Apr 13, 2019

Failings of Monetarism Theory, Central Banks Need to Adapt in the Age of Technology

Hope all had an opportunity to watch Ray Dalio last week. I would like to add that his warnings and the posts I have been running on economic conditions are not immediate so zero correlation with day to day market conditions. Economics is important because as an investor it changes periodically and a basic understanding will help guide your investment decisions. Ray’s interview and the Japanese symposium were strikingly similar in that they dealt with the idea that the flaws of the current system are starting to reveal themselves and changes are needed to insure stability and sustainability.  

The modern economic system is known as “Monetarism theory” (trickle down). In 2014 Paul Volker said he was already seeing problems with this economic theory and called for a “new” Bretton Woods Agreement (Bretton Woods was a post WWll economic agreement).  


I suspect the global political dislocations might make a new agreement difficult however if Paul Volcker speaks about economic instability many pay attention. 

What is Monetarism and what/where are the problems? Basic Monetarism is the theory that “money” should control economies by pushing money in to expand the economy and withdrawing money (raising rates etc) to contract the economy. The slow move from Bretton woods to Monetarism started in the 70’s through 80’s. As of 2015 two countries have started to abandon this theory. Israel and Spain (believe it’s the Catalonia district) so will be watching output numbers for those economies. The Monetarism system is not focused exclusively on “productivity” it instead focuses on capital formation which theoretically increases/decreases productivity. As I see it, it doesn’t always guide the capital in a productive manner vs. a unproductive manner (self liquidating loans vs. non-self liquidating loans) so the tech wreck (2000), housing crisis (2007) were nothing more than capital formation going into unsustainable areas where it balloons and pops. Even under China’s political extreme (Communism) Monetarism is having difficulty. A division in China called the state planning division sets prices for everything from bicycles to grains so one would think that controlling prices along with a State run capitalism you should achieve economic nirvana. Not so. Liu He current Vice Premier of China is responsible for guiding China’s economy (Seton Hall/Harvard educated) his goal is reforming the Chinese system (slowly) however China must maintain a fully employed society for obvious reasons. 

Here is an excerpt from a Princeton economic professor

While a freely floating national money has advantages, however, it also has risks. For one thing, it can create uncertainties for international traders and investors. Over the past five years, the dollar has been worth as much as 120 yen and as little as 80. The costs of this volatility are hard to measure (partly because sophisticated financial markets allow businesses to hedge much of that risk), but they must be significant. Furthermore, a system that leaves monetary managers free to do good also leaves them free to be irresponsible—and, in some countries, they have been quick to take the opportunity.

Richard Nixon asked John Connally about floating currencies as it pertains to trade (they were about to remove the dollar from the gold standard). It always amazes me that economists think that markets will self correct and not succumb to manipulation? Connally’s response was “markets adjust”? Never took into consideration that participants might have an agenda? Duh

I believe markets are saying Monetarism is having less and less affect on productivity (GDP) and if central banks or governments remove accommodation there will be hell to pay (2018 selloff). As a result political dislocations will be an effect and economics will be the cause. History rhymes.

At the Tokyo symposium I heard some interesting ideas some of which I had never heard before.  See how Japan implements any of the ideas or if they stay with the current system? Even in Japan another decade is sustainable.

America's output peaked during WWll. The US government bought one third the production however because the work force saw wage growth, overtime and the full employment (all available workers were utilized, women & minorities) as a result the supply of consumer goods also exploded. I believe an economic system based on the expansion of production is more stable than one based on capital. That’s a neoclassical economic view and it supports bold visions from governments and free enterprise.  China’s “one belt one road” initiative could never be done by the private sector alone nor could the Luna project 1959 or the Apollo project 1969. 

One thing that Monetarism could not foresee is that technology lowers the need for capital and one of it’s attractiveness is it’s ability to be less capital intensive while increasing productivity (Amazon effect) so a system based on capital seems arcane to me.  

I wanted to add one more concern I have going forward adding this to the list from last week. Because of rampant manipulation of LIBOR (London Inter-Bank offer rate) peg rates will change to either SOFR or ARRC (perhaps a combination of the two?). The move because of the size of financial instruments linked to LIBOR must go smoothly (Federal Reserve is pushing to move this delinking soon). According to Bloomberg the OTC Derivatives, ETN Derivatives, Loans (student-personal-commercial etc), Bonds- Securitization etc. etc. total somewhere in the neighborhood of 370 Trillion? What? That's a staggering figure.


This post is intended to enlighten about what central bankers/politicians are facing and not cause investor anxiety. Hope it accomplishes that. Trade safe