No Way Out

One of the important factors behind the fluctuation between bull and bear markets, between booms and crashes and bubbles, is that investor memory has to fail us – and fail universally – in order for the extremes to be reached. – Howard Marks

Most people are familiar with Carl Menger because he was one of the initiators of the "Marginal Revolution," along with Leon Walras and William Stanley Jevons. Their finding that the price of a good is influenced by the value that consumers attribute to its last available unit was groundbreaking in the history of economics.

However, while Walras and Jevons described the concept through several mathematical equations, Menger only used minimal mathematics. His focus was more on verbal reasoning and conceptual analysis. While this method, which later became known as the "Austrian Method," is often criticized by modern economists due to the lack of mathematical equations, it's not that Menger's verbal reasoning isn't related to mathematics. I'd argue it's more "mathematics" than the works of Jevons and Walras.

Mathematics is simply a formal system of symbols and rules that allows us to describe, analyze, and manipulate abstract concepts. Conceptually, that is precisely what Menger and his successors in the Austrian tradition do in a verbal form when they study economic phenomena.

On the other hand, Jevons and Walras, whose work heavily influenced modern-day economists, is more related to physics. While they're similar to Menger's "verbal mathematics" in the sense that they formulate relationships among variables, they also aim to make precise predictions by using that formula. Their approach further developed and became what is now called "econometrics.”

Menger, however, preferred verbal logic over mathematical formulation. Before his career in economics, Menger worked for the Wiener Zeitung as a market analyst. As such, he was a regular visitor to the floor of the Vienna Stock Exchange, which arguably shaped his thinking about the economy.

Eugen-Maria Schulak and Herbert Unterköfler explain it this way:

The particular atmosphere in the Vienna stock exchange, then one of the most important in Europe, has been handed down to us vividly in the repeatedly reprinted Handbuch für Börse-Speculation (Rubrom 1861 and 1871) ("Handbook for Gambling at the Stock Exchange"). What counted most in day-to-day dealings were future expectations. Past events were irrelevant (Rubrom 1861, p. 119). The market price was apparently determined solely by subjective preferences, by "multiple emotions, conjectures and opinions, hopes and fears" (ibid., p. 115). Knowledge and information were critical (ibid., pp. 210–212). Menger, who in his Principles stressed the importance of observation of real business life as a rich source of insight, must have received decisive inspiration from this environment (Menger 1950/2007, pp. 47, 56).

However, it shouldn't be excluded that Menger theoretically envisioned economics becoming precisely what current modern economists attempt but repeatedly fail at, namely using mathematics to explain economic phenomena. Moreover, it seems as if he refrained from using it because of the world's complexity.

The reliance on natural language concepts makes Menger's economic theory both richer and fuzzier. This seems as a deliberate choice by Menger done with respect to the nature of the object of study, the social economy. A more realistic theory is thus achieved at the price of lesser exactness. – Mensik, Josef: Mathematics and economics: the case of Menger, Journal of Economic Methodology, 22:4, 479-490

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When we examine the developments in financial markets today, I'd argue that one should observe them more through a Mengerian or Austrian lens rather than a neoclassical one. It's been two years since the Federal Reserve raised interest rates for the first time to combat the inflation resulting from expansionary monetary and fiscal policy.

As a result, nearly every financial market analyst and economist expected a recession to be imminent due to the rate hikes and the implementation of quantitative tightening. It was assumed that the rate hikes would pose a significant headwind for stock prices and result in a correction. While this did indeed occur in the first half of 2022, to the surprise of many, the US stock market bounced back from its lows on December 22 and is now at all-time highs.

This development has puzzled many and completely shifted the narrative. While in early 2022, hardly anyone doubted that rising interest rates would dampen economic activity, now an increasing number of people suggest that the level of interest rates is probably not restrictive. After all, the economy is still robust, unemployment remains at record lows, inflation has declined, resulting in higher real wages, bond spreads are narrow, and, as mentioned earlier, the stock market is trading around record highs.

While there is certainly a lot to discuss regarding whether this assessment is accurate enough, another point worth considering is whether the mainstream is correct in its notion that the market is currently in "unknown territory" and whether economic theory has once again failed to explain how the economy reached its current state.

Clearly, the current consensus has shifted dramatically compared to last year. While everyone thought that 2023 would be the year a recession would hit the US economy, the consensus now is that the economy will experience a soft landing. The soft landing argument goes as follows: the economy might continue to slow down, but economic growth will remain solid as the Fed will, at least gradually, cut interest rates.

As we speak, overnight index swaps and the futures market are pricing in 4 Fed rate cuts, meaning the consensus expects rate cuts of about 100 basis points. Overnight index swaps in Europe have priced in about 3.5 ECB rate cuts, approximately 90 basis points. I interpret this as a perfectly priced-in soft landing.

Apparently, two other scenarios are not reflected in the current pricing. After reading extensively over the last two weeks, I feel that a growing number of people are calling for a "no-landing" or a "touchdown." They argue that the US economy shows signs of re-acceleration and will continuously experience solid growth above potential and higher inflation.

The argument goes that the Federal Reserve might not cut interest rates at all. Consequently, these individuals expect long-duration bond yields to rise again, back to their 2023 highs. Their view on the stock market is not that clear. Some expect that the bull market will continue, while others argue that no rate hikes might have a negative impact on stocks.

Proponents of the "no-landing" theory often point out that there is a correlation between rising South Korean semiconductor exports and ISM Manufacturing PMIs. The latest pickup in the year-over-year change suggests that manufacturing confidence will increase as the exports reflect rising US demand and that Artificial Intelligence will create a solid boom.

Another argument is that the Federal Reserve's monetary policy isn't as restrictive as most people believe. According to this argument, long-term treasury yields, usually considered the "risk-free rate," are no longer the risk-free rate. As far as I understand the argument, the claim is that one shouldn't look at the shape of the treasury yield curve but derive the yield curve from long-term mortgage rates because they can serve as a proxy for risk-free yields as well.

If the argument were correct, the conclusion would be that interest rates are currently not restrictive enough to slow economic activity down, nominal and real GDP will run above potential, and inflation will not fall back to 2% anytime this year, thus proving all the economic theories suggesting otherwise wrong. This is also supported by metrics that attempt to measure the current state of financial conditions, or whether there's financial stress in the system, so they say.

In my view, there are several reasons to support this claim, which further highlights the problem of modern economics, where individuals within the profession attempt to fit current and past data into a model and extrapolate it into the future, as if economic actors behave like atoms and react to specific changes in the economy.

First, let's briefly discuss the claim that financial conditions are not tight, as the GS Financial Conditions Index suggests, and that global financial stress is not imminent. In my opinion, there's a misconception when people look at these factors to assess how they evolve as the economy progresses.

Usually, these indices are computed using various economic variables such as market volatility, stock prices, credit spreads, interest rates, GDP growth, the unemployment rate, inflation, or consumer confidence. Considering the current economic data used in the index, it's easy to understand why these indices show that there's hardly any financial stress or tight financial conditions.

However, looking back, one also finds that these indices only showed increasing financial stress when the damage was already in the making. The only times when they work are when things happen gradually, and even then, it is hard to use a gradual improvement or deterioration to extrapolate these numbers into the future.

Then there's the argument that interest rates aren't restrictive, meaning that the current borrowing cost level is insufficient to dampen economic activity. In such an environment, businesses should continue to borrow money for real economic investments, and people should continue to borrow to buy real estate or finance consumption, which should fuel economic growth.

High economic growth should be reflected in bank lending numbers, as higher consumption should lead to higher investment and accelerating production. Some statistics suggest strong economic activity, such as increased manufacturing construction spending. This was fueled by economic policies from the Biden administration, like the Inflation Reduction Act that subsidizes manufacturing construction in the US.

Nevertheless, if one looks at the year-over-year change, one can clearly see that the growth is rapidly decelerating. That is quite logical, as every artificially created boom will eventually end, and the Biden administration's policies undoubtedly fueled this boom.

I have written about excessive government spending before, so I won't explicitly discuss it further here. However, it should be understandable that this also plays a significant role because the US economy is still growing and inflation is still higher than one would think by looking at the money supply.

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This leads me to the money supply. To paraphrase Johns Hopkins's Steve Hanke, "money is the fuel that runs the economy," which is a pretty fair assessment in our current debt-based fiat money system. The money supply can grow either when the central bank actively injects new currency into the economy or if commercial banks lend money and expand their balance sheets.

The current state is that money is not created by the central bank. Neither the Federal Reserve in the US nor the ECB in the Eurozone is expanding the money supply. On the contrary, they are actively reducing it by selling bonds they hold on their balance sheets, which takes money out of economic circulation.

Although the measurement for M2 in both currency areas shows that the increase in bank lending doesn't offset the Fed's reduction of the money supply, it's worth looking at the current levels of bank lending to assess whether interest rates are restrictive. If interest rates aren't restrictive and the economy is expansionary, one should expect solid credit growth of about 7-10%, looking at the average between 1985 and today.

If one looks at bank lending, one can see it has slowed considerably from its 2023 peak. Commercial and Industrial loan growth is contracting year-over-year, while real estate lending and overall lending are only slightly positive, significantly below levels where the economy is expansionary.

Chart 3 also displays the Effective Federal Funds rate, which illustrates another aspect Milton Friedman once described as the "interest rate fallacy." Typically, one would expect that bank lending grows when interest rates fall and declines when interest rates rise. However, as the chart clearly depicts, the opposite occurs—bank lending contracts when interest rates fall and increases when interest rates rise.

In my opinion, the reason behind this paradox is twofold. Firstly, from a business perspective, it's logical to increase lending when one anticipates interest rates rising. Borrowing today means less borrowing will be needed in the future when rates are higher.

Moreover, it contradicts the Keynesian assumption that low-interest rates stimulate investment. From a business standpoint, this makes sense because why borrow when rates are high when one can borrow when rates are low? However, this is only true when examining one side of the equation.

Demand and supply play crucial roles, and this is where the "interest rate fallacy" suddenly makes total sense. Banks boost the supply of loans when interest rates rise since they are more inclined to lend at higher rates. Consequently, as interest rates climb, banks become more willing to lend, while borrowers also increase their demand in anticipation of higher future rates.

When loan growth declines or contracts amidst high-interest rates, it reflects a dwindling demand for loans, as banks would typically be eager to lend, especially to creditworthy borrowers. If interest rates begin to fall, it usually signals worsening economic conditions to which the central bank is responding. In such cases, banks start to tighten their lending standards, resulting in reduced supply as they are hesitant to lend in a riskier economic climate.

Considering all these factors, the argument for a "no-landing" scenario appears highly dubious. The indices used to support this argument may not necessarily reflect the actual situation, as evidenced by declining loan growth.

However, one could argue that the recent upturn in the stock market suggests the US economy will expand. After all, the stock market can be viewed as a leading indicator of economic activity, reflecting the expectations of buyers and sellers. If fewer people are willing to sell, those willing to buy will have to pay higher prices.

Yet, akin to the "interest rate fallacy," stock investors' decisions are driven by expectations. Following years of central bank interventions, stock market participants are increasingly fixated on future monetary policy. When central banks maintain interest rates, it suggests robust economic conditions. Typically, stocks begin to decline when interest rates are swiftly cut in response to economic turmoil, reaching their nadir when cuts cease.

Lastly, there's the argument that inflation bottomed out last year and will begin to rise again due to high wage growth, increasing inflation expectations and ongoing high government spending. Some even conflate the issuance of government bonds with money printing.

As noted earlier, inflation stems from an increased money supply, which can result from increased commercial bank lending or central bank money creation. While interest rates play a role here, the primary driving forces are the money supply and money demand. Elevated asset prices may indicate high money demand, suggesting that the trajectory of inflation is downward.

While government spending potentially could have helped increase inflation by transferring money out of financial markets and into the real economy, on its own, it cannot unleash another inflation wave once the treasury spends it. In 2020, the central banks monetized the increase in debt, which increased the money supply and resulted in inflation.

Most inflation models used are New Keynesian models, which are based on inflation expectations, monetary policy transmission, nominal rigidities, and Phillips Curve frameworks to forecast inflation. They don't even consider changes in the money supply when forecasting inflation, missing the fact that actual inflation is mainly determined by changes in the money supply one to three years ago.

The current situation also reflects the long and variable lags in which changes in the money supply influence the economy. An explanation might be that the money was distributed by stimulus payments across the population, starting to "trickle up" to higher income brackets.

Considering this, it isn't surprising that there is currently enough liquidity in the stock market. A study in 2023 estimated that excess savings could take up to 5 years to flow back into consumption. Thus, the longer time proceeds, the more is used to increase demand for financial assets. The current state of financial markets seems to reflect that assumption.

While the current market trends seem to continue for some time longer, there's no way out of the looming economic contraction. Modern-day economists should have listened to Carl Menger and later Austrians and developed a more realistic theory at the price of lesser exactness.

Have a great weekend!

Fabian Wintersberger

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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.