneurs’ animal spirits by maintaining artificially low interest rates. And the best performance was generated when US entrepreneurs were paying the right price for the money they borrowed—during the green-shaded Wicksellian periods.
When it comes to value creation, it seems there is very little mileage in trying to proceed to the euthanasia of the rentier through very low rates or devaluation. In fact, attempting to euthanase the rentier appears to be one of the stupidest policies a central bank can follow. Always and everywhere the results have been disastrous. Of course, just because a policy has consistently failed in the past does not mean that it will not be pursued with even greater vigour in the future by the economic geniuses who run the world’s central banks.
Running towards the bear
In the near future, it looks very much as if US shares are once again going to underperform German bunds. And since the yield on bunds is currently at zero, we can conclude that the US stock market is going to go down in absolute terms. Indeed, it is highly probable that a bear market has already started. That shouldn’t be surprising. In every previous Keynesian period, the US entered a bear market roughly three years after the launch of excessively low rate policies. Why three years? Because apparently that is how long it takes to misallocate capital on a scale big enough to precipitate a bear market.
So with the US probably now entering a bear market, the big question for investors is this: Will it be a gentle cub? Or a ferocious Ursus Magnus? According to Wicksell, when market rates are too low versus the natural rate for too long, the economy will go through a boom with massive capital misallocation, followed by a bust in which the misallocated capital is eliminated. As a result, every Keynesian period should be followed by an Ursus Magnus. Sure enough, this is exactly what the chart below confirms. The next bear market is very likely going to be of the species Ursus Magnus.
The world today is managed by a bunch of fellows who believe with religious fervour that low rates favour growth and prosperity. If Wicksell was right, the reality is the complete opposite. Low rates lead to stagnation and misery. And surprise, surprise: since central banks started manipulating the cost of money downwards, stagnation and misery have spread like a malignant cancer throughout the body economic.
In reality, there is no reason at all why the world should have to endure a period of secular stagnation. The current malaise is due entirely to the incompetence of those who manage monetary policy in the major economies (except perhaps in China). The problem is that we are managed by people with a religious frame of mind, and theocracies seldom bring prosperity to the masses, even though the priests themselves certainly prosper.
With more and more of my research suggesting that Ursus Magnus has emerged from hibernation and is about to start roaming the land, I advise portfolio managers to maintain a position in long-dated US treasuries as a hedge against their equity exposure.
Having now followed my Wicksellian trail to its conclusion, I intend to present my findings in a small book to be published by Gavekal Research. It is not that I believe anything I write is likely to convince the world’s policymakers. It is simply so that readers will be able to find the results of more than 10 years of effort in one place—and also because if I ever have the honour of meeting the Queen of England and she demands, as she did in November 2008, “Why did no one see this coming?”, I would like to be able to answer, “Some of us did, Ma’am”.