Book Review: "Profiting From Monetary Policy" by Thomas Aubrey, (Palgrave Macmillan: 2013)
For someone like myself who has written blog posts like "Bernanke is Underwriting the Wealthy" and "A Superabundance of Capital But Not For Economic Growth", this book is a welcome read.
To read that the economy does not revolve around the equilibrium solution of a general equilibrium economic model or to read that the Efficient Market Hypothesis (EMH) is not the "true" paradigm for managing money if you run a hedge fund…or a pension fund…or, even your own portfolio…is refreshing…and enlightening…and helpful. Here is an author who claims that the Great Moderation was "one of the largest ever credit booms in financial history." (Page 158)
Thomas Aubrey, according to the material given on the book cover, is "the founder of Credit Capital Advisory, a consultancy specializing in the relationship between credit markets and the wider economy. He has substantial experience running credit and economic analytics businesses...." He also has academic credentials, which show up in his historical discussions.
The crucial thing about his background, to me, is that he believes that how one views the world should contribute to a person's ability to make money. And, he believes that actual money managers around the world have made a lot of money by taking advantage of the opportunities created by central banks, central banks who believe that the world revolves around an economic equilibrium, a world in which financial markets are efficient.
Be warned, however, that the book is not easy reading. It is not a book that provides stock market tips or that presents itself as an easy trading guide for making money. Furthermore, the book is not the clearest or the best written. It is a book about understanding financial markets and how to interpret them and use them to achieve better investment returns.
Aubrey's basic argument is that credit is a very crucial part of the modern economy and that credit markets are very seldom in equilibrium. Credit markets are always moving one way or another. They are very seldom, if ever, in equilibrium. Hence, they do not fit well into the models created using the methodology of modern economics, a methodology that turns out models that are logically consistent, that are based upon people who have complete information, that are linear in most cases, and always return to equilibrium. Credit markets are just too messy and are never at rest.
Yet, these economic models are the ones used by central banks and democratic governments to construct their economic policies…their monetary and fiscal policies. These models Aubrey contends are not adequate for the real world of incomplete information, non-linearity, and disequilibrium. However, working from these models, policymakers build their policies that focus upon inflation targeting, rules for monetary growth (Friedman), Taylor rules, and estimates of full employment output, Phillips curves, and so forth. But, these policies produce unintended consequences that do not get the policymakers what they want, and produce many opportunities for some people to make lots of money. And this is what Mr. Aubrey is interested in.
In chapters one and two, Mr. Aubrey discusses the shortcomings of the "equilibrium" approach to economics and policy building. In chapter three he introduces the role of credit in the modern economy. In chapter four he begins to discuss the strand of thinking that includes the role of credit in economic analysis. These chapters include a little bit of history and lots of references to economists who have developed the theories behind the economic policies. The reading can get tedious at times. For example, in chapter four, he discusses the work of the Stiglitz and Minsky, mavericks from the Keynesian tradition, before getting into the Austrian school of Bohm-Bawerk, Menger, Von Mises and Hayek, and the Swedish economists Wicksell and Myrdal.
His ultimate focus is on Wicksell, the person who developed the "first coherent economic theory based on credit." (Page 76) This is the theory that Aubrey uses to present his case in the rest of the book. There is not enough space here to discuss this theory in great detail.
The essence of the theory is that the driver of economic activity is the relationship between the rate of return producers earn on invested capital (the natural rate of interest) and the cost of capital. One can examine this relationship for the aggregate economy and one can also examine this relationship industry-by-industry…and firm-by-firm. "Notional equilibrium" is the state "when the natural rate of interest equates to the money rate of interest for an economy." (Page 97)
The problem is that "an economy is clearly in a state of continuous disequilibrium." (Page 97) That is, very seldom, if ever is the notional equilibrium achieved. Mr. Aubrey's working relationship is call the "Wicksellian Differential" which is defined as the difference between the rate of return producers earn on invested capital and the cost of capital. A notional equilibrium is achieved when the Wicksellian Differential is zero.
He provides information on how to calculate the Wicksellian Differential for an economy as a whole, for individual industries, and for individual firms. He provides a source of data for calculating the Wicksellian Differential for each of the above: go to the Worldscope datastream database which can be accessed through this link.
The basic assumption is that business investment is based upon future expected profits. Aubrey argues later on that business investment should not be considered to be just physical capital but also human capital. And, without the investment in human capital, the productivity of physical capital may be limited. Furthermore, when future expected profits are low and there is excess liquidity, the excess liquidity going into financial assets rather than physical capital or human capital. Does this sound familiar at all?
This is just a brief picture of what Mr. Aubrey presents. He also produces a review of history, with statistics, with the use of this Wicksellian theory. He begins with the United States and discusses in detail the period from 1980 through 2011. He also examines the 1970s and stagflation. One conclusion he draws is that the period from the 1960s through 2011 is one of extreme credit inflation, even though some of the time did not experience the price inflation that so many associate with the term "inflation", something that not all interpreters would agree with.
Aubrey then goes back and reviews the credit inflation of the 1920s. But, to add further justification to his approach the author examines the credit inflations in the 1980 to 2011 period in the United Kingdom, Japan, Australia and Canada. He also looks at the credit inflation in the eurozone from 1996 to 2011. As you might imagine, the history that is told is consistent with the data Aubrey has assembled.
Three more things I would like to emphasize. The disequilibrium situation in the economy is augmented by the fact that production in the modern economy takes a very long time and there are lots of places that can be "out-of-equilibrium". This just makes the whole economic process more complex and sophisticated than can be captured by the modern economic model. Second, the financial system is always changing. It used to be just credit. Then "money" came along. Then demand deposits. Then time accounts. Then money market funds. Now there is the "shadow banking" system. Aubrey examines latter development and its implications on pages 162 through 168. No wonder, he says, that basic "Monetarism" could not succeed in the long run.
Finally, Aubrey argues that the Wicksellian framework shows that "economic instability cannot be eliminated but only minimized." (Page 96) An active monetary policy that has an inflation target or an unemployment target is going to create unintended consequences because the authorities are attempting to do something that cannot be achieved. Economics is full of examples of situations where people tried to do something that markets would not allow, but by persisting in the attempt opportunities to make money are available. Just ask George Soros about how he made all the money speculating against the value of the British pound in 1992.