Profiting [rom Monetary Policy

Transcription

1 Profiting [rom Monetary Policy

2 Profiting from M onetary Policy Investing through the Business Cycle Thomas Aubrey palgrave macmillan

3 * Thomas Aubrey 2013 Softcover reprint ofthe hardcover lst edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2013 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number , of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin's Press LLC, 175 Fifth Avenue, New York, NY Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging. pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress

4 FOT Yanina, Thea and Ethan

5 The futility of price level stabilization as a goal of credit policy is evidenced by the fact that the end-result of what was probably the greatest price-stabilization experiment in history proved to be, simply, the greatest and worst depression. Banking and the Business Cycle - Phillips, McManus, Nelson 1937 Stock market bubbles don't grow out of thin air. They have asolid basis in reality, but reality as distorted by a misconception. George Soros Buzzjlash Interview

6 Contents List of Figures List of Tables Preface Acknowledgements Introduction 1 1 The Great Moderation and the unravelling of a Great Myth 10 2 From model failures to streams of data 32 3 The problem of credit 51 4 The Vienna and Stockholm schools: A dynamic disequilibrium approach 66 5 The neo-wicksellian framework 96 6 Testing Wicksellianism The creation and destruction of capital Where are the customer's yachts? Post-script - Constructing business cyde tracking funds 180 Notes 188 Bibliography 199 Index 208 Vlll IX X XlI

7 Figures 1.1 Five-year credit default swap (CDS) spread - Germany vs Greece US inflation vs Fed funds rate US unemployment, inflation and real GDP growth N orth America one-year probability of default index US consumer leverage ratio vs Wicksellian Differential US Wicksellian Differential, real GDP growth and equity returns US leverage ratios and Wicksellian Differential US inflation vs real equity returns UK Wicksellian Differential, real GDP growth and equity returns UK vs US in the 1990s recession UK leverage ratios vs Wicksellian Differential US and Japan inflation vs equity returns Japan Wicksellian Differential, real GDP growth and equity returns Japan natural rate ofinterest vs money rate ofinterest Japan leverage ratios vs Wicksellian Differential BRIC equity return indices Real GDP growth and equity market performance - Canada, Australia and the US Canada and Australia Wicksellian Differential vs equity market performance Canada and Australia consumer leverage vs equity market performance Return on capital- Germany, France, Ireland, Spain Wicksellian Differential- Germany, France, Ireland, Spain Germany, France, Ireland, Spain equity market performance and Ireland and Spain house prices ( ) Germany, France, Ireland, Spain equity market performance and Ireland and Spain house prices ( ) Five-year CDS spread - US, China and Brazil 161

8 Tables 5.1 Value of a Viceroy tulip at the height of Tulip Mania 6.1 Australia and Canada average banking sector leverage ratios (common equity/total assets)

9 Preface When the Nobel Laureate Robert Solow gave evidence to the House Committee on Science and Technology in 2010, as part of an investigation into the limits of economic theory, he asserted that elements of modern macroeconomic theory did not pass the smell test. Either those supporters of modern macroeconomic theory, he argued, had stopped sniffing or they had lost their sense of smell altogether. I went back to university after a career in management consulting to study mathematical economics in an attempt to explain why the UK economy had been plagued by housing market bubbles. Much of what I was taught did not pass the smell test either, particularly the pervasiveness of the role of price stability in maintaining a general equilibrium. Worse still, this principle seemed to be guiding the investment community in the way it thought about asset returns through time. As house prices boomed in the period leading up to the financial crisis, I returned to the problem using the framework of the Swedish economist Knut Wicksell, who had developed a dynamic, credit-based view of an economy. Using Wicksell's ideas of excess credit growth, with additional guidance from the writings of the 1974 Nobel Prize winners Gunnar M yrdal and Friedrich Hayek, I attempted to empirically measure the extent of disequilibrium in the US and UK economies. Initial estimates from analyses of both economies suggested that they had been operating significantly above equilibrium for aperiod of 20 years, despite the fact that inflation had remained subdued. This implied that the robust returns generated by financial assets du ring the Great Moderation were therefore an anomaly rather than the expected market rate of return. Hence, future returns would be much lower than the past given that the excess growth in credit was not sustainable with significant implications for pension schemes The dramatic fall in asset prices that came about in 2008 has largely been responsible for a decade of poor returns. However, such a level of capital destruction could have been anticipated given that the economy had been operating at a level substantially above equilibrium since the early 1980s. As the investment community has attempted to avoid further capital destruction by moving into

10 Preface xi liquid and high-quality government bonds, it seemed logieal that Wieksell's analytieal approach eould be applied by the investment eommunity to avoid the peaks and troughs of the business eyde by monitoring the rise and fall of eredit growth as an investment signal. This book is thus an attempt to explain how investors ean reduee the volatility of returns and invest through the business eyde to ensure that the eapital tied up in pension sehemes doesn't get periodieally destroyed. During the 1930s, Hayek and Myrdal both argued that signals based on priee stability and general equilibrium were misleading for market partieipants. They have been proven right, again. The challenge of funding future pension liabilities is a daunting prospeet for poliey makers, wh ich has been exaeerbated by a deeade of poor returns. Until investors rejeet the prevailing monetary poliey consensus as an investment framework and switeh to eredit-based investment strategies that track the business eyde, pension sehemes will eontinue to suffer poor returns due to the periodie destruetion of eapital.

11 Acknowledgements This book could not have been written without the support of some incredibly generous people who have given their time and knowledge and who have encouraged me in my endeavours in attempting to explain the nature of business cydes. In particular, I'd like to thank Meghnad Desai for introducing me to the work of Wicksell and Hayek, and Max Steuer for his encouragement to pursue my ideas. I'd also like to thank Charles Goodhart, Steve NickeIl and George Selgin for their helpful comments and pointers on my empirical work. I'd also like to thank the numerous reviewers as weil as Glenn Bedwin, Norman Bernard, Vit Bubak, Simon Commander, J oao Garcia, Tiziana di Matteo and William White for their comments on various sections and drafts of the manuscript. I would also like to thank Thomson Reuters and Fitch Solutions for allowing me to use their data to support my argument. I am also grateful to the Hayek estate, the Karl Popper library, Taylor & Francis Books and Buzzflash for permitting me to reproduce material. Finally, this book could not have been written without Datastream. Empirical work is an almost never ending quest of trial and error, and the advice of the Datastream product and content experts, in conjunction with the vast array of available data, has been invaluable. The views expressed in this publication are solely the opinions of the author. Nothing in this book is a recommendation to buy, seil or hold any security or financial instrument. The author and the publisher cannot be held responsible for any loss incurred as a result of specific investment decisions made by the reader.