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20141005 Profiting from Monetary Policy



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The idea is that existing theoretical framework of equilibriums used for monetary policy proved to be incorrect by the crisis of 2007. The main flow of this framework is not taking credit into account and maintains notion of equilibrium as something static that could be achieved by raising or lowing interest rates. Instead the Wicksellian framework of dynamic equilibrium between natural rate and money rate could generate correct signal about macro movements of market.



Key financial Issues that had to be dealt with:

  • Pensions crises: In addition to aging population the return on pension funds proved to be far lower than was used in calculations for needed set aside funds. Current financial framework cannot resolve this crisis.
  • A handful of dissenters not only denied contemporary theory (Hyman Minsky and Joseph Stiglitz), but proved in investment practice that other option exists (Soros, Brevan Howard)
  • A new hope? Ideas of Knut Wicksell based on role of credit with denial of equilibrium refined by Hayek and Myrdal could possibly allow generating correct signals of business trend and dramatically improve returns on investments.

1 The Great Moderation and the unraveling of a Great Myth

The great moderation is period from 1980s to 2007 when economy grew at reasonable pace and central banks seems to be able to control inflation and economic cycles by changing interest rates policy increasing rates when inflation was growing and decreasing when economy was slowing down. The core ideas of general equilibrium, rational expectations, and inflation control as implemented in policy failed to prevent economic crash of 2007. This chapter is the story of development of these ideas, their triumph, and eventual failure to provide reliable market signals.

2 From model failures to streams of data

Before 2007 economists like Ben Bernanke believed that their models are pretty good and just need a little bit of tweaking. However it was not really possible to define equilibrium that these models are based on. The reason for that is powerful exogenous factors that is just not possible to predict. Besides all measurements depend on statistical estimates, which are far from exact. The analysis in 2011 by Feds demonstrated that economic forecast models failed.

One of the most important reasons is that modeling assumptions were far away from real world. For example typical assumption that firms try to maximize profit is incorrect. Detailed analysis shows that much higher priority is to build relationships with customers while earning acceptable profit. Pursuit of short-term maximization would undermine firm even on medium run.

Instead of equilibrium analysis author suggest to rely more on analysis of streams of data and chaos theory to understand general trends. Especially important is analysis of credit data, which traditional equilibrium models completely missing.

3 The problem of credit

Analysis of boom and busts shows that they are directly related to credit availability variations. Here it also seems to be clear that there is no equilibrium in credit market. This is because it depends of value of collateral, which grows dramatically in boom time and collapses during the bust. This chapter describes ideas of Minsky and Stiglitz regarding business cycle.

4 The Vienna and Stockholm schools: A dynamic disequilibrium approach

Inability to explain behavior of credit resulted in monetary policy generating false signals for investors. One of important facts is that credit bubble does not coincide with inflation. Chapter goes through Hayek’s theory of cycles, Menger’s marginal utility, and money as calculation medium rather then measure of exchange value. It follows with Bohm-Bawerk analysis of capital as sum total of intermediate products. Also reviewed are ideas of Karl Wicksell with emphasis on credit and two different interest rates one for money and another for loans. There is also natural rate of interest defined in relation to current value of future product. Economy is in equilibrium if rates are equal. If money rate is higher then returns are unprofitable.

If money rate is lower, then entrepreneur generates higher profit at the expense of creditor. Finally ideas of Gunnar Myrdal of economy in continuing disequilibrium reviewed.

5 The neo-Wicksellian framework

Theory of credit and business cycle is based on variance between natural rate and money rate. Natural rate divided into ex-post measures (investment made) and ex-ante (investor expectations). The problem is that to measure natural rate is not really possible, but this chapter provides some approximate methods to do it.

6 Testing Wicksellianism

In this chapter author uses economic history of XX century to test application of Wicksellianism. The inference is that analysis based on Wicksellian theory of credit has better explanatory power then any of GDP factor. Relationship between Wicksellian Differential and return on equity is stronger then it is for GDP.

7 The creation and destruction of capital

This chapter analyses consequences of government interference with banks and credit. It is done in relation to huge balances of pension funds in developed countries which is also require high rate of return if they to meet future payment needs. Overall ability to produce high return is linked at its core to productivity growth and it is slowing down. Author relates this slowing down to failure increase educational achievement. After that there is a discussion of government ability create of destroy capital and its necessity as preventer of market failure. There is a wise advice at the end of chapter: Junk the models and look at the data.

8 Where are the customer’s yachts?

This chapter starts with fascinating anecdote about fund managers’ yachts and lack of those for customers. The idea is that credit based analysis could allow investors to make effective investment decisions.

9 Post-script- Constructing business cycle tracking funds

The key conclusion of analysis in this book is that Efficient Market Theory works fine at the micro level, but it does not at the macro level. Thus the opportunity to invest had to be brought to macro level through asset allocation technic investing into undervalued asset classes and shorting overvalued. At the end author provides a short description of use of Wicksellian ex-ante signaling in asset allocation.


I find strange the very idea of using monetary policy without taking credit into account. As far as I’m concerned money are created every time when two individuals agreed to exchange something in two steps one now and another at some point in the future. In other words I consider credit as part of money and as such it increases or decreases money amounts and consequently can create booms and boost that is consistent with Austrian theory of business cycles. I am not sure to what extent Wicksellian framework allows generate investment signals, but I completely in agreement with author that EMT works at micro level, but not at macro level and therefore idea to react to market signals via asset class allocation makes sense.

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