Table Of ContentProfiting [rom Monetary Policy
Profiting from M onetary
Policy
Investing through the Business Cycle
Thomas Aubrey
palgrave
macmillan
* © Thomas Aubrey 2013
Softcover reprint ofthe hardcover lst edition 2013 978-1-137-28969-8
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First published 2013 by
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10 9 8 7 6 5 4 3 2 1
22 21 20 19 18 17 16 15 14 13
FOT Yanina, Thea and Ethan
The futility of price level stabilization as a goal of credit policy
is evidenced by the fact that the end-result of what was probably
the greatest price-stabilization experiment in history proved to be,
simply, the greatest and worst depression.
Banking and the Business Cycle - Phillips, McManus, Nelson 1937
Stock market bubbles don't grow out of thin air. They have asolid
basis in reality, but reality as distorted by a misconception.
George Soros 2004 - Buzzjlash Interview
Contents
List of Figures Vlll
List of Tables IX
Preface X
Acknowledgements XlI
Introduction 1
1 The Great Moderation and the unravelling of a Great Myth 10
2 From model failures to streams of data 32
3 The problem of credit 51
4 The Vienna and Stockholm schools: A dynamic
disequilibrium approach 66
5 The neo-Wicksellian framework 96
6 Testing Wicksellianism 113
7 The creation and destruction of capital 156
8 Where are the customer's yachts? 176
9 Post-script - Constructing business cyde tracking funds 180
Notes 188
Bibliography 199
Index 208
Figures
1.1 Five-year credit default swap (CDS) spread - Germany vs
Greece 11
1.2 US inflation vs Fed funds rate 12
1.3 US unemployment, inflation and real GDP growth 14
3.1 N orth America one-year probability of default index 54
5.1 US consumer leverage ratio vs Wicksellian Differential 108
6.1 US Wicksellian Differential, real GDP growth and equity
returns 115
6.2 US leverage ratios and Wicksellian Differential 119
6.3 US inflation vs real equity returns 122
6.4 UK Wicksellian Differential, real GDP growth and equity
returns 127
6.5 UK vs US in the 1990s recession 128
6.6 UK leverage ratios vs Wicksellian Differential 129
6.7 US and Japan inflation vs equity returns 132
6.8 Japan Wicksellian Differential, real GDP growth and
equity returns 133
6.9 Japan natural rate ofinterest vs money rate ofinterest 135
6.10 Japan leverage ratios vs Wicksellian Differential 136
6.11 BRIC equity return indices 138
6.12 Real GDP growth and equity market performance -
Canada, Australia and the US 140
6.13 Canada and Australia Wicksellian Differential vs equity
market performance 141
6.14 Canada and Australia consumer leverage vs equity market
performance 144
6.15 Return on capital-Germany, France, Ireland, Spain 150
6.16 Wicksellian Differential-Germany, France, Ireland, Spain 151
6.17 Germany, France, Ireland, Spain equity market
performance and Ireland and Spain house prices (1996-2007) 153
6.18 Germany, France, Ireland, Spain equity market
performance and Ireland and Spain house prices (2007-2011) 154
7.1 Five-year CDS spread - US, China and Brazil 161
Tables
5.1 Value of a Viceroy tulip at the height of Tulip Mania 111
6.1 Australia and Canada average banking sector leverage
ratios (common equity/total assets) 145
Preface
When the Nobel Laureate Robert Solow gave evidence to the House
Committee on Science and Technology in 2010, as part of an inves
tigation into the limits of economic theory, he asserted that elements
of modern macroeconomic theory did not pass the smell test. Either
those supporters of modern macroeconomic theory, he argued, had
stopped sniffing or they had lost their sense of smell altogether.
I went back to university after a career in management consulting
to study mathematical economics in an attempt to explain why the
UK economy had been plagued by housing market bubbles. Much
of what I was taught did not pass the smell test either, particularly
the pervasiveness of the role of price stability in maintaining a gen
eral equilibrium. Worse still, this principle seemed to be guiding
the investment community in the way it thought about asset returns
through time.
As house prices boomed in the period leading up to the finan
cial crisis, I returned to the problem using the framework of the
Swedish economist Knut Wicksell, who had developed a dynamic,
credit-based view of an economy. Using Wicksell's ideas of excess
credit growth, with additional guidance from the writings of the
1974 Nobel Prize winners Gunnar M yrdal and Friedrich Hayek,
I attempted to empirically measure the extent of disequilibrium
in the US and UK economies. Initial estimates from analyses of
both economies suggested that they had been operating signifi
cantly above equilibrium for aperiod of 20 years, despite the fact
that inflation had remained subdued. This implied that the robust
returns generated by financial assets du ring the Great Moderation
were therefore an anomaly rather than the expected market rate
of return. Hence, future returns would be much lower than the
past given that the excess growth in credit was not sustainable with
significant implications for pension schemes
The dramatic fall in asset prices that came about in 2008 has
largely been responsible for a decade of poor returns. However,
such a level of capital destruction could have been anticipated given
that the economy had been operating at a level substantially above
equilibrium since the early 1980s. As the investment community
has attempted to avoid further capital destruction by moving into
