Archive for How To

Revisiting Price Compression

5 weeks ago I posted some thoughts on the concept of “price compression” (see here).  I said:

“Price compression is when market participants price in many years worth of future performance into the current price.  They are, in effect, buying today with the expectation that future earnings will justify current prices.   When you combine this concept with an understanding of behavioral finance and the understanding that market expectations can become irrational, you can build some understanding behind the concept of market bubbles.  As I’ve described before, A bubble is an environment in which the market price of an asset has deviated from the underlying asset’s fundamentals to an extent that renders the current market price unstable relative to the underlying asset’s ability to deliver the expected result.”

Along with that explanation I posted a chart of the iShares Biotech Index saying “Who buys stuff like this?”  Since then, the index is off 15%.  I wasn’t making a market call.  In fact, the purpose of this concept is not to make market calls.  But to be able to understand certain market dynamics and when the market appears to be getting ahead of itself.

The concept of price compression isn’t intended to help you time bubbles or short the market.  It’s a concept that helps us merely identify markets that may be a bit irrationally exuberant or irrationally bearish.  In better conceptualizing the markets through an understanding of pricing dynamics we can be better prepared to manage certain risks that will inevitably arise.

On Portfolio Differentiation

The latest from Howard Marks of Oaktree is as good as always.  But I wanted to highlight something that I found particularly important – differentiation.  Marks says:

“Here’s a line from Dare to Be Great: “This just in: you can’t take the same actions as everyone else and expect to outperform.” Simple, but still appropriate.

For years I’ve posed the following riddle: Suppose I hire you as a portfolio manager and we agree you will get no compensation next year if your return is in the bottom nine deciles of the investor universe but $10 million if you’re in the top decile. What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money? No one has ever answered it right.

The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors. If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different.”

This is important to understand when analyzing portfolios and constructing your own for several reasons:

  • First, be wary of people who refer to sweeping studies about portfolio manager “underperformance” when they compare all funds or managers with some broader index.  The vast majority of the studies I see are engaged in apples to oranges comparisons which take something like the S&P 500 and compare it to something like an actively managed multi-strategy hedge fund.  These are two totally different animals and if they’re not benchmarked appropriately (as most funds aren’t) then the comparison doesn’t really tell you much about anything.
  • Second, be wary of those who aren’t differentiated, but sell you their services as though it is.  There are a huge number of portfolio managers and strategies out there that merely mimic a closely correlated index without actually doing anything that differentiates the fund or strategy from the index.  They usually go by fancy sounding names like the “So and So Global Value Fund” or something, but the reality is that many of these funds are simply their benchmark masquerading as something different with a huge fee attached.
  • If you’re going to run a strategy that adds value relative to a benchmark then it needs to be differentiated.  This can be done in lots of different ways, but it’s not easy to construct a strategy like this that would outperform a closely correlated aggregate.

Differentiation is important.  But in addition to finding differentiation you have to ensure that you’re properly benchmarking it, properly evaluating it on a risk adjusted basis and ensuring that there’s more to this differentiation than a fancy sounding name and a high fee structure.

Vanguard’s Principles for Investing Success

I really liked this white paper from Vanguard.  It’s fairly basic, but it applies whether you’re a highly sophisticated trader or a more “passive” investor.  The core of the philosophy:

  1. Goals
  2. Balance
  3. Cost
  4. Discipline

These factors always matter.  Having a structured set of goals helps define your process.  Balance helps to diversify your ignorance.  Costs will always eat into returns.  And discipline is the ability to follow through with your process.

Read the full paper here.

Bank Lending is Primarily a Demand Side Issue

The real problem with concepts like the money multiplier and bank lending is that it boils bank lending down to a supply side issue.  In essence, it implies that banks can only make loans if they have some supply of loans.  It’s the mythical loanable funds or reserve constraint idea.  As if banks have to go bid on some loanable funds market or find reserves that they can go out and multiply BEFORE they make loans.

Of course, as the Bank of England nicely explained (and I’ve been explaining for years) this is wrong.  Yes, a bank has to be willing to supply loans (in other words, borrowers must be deemed “creditworthy”), but that doesn’t mean the bank is necessarily supply constrained.  After all, banks are in the business of creating debt contracts from thin air.  Unless the world runs out of air their supply of loans should be in safe supply.

I was reminded of this point as I was reading this excellent post from Frances Coppola.  She’s responding to a UK economist who is responding to the recent piece from the Bank of England on endogenous money (you can read his response here).  And as I was reading his response it occurred to me that one of the major hurdles to understanding endogenous money appears to be this concept of supply side monetary thinking.  As if banks are constrained by their ability to create loans from thin air because of reserve requirements or “savings” or something else.  But this is the wrong way to think about endogenous money.

It’s better to start from the demand side.  Remember, banks are in the business of making loans.  If creditworthy customers are walking in their doors they don’t turn them down.  And if the bank has adequate capital levels and deems the customer to be creditworthy then they write up a loan contract, expand their balance sheet endogenously (which creates a loan asset for the bank, a deposit liability for the bank, a deposit asset for the borrower and a loan liability for the customer) and, if they must, the bank will find reserves to meet reserve requirements AFTER the fact (in the interbank market or via the Central Bank).

So, when we think of banking it’s really better to think of it as being a demand side issue. If you start from the supply side you’ll likely get confused.  Yes, banks have real constraints (like capital and their own lending standards), but in a healthy functioning economic environment a well capitalized bank will service as many creditworthy customers as it can.  After all, that’s their line of business.

Some related work:

 

The Bank of England Debunks the Money Multiplier

Regular readers will be more than familiar with the debunking of the money multiplier and the concept that banks don’t lend out reserves or deposits (see here & here), but it’s nice to see it catching on in places more important than this lowly blog.  A new research report out of the Bank of England debunks the money multplier in one of the best overall presentations of the concept that I’ve seen.   And much of it sounds like stuff I could have written (in fact, I’ve stated almost all of these points at times during the last 5 years).  I won’t go into too much detail, but here are a few highlights:

• the majority of money in the modern economy is created by commercial banks making loans.
• Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.
• The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

They also do a good bit of explaining on QE and its operations.  I personally think they overstate the case with regards to how the central bank “ultimately” determines the amount of money created, but I think they’re trying to emphasize the fact that the Central Bank is the regulator and price setter of reserves.  But don’t mistake this for the BOE implying that the Central Bank controls loan creation directly.  I might have said it a bit differently, but their point is totally consistent with Monetary Realism’s views.

You can read the full report here.  I highly recommend it.

Some related work:

New Primer on SSRN – Understanding Quantitative Easing

New white paper of mine at SSRN on QE.  It’s a brief primer that offers a succinct undertanding of QE and debunks some misunderstandings:

“Many misunderstandings are still circulating about the actual operational aspects and impacts of Quantitative Easing, also known as Permanent Open Market Operations or Large Scale Asset Purchases. This brief primer will provide a series of basic understandings that give the reader better insights as to the actual impacts of the program and how it works with the hope of clarifying some of the misconceptions.”
Read the whole paper here.

10 Lessons To Learn From Poker

By Lance Roberts, CEO, STA Wealth

“Step right up and try your luck…spin the wheel and watch where she lands…everybody’s a winner” - sometimes if you listen hard enough you can almost hear the Carney coaxing unwary investors to step up and try their luck in a game that has been rigged against them.  During the last two decades, I have been amazed to watch as individuals strolled through the doors of the Wall Street casino to try their luck by betting “against the house” for a dream of riches.   Just as with anyone who has ever gone to Vegas – you will win sometimes but the“house” wins most of the time.

However, there are always the “professional gamblers” that can do better than the average most of the time.  Why?  Because they understand “risk” in its various forms.   Most amateurs tend to bet on most hands.  They take speculative positions where the odds of success are stacked against them, or try to bluff their way through a losing hand.  Professionals play cold, calculated and unemotional.  The professional gambler understands the odds of success of every play and measures his “bets” accordingly.   He knows when to be “all in” and when to fold and walk away.   Do they succeed all the time? Of course not.  However, by understanding how to limit losses they survive long enough to come out a winner over time.

There are 10 lessons that can be learned from being a good poker player.

1) You need an edge

As Peter Lynch offers:

“Investing without research is like playing stud poker and never looking at the cards.”

He’s absolutely right; it is a clear parallel to how successful poker players operate as people who play cards for a living sit only at tables where the other participants are less sober, more emotional, or less expert. The financial markets are a very large table, and it is your job to take advantage of those that are far too emotional to make “sober” decisions, or perhaps just not informed enough to be comfortable accepting them.

2) Develop expertise in more than one area

In the financial markets the difference between winning occasionally or consistently is the ability to adapt to the changing market environments.  There is no one investment style that is in favor every single year – which is why those that chase last years performing mutual funds are generally the least successful investors over a 10 and 20 year period.  Flexibility is the cornerstone of long term investing success and investors that are unwilling to adapt and change are doomed to extinction – much like the dinosaur.  Having a methodology that acts as an operating system where all types of applications can be used will separate you from the weak players and allow you to capitalize on their mistakes.

3) Figure out why people are betting against you.

In essence, if there is one thing that we must always remember, and keep with us daily, is that basically “we know nothing”. Sure, there are some things we can determine like what a particular company’s business is today, what they most likely will do in the coming months, and whether the price of its stock is trending higher or lower. However, in the grand scheme of things, we don’t know much as we are closer to knowing nothing than to knowing everything, so let’s just round down and be done with it.

All we really know is what “IS” and all we can really do is create and implement a plan that will deal with what “IS” and protect us from what “Might Be”. Most investors can not accept, or comprehend, the concept where a companies earnings are rising but the price of the stock is falling.  It is at this point the realization of what is “unknown” is critically important.

We must always remember that there is someone on the other side of every trade, for every seller there must be a buyer. If there is not, the price will fall until one is found, that’s simple supply and demand, but don’t assume the person on the other side of the transaction is any more or less informed than you. You have your reasons to buy, they have their reasons to sell, technical analysis is simply a way of recording the overall battle of those willing to sell versus those willing to buy. In poker, you may see a few aces in your hand and think that now is the time to bet it all, but there is often a calculated reason for the guy across the table to match your bets. In poker it is called “checking,” in investing it is called “hedging,” but both are simply forms of risk management.

Don’t assume you are the smartest person at the table, when stocks meet your objectives, be willing to trim, when they begin to break down, begin to become defensive, when your reasons for buying have changed and no longer exist, be willing call it a day and remove your risk.

4) When you have the best of it – make the most of it.

In a game of “Texas Hold’um” when the right hand comes along you can be ”all in” and bet it all.   The risk with this, of course, is that if another player ”calls” you and you lose – your busted.   In investing when you have the right set of environmental ingredients in your favor such as an extreme oversold market condition, panic and fear from investors, deep discounts in valuations, etc. those are times to invest more heavily into equities as the “risk” of loss is outweighed by the potential for reward because the “hand” you are holding is a strong one.

The single biggest mistake that investors make today is they continue to be “all in” on every hand regardless of market conditions.  “Risk” is only a function of how much money you will lose “when”, not “if”, you are wrong.

5) It often pays to pass; and 6) Know when to quit and cash in your chips

Kenny Rogers summed this up best: 

“If you’re gonna play the game, boy…You gotta learn to play it right - You’ve got to know when to hold ‘em. Know when to fold ‘em. Know when to walk away.  Know when to run. You never count your money when you’re sittin’ at the table.  There’ll be time enough for countin’ when the dealin’s done.

Now every gambler knows the secret to survivin’ – Is knowin’ what to throw away and knowin’ what to keep.  ‘Cause every hand’s a winner and every hand’s a loser and the best you can hope for is to die in the sleep”.

This is the hardest thing for individuals to do.   Your portfolio is your “hand”.   There are times that you have to get rid of bad cards (losing positions) and replace them with hopefully better ones.   However, even that may not be enough as there are times that things are just working against you in general and it is time to walk away from the table.   This is why using some measure of risk management in your portfolio is critical to long term success.   Most people do the opposite of what they should due to emotional biases – the sell when they should buy, the hold onto losing positions hoping they will come back, they double down on losing positions, they sell winning positions too soon and many more mistakes that are almost all entirely driven by emotion rather than logic.  Emotional players ALWAYS lose in gambling and investing.

The error that most investors make is that they are playing poker without a hand of cards. Since most investors buy investments, because of what they read in a newspaper, saw on television or heard about on the radio, they have effectively “anted” up for the game. They then basically walk away from the table and begin to hope that the hand they were dealt is the winning hand – this is the basis of the “buy & hold” strategy.

A good investor must develop a risk management philosophy (a sell discipline) and combine that with a set of tools to implement a successful investment strategy.  The odds of success can be substantially increased by removing the emotional biases that drive most investment decisions.  Being well disciplined within an investment strategy, just as a professional poker player is disciplined in his game, allows you to act and react successful to a fluid and changing investment landscape.   Sell signals, trend changes, pre-determined exit strategies, etc. will give you the chance to fold before losses mount.

7) Know your strengths AND your weaknesses & 8) When you can’t focus 100% on the task at hand – take a break.

Two-time World Series of Poker winner Doyle Brunson joked a bit about his book “Super/System,” of which he had thrown around two alternative ideas for titles before going with “Super/System“. The first of which was “How I made over $1,000,000 Playing Poker,” and the second equally accurate idea was, “How I lost over $1,000,000 playing Golf.

The larger point here is that invariably there will be things in life that you are good at, and there will be things out there that you are much better paying someone else to do. Many investors believe that they can manage their money effectively on their own – and they are most likely right – as long as we are in a cyclical or secular bull market. Of course, this idea is equivalent to being the only person seated at a blackjack table and the dealers cards are all face up. You might still lose a hand now and then – but most likely you are going to win.

Me, I would love to be a graphic artist, but until pie charts and analytical tables come into vogue as contemporary art it is unlikely I will be able to fund my retirement by doing it. However, just because my emotions tell me I want to be an artist doesn’t mean that I will be good at it. So, for the time being, I will leave it to others that have a penchant for paint. (But if you are interested in a pie chart for your living room let me know…)

Emotion causes us to attach significance to things that have little influence on whether a trade works out or not. Short-term traders often rely on a narrow statistical advantage in their methodology that allows them to be profitable over time. Emotions will deter this and over time have caused countless trading debacles, some of which ended in large hedge funds causing near-currency collapses. And that’s only looking at the Nobel Laureates.

Tom Dorsey wrote;

“Consider this, if someone offered to flip a coin for you and offers you a better payout on heads than tails, the only logical bet would be on heads. So there is only one decision, logically, but emotion may cause you to remember that the last time you took heads was in the 1958 NFL Championship game at Yankee stadium. You were with the Giants and called for heads in the overtime session, losing not only the coin toss, but also the game, eventually, to Johnny Unitas and the Colts.

That decision may be one you will remember for the rest of your life, but it isn’t one that will have any impact on the bet at hand. Nonetheless, we are all human and all susceptible to these types of thoughts, just some more than others.”

That is why there are so few successful poker players in the world but so many people willing to fund the Las Vegas strip. Most people are more than willing to take a risk with their money in the hopes of hitting the jackpot, the dream of being rich has been embedded in us since birth, however, very few investors have any idea of the “possibilities” of success versus the overwhelming “probabilities” of failure. Therefore, as in my case, I can’t paint, therefore, I understand that there is a huge probability that I will not be successful as an artist versus the slim hope (possibility) that people will flock to my door wanting 8 ½ X 11 framed pie charts. (Readily available at our website)

If you are not successful at managing your money over the long term, you will wind up losing money as roughly 80% of all investors do. It is better to be honest with yourself and begin an approach to increase your probabilities of success.   There are literally thousands of articles, research reports, contradicting opinions, radio programs, television shows, etc. – how are you supposed to determine what’s important and what’s not – that is the difference between a professional poker player and everyone else. In a blink of an eye, the professional can read the table and make a determination as to whether it’s time to “hold’em” or “fold’em”.

9) Be patient

Patience is hard.  Most investors want immediate gratification when they make an investment.   However, real investments can take years to produce their real results, sometimes, even decades.  More importantly, just like in playing poker, you are not going to win every hand and there are going to be times that nothing seems to be “going your way”.

No investment discipline works ALL of the time.   However, it is sticking with your discipline and remaining patient, provided it is a sound discipline to start with, that will ultimately lead to long term success.   I remember in the late 1990′s the media equated investing with Warren Buffet to driving “Dad’s old Pontiac” as Warren didn’t embrace new technology.   He didn’t embrace new technology because he didn’t understand and valuations on those companies made no sense to him.   He stuck with his discipline even though he was grossly under performing the market.   Eventually, his discipline paid off because it was a sound investment discipline to begin with and he was patient to allow it to work for him over time.

10) Examine your motivation for playing.

Why are you trying to manage your own money? Is it that you love doing it? Is it the “thrill of the chase and the agony of defeat” syndrome? Or, did you just think that is what you are supposed to do?   It’s a fair question, you’ve probably been asked it before, you’ve probably even got a well thought out answer. However, the real question that you need to ask yourself is “Am I successful at managing the future of my family and my retirement?”

“To a real player, gambling is only a certain part of what happens at casinos or at the track. Gamblers (or average investors) are people who either don’t know what they are doing, or like to bet against the odds. Good poker players (and good investment advisors), like good horse players, search for value. They leverage advantage. They look for small truths and they hope other people (competitors) don’t notice. They manage risk, and expect rewards for playing well. They like the sport. They like knowing. Call these people craftsmen. Don’t call them gamblers.”

The 13 Biggest Investing Mistakes to Avoid

I really liked this concise view on investing mistakes to avoid via Ben Carlons at A Wealth of Common Sense:

The Bill Russell investment strategy is about avoiding the crippling mistakes that so many investors make on a consistent basis.

Here’s my list of the biggest mistakes to avoid:

  • Making investment decisions based on your political views.
  • Confusing your risk profile and time horizon with someone else’s.
  • Consistently trying to time the market.
  • Losing site of your long term financial goals.
  • Paying high fees on investments.
  • Having high trading activity.
  • Letting fear and greed take over at the extremes in market sentiment.
  • Having the majority of your investments tied up in one asset (company stock, your house, etc.).
  • Basing your decisions on what you heard on CNBC or Fox Business News.
  • Following every tick in the market and constantly checking the value of your portfolio.
  • Making too many short term moves with long term capital.
  • Basing your investments on the most recent performance.
  • Not saving enough.

Government Bonds in a World of Moneyness

When you learn about the monetary system from the perspective of Monetary Realism you learn about a world with the concept of “moneyness” (see here for details).  The concept of “moneyness” helps us decipher how different financial assets fit into our traditional thinking of “money”.  It’s important to differentiate between the different types of financial instruments we utilize so we can better understand exactly how the monetary system is designed and operates.

“Money”, at its most basic form, is simply that which serves as the dominant medium of exchange.  In a world of “moneyness” lots of things can meet this definition, but some items apply more widely than others.  For instance, Bitcoin is a medium of exchange, but it has a low level of moneyness because it’s not very widely accepted as a means of payment.  Bank deposits, on the other hand, have a very high level of moneyness because they are so widely accepted as a means of payment.  You can buy almost anything these days if you have access to bank deposits.  I argue that, in our electronic age, bank deposits have usurped even cash in terms of moneyness.  Of course, there are lots of different instruments in the financial world that have money-like properties.  For instance, stock options are often used to pay employees, but you can’t buy much with your stock options.  You have to convert them into something with a higher level of moneyness like bank deposits.  So stock options don’t have a very high level of moneyness.

When we think of “money” it’s best to think of it as the medium of exchange.  But we must also understand that “money” is simply one type of financial asset that exists in a financial world with a plethora of financial instruments. In fact, our stock of financial assets is primarily made up of assets that aren’t of the highest moneyness.  Things like stocks, bonds and other assets comprise the vast majority of the financial instruments in our world.  We all want money to be able to spend in the present, but we also want to hold other financial instruments so we can plan and prepare for our future spending.  If we get too bogged down in the concept of “money” we can begin to think too narrowly about its impact on the overall economy.

More importantly, when we begin to think of all of these other types of financial instruments that comprise our financial world we have to consider why there are instruments with varying levels of moneyness in the first place.  For instance, when a corporation issues common stock they are giving the buyers of this stock a claim on future cash flows in exchange for money today.  The company is essentially trying to convince investors that they should give up their cash today so they can have more of it at a later date.  And in doing so, they have to convince someone that they should forego using their money today and instead hold onto an instrument that will potentially allow them to spend more in the future.  The investors have money they don’t need today.  The company has a cash flow machine they believe can generate higher future potential profits.  So there is a mutually beneficial financial arrangement that provides investors with an instrument of lower moneyness today with the hope that they can convert it into something more valuable with a higher level of moneyness in the future.

It’s important to understand the structure of this relationship, however.  Entities that need money must issue an instrument that convinces the buyers that they can utilize that instrument in the future to convert it into something in the future with a higher level of moneyness and greater purchasing power.  Otherwise, there is no point buying a financial instrument that is more risky than the cash or deposit they would otherwise hold.

And this brings us to a crucial point that John Carney of CNBC discussed today – are US government bonds “money”?  I would argue that US government bonds are an instrument with a high level of moneyness because they can be easily converted into something of higher moneyness (like deposits) and because they are backed by the taxing authority of the US government as well as a productive economy.  But they are not “money” in the same sense that bank deposits are because, as Scott Sumner notes, they aren’t a very useful medium of exchange for practical purposes.  And this brings us to an even more important point.  Our monetary system is designed so that the US government must obtain bank deposits.  In fact, it cannot spend if it cannot obtain these bank deposits and the US government cannot just force everyone to hold new bond issues or new currency issue (although I think such a scenario is incredibly unlikely).  And if the US government cannot convince the users of government bonds to hold these instruments (for whatever reason) then the government suffers a catastrophic demise as the collapse in its bonds would almost certainly coincide with a collapse in its currency.

This brings us to the most interesting point here.  The moneyness of different instruments can change!  And in fact, we find that in a hyperinflation or high inflation many instruments lose their moneyness.  In a hyperinflation something like gold and even common stock becomes a more viable form of money while government currency virtually dies.  So it’s important to understand that currency and US government bonds are instruments that are issued just like any other financial instrument and they serve a specific purpose under a specific institutional framework.   These instruments must find willing owners who want to hold onto these instruments with the expectation that their purchasing power will be maintained.  In the case of cash currency it is issued through the US banking system to facilitate the use of deposit accounts (mainly through ATM usage).  Currency in the form of reserves facilitates the use of deposits in the interbank system.  And US government bonds are issued because our government is structured in a manner that the Executive Branch cannot merely credit its own account and spend.  This is the result of very specific legal and institutional structures that are in place.  So, despite the fact that the US government is a currency issuer and a very powerful one at that, it is not exempted from the fact that it must always be able to find willing holders of the instruments that it issues to facilitate its cash management needs.  And under the current monetary design, US government bonds resemble something like corporate bonds much more than they resemble something like bank deposits.  Therefore, government bonds should best be thought of as financial instruments with a high level of moneyness, but a lower level of moneyness than something like bank deposits.

 

Credit IS Money

It’s common in economics and in general, for people to differentiate between “money” and “credit” (Scott Sumner did it here today).  This is largely the result of gold standard mythology when gold was viewed as the primary form of money and “bankers” would issue notes that were redeemable for gold.  They were, in essence, issuing a claim on gold.  When we went off the gold standard economists didn’t really change their model much.  They just substituted central bank reserves and cash for gold and said that when banks were lending they were issuing claims on central bank money and vault cash.  I think this is totally wrong.

The system we reside in today is not one designed around central bank reserves and cash.  In fact, central bank reserves and cash are playing an increasingly less important role in the economy as time goes on.  Reserve requirements are no longer necessary in well managed banking systems, cash is becoming a less common form of money and the importance of inside money (bank money or deposits) has become increasingly evident to the economy as the credit crisis proved.

The problem with this focus on central bank money and reserves is that it seems to get the entire focus of the monetary system wrong.  We start from the government and build out from there without realizing that the private sector steers the economy and the money the non-bank private sector primarily uses (inside money) dominates how output is created, where prices settle and how we engage in the economy.

It’s also important to note that everything that involves outside money (central bank money) is a facilitating feature of what is clearly an inside money system.  That is, reserves exist primarily to help settle interbank settlement.  And cash exists primarily to allow an inside money bank customer to draw down an account to transact more conveniently.  These forms of money like reserves, cash and coins (outside money) all facilitate the use of the dominant money – inside money.   Saying that inside  money or credit is just a claim on outside money is clearly false.  For instance, a transaction occurring between two customers in credit at Bank of America doesn’t even involve outside money.  But more importantly, what we’re all really after in the economy is not claims on outside money.  We’re all seeking the real money – bank deposits.  The primary way cash comes into circulation is when an inside money holder draws down a bank account.  And the non-bank private sector cannot even access bank reserves so it’s totally illogical to build a real understanding of the economy around outside money.

Focusing on outside money and building a world view around it is like trying to understand how a man walks by studying the crutch he uses.  Outside money is merely a crutch while inside money is the legs!  Yes, outside money is important and it can be particularly important when your legs break (during a credit crisis), but that doesn’t change the fact that the legs are the form of money that “rules the roost” 99% of the time.   There are hardly any schools of economic thought that get this balance correct.  Which is a big contributing factor to why the entire “dismal science” appears so dismal at present.

Related:

Understanding the Modern Monetary System

The Lead Role of the Private Sector & “Inside Money”

Understanding Inside Money and Outside Money

Understanding why Austrian Economics is Flawed

Austrian economics has been through quite a rollercoaster ride over the last 10 years as the housing bubble appeared to vindicate many of their views and then the economic recovery proved many of their dire predictions completely wrong.  I think Austrian Economics is deficient and Austrian Business Cycle Theory is inherently flawed and built on misunderstandings about the way the modern monetary system actually works.  Allow me to provide three core reasons why I believe this:

1)  Austrian economics is a political ideology that masquerades as an economic school of thought.  Like most of the economic schools in existence today, Austrian Economics is predicated on a political ideology.  Austrians tend to be vehemently anti-government and pro-market.  So they build a world view that conforms to the world they want and not the world we actually have.

We’ve seen this time and time again in the last 5 years during the recovery as the government picked up spending when the private sector cratered.  There is always an excuse within Austrian Economics that implicitly assumes government cannot spend dollars any better than a household.  This might be true in a general sense, but it is not always true.  For that implies that households and businesses always make rational decisions.  As if choosing to have our government spend money on wars and welfare is all that much different than households spending money on the next release of the tech gadget they probably don’t need or the McMansion they can’t afford.

Austrians aren’t the only offenders of this (see here).  We see it in Keynesian approaches, Market Monetarist approaches, Monetarist approaches and just about all of economics these days.  Economics is built primarily on a bunch of political agendas designed to look like a science.  Austrians (particularly the Rothbardians) are so vehemently against government involvement in the economy that they are among the very worst offenders of trying to pass an ideology off as a school of thought.  It results in a very unbalanced presentation of our reality.

2)  Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system.

The act of targeting interest rates and implementing monetary policy are very much secondary to this primary purpose and the powers of such policy, as presently constructed, are vastly overstated by most economists.  Yes, the central bank controls a component of the interest rate that helps determine the spread at which banks can lend, but the central bank does not determine the rate at which banks borrow to customers.  It merely influences the spread.  Overemphasizing the Fed’s “control” over interest rates misunderstands how banks actually create money and influence economic output.

The primary flaw in the Austrian view of the central bank has been most obvious since Quantitative Easing started in 2008.  Austrian economists came out at the time saying that the increase in reserves in the banking system was the equivalent of “money printing” and that this would “devalue the dollar”, crash T-bonds and cause hyperinflation.  It was standard operating procedure to see charts of the monetary base like this one followed by dire predictions of high inflation or hyperinflation.  Of course, none of this actually panned out.  The high inflation never came, the hyperinflation definitely never came, the T-bond collapse was a terrible call and the USD has remained extremely stable.

So why was Austrian economics wrong on this point?  Because their model is predicated on the same faulty loanable funds based model that most other economists use.  So they assumed that more reserves would mean more “multiplication” of money and thus hyperinflation.   Of course, as I’ve explained numerous times here before, banks are never reserve constrained and do not make loans when they have more reserves.  Further, QE is a simple asset swap that changes the composition of private sector assets.  Referring to this as “money printing” is highly misleading (see here for more details).  Austrians got this wrong because, in an attempt to attack government, they have devised a government centric view of money creation that misunderstand the way money is created primarily by private competitive banks endogenously.

3)  Austrians misunderstand inflation.  Austrian economists actually change the definition of inflation to serve their own ideological needs.  In Austrian Economics inflation is not the standard economics concept of a rise in the price level.  Inflation in Austrian economics is just a rise in the amount of money.  This leads to all sorts of emotional commentary, the most common of which, is the idea that the USD has declined 95% since the creation of the Fed in 1913 (which is true).   But this misunderstands several concepts and misleads us in understanding how the monetary system works.

First of all, the private sector creates lots of “money like” instruments that are not technically included in the money supply but comprise the vast majority of private sector net worth.  I use a “scale of moneyness” to help better understand this concept so that we don’t place an undue specialness on the idea of “money” when trying to understand inflation.  Instead, I try to explain that spending is a function of income relative to desired saving.  And that saving is comprised not only of “money”, but money-like instruments like stocks, bonds, options, etc.  To completely understand how the economy is impacted by inflation we shouldn’t merely focus on narrow definitions of “money”, but should understand the aggregate economic balance sheet.  For instance, if you sell a stock at no gain and obtain cash you’re not necessarily more likely to spend than you were before because your net worth is the same.  Your income relative to desired saving is precisely the same as it was before.  This is basically what QE is.  It is a swap of one type of asset for another and doesn’t actually alter the net worth of the private sector.  Changing the moneyness of private assets does not necessarily mean there will be higher inflation!

But there is a more egregious and nefarious error in this “decline” of the dollar myth.  It completely misunderstands how living standards can rise even while the money supply rises.  In our credit based monetary system the money supply rises primarily when banks make loans which create deposits.  In a highly productive economic environment these loans are distributed by private competitive banks and provide the borrower with the capability to invest in a manner that actually enhances the living standards of society.  So, you borrow $100,000 from the bank, you invent and distribute the washing machine and suddenly we’re all better off because we no longer have to go to the river to wash clothes.  The technological advancement enhances our lives by giving us more time to consume and produce OTHER goods and services.  In other words, the money supply has technically increased, but we’re not worse off because of it.  We’re better off because of it!  What’s happened since 1913 in the USA is just one gigantic version of the washing machine example where our living standards have exploded through the roof in tandem with a rising level of credit and an innovation boom that human beings have never come close to experiencing in the past.

Austrians, in their fervor to demonize the fiat money system, make several errors here.  First, they assume the government controls the money supply (which they don’t).  It’s actually controlled primarily by private banks in a market system that Austrians should love.  Second, they move the goal posts on the definition of inflation to imply that inflation is always and everywhere a bad thing (which, it can be, but generally isn’t).

That really just scratches the surface on some of the flaws in Austrian Economics.  I think Austrians provide some good insights on the way the economy and money works, but these are glaring flaws in the school of thought that render it highly inadequate in helping us understand the world of money in a balanced and objective way.

See also: 

Understand the Modern Monetary System

Monetary Realism Recommended Reading

“Don’t Work Harder, Work Smarter”

One of the cornerstones of Monetary Realism is understanding the importance of time.  We’re all here for a finite period and we can choose how we use that time and whether it’s going to work for us or against us.  Now, I’m not good at many things, but I think one of the few things I really understand is time management.  I really value my time.  And I use it wisely.

The saying “don’t work harder, work smarter” is one of those cheesy taglines that you hear all the time and never quite find any real world application for, but it’s dead on.  Here are a few thoughts about working smarter rather than working harder:

  • Don’t conform to everyone else’s schedule.  Yes, I know, most of us work for someone else and have to conform to their schedule, but that doesn’t mean you have zero flexibility within that schedule.  So what if you have to show up at 9 and leave by 5.  Does that mean you have 8 hours to do an allotted amount of work or does it mean you can design your 8 hours however you like?  Most of us have deadlines we have to meet and we build a schedule around your employer’s deadlines.  But you can still design your own deadlines and use your time how you like.  You don’t have to meet a deadline by Friday just because that’s when it’s due.  Can the work be done by Thursday so your Friday is open to focus on other things?  If so, why wait?  Don’t let everyone else control your schedule….
  • Stop procrastinating and create a sense of urgency.  Most of us procrastinate and wait until there’s a sense of urgency to get something done.  Create your own sense of urgency right now.  Set your own personal deadlines by creating goals and forcing yourself to work smarter.
  • Organize your schedule.  I spend a huge amount of time organizing a schedule.  I usually spend every Sunday evening planning my week.  When do I work on this project, that project, when I eat, when I workout, when I read, when I relax, etc.  If you’re not organized then working smarter is never going to work for you.
  • Make the robots work for you.  Don’t let the “world is ending because of robots” meme get you down.  All that technology is out there to help you work smarter so you don’t have to work harder.  Take advantage of it, learn about it and use it to become more efficient.
  • Stop getting distracted.  Are you on Twitter, Gchat, the phone, email or Facebook all day?  Why?  It’s a waste of time unless it’s helping you achieve your goals.  Cut out the waste!  Learn to stop filling your email box with clutter.  Stop spending time on the phone with people who are just chewing up time.  Stop Gchatting about what you’re going to do next weekend.  Stop checking Facebook.  It’s so easy to get distracted these days.  Yes, it’s perfectly fine to take time off, but don’t let it control the time when you should be getting things done.  Block out your time for social interaction so that it’s working to benefit you and not working against you. You don’t live to work, you work to live, but when you’re working you need to actually be working!

That’s my thought process about managing time efficiently.  If you have more tips or thoughts please add them in the comments.

H/t Medium.com