THE AUSTRIAN: What is the “Great Monetary Experiment” you refer to in your book?
Brendan Brown: The Federal Reserve has sought by using non-conventional monetary tools to produce a stronger than normal economic expansion following the Great Recession. The resort to such tools has occurred in a context where money market rates have already fallen to near zero, meaning that the conventional tool of rate cuts is not available. The ECB and Bank of Japan joined in the experiment with a considerable lag behind the Federal Reserve.
The non-conventional tools have included massive expansion of the monetary base, manipulation of long-term interest rates — and in the case of Europe — sub-zero interest rates. The tools have been applied toward achieving an inflation rate over the medium-term (in practice two years) of 2 percent per annum.
The setting of an inflation target pre-dates the Great Monetary Experiment. Transcripts reveal that at an FOMC meeting in summer 1996, then-Governor Janet Yellen presented a paper (invited by then-Chair Greenspan) arguing that the aim of “price stability” should be interpreted to mean perpetual “low” inflation.
The architects claim the monetary experiment has been a great success even though this is the slowest US economic expansion ever. And of course we cannot estimate the full costs including malinvestment until the record of the full business cycle including its asset price deflation phase is available.
TA: What does it mean that investors have become starved for yield? In your book you call it “interest-income famine.”
BB: The nineteenth-century English financial journalist Walter Bagehot coined the concept of “yield starvation” when he said that “John Bull will stand for many things but not interest rates below 2 percent.” He meant that in such a situation the investor would act “madly.” In today’s terms, we could translate that into the observation that if interest income from safe investments is very low, then investors, in their desperation for yield, chase uncritically a succession of speculative ideas. These apparently justify high and rising prices (relative to sober valuations) in presently hot asset classes. Investor decision-making reveals abnormally flawed mental processes.
Of course, sometimes even under a sound money regime interest rates would reach very low levels as during a recession. But so long as these are regarded as transitory and there is no serious danger of an erosion of wealth by the eruption of inflation, rationality would dominate especially as longer term interest rates would remain substantially positive. But under the Great Monetary Experiment investors have been deeply troubled by the far-out danger of inflation — especially given the bloated size of the monetary base. They also fear that the Experiment will eventually bring a crash which would be followed by an even bigger experiment.
Time-horizons also shorten for many investors as they enter into desperate gambles to make returns before the Day of Reckoning. Companies get rewarded by the equity markets for paying out cash and making profits from financial engineering rather than for undertaking bold long-gestation investments.
TA: You speak often of asset-price inflation. It seems that measuring inflation is easier said than done, however. What are some of the challenges in measuring inflation?
BB: Asset price inflation is hard to measure and diagnose because it involves a comparison between actual capital-market prices as influenced by strong irrational forces, and hypothetical prices that would exist under conditions of sound money. Moreover, asset price inflation does not affect all markets simultaneously. Indeed there is a mid-phase of the disease when speculative temperatures may be rising in some markets at the same time as falling in others.
These difficulties in measurement and diagnosis of asset price have been seized on by some critics to say that the disease does not exist. Other critics admit that there are periods in economic history when irrational exuberance in various forms is evident but maintain that the essence of the phenomenon is purely psychological (i.e., created by “animal spirits”). One answer to these criticisms is to take these episodes through history and demonstrate each time that monetary disorder has been present in a big way. The other part is to outline a clear chain of causality between monetary disorder and the growth of the irrational forces in asset markets. I try to do both in my book.
TA: In the past, we’ve seen the dot-com boom and the housing boom. This time around, the boom is different. What are the boom industries right now, and why has money gravitated toward those industries?
BB: This time the boom has been in the oil industry (including shale), in other commodity extraction industries, in emerging markets (including their real estate sectors), in export sectors in the advanced economies supplying the emerging markets especially China, and in Silicon Valley. Much of this boom (but not all) has turned to bust.
These stories fueled the flow of funds into high-yield credits and currencies in the pursuit of yield. Fantasy prices for high-yield credits were an essential condition for the boom in the private equity industry which in turn invested in the sub-prime auto finance and aircraft leasing sectors on a highly leveraged basis. Similar things happened in the shale gas and oil industry. Alongside there has been the boom in the currency carry trade into China and emerging markets whose economies were very dependent on the China boom. This speculative inflow into Chinese and wider emerging market currencies and credits as driven by the Great Monetary Experiment created economic boom and bust. The closest historical parallel to the carry trade boom in this cycle was perhaps the huge inflows of capital into the Weimar Republic between 1924–28 as fueled by the combination of monetary disorder as generated by the Benjamin Strong Fed, and the fantastic speculative activity surrounding the German “miracle economy” emerging from the destruction of war and hyperinflation.
TA: There are a lot of people out there who have been predicting a meltdown for years. You, on the other hand have identified several reasons as to why the current boom has not yet collapsed. What are some of these reasons?
BB: Each episode of asset price inflation disease through history has some elements common with others and some distinct. Since the early years of this episode — back in, say, 2010–12 — I have sought to diagnose the stage of the disease that we are in. Yet in my work I have been very aware of Mises’s advice against firm predictions in such matters. The weak overall economic expansion in the US and other advanced economies meant that an early end to the cycle was not going to come from general overheating accompanied by a substantial rise in interest rates. Indeed the economic sluggishness could be explained by huge monetary uncertainty weighing on business confidence. Instead, the end phase of the disease this time could arrive through a speculative burn-out — a disappointing reality causing rose-colored spectacles to splinter.