In “Bubble Psychology and Valuations“, Tenebrarum takes a look at current economic conditions via the lens of Austrian school economics. As always, Tenebrarum makes a number of important observations in the article. Below are a couple that struck me as particularly apt.
‘One point on which we agree with Mr. Garnry is when he notes that one’s analysis of the market must differentiate between the pure fiat money system that has been established in 1971 and the time period preceding it. The fact that money supply and credit expansion have gone into overdrive ever since has altered a number of “tried and true” yardsticks that served as good rules of thumb back when at least still a gold exchange standard was still in place.
For example, prior to the asset bubble becoming greatly extended for the first time in the mid to late 1990s, the market’s overall dividend yield never fell much below 3%. This has changed, and the author is on the right trail when he blames the monetary system, or rather, when he points out that different monetary and institutional dispensations do make a difference to market analysis.
We disagree with a subsidiary assumption though, namely that therefore, anything that happened before 1971 is basically irrelevant. This is surely not correct. For instance, during the “roaring 20s”, the true US money supply increased by about 65% (see Rothbard’s “America’s Great Depression”, which contains a very precise calculation of the era’s money supply growth), which is a far cry from today’s monetary expansions, but was certainly extreme at the time. There are no fixed quantitative relations between the size of such an expansion and its effects, such as those on the prices of assets or on other goods. At the time, the bulk of the price effects was concentrated first in real estate and later in securities – just as is the case today. Surely we cannot say that everything that happened before 1971 is entirely irrelevant.
However, Mr. Garnry is correct when he states that every slice of economic and financial history is different, and that these differences often encompass major aspects of the contingent historical setting:
“We do not subscribe to the valuation analysis since 1870 being thrown around on Wall Street. This is because the period includes many regime shifts in inflation, real interest rates, nominal interest rates, economic growth, monetary policy, the nature of businesses and the government’s size relative to the economy. All these parameters have changed so much that going too far back distorts the overall conclusion and causes inferences that are wrong.”
Sure enough, predictions can not possibly be based solely on empirical data, as there can be no empirical causal constants in human action (thus, every historical boom and bust sequence looks different, even though there are many parallels between them as well). This is where economic theory comes in. While it does not allow us to make precise “predictions” either, it can at least tell us what is and what isn’t logically possible. From this we can, in concert with historical understanding, deduce what is likely. The reason why many historical bubbles evince numerous parallels in spite of their differences is precisely that the same economic laws are in operation every time.‘
‘Current low government and corporate bond yields – which are a direct result of central bank manipulation of interest rates and the money supply – are not a reason to deem current valuations not excessive – quite the contrary. The losses following the 2007 peak were only booked in 2008 and 2009, but they were actually made long before that time. When market interest rates are distorted, economic calculation is falsified, hence the accounting profits booked during the boom period are actually to a large part fictitious – they effectively tend to mask capital consumption. It is easy to see why this must be so: the money supply expansion and artificially lowered market interest rates must lead to capital malinvestment, which by its very nature is destined to destroy wealth.
However, this is never immediately apparent, since it takes time for long term investments to turn out to have been misguided. Amid monetary inflation, businessmen inter alia reckon with depreciation rates that refer to the price structure that existed before the inflationary policy was set into motion. They therefore report a part of the funds that are actually required to maintain their capital as profits. It matters not in what form these funds are then distributed – whether as higher wages, higher dividends or as share buybacks. A large portion of them is paid out of the substance of companies, and as a general rule of thumb, we can say that the bigger the money supply inflation, the more distorted economic calculation will tend to be. Consequently, the errors will tend to be commensurately larger as well (again, no fixed quantitative relationships can be ascertained in this context, thus it is a “rule of thumb”).
This is what is meant by the saying that we are “eating our seed corn”, or are “heating the house by burning the furniture”. Mr. Garnry asked us what we meant by capital consumption and whether it could be measured. The answer is that it cannot be measured while it occurs. However, there will come a point in time when measurements will be taken.‘
The entire article can be read here.