by Mark Spitznagel
Business Insider
December 26, 2016

 There's a lot of talk these days about the so-called “neutral” (or “natural” or “terminal”) interest rate projections of the Federal Reserve. In fact, their projection of this number is a key argument in their ongoing decision to keep rates at historically very low levels for what has been an extended period of time. (Specifically, Federal Reserve officials have argued that the neutral interest rate has sharply declined in recent years, meaning that apparently ultra-low interest rates really do not signify easy monetary policy.)

What is this neutral rate? The neutral rate is simply the federal funds rate at which the economy is in equilibrium or balance. If the federal funds rate were at this mysterious neutral rate level, monetary policy would be neither loose nor tight, and the economy neither too hot nor too cold, but rather just chugging along at its long-run optimal potential. The underlying theory is that loose monetary policy—where the Fed’s policy rate is set below the neutral rate—can temporarily stimulate the economy, but only by causing price inflation that exceeds the Fed’s desired target (which, by the way, eventually causes overheating and a crash). On the other hand, if the Fed is too tight and sets the policy rate above the neutral rate, then unemployment creeps higher than desired and price inflation comes in below target.

In short, the neutral interest rate is one where the central bank is not itself distorting the economy. Monetary policy would really be nonexistent, as the Fed would not be altering the interest rate resulting from a free market discovery process between borrowers and savers. (This of course raises the question, why do central planners need to fabricate something that would naturally exist in their absence?) This is near where Yellen actually thinks we are these days, hence she sees little urgency in raising rates and thus lessening what, on the face of it, looks like a very loose current monetary policy.

Much of this neutral rate talk at the Fed is supposedly supported by the work of Swedish economist Knut Wicksell (1851-1926), who argued that the “natural” interest rate would express the exchange rate of present for future goods in a barter economy. If in practice the banks actually charged an interest rate below this natural rate, Wicksell argued that commodity prices would rise, whereas if the banks in practice charged an interest rate above the natural one, then commodity prices would fall. But that’s where Wicksell—often associated with the free-market Austrian School of economics—would cease to recognize his own ideas in current central bank thinking. Wicksell’s natural rate was a freely discovered market price in an economy, which reflected the implicit (real) rate of return on capital investments. For Wicksell, the natural interest rate was not a policy lever to be manipulated, in order to hit some employment or output goal. Yellen and the other Fed economists writing on this topic have conveniently (and probably unwittingly) co-opted Wicksell into their own Keynesian (and exceedingly un-Austrian) framework.

That’s the theoretical explanation of the neutral or natural rate. From a more practical standpoint, one must ask: How do we even know what that neutral rate is? The neutral rate is, by its current definition, inherently unobservable, as there is no discovery process in short term interest rates (and there hasn't been for as long as any of us have been around). Central banks calculate the neutral rate based on their formulas and identifying assumptions about output gaps and what interest rates, according to those models, will close those gaps. Here we have an immense circularity problem: Policymakers think they know the neutral rate because the assumptions of their interventionist model that they impose on the data say so, not because they have any insight that the market would actually clear at that rate, sans intervention. There is an underlying assumption that “markets, left on their own, are wrong, while our model is right.” Moreover, they are using observable data as model inputs that are the result of interventions that are already in effect. There are no controlled experiments in economics. Only market participants, acting freely in borrowing and lending at whatever interest rates make sense for that borrowing and lending, can ever discover what the neutral rate should be.

 (To give a specific example: One of the key alleged pieces of evidence that the neutral rate has fallen in recent years is the sluggish growth of productivity. But suppose the ZIRP of the Fed itself has been choking off real savings and distorting credit allocation among deserving borrowers, and hence has crippled sustainable growth in output? In this case, the Fed models would conclude, “Nope, our policy rate hasn’t been too low, look at the weak productivity growth,” confusing cause and effect.)

In fact, the circular logic is such that economists are far from an agreement on the current calculation, and their admitted model estimation errors are enormous. Contrary to Yellen’s recent monetary policy ruminations, reputable estimates using two different approaches have concluded that the Fed has set policy rates below the neutral rate since 2009.

(Things get worse. It’s not merely that we can’t know in real-time what the neutral rate is; we can’t even know after the fact. Suppose the Fed gradually hikes rates, and then the economy crashes. Dovish Keynesians would no doubt say, “We told you not to tighten! The neutral rate was obviously lower than the Fed realized, and they just raised the policy rate above it.” But this isn’t necessarily so. It could be that the policy rate had been below the neutral rate for years, fostering a giant asset bubble which eventually had to collapse. Both theories are consistent with the observed outcome of modest rate hikes leading to a crash.)

The great Austrian economist Friedrich Hayek stressed the role of market prices in communicating information to firms and households, and the impossibility that central planners can ever effectively calculate those prices. If the Fed’s economists think they are able to estimate what the neutral interest rate is, then we can dispense with prices altogether. The Fed’s economists can estimate the “neutral wage rates” for various types of labor, the “neutral commodity prices” for various inputs, and so forth, and issue comprehensive plans for the economy, all calculated in kind.

Of course, this is absurd. The point is, in a capitalist economy, the interest rates themselves—as determined in a competitive discovery process in the bond and credit markets—are central to the coordination of the economy. To assume experts at the Fed could determine the proper, optimal interest rate, without that discovery process, is to assume away the real-world information problems that we all can agree market prices solve. Indeed, perhaps this is why our economic problems persist?

Mark Spitznagel is Founder and Chief Investment Officer of Universa Investments. Spitznagel is the author of The Dao of Capital: Austrian Investing in a Distorted World and was the Senior Economic Advisor to Rand Paul.

by Danielle DiMartino Booth
21 December, 2016

“Gentlemen prefer bonds.” So quipped Andrew Mellon in 1929 as stocks fell and investors rushed into bonds, pushing their yields down and prices up. Historians recount that the flight to safety had anything but a smooth landing. Within two years, almost all of the sovereign bonds of foreign nations had defaulted, triggering massive losses for American investors and a stream of bank runs that would mark the darkest days of the Great Depression.

What cometh from this despair? Why hope, of course.

Picture the backdrop 85 years ago: Shanty towns that would come to be called ‘Hoovervilles’ had sprung up across the nation as the Clutch Plague took hold. The largest was located in New York’s Central Park. Suffice it to say, the men laboring a handful of city blocks south did anything but take their good fortune for granted. They knew penury was but a paycheck away. In response, they did as we all must during this season – they gave of what they had.

On Christmas Eve, 1931, workers at the Rockefeller Center Construction site pooled their money together to buy a 20-foot balsam fir tree. Erected at the work site, it was decorated with, “strings of cranberries, garlands of paper and even a few tin cans.” Today, a half a million people from all over the world will gaze with wonder at this humble tree’s successor. Another half million will follow in their footsteps tomorrow as will be the case every day it stands, shining as a beacon of hope in its purest form.

To mark the occasion of this holiday season, please accept all I can humbly offer you, week in and week out – my words. For those of you who have read these missives for some time or ever heard me speak, you’ll recognize what follows. For newer readers, settle back. You’re in for not one, but two, real treats, one of which is wrapped in an iconic robin’s egg blue box.

It will come as no surprise to any who have met him that the giver of the gifts you’re about to receive is Arthur Cashin, one of the greatest storytellers of all time. For over a decade, I’ve had the honor to call him friend. Readers of Cashin’s Comments, a daily offering that delights his followers the world round, would agree that it’s hard to pin down the very best story he has told over the years. These are my two favorites.

You may note that 2017 marks the 30-year anniversary of a momentous day in stock market history. It is Cashin’s recollection of the day that followed the 1987 crash that is among my favorites. On the Tuesday, October the 20th, the Dow initially opened up 200 points. But trading quickly turned negative. Adding fuel to the panicked fire, banks were in the process of cutting off lines of credit to the specialists on the floor. What would have followed, had the banks stood firm, could have been catastrophic.

At the moment bad was turning to worse, Alan Greenspan was on an airplane headed back to Washington DC. The freshly appointed Federal Reserve chairman had landed in Dallas on Black Monday just in time to learn that while he had been in flight, the Dow had fallen by 22 percent. This shocking news prompted Greenspan’s cancelling his Dallas engagement and heading back to DC. Unfortunately, for the markets, he was once again in the air, just as another historic sell-off ensued.

As Cashin wrote on the 25th anniversary of the crash, news that Greenspan couldn’t be reached was of little comfort to NYSE Chairman John Phelan: “Desperate, Phelan called the President of the New York Fed, Gerry Corrigan. He sensed the danger immediately and began calling the banks to reopen the credit lines. They were reluctant but Corrigan ultimately cajoled them. The credit lines were reopened and the halted stocks were reopened. Best of all, the market started to rally and closed higher on the day.”

I hope you agree the story of the day the NYSE didn’t crash harder is a classic. But it doesn’t resonate as much as it once did. Since October 19, 1987, the stock market has operated in an increasingly contained vacuum thanks in large part to overly-easy monetary policy. That makes the following story, generously gifted to me in its unabridged form by Cashin, the most relevant of the day as we look to the new year with stocks at record highs. The two main characters of this timeless tale are Charles Lewis Tiffany and John Pierpont Morgan.

Being the astute jeweler that he was, Mr. Tiffany knew that Mr. Morgan had an acute affinity for diamond stickpins. One day, Tiffany came across a particularly unusual and extraordinarily beautiful stickpin. As was the custom of the day, he sent a man around to Morgan’s office with the stickpin elegantly wrapped in a robin’s egg blue gift box with the following note:

“My dear Mr. Morgan. Knowing your exceptional taste in stickpins, I have sent this rare and exquisite piece for your consideration. Due to its rarity, it is priced at $5,000. If you choose to accept it, please send a man to my offices tomorrow with your check for $5,000. If you choose not to accept, you may send your man back with the pin.”

The next day, the Morgan man arrived at Tiffany’s with the same box in new wrapping and a different envelope. In that envelope was a note which read:

“Dear Mr. Tiffany. The pin is truly magnificent. The price of $5,000 may be a bit rich. I have enclosed a check for $4,000. If you choose to accept, send my man back with the box. If not, send back the check and he will leave the box with you.”

Tiffany stared at the check for several minutes. It was indeed a great deal of money. Yet he was sure the pin was worth $5,000. Finally, he said to the man: “You may return the check to Mr. Morgan. My price was firm.”

And so, the man took the check and placed the gift-wrapped box on Tiffany’s desk. Tiffany sat for a minute thinking of the check he had returned. Then he unwrapped the box to remove the stickpin.

When he opened the box he found – not the stickpin – but rather a check from Morgan for $5,000 and a note with a single sentence – “JUST CHECKING THE PRICE.”

Please share this timeless legend of price discovery far and wide. Do your part to make sure this priceless parable keeps giving the greatest gift of all — hope.

by Mark Spitznagel
December 15, 2016
New York Times

The “big, fat, ugly bubble” in the stock market that President-elect Donald J. Trump so astutely identified during his campaign now becomes one of the greatest potential liabilities of his presidency.

If that bubble bursts soon, the pain will correctly be understood to be the result of monetary manipulations during the Obama years. But if it persists and the United States economy manages to further postpone its long-overdue recession (following an expansion that was barely that), Mr. Trump’s ostensibly “free-market” policies will unfairly bear the blame when the markets finally do return to reality — perhaps a year or two down the road.

The postelection Trump rally in the stock market is evidence of euphoric optimism about the fiscal stimulus, reduced regulations and lower taxes that are hoped for. And yet we mustn’t forget where we are today, with distorted pricing in virtually all markets and extremely levered public and private balance sheets, all driven by monetary interventionism on a scale never seen before: By most measures, the stock market is as expensive as it has been for a century, save only the giddy late 1990s.

We must also remember what got us to this spot: namely, extreme, collectivist interventionism by the heavy hand of the state. Perhaps never before have we had such a clear case of a controlled experiment in the effects of economic (and especially monetary) interventionism. Problem is, the election of Mr. Trump is adding noise to this otherwise transparent experiment, and is extremely risky for supporters of his policies because he is poised to take office near such a peak in economic distortion.

The challenge, therefore, is for the incoming administration to let the authorities own the initial pain that is sure to come, such as the pain of pulling off the bandages, while letting the later recovery be his — as it should be. Though the Obama administration was able to blame a previous administration’s presumed free-market policies for eight years of lackluster recovery, it will be much harder for Mr. Trump to transfer blame for any economic crisis that occurs on his watch.

There’s something about a government that steps back to let free markets fix themselves that invariably renders it a ripe target for blame. “Couldn’t you have done something?”

After all, if the rally following his surprise election bears Mr. Trump’s name, the danger is that so, too, will the inevitable correction that neither he nor the Fed can stop. What could result — and what we should all fear, specifically — is the political pendulum swinging violently back toward big government and even greater market interventionism.

If Mr. Trump can focus on the long term and encourage asset prices and investments to correct themselves early (to the extent that he even holds such sway over them), perhaps this controlled experiment can remain obvious to everyone. Worthy or not, as the current general for advocates of the free market, he should hope to lose the short-term battle to win the bigger war, to gain positional advantage for the looming contest ahead.