A book finds favor when
public opinion is willing to accept its proposition. This Time is Different:
Eight Centuries of Financial Folly (2009) by Carmen Reinhart and Ken Rogoff
funneled the debate of whether post-2008-crisis governments should increase
spending ("fiscal stimulus") or cut it ("austerity"). The
media's interpretative abilities further refined the on-off debate into a
single interpretation of Rogoff and Reinhart's book. A country where public
debt exceeds 90% of GDP is walking the gangplank. There is no shortage of such
countries; the most heated debate has been in Europe. It is at emergency
meetings among the world's acronyms where bureaucrats decide whether formerly
sovereign nations are to be hexed with "austerity," or not.
At the moment, there is a hiccup over the book's interpretation. That is not
the topic here. The ruckus among noted economists concerns some
re-regurgitation of the authors' data. Some new computer output aids the
anti-austerity forces, who believe central bankers can eventually produce
enough money on a keyboard to restore world prosperity. This accumulated phony
wealth accompanied by asset-price targeting is the reason these institutional
has-beens still control the public forum and weary us with recreational
mathematics.
Outlined below is an interpretation that
matters. The Summer 2012 edition of The International Economy published "Rethinking
the Rogoff-Reinhoff Thesis," by economist Bernard Connolly,
author of The Rotten Heart of Europe, and proprietor of Connolly
Insight, his economic consulting firm in New York.
Connolly recognizes that the parties above
(Rogoff, Reinhardt and all the categories of data interpreters mentioned) have
mishandled This Time is Different. They have done so because the data
has "not been set within a theoretical framework." The reason for
such ignorance is "straightforward. The world, or at least the United
States, became dynamically inefficient in the second half of the 1990s (perhaps
for the first time since the 'roaring twenties'): the real interest rates
tended to be less than the expected trend real growth rate. The culprits? Fed
Chairman Alan Greenspan, European monetary union, the academic macroeconomics
industry as a whole and its worse-than-useless DSGE models, and central banking
theology as a whole with its dangerous inflation-targeting obsession.
Over-financialization and excessive risk-taking by financial institutions were
the consequence of this mess, not the cause."
Cutting to Connolly's point of illusory
wealth, central bankers believe they can right any economic disturbance: the
heart of their DSGE model. Why did Ben Bernanke claim sub-prime was
"contained" in 2007 and wave off bubble concerns presented to him
(February 2013) by the new bureaucracy he commissioned to warn him of bubbles?
Because his dynamic stochastic equilibrium model is correct. It is always
correct. He is the "A" student.
Except, it is wrong when the economy is
dynamically inefficient, characteristics of which (see examples above) are
exactly those being chased by central bankers today. Connolly quotes from
"the magnificent, awe-inspiring Foundations of International Economics"
(1996), written by Rogoff and Maurice Obstfeld: "The behavior of
dynamically inefficient economies wreaks havoc with much of our intuition about
the laws of economics." (Connolly explains the economic problems currently
being exacerbated by official policy cause a reduction in future consumption
possibilities, meaning, much of the capital formation is based "on
excessively optimistic expectations of future demand." This is explained
in his paper.)
Connolly corrects a possible
misunderstanding of how the illusion of wealth will end: "It is very
important, in thinking about the implications of the Reinhoff-Rogoff research,
to realize that what deters new participants in a Ponzi scheme is not an
accumulation of debt, but a destruction of wealth, or more accurately, a
realization that the wealth supposedly backing debt is illusory.... [I]f the
wealth of debtors is illusory, the wealth of creditors must also be
illusory."
The illusory wealth will be extinguished.
Capital formation based on excessively optimistic expectations of future demand
will end where it started. This may happen quite fast. I tend to think Bill
Fleckenstein, my co-author of Greenspan's Bubbles, is correct. Bill has
written on his "Daily
Rap," that, "in today's money printing world, as I have
noted, problems don't matter until they do, as the discounting process
essentially fails to function."("Daily Rap," April 3, 2013)
Current market prices are controlled, or,
at least significantly altered, by central-bank interference. Investors who
enjoy the latitude of investing or not investing, and choose to hold "risk
assets" (discussion for another day) believe, or hope, that central banks
will continue to boost prices. There is no question that boosting asset prices
is the top goal of central banks today.
The "realization that the wealth
supposedly backing debt is illusory" (paper currencies are a liability of
the issuer) will end. Connolly writes: "traditional 'fundamentals' have
now largely been transformed into one overarching 'fundamental': the assessment
of solvency. As a result, markets are exhibiting binary behavior ('risk-on' and
'risk-off'.)"
This is another way of saying: "the
discounting process essentially [is] fail[ing] to function." When ro-ro
goes no-no, the currency of choice will be real money: gold and silver.
As it happens, Bill Fleckenstein quoted
Paul Singer of Elliott Management (who has been quoted here before), in this
afternoon's "Daily Rap":
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