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Brendan Brown

What are the principles of monetary economics applied in our analysis of financial markets?

These are derived essentially from Austrian School Economics, taking account though of new developments in the past 40 years which go beyond the original texts.

A good starting point is the quote from J.S. Mill made famous by Milton Friedman: “Most of the time money does not matter but when it gets out of control it becomes the monkey wrench in all the machinery of the economy”.

J.S. Mill wrote at a time when money was mainly of metallic form. In today’s world of fiat moneys, dominated by the US hegemon, money matters most of the time because it is almost permanently out of control.

Analysis of this chaos and how it distorts the functioning of the global economy is not of periodic interest only but should be permanently at the forefront of economic and market appraisal.

For Milton Friedman, “getting out of control” meant money supply growing cumulatively at a rate seriously different from demand for such money in real terms. This judgement rested on the assumption that the analyst could identify empirically a monetary aggregate (one of the so-called Ms) for which a broadly stable demand existed over medium and long periods of time and whose supply could be determined autonomously by a set of rules. “The monkey wrench in the machinery of the economy” corresponded to the emergence of inflation or deflation and at times violent cyclical turbulence.

The Austrians have a quite different perspective on money getting out of control. This means unsound money. The key features of unsoundness are interest rates manipulated by the authorities rather than market determined and crucially no pivot to the monetary system, whether in the form of a well-constructed monetary base or gold convertibility (or both). There is no presumption that a stable empirically determined demand for money in any broad form exists over the short or medium-term.

Prices of goods and services on average under a sound money regime would rise or fall for sustained periods. There is no reason to expect that in a vibrant capitalist and competitive economy prices would be stable – except in the sense of having tendency to revert to the mean over the very long run, but that mean can shift. Too stable prices or too stable inflation are indicative of monetary malaise. A strong natural rhythm of prices is due to factors such as spurts or lulls in productivity growth, the path of technological change and globalization, abundance or scarcity of natural resources. Under sound money this natural rhythm of prices overpowers any monetary influence over the short term.

Becoming the monkey wrench in the machine for the Austrians describes the total effects of price-signalling in markets – and especially capital markets – becoming dysfunctional. The related process of asset inflation (which does not feature in monetarist analysis) imposes potentially heavy economic costs. In the “classical” Austrian texts these costs took the form of an over-expansion of capital goods industries during the period of monetary inflation (which holds the cost of capital to artificially low levels). This over-investment or malinvestment is subsequently reversed in economically painful fashions.

The long and persistent monetary inflations of the past half-century (together with further study of the 1920s monetary inflation) have brought new perspectives to bear on the process of asset inflation. Dysfunctional price signalling goes far beyond the level of interest rates. We should look at the irrational forces which are strengthened by monetary inflation and which determine a large range of capital market prices – so spurring mal-investment.

Austrian school monetary analysis at this point can embrace findings from behavioural finance theory, whose pioneers have so far largely failed to connect various mental impairments in financial decision making to the monetary environment. Speculative narratives form and gain power which under dominant rationality in markets would not gain much circulation. Desperation for yield and positive feedback loops from capital gains play a role here. Financial engineering alongside carry-trades (in credit, currency, term risk and illiquidity) boom, adding to the scope for mal-investment which culminates in painful and costly busts.

Central banks, led by the Fed, in pursuing their unsound policies, seem for many years to deliver stability and indefinite postponement of recession. Even some great contemporary economists have been fooled by such “moderation and stability” to prematurely sing the praises of the Fed. These super-long cyclical expansions, however, are a monetary monstrosity. The accumulating mal-investments and financial dangers which build up mean that they culminate in big crashes and recessions – or perhaps milder recessions but prolonged stagnant or falling living standards.

Whilst the asset inflations persist, the central bankers are popular. Yes, the Austrians may argue that they are in effect collecting huge monetary repression taxes for governments, but investors look through these when equities and real estate prices are booming.

Austrian school analysis of money, as it develops, will continue to lack the superficial attractions of neo-Keynesianism, whether the policy prescriptions or the short-term economic forecasts. It is the mission of Macro Hedge Advisors to demonstrate to our members how this analysis will fortify their planning of strategies to cope with the continuing economic disappointments and accumulating end-game dangers from the latest decade of radical monetary experimentation. These strategies should also include a realistic defence against ever larger monetary repression taxes stemming from central banks manipulates rates to levels far below what would prevail under sound money regimes.