In Keynesian Psychology With Austrian Tails, I detailed a personal trading transition above and beyond Austrian economics.
In short, while believing the Austrian school to be more or less correct â?? especially in respect to human nature â?? when it comes to real world implications (and trading decisions), there is a human psychology standoff that involves a time element.
The Keynesian approach â?? which advocates government stepping into the breach â?? essentially overlooks the corrupt, inefficient nature of public policy, and also promises something for nothing.
But people like promises of something for nothingâ?¦ thatâ??s practically a foundational principle of politicsâ?¦ and persistent delusions can go on for a very long time.
To put it another way, the market can be like an emotional spouse: For extended periods of time, â??factsâ? donâ??t matter so much as â??feelings.â?
Keynesians call these feelings â??animal spirits,â? and there have been entire books (written by Keynesian acolytes) on how important it is to revive animal spirits for the sake of the economy.
In capturing the tendency of markets to doggedly embrace Keynesianism â?? even when such a track seems delusional â?? Emanuel Derman nails it in his book My Life as a Quant:
In physics youâ??re playing against God, and he doesnâ??t change his laws very often. In finance youâ??re playing against Godâ??s creatures, agents who value assets based on their ephemeral opinions. They donâ??t know when theyâ??ve lost, so they keep trying.
To wit: In the same way that you canâ??t â??winâ? an argument with your overly emotional wife (or husband), nor can you â??winâ? an argument with a persistently delusion-embracing market.
Except, of course, by 1) going with the flow in the near term, and 2) waiting for the longer-term â??factsâ? to actually pan outâ?¦
The Von Mises Prophecy
Despite very long interims, reality (and gravity) tends to eventually reassert itself. This is why the Austrian school will always have relevance.
In that respect, there is something I think of as â??the Von Mises prophecy,â? which is a sort of one paragraph summation of Austrian thought â?? anchored to a prediction â?? as put forth by Ludwig Von Mises himself:
There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
The Von Mises prophecy can further be understood in the context of â??exploding debt dynamicsâ? (a highly useful term coined by an IMF staffer).
To wit, your debt dynamics become explosive when debt service costs overtake your ability to arrange new financing. â??A rolling loan gathers no loss,â? as the Wall Street wags say, but once that loan stops rolling? Game over man.
The â??boom expansion brought about by credit expansionâ? Von Mises refers to sits atop a mass pyramid scheme of leverage and debt.
As credit expands, more and more unproductive debt is taken on in pursuit of marginal return investments. This process can play out over years, or even decades (as we have seen in the U.S. via a 25-year leverage and debt supercycle).
The prophecyâ??s â??final and total catastrophe of the currency systemâ? comes from last ditch emergency measures in the face of a debt avalanche.
An economy that is lightly (reasonably) leveraged can handle a slowdown without imploding. An economy that is leveraged to its eyeballs cannot. A catch-22 is thus created, in which the taking on of excess leverage requires the application of even more leverage (via the authorities) to save the system from itself. This feedback loop is, of course, unsustainable, barring the economyâ??s ability to â??grow its way outâ? of the problem.
So the process by which the Von Mises prophecy is fulfilled can be generalized like this:
The pattern as described above is now in full swing in the United States and Europe, and coming to potentially spectacular fruition in Japan.
While there is heavy emphasis on the Fed and the $USD, the eurozoneâ??s sovereign debt crisis is perhaps an even clearer example of the â??mountain of debtâ? phenomenon. Over a period of many years the peripheral eurozone countries were allowed to spend borrowed funds (on a borrowed credit rating) they could never pay back.
Now there will likely prove no final option in saving the eurozone, other than monetizing the non-serviceable debt (i.e. the ECB will eventually have to disavow its Bundesbank roots and print, taking up local debt issuances with fiat paper and massively devaluing the euro).
The United States too, of course, is on a similar path. This is why U.S. yields have been rising, not falling, even as the Bernanke Fed has promised to keep rates low. As we wrote in the 12-2 Global Macro Notes:
In short, the Federal Reserve has made clear its intentions to utterly trash America's finances, as it seeks to paper over the excess leverage and debt sins of the entire planet.
Delayed Payback
The dynamics of the Von Mises prophecy also help clarify why we have rough waters ahead. The problems of the â??debt mountainâ? have not been dealt with â?? which means they will continue to press in future.
Understand that the majority of market participants (as represented by CNBC and the like) do not actually understand economics. Worse still, they do not actually CARE about understanding economics.
This is what makes it all too easy for misplaced optimism to take hold (with talking heads and banking house strategists cheering it on). When oneâ??s entire focus is on straining to see â??green shoots,â? and oneâ??s psychological orientation is towards justifying optimism whenever possible (rather than developing as realistic a worldview as possible), every extended period of temporary Keynesian relief becomes reason to believe that all is coming up roses and the worst has passed.
Are the Bond Vigilantes Returning?
Above is a chart of 30 year t-bond interest rates, dating back to the mid-1990s.
Though the actual trend goes back farther, you can see the key point illustrated here â?? interest rates have been falling for decades. The aberrational low point came at the height of the 2008 financial crisis, when seemingly the whole world piled into USTs.
In respect to this long, long trend, Fall 2010 represents a potential inflection point of great magnitude. Why? Because this is when two things happened:
In short: The bond vigilantes, long in Rip Van Winkle slumber, may now be waking up.
The Von Mises prophecy, remember, involves panic fears of being crushed under a mountain of long-accumulated debt. As the authorities seek to alleviate presssure by monetizing that debt (turning it into paper currency), faith in the system on the whole (currency and debt) is eroded, and investor preference for holding said debt (or currency) shifts at the margins in favor of something else.
There are, of course, other explanations for why bonds are falling (and rates rising) in the face of the Fed. Optimistic bulls will argue that rising rates are a function of a U.S. economy returning to health, and may go even further in arguing that rising rates will not derail a sustainable recovery.
That is one possible interpretation of the future path. Another is that:
Of course, with all three of the major currencies ($USD, euro, yen) in various stages of this same cycle â?? just wait until Japan hits a loss of faith patch! â?? itâ??s little wonder that forex forecasters are calling for â??Super Volatilityâ? in 2011.
Itâ??s a great time to be a traderâ?¦
JS
More on this topic (What's this?) Depression Within a Depression (Learn Mining News, 10/22/10) Another Keynesian Idea: G3 Needs To Print More Money To Avoid Trade War (Black Swan Insights, 9/30/10) There is no means of avoiding the final collapse of a boom brought on by credit and fiat monetary... (Stock Market Analysis, Trading, ..., 10/24/10) 12 Keynesian Insights to Blow the Mind of Larry Kudlow (Wall St. Cheat Sheet, 9/9/10) Read more on Keynesian Economics at Wikinvest Jack Sparrow - December 12th, 2010, - Category: Deep Thoughts, Macro Data / Market Quadrant, Weekender Disclaimer: This content is general information only, not to be taken as investment advice or invitation to buy or sell securities. As active traders, we may or may not have positions in securities mentioned. For full disclaimer click here
83428 comments to http://mercenarytrader.com/2010/12/weekender-the-von-mises-prophecy-explained/Weekender%3A+The+Von+Mises+Prophecy+Explained2010-12-12+19%3A55%3A51Jack+SparrowWeekender: The Von Mises Prophecy Explained Adam December 14th, 2010 at 5:51 pm Replyhow do save yourself from this
Jack Sparrow December 14th, 2010 at 5:59 pm ReplyTrade!
Econophile December 14th, 2010 at 5:51 pm ReplyWhat books have you read about Austrian theory?
Jack Sparrow December 14th, 2010 at 5:58 pm ReplyHayek, Rothbard, Mises, Friedmanâ?¦ many of the names and titles featured on your reading list actually. Any particular thoughts or recommendations?
Econophile December 14th, 2010 at 6:46 pm ReplyIt is always nice to find Austrian theory compatriots. I just wanted to know if you were for real. I see a lot of folks talk about Austrian theory but know nothing about it. I would quibble with your assessment of the essence of the theory. To me the damage occurs on the upside of monetary stimulus. Fiat money expansion is the mother's milk of the boom-bust cycle.
Jack Sparrow December 14th, 2010 at 7:12 pm ReplyWell, we could certainly hash out some of the finer details â?? but ultimately I suspect our differences would be small. My sense of essence focuses on endgame consequences, but that is not to dismiss the long-run build-up that brings the endgame about.
Econophile December 15th, 2010 at 12:10 am ReplyBut then you are a trader and I'm just a dilettante. Good work and I look forward to your analysis.
Jack Sparrow December 15th, 2010 at 12:21 am ReplySome might say just the reverse in respect to more formal grounding (simple caveman trader here)â?¦ at any rate, thanks for the visit and the kind words!
Leave a Reply CancelName
Mail (will not be published)
Website
/* Loading IntenseDebate Comments..."; idc_ns.parentNode.insertBefore(idc_ld, idc_ns); setTimeout( IDC_revert, 5000 ); /* ]]> */ /* */ /* */ Select Month December 2010 November 2010 October 2010 September 2010 August 2010 July 2010 June 2010 May 2010 April 2010 Select Category Amusing / Inspiring Barronâ??s Notes Books and Articles Bulletin Board Catalysts and Drivers Deep Thoughts Global Macro Notes Hedge Funds Holiday Ideas & Research â?? Investing Ideas & Research â?? Trading Jackâ??s Trade Notes Knowledge Center Links Roundup Macro Data / Market Quadrant Market Climate Mikeâ??s Market Notes Mikeâ??s Trade Notes Mistakes / Lessons Learned MM Daily Notes Monetary Policy Poker and Trading Rants Review / Preview Sectors and Industries Strategic Intelligence Reports Thematic Roundups Themes & Trends Theory Trader Profiles Trading Ideas Trading Methodology Trading Psychology Trading Wisdom Uncategorized View from the Turret Wall Street Weekender /* 0 ) { location.href = "http://mercenarytrader.com/?cat="+dropdown.options[dropdown.selectedIndex].value; } } dropdown.onchange = onCatChange; /* ]]> */
Copyright © 2010 Mercenary Trader - All Rights ReservedWordPress · BFA Wordpress Layouts · Premium Wordpress Layouts
var vglnk_api_key = "bcb4fe0a43f090de3e0df972cbae2883"; var vglnk_domain = (("https:" == document.location.protocol) ? "https://" : "http://") + "api.viglink.com"; document.write(unescape("%3Cscript src='" + vglnk_domain + "/api/vglnk.js?key=" + vglnk_api_key + "' type='text/javascript'%3E%3C/script%3E")); try { vglnk(vglnk_domain, vglnk_api_key); } catch(err) {}how do save yourself from this
Trade!
What books have you read about Austrian theory?
Hayek, Rothbard, Mises, Friedmanâ?¦ many of the names and titles featured on your reading list actually. Any particular thoughts or recommendations?
It is always nice to find Austrian theory compatriots. I just wanted to know if you were for real. I see a lot of folks talk about Austrian theory but know nothing about it. I would quibble with your assessment of the essence of the theory. To me the damage occurs on the upside of monetary stimulus. Fiat money expansion is the mother's milk of the boom-bust cycle.
Well, we could certainly hash out some of the finer details â?? but ultimately I suspect our differences would be small. My sense of essence focuses on endgame consequences, but that is not to dismiss the long-run build-up that brings the endgame about.
Read Full Article »