Leithner Letter No. 66
26 June, 2005

Present goods are as a general rule worth more than future goods of equal quality and quantity. That sentence is the nub and kernel of the theory of interest.

Eugen von Böhm-Bawerk
Capital and Interest (1889)

In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. ... For the moment, the broadly unanticipated behaviour of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.

Alan Greenspan
Testimony Before the Committee on Banking, U.S. Senate
(16 February 2005)

Most economists think they’re smarter than Alan Greenspan. At least, they think they have the answer to a ‘conundrum’ he posed in congressional testimony last month. Namely, Mr Greenspan wondered why long-term interest rates had fallen, ignoring his campaign to raise short-term rates. Usually, the two rates move in tandem. Mr Greenspan threw around some possible explanations, but in the end, ‘the Maestro’ threw up his hands. Why should normal people with normal lives care about the difference between long- and short-term interest rates? Because when that gap shrinks or inverts itself, it’s usually followed by an economic downturn or an outright recession.

The Wall Street Journal
(10 March 2005)

Leithner & Co. Pty Ltd is a private investment company that adheres strictly to the Graham-and-Buffett “value” approach to investment. Its goal is its method: to undertake investment operations which are based upon thorough research and cautious assumptions; to provide reasonable safety of principal and offer an adequate return; and to inform shareholders regularly, fully and in plain language about these investment operations. Like most Australian corporations, its financial year begins on 1 July and ends on 30 June. The arrival of winter is therefore an appropriate time to conduct two exercises. The first is to contemplate the twists and turns, triumphs, trials and tribulations of the financial year coming to a close; and the second is to subsume these events under principles, revisit these principles, learn one’s lessons and adjust one’s sails for the next twelve months.

For several years, my appraisal of financial events and developments has been unfashionably severe and my assessment of the road ahead correspondingly cautious. Letter 24-25 (26 December 2001 – 26 January 2002) stated “in many countries, including Australia, Britain, Canada and (especially) the U.S., the boom of the late 1990s sowed the seeds of bust. Australia’s boom ended in 2000 and signs of bust gathered pace in 2001. ... [Our] plans for 2002 are based on the premise that many of the excesses of the 1990s remain unrecognised and therefore unpurged, and that the bust may be extended and sharp” (see also Letter 36-37, Letter 48-49 and Letter 60-61). Underscoring this dour tone, Letter 24-25 also stated that a “renewed misallocation of resources ... may manifest itself in 2002 through a ‘recovery.’ Whatever the euphoria it incites in financial circles, such a recovery neither causes economic growth nor creates wealth. Rather, it misdirects Australia’s small and eroding pool of funding and thereby weakens the potential for longer term and sustainable prosperity. Leithner & Co. will [therefore] be in no hurry to sing ‘Happy Days Are Here Again.’”

In mid-2002 (see Letter 30) and again mid-2003 (Letter 42) and mid-2004 (Letter 54), this cheerless assessment remained mostly unrevised and unrepentant. And in at least one respect – although hardly, to put it mildly, in others – it has been vindicated. Scepticism and caution have helped Leithner & Co. to avoid foolish behaviour. But they have not crimped its fortunes. Quite the contrary: they have helped it to generate reasonable (both relative to others and in an absolute sense) results since its inception in 1999; and notwithstanding its hefty cash weighting and conservative tallying (unrealised capital gains, for example, are not counted towards its results), doubt and prudence have enabled it to extend these reasonable results into the 2004-2005 financial year.

Is Australia on the Verge of Recession?

Better than any other set of figures, it seems to me that Table 1 encapsulates recent developments and suggests something that Australian investors might want to ponder. It summarises short-, medium- and long-term rates of interest in this country on an annual basis in 2001 and 2002, on a quarterly basis in 2003 and 2004 and on a monthly basis for the most recent couple of months. The 90-day bank bill rate is the “coupon” of bills of exchange accepted or endorsed by major Australian banks. The yields of 5-year and 10-year Commonwealth bonds express the annualised “coupons” of Australian government paper as a percentage of their purchase price.

Table 1: Australia’s Recently-Inverted Yield Curve

  90-Day Bank Bill Rate (%) Yield of 5-Year Commonwealth Bond (%) Yield of 10-Year Commonwealth Bond (%)
Jan-Dec 2001 4.90 5.23 5.64
Jan-Dec 2002 4.75 5.53 5.83
Jan-Mar 2003 4.77 4.77 5.19
Apr-Jun 2003 4.75 4.74 5.05
Jul-Sep 2003 4.82 5.18 5.43
Oct-Dec 2003 5.25 5.71 5.77
Jan-Mar 2004 5.54 5.53 5.62
Apr-Jun 2004 5.51 5.67 5.89
Jul-Sep 2004 5.44 5.50 5.62
Oct-Dec 2004 5.42 5.19 5.32
Jan-Mar 2005 5.62 5.53 5.54
Apr 2005 5.75 5.32 5.35
May 2005 5.68 5.27 5.20

A yield curve is a chart that plots interest rates on its vertical axis and bonds’ time-to-maturity on its horizontal axis. It represents the returns of bills/bonds whose maturities differ but whose risk is comparable. Table 1 shows that throughout 2003 and during the first three quarters of 2004, 90-day yields tended to be lower than 5-year yields, and that 5-year yields tended to be lower than 10-year yields. Similarly (and except in January, February and March 2001), a similar pattern prevailed during 2001 and 2002. The longer the duration of otherwise comparable bonds, in other words, the higher their yields. Between April 2001 and September 2004 the Australian yield curve conformed to this norm.

Paul Kasriel (The Fed: A Failure to Communicate or Communicated Only Too Well?) makes a much more general and fundamental point, namely “the tendency for yield curves to be upward sloping since the inception of [central banks], whereas, prior to this event, they were, more often than not, downward sloping” (see also James Grant, The Trouble With Prosperity: A Contrarian’s Tale of Boom, Bust and Speculation, Random House, 1996, ISBN: 0812929918). Kasriel notes that the median ratio of high-grade corporate bond yields (i.e., longer-term interest rates) to commercial paper (i.e., short-term) rates in the U.S. between 1857 and 1913 was 0.87. “Thus, prior to the inception of the Fed, there was a tendency for bond yields to be below money market yields. With the creation of the Federal Reserve System [in 1913] through 2002, the median of this ratio jumped by 52% to 1.32. That is, since the Fed came into existence, it has been more common for bond yields to be above money market yields. Of course, this change in relationships between bond yields and money market interest rates is not surprising given the change in the behaviour of [price] inflation. If inflation is the rule rather than the exception, then higher future interest rates would be more likely than not. Hence, a positively sloped yield curve would be the norm” (see also What’s With the Yield Curve? by Frank Shostak).

So why, since October 2004 and as shown in the bold font in Table 1, has the Australian yield curve flattened and inverted such that 90-day yields are higher than their 10-year counterparts? Why should investors care – or even notice? Because since the Second World War in most Western countries including Australia, the yield curve has tended to invert roughly 6-18 months before the onset of recession (for a recent summary of this literature, see Paul Cwik, An Investigation of Inverted Yield Curves and Economic Downturns, Ph.D. Thesis, Auburn University, May 2004). An inversion today does not necessarily mean recession tomorrow; but a recession is almost always preceded by an inversion. Japan since the mid-1980s is the major exception – perhaps because during most of this period that country has been mired in recession.

In the U.S. during the past six months, the slope of the Treasury yield curve has flattened considerably and is presently flatter than at any time since early 2001. At the beginning of 2005, 10-year Treasuries yielded 200 basis points more than 90-day T-bills. By the end of April, that spread had fallen to 130 points and at the beginning of May it increased slightly to 144. Accordingly, for the past six months the spread has remained below the median (173 basis points) of the past 20 years. The spread in Canada, where the yield of 10-year government paper is lower than at any time since that country’s last sane Prime Minister, Louis St Laurent, held office (1948-57), is even lower (i.e., its yield curve even flatter).

Assuming for the moment that a flat yield curve signals stagnation and that an inverted one is a harbinger of recession, how should the investor react? These days, virtually all economists, politicians, bureaucrats, commentators and investors regard recessions as unspeakably horrible things that must be avoided at all costs (people whose sensibilities are too delicate to tolerate this term talk of “slowdowns” and “soft landings” – the word “depression” is utterly taboo). As a result, virtually nobody recognises a recession for what it really is: a healthy tonic, or a salutary restorative, that is necessary in an economic system where central and commercial banks, politicians and herd-like market participants regularly connive to create artificial booms. A recession purges financial excesses that accumulate during sham booms. Like a bushfire that temporarily razes the landscape but also clears the way for healthy long-term growth, a recession destroys poor “investments” and thereby enables a sound allocation of capital to occur. A recession, in short, is a restorative interlude during which some semblance of sanity returns and capital reverts to its rightful owners.

Seen from this point of view, the idea that “countercyclical” and “stimulatory” fiscal and monetary policies should be adopted because they will forestall recession – which, in a nutshell, is exactly what central banks and politicians have moved heaven and earth to achieve since 2000 – is clearly absurd. One cannot cure an alcoholic by continuing to ply him with grog. Indeed, it harms the alcoholic; and doing so long enough and in big enough doses hastens his death. Stripped of his deft evasions and fluent use of central bank obscurantism, does Mr Macfarlane really know the appropriate “equilibrium rate” of interest at any given point in time? Is he so omniscient that he can divine when and to what extent it is appropriate to countermand price signals in the market? Is he (and his political master, Mr Costello) so omnipotent that Australians can be confident that interventionist policies will produce more good than harm? Or is he no more than the avuncular embodiment of moral hazard in Australia?

An inverted yield curve is usually but not invariably an early manifestation of two variants of recession (i.e., a credit crunch and a resource crunch). Before and perhaps during the “crunch” phase of the business cycle, the central bank begins to fear incipient price inflation. It therefore tends to decelerate its rate of monetary expansion. This, it is important to note, has occurred in Australia since roughly mid-2004. Also at this point in the business cycle, the prices of inputs tend to rise more quickly than prices of outputs (ditto in Oz since last year). Each of these scenarios, as we will see below, encourages the inversion of the yield curve. Indeed, as we will also see, the inversion reflects central and commercial banks’ and entrepreneurs’ efforts to avoid the unpalatable consequences of their poor investments (“malinvestments”). During the recession caused by the boom and which generally follows the inversion, the market mechanism liquidates these poor investments and – given the heroic assumption that governments do not continue to intervene – sets the stage for proper recovery and healthy long-term growth. In that respect, and subject to this critical (and probably naïve) assumption, Leithner & Co. is preparing – very cautiously and tentatively – to sing “Happy Days Are Here Again.”

What Is Interest, Anyway?

Spare a compassionate thought for 99.9% of Australian market participants – including the highest and the mightiest. These poor souls believe, uncritically and often fervently, that the rate of interest is the cost of a loan. This cost, in turn, is strongly influenced if not dictated by a benign, omniscient and omnipotent Reserve Bank of Australia. Utterly alien to them are the insights devised by Eugen von Böhm-Bawerk and elaborated by his Austrian School successors: in an unfettered market, interest harmonises the quantities saved and invested (see Letter 51). The “pure” or “natural” rate of interest depends upon individuals’ time preference – that is to say, their willingness to exchange a given amount of present goods and services (those which can be consumed today) for a specified greater amount of future goods (intermediate or unfinished goods which will become present goods at some point in the future). The greater (less) the willingness to trade present for future goods, or to outlay a given amount of money today in order to receive a specified greater amount at a particular point in the future – the greater, in short, the preparedness to wait – the lower (higher) the natural rate of interest (for some very wide and illuminating applications of this principle, see Hans-Hermann Hoppe, Democracy, The God That Failed: The Economics and Politics of Monarchy, Democracy and Natural Order, Transaction Books, 2002, ISBN: 0765800888).

The Austrian School conception of interest, at whose heart lies the notion of time preference, emphasises that the discount of future goods vis-à-vis present goods (or, equivalently, the premium that present goods command over future goods) is at best indirectly observable. Observable or “market” rates of interest comprise three things: the pure rate, an entrepreneurial or “risk” component (which is roughly akin to the “risk premium” in the mainstream literature) and any expected change in the currency’s purchasing power (“inflation premium”) over some relevant period. The greater the pure rate and these premiums, the higher is the yield that lenders will demand. Given a modern central bank, inflation of the money supply almost inevitably follows; and the longer the future period of time under consideration the more likely it is that price inflation will materialise. Hence the ubiquity of the inflation premium and the strong tendency for modern yield curves to slope upwards.

In an unfettered market (i.e., in the absence of a central bank), interest responds to the laws of supply and demand. In a free market, in other words, interest smoothly co-ordinates the actions of borrowers and lenders. Anchored by the natural rate and varying from case to case and time to time according to risk and inflation premiums, the financial resources committed to investment projects will accurately reflect individuals’ willingness to sacrifice consumption today in order (they hope) to consume more in the future. As a rule, they will also reflect these projects’ risks. This market-directed process of saving and investment underwrites healthy economic growth; further, minor and gradual movements in the natural rate of interest, together with isolated and stochastic miscalculations by investors, generate small adjustments to the rate of growth and thus protect the structure of production against larger, more abrupt, geographically extensive corrections (i.e., recessions).

Alas, the contemporary mainstream indignantly rejects the very possibility that interest might co-ordinate the activities of borrowers and lenders. It therefore denies that interest can equilibrate the desire for jam today versus more jam in the future. As with so much in contemporary economics, much of the blame can be sheeted to the malignant influence of John Maynard Keynes. In The General Theory of Employment, Interest, and Money (1936) he said “classical economists” (a phrase he used mischievously to tar most of the economists who preceded him) “are fallaciously supposing that there is a nexus which unites decisions to abstain from current consumption with decisions to provide for future consumption.” This rejection has fundamental implications. As Roger Garrison (Ditch the Keynesians: Why Policy-Infected Rates Must Go, Barron’s, 2 September 2002) put it, “Keynes’s verdict of ‘no nexus’ left interest rates up for grabs. And if they weren’t doing [any useful job], maybe they could be used for macro-management.”

Bloody Keynes Yet Again

In Keynes’s world, the optimism (“animal spirits”) of consumers and businessmen inspires them – with credit not backed by savings – to spend and invest. (Keynesians, it is worth mentioning, notoriously confuse and conflate the distinct concepts of investment and consumption). It is this bullishness, Keynesians say (as opposed to accurate calculations of what consumers want and the prices they are prepared to pay), which creates jobs, bolsters spending and generates economic growth. Sunny dispositions beget the prosperity that reinforces the optimism. If Australians were only more exuberant, Keynes implies, they would be more prosperous. (Yes, that’s right: upon careful reading much of his reasoning, such as it is, reveals itself as circular and reliant upon absurd self-fulfilling prophesies).

To Keynes, interest reflects people’s “liquidity-preference” (i.e., the extent of their desire to hold cash). The greater this desire, the greater the inducement – the rate of interest – required in order to persuade them to exchange cash for less liquid assets. Three things underlie the liquidity preference. The first is the “transactions motive.” This is the cash required to finance everyday personal and business transactions. The second is the “precautionary motive,” i.e., the desire for a hoard of cash stuffed under the mattress as a hedge against the uncertainty of the future. And the third is the speculative motive, i.e., the desire to profit “from knowing better than the market what the market will bring forth.” Keynes denounced high interest rates and blamed them upon “excessive liquidity preference” and an “insufficient propensity to consume.” In his view, the creation of credit not backed by savings – the central bank’s manufacture of artificially low rates of interest – is a good thing because it induces greater spending (which is an even better thing). To borrow the vernacular of today’s financial commentators, the object of central banking is to “make cash trash.” And in that narrow and destructive respect – compare the purchasing power of today’s $A with its equivalent in decades past – it has been spectacularly successful.

Interest rate “stimulus” is a vital spanner in the Keynesian policy toolkit because the spending spurred by optimism and animal spirits may be insufficient to satisfy politicians’ electoral promises and bureaucrats’ appetite for bigger empires. If not, then lower rates (which render credit cheaper, reduce the liquidity preference and thereby induce more borrowing and spending), engineered by the central bank’s expansion of the base and supply of money, may be required. Conversely, if the coup de whiskey of easy money produces too much optimism for mainstream economists’ and politicians’ liking, then higher rates engineered by a slower rate of monetary expansion may be the order of the day.

In today’s world, then, individuals and the natural rate of interest, the risk premium, etc., are denied, obscured and bastardised by central and commercial banks and their political overlords. At a press conference on 8 December 2003, after he released the Commonwealth’s Mid-Year Economic and Fiscal Outlook 2003-2004, Mr Costello outed himself from his Keynesian closet. He said “if interest rates come down, people tend to borrow more. That is one of the reasons why you reduce interest rates, incidentally. You reduce interest rates so that people can buy more. It is considered stimulation for the economy. And nobody should be surprised that if interest rates are lower, people buy more; that is what the whole theory of monetary policy as stimulation is all about.”

.Hence today’s conventional, man-in-the-street conception of interest: it is the cost of a loan to the borrower (or its proceeds to the lender), decreed by the government via its central bank proxy and accepted without demur by borrowers and lenders. To most homeowners these days, the cost of a loan is the monthly mortgage payment on the house that is financed by the loan. The highest and the mightiest agree: U.S. Treasury Secretary John Snow, for example, told The Washington Post (21 October 2003) “interest rates are the price of capital.” Alien to Mr Snow, Mr Costello, homeowners and the contemporary mainstream is the notion that lack of capital is dearth of time and that interest, when not bastardised by governments, expresses time preference and harmonises the behaviour of borrowers and lenders.

But we no longer inhabit that world. Instead, if interest rates are instruments of policy that are strongly influenced by extra-market entities such as central banks, and if their purpose is to yoke investors’ expectations to politicians’ dictates, then rates cannot normally perform the harmonising, market-based and growth-governing function that Austrian and some other early neo-classical economists attributed to them. Roger Garrison’s insight deserves emphasis: to believe as Keynes did and his successors do that interest rates cannot or should not do their “traditional” job is effectively to unleash interventionist institutions (such as central banks) and interventionist policies (such as “accommodative” monetary policy) whose raison d’être is to ensure that interest rates will not do their traditional job.

The Mainstream’s Disastrous Legacy

Alas, central bankers and interventionist monetary policies have occasionally (i.e., during the late 1920s-to-early 1940s and late 1960s-to-mid-1970s) grievously misjudged and backfired spectacularly. Central banks have also regularly – most recently, during the late 1980s, early 1990s and mid-1990s-to-early 2000s – misjudged less disastrously. And it is not at all clear that the most recent misjudgment will in retrospect be categorised on the less disastrous end of the spectrum. Disastrous or not, during each of these unfortunate episodes entrepreneurs, savers and investors were implicitly encouraged to undertake transactions which in retrospect were much riskier than they realised. This belated realisation cost many people very dearly for extended periods of time.

But no matter: central bankers are sorry and promise that they will not do it again (tellingly, however, they have not offered a penny of restitution from their own pockets to their many victims). On 8 November 2002, for example, at the conference celebrating Milton Friedman’s 90th birthday, Benjamin Bernanke, a prominent member of the Federal Reserve’s Board of Governors (and, God help us all, a mooted frontrunner to succeed Mr Greenspan), stated “let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton: regarding the Great Depression, you’re right; we did it. We’re very sorry. But thanks to you, we won’t do it again.” Even the mainstream now acknowledges that the interventionism of the U.S. Federal Reserve transformed a severe recession into the Great Depression (see in particular Alan Meltzer, A History of the Federal Reserve, Vol. 1: 1913-1951, University of Chicago Press, 2003, ISBN: 0226519996). Unfortunately, the lesson learnt from this débâcle is that the central bank should intervene even more aggressively next time (see in particular Alan Ahearne et al., Preventing Deflation: Lessons from Japan’s Experience in the 1990s, Federal Reserve International Discussion Paper No. 729, June 2002).

Hence the damaging conception of interest and practice of monetary policy that the mainstream has imposed upon borrowers and lenders. And hence the insuperable problem that lies at the heart of this conception: policy-makers do their best to ensure that interest rates cannot do their traditional job of harmonising and equilibrating the behaviour of borrowers and lenders. They create a wedge between borrowers and lenders – the mainstream uses words like “disequilibria” – by imposing upon them rates that do not tell the truth about time. Accordingly, the interventionist policies unleashed by Keynesian hubris routinely create imbalances among borrowers and lenders – and eventually induce both parties to commit egregious and painful mistakes. Despite their laudatory press, only irregularly (and in no small measure by happy accident) do the results of interventionist policies correspond to their authors’ intentions; and when these élites make mistakes, which as humans they necessarily and regularly do, their exalted and protected status shields them from the harsher fate that befalls small businessmen and investors of modest means.

Given this spotty track record and assuming for the sake of argument that Böhm-Bawerk correctly defined interest and identified the role it plays, it follows that much of what is uncritically accepted by today’s investors in order to value securities and undertake investment is flatly wrong. The conventional wisdom bequeaths to us institutions and policies that usually generate artificially low interest rates – and therefore artificially high asset prices. But not even governments and central banks can indefinitely flout the laws of economics: over more extended periods of time, interest rates and assets’ yields regress towards historical “base rates.” Accordingly, to follow Keynes and the mainstream – consciously or otherwise – is occasionally to participate, like an exuberant lemming in a mad herd, in mania and egregious error. Fortunately, although it is corrupted by interventionist policies, the yield curve nonetheless emits signals that sometimes enable vigilant investors to step out of the way.

Deriving and Explaining Yield Curves

Central banks, it is vital to appreciate, do not set interest rates; instead, they can only dictate a single rate (in Australia, the overnight cash rate at which commercial banks lend excess reserves to one another in order to remain within legal requirements set by the central bank). The OCR influences rates further to the right along the yield curve – but so too do other factors beyond the central bank’s direct control. The central bank’s normal policy (i.e., the damaging inflation which it obscures under the pleasant euphemism “monetary stimulus”) thus depresses short-term rates below the level that would prevail in an unfettered market. By decreasing short-term rates relative to longer-term rates, this policy causes the yield curve’s slope to become (more) positive. The steepening curve, in turn, generates very strong incentives to undertake “carry trades” – i.e., to borrow short-term money (and pay relatively low rates of interest) and to invest it in longer-term projects and securities that produce high (relative to short-term rates of interest) yields.

A positive and steepening yield curve is to investors what crack cocaine is to junkies: it has superficial attractions and a positive initial impact, but is also dangerously addictive and thereby risks long-term destruction. Human beings have an innate capacity to overdo things; accordingly, too much of something (such as artificially cheap credit) that seems superficially to be a good thing is never enough. And hence the bitter fruit of the central bank’s monetary stimulus: it eventually induces many otherwise intelligent people to undertake “malinvestments.” An investment project such as a factory or an apartment building that would not be undertaken if the rate of interest were (say) an honest 8% may become feasible at an artificial rate of 5%. The trouble, of course, is that the project’s false viability quickly becomes evident if rates revert to 8%. The positively sloped yield curve and the attractions of various borrow-short-and-invest-long “carry trades” entice entrepreneurs such that – even if they know better – they undertake and do not quickly terminate such “investments.”

Given artificially low rates of interest, poor investments accumulate throughout the structure of production. In other words, both short-term and long-term malinvestments emerge. The short-term ones are direct consequence of the artificial decrease of short-term rates. The long-term ones, on the other hand, are an indirect consequence of the carry trade. People who borrow “short” in order to invest “long” tend to increase the demand for long-term assets (including bonds). This demand increases their prices – and thereby places downward pressure upon their yields. In so doing, central banks and participants in carry trades connive to make long-term credit available at rates below those that would prevail without these interventionist shenanigans. And to depress long-term rates below free market levels is to invite long-term malinvestments.

During the “boom” phase of the business cycle, which is fuelled by monetary stimulus and reflected in a steepening and upwardly sloping yield curve, poor investments are made throughout the structure of production but tend to cluster in its early (i.e., raw materials and capital goods) stages. As their name implies, these malinvestments are uneconomic; as such, they must eventually be purged. Before or at the boom’s apex, expectations therefore begin in three senses to fall short of reality. First, the monetary authority’s fear of price inflation (an eventual consequence of its inflation of the money supply) induces it to reduce the rate of monetary growth. To do this, it typically must threaten to raise or actually raise the OCR. Second, people and projects whom commercial banks belatedly realise are not creditworthy are less and less able to obtain the funds necessary to complete their investment projects. Third, creditworthy people can obtain additional finance only on terms that render their projects unviable (the second and third points are partly but not wholly a consequence of the first). Notice that under these infrequent conditions, interest rates are able (if only imperfectly) to perform the job that the laws of economics give to them and governments strive to deny them.

During the boom, entrepreneurs scramble to obtain the finance required to complete their projects, repay project-related debt and proceed to the next debt-financed project. And towards its apex their demand for short-term finance (they typically cannot meet the more stringent terms of longer-term credit) places upward pressure upon short-term rates. This rise of rates renders their projects even less viable and hence their malinvestments more visible. Their liquidation (i.e., the recession or downward leg of the business cycle) thus begins. When short-term rates rise relative to long-term rates, the yield curve flattens; and if entrepreneurs’ desire for the short-term finance required to complete their projects is sufficiently voracious – and if central and commercial bankers belatedly find sufficient religion (this, of course, seldom occurs) – short-term rates rise above long-term rates and the yield curve inverts.

This development, from the point of view of participants in various carry trades, is extremely painful. Traders now possess short term debt on which a rising rate of interest is payable; and if the coupons and unrealised capital gains from their longer-term investments cannot cover these short-term debts, they will find themselves in an increasingly bitter pickle. Paul Cwik notes that the business cycle’s crunch phase may take the form of

  1. a credit crunch: when significant numbers of entrepreneurs (i.e., those who cannot finance themselves with long-term and investment-grade bonds) are no longer able to obtain at an affordable price the finance they require to complete what they begin to realise are malinvestments;
  2. a resource crunch: when the monetary authority’s policy of inflation increases the prices of many inputs relative to the prices of many outputs, such that entrepreneurs cannot obtain at affordable prices the goods, services and labour they require to complete what they come to realise are malinvestments;
  3. or some combination of the two.

Those firms that fall prey to credit or resource crunches enter administration and perhaps liquidation. But these things do not happen overnight. The yield curve thus tends to invert before – in practice, roughly 6-18 months before – the business cycle’s turning point. Its crunch or recession phase commences the salutary process whereby unviable (in the sense that they do not conform to consumers’ wishes) investment projects are liquidated. Given contemporary monetary arrangements, genuine bust is an eventual and inevitable consequence of artificial boom. The monetary manifestation of incipient bust (i.e., an inverted yield curve) is thus a logical consequence of the monetary manifestation of artificial boom (a positively sloped curve).

Scenarios versus Predictions

Just as there is a structure of production, there is also a structure of financial speculation. Its most visible manifestation is the yield curve. Like virtually everything else these days, governments corrupt it; yet despite its distortion, the curve occasionally emits genuine warning signs. But these signs are not infallible. The larger body of Austrian School economics also includes many insights about uncertainty, subjective valuations and individuals’ many and varied perceptions. On any given day and from week to week, much occurs in financial markets that has much to do with individuals’ attitudes and little to do with central banks’ policies. Accordingly, Austrians and investors must resist the temptation to interpret the yield curve (and apply the broader theory of the business cycle) deterministically.

Decisions that rely upon forecasts tend not only to be erroneous and costly: rather than attenuate uncertainty – which, presumably, is a key purpose of prediction – they can actually amplify it. If manufacturers depended solely upon forecasts to plan their production, they would incur huge costs. Forecasts change often and abruptly and can differ widely; accordingly, any manufacturer daft enough to let predictions determine his decisions would add new capacity and increase inventories in response to rosy projections – and suddenly shut plants and cancel contracts with suppliers in response to gloomy ones. Instead of relying on forecasts, sensible managers treat them cautiously (or, better yet, ignore them) and put in place robust plans that remain viable under very different conditions and quickly changing perceptions of those conditions.

Grahamite investors use similar ideas to plan their investments (see Principle #1 and Principle #2 of Leithner & Co.’s investment philosophy). They keep firmly in mind that economics is not a quantitative science whose practitioners can routinely make accurate forecasts. For every economist, “market strategist” and the like there will be an equal and opposed economist – and the predictions of both are likely to be wrong. Forecasters, in short, are seldom in doubt but usually in error. Yet intelligent investors recognise that the inability to divine the future with any useful degree of accuracy is no reason to ignore the future. Quite the contrary: they cope with its inherent uncertainty by considering scenarios – and concentrating upon somewhat pessimistic scenarios – of what might plausibly happen (as opposed to confident predictions of what will likely happen). They then use these situations (with an emphasis upon the creation of a “margin of safety” and the protection of the “downside”) to structure their investment operations and portfolio accordingly.

Only a dummy, then, would automatically conclude from the foregoing that Australia has entered or will shortly succumb to recession. Forecasters, it bears repeating, are seldom in doubt but usually in error. The contents of this newsletter are not a forecast: they constitute no more than a cautious, contrarian and possible scenario that investors might incorporate into their plans. Yet modern yield curves do not often invert, and still less often do they invert for eight months without breaking something. On that basis, only a drongo believes that during the next couple of years Australia will be immune to recession. The fundamental point, then, is not whether Australia is on the verge of a downward leg of the business cycle: much more important are the principles, methods and plans that enable the investor – whatever the current and future conditions – to navigate variable investment waters.

Two Real Conundrums

Earlier this year, Mr Greenspan noted the occurrence of two things (namely the recent tendency of long-term interest rates in the U.S. to fall at the same time that the Fed has been raising the target level of the federal funds rate) that from his point of view are unusual. “For the moment, the broadly unanticipated behaviour of world bond markets remains a conundrum.” From my point of view, this behaviour is not a mystery – quite the contrary, it is broadly consistent with Austrian Business Cycle Theory (ABCT). If one admits the possibility of recession, then no riddle exists.

What is a puzzle is that although central planning in its broadest sense has been utterly discredited (such that few people believe that governments should fix the price of say, Vegemite or petrol), most people – and particularly powerful and influential people within governments, universities and major financial institutions – fervently support central planning as practiced by central banks. But their support exacts a heavy toll. The trouble with the “welfare state of credit,” as James Grant dubbed it in The Trouble With Prosperity, is that it unleashes speculative frenzies. It ignites excessive risk-taking whilst simultaneously attempting to prevent the losses that inevitably follow the speculation. The central bank launches the false boom that causes the genuine bust; and it attempts – successfully for a time, perhaps a long time, but never forever – to abolish the bust. Like other forms of the welfare-warfare state, it featherbeds the anointed élite and leaves the benighted mass to fend for itself.

One puzzle, in other words, is not that the welfare state of credit regularly bequeaths to borrowers and lenders interest rates that do not tell the truth about time. No individual, however intelligent and dedicated, knows what a “correct” rate is or should be or will be. The puzzle is that virtually all Australians happily assume (if they ever bother to think about it) that a very small number of their countrymen in Martin Place, Sydney, do know. Australians, it seems, need to believe that somebody is in charge. The idea that the man at the controls is neither omniscient nor omnipotent would probably startle the Australian who borrows heavily to buy an “investment” property or opens a margin loan to buy a portfolio of stocks. And the entire point of a welfare state is to infantilise rather than frighten (see, for example, Sheldon Richman’s Turning Off the Government’s Money Spigot). Instead of this torpor, Australians would be far better served by epiphanies like the one Dorothy experienced when Toto opened the long curtains and she spotted the “Wizard” frantically – and absurdly – trying to maintain appearances.

A second conundrum is that if anyone within America’s vast bureaucracy could write an intelligent essay on free-market monetary ideas, it would be Alan Greenspan. Not only does he understand them: during the 1960s he professed them passionately (see in particular his chapter entitled “Gold and Economic Freedom” in Ayn Rand, ed., Capitalism: The Unknown Ideal, Signet, 1966, repr. 1986, ISBN: 0451147952). It is true that since 1987 he has often warned about cycles and excesses. But never profoundly: as a central banker, Mr Greenspan has never acknowledged the crucial insight, of which he is well aware, that artificial booms cause genuine busts. Instead, he has repeatedly regarded the ups-and-downs of the business cycle as things that – trust him – he can put right. Why do Mssrs Greenspan and Macfarlane and their counterparts in other countries present themselves as stabilising hands at the controls? Precisely because they roil rather than calm the economic waters, they are very powerful; further, soothing words and an aura of stability maintain their power and lengthen their tenure. Human nature being what it is, the desire for long-term authority poses absolutely no conundrums.

Chris Leithner


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