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There are some in the economic and investment world who claim that it doesn’t matter how you’re right, it only matters that you’re right.  And this is quite common in the financial world.  Your thesis might be 100% off-base, but the markets or economy might still respond in a manner that validate your original thesis even if things didn’t play out exactly as you expected.  This is not surprising given the complexity of the financial markets. In a way, they are the most complex non-linear dynamical systems we deal with on a daily basis.  With so many moving parts it’s easy to see how we can make broad prognostications about one facet of this system and misinterpret its impacts on the system as a whole.

This general misinterpretation is nowhere more apparent than it is in the mainstream economic communities where myths run rampant due to the propagation of convertible currency system beliefs.  Combine this misunderstanding with the even broader misunderstandings that are based on equilibrium theory (people are rational, markets are efficient, information is quickly and accurately disseminated, etc) and you have an environment that is essentially the equivalent of blind people throwing darts at a Wall Street Journal quote page and congratulating themselves for being great stock pickers.

A real-time example of this is Dr. Krugman’s latest blog post.  He says:

“I’m glad to see some people noticing that those of us who have taken the basic theory of the liquidity trap seriously have done very well at calling the economy these past three years. This was big stuff: predicting that a tripling of the monetary base would not be inflationary, that deficits exceeding a trillion dollars a year wouldn’t drive up interest rates. In a rational world, the way things have panned out would add a lot of credibility.”

It’s true.  Dr. Krugman has called this economic environment far better than most.  And his understanding of this dynamical system is better than most.  But that doesn’t mean it is entirely accurate and worthy of “praise”.  For instance, the liquidity trap is based on an incomplete understanding of the monetary system.  So, while it appears to explain the many unusual economic reactions in recent years it is misleading to imply that it has been some sort of crystal ball.  For instance, in early 2009 Dr. Krugman said interest rates would remain low unless the economy recovered.  He said the economy wouldn’t recover as the stimulus was too small so do the math.   And he had all the charts and math to back up his argument.  He broke out the old IS-LM curve (which its founder rejected), the loanable funds theory (which is a myth) and went on to explain how zero interest rate policy resulted in inept monetary policy during a liquidity trap.  The only problem is that the dots are not exactly connected here and it is because Dr. Krugman is working from this defunct model (also on display in his 2009 post where he compared the USA to Ireland – a big no no as we all know by now).

When one understands the actual operations of the modern monetary system, it’s quite easy to decipher why interest rates behave in a particular manner (though more difficult to predict how they’ll behave).  In a non-convertible fiat currency system where the currency issuer has endless supply of that currency within a floating exchange rate regime, deficits always put pressure on interest rates.  This is because deficits result in reserves in the banking system.  Reserves, which left untouched, will result in lower rates as banks bid down rates in the overnight market as they try to rid themselves of these reserves.  If the central bank and Treasury do not actively manage these reserves they will lose control of the overnight interest rate.  Of course, they don’t let that happen (interest on reserves make this easier given the Fed’s asset purchases).  And as the supplier of reserves to the banking system they always have the firepower to control the interest rate on their “debt”.  So, in order to understand why interest rates are low we merely have to listen to the bond market’s master – Ben Bernanke.  His interpretation of the environment (recovery or not) could be entirely wrong and it matters not what the market thinks.  If Ben wants to set the long bond at 0% for the rest of eternity he merely has to deem it so.

Perhaps more importantly though, there is no loanable funds market.  The loanable funds theory implies that there is some enormous market of savings just waiting for borrowers to tap into (the government included).  This makes several mistakes though.  First it implies that a sovereign currency issuer must borrow back the currency it can freely create.  That’s as illogical as a Broadway Theater company borrowing back its tickets so it can issue more of them the next night.  Of course it would never do such a thing.  It would merely print up fresh new tickets as opposed to reaching into the bin of ripped up tickets at the end of each night and reissuing them.

Additionally, this implies an inaccurate functioning of the modern banking system.  Banks aren’t sitting around trying to compile savings so they can then meet borrowers at this loanable funds market where they lend them money.  Instead, banks lend money when creditworthy customers enter their establishments.  The loans actually create new deposits.  The bank doesn’t check their reserve balance before lending money, so the reserve position of the bank matters little at the time of lending.  If they need reserves they’ll go into the overnight market where they’ll obtain the reserves from another bank or the bond market’s master (the Fed) will supply them as the supplier.  You didn’t need to understand the loanable funds theory to know that more reserves in the banking system wouldn’t result in more loans or hyperinflation.  You merely needed to understand how modern banking actually works.

The point is, you don’t have to understand the liquidity trap to understand the current economic environment (in fact, it might hurt you as it’s based on several misconceptions).  You merely need to understand how a modern monetary system actually works.   More importantly though, being right doesn’t always justify one’s original thesis.  In fact, it can potentially harm us all by leading others to believe that this original thesis was accurate and is therefore worthy of praise.  Being right matters.  But being right for the right reasons matters a hell of a lot more.


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