Theory shootout

[Libertarian666]

Luckily, it seems that there are some differences between Austrian economics and monetary realism that are testable.
One of these is the prediction of Fed tapering and its consequences.

My prediction is that either:
1. The Fed will not stop buying bonds. They will continue to mention it but not ever actually stop.
2. Or, if they actually do stop, the markets will react very severely, with bond and stock market crashes.

On the other hand, I assume that MR advocates would say that the Fed will indeed stop buying bonds sometime in the next couple of years, and that the markets will take this calmly.

If this is correct, then we have a test of which theory is better at predicting what happens in the real world.

Any comments?

[MediumTex]

Luckily, it seems that there are some differences between Austrian economics and monetary realism that are testable.
One of these is the prediction of Fed tapering and its consequences.

My prediction is that either:
1. The Fed will not stop buying bonds. They will continue to mention it but not ever actually stop.
2. Or, if they actually do stop, the markets will react very severely, with bond and stock market crashes.

I understand why the stock market would crash, but why would the bond market crash in that scenario?  If both markets crashed simultaneously, where would all the money exiting those markets be going?

On the other hand, I assume that MR advocates would say that the Fed will indeed stop buying bonds sometime in the next couple of years, and that the markets will take this calmly.

Why would they say that?  The Fed is going to do what it wants to do.  That has nothing to do with MR.

If this is correct, then we have a test of which theory is better at predicting what happens in the real world.

I don't think that MR is intended to be a predictive tool.  It's more of a descriptive tool.  I may be able to explain the internal structure of Britney Spears' songs, but that doesn't mean I can predict what her next album is going to sound like.

Maybe a better test would simply be to see if inflation tops 10% at any time in the next decade.  Would that be a good test?

[Pointedstick]

I don't think MR proponents would necessarily predict that the market will take it calmly. Markets can be irrational and volatile. Personally, I think that if the Fed tapers before the economy is back in full swing, stocks are going to get crushed.

Rather, what I think us MR'ers would claim is that the federal government will face no difficulty borrowing once the fed stops buying bonds. And even if borrowing costs rise, it will still make no real difference for the government. The percentage of the budget devoted to interest payments will rise, and all the people buying those new Treasury bonds will celebrate that they finally have some decent yield. And all the people who refinanced their mortgages at 2.9% will be dancing in the streets.

[Libertarian666]

Luckily, it seems that there are some differences between Austrian economics and monetary realism that are testable.
One of these is the prediction of Fed tapering and its consequences.

My prediction is that either:
1. The Fed will not stop buying bonds. They will continue to mention it but not ever actually stop.
2. Or, if they actually do stop, the markets will react very severely, with bond and stock market crashes.

I understand why the stock market would crash, but why would the bond market crash in that scenario?  If both markets crashed simultaneously, where would all the money exiting those markets be going?

On the other hand, I assume that MR advocates would say that the Fed will indeed stop buying bonds sometime in the next couple of years, and that the markets will take this calmly.

Why would they say that?  The Fed is going to do what it wants to do.  That has nothing to do with MR.

If this is correct, then we have a test of which theory is better at predicting what happens in the real world.

I don't think that MR is intended to be a predictive tool.  It's more of a descriptive tool.  I may be able to explain the internal structure of Britney Spears' songs, but that doesn't mean I can predict what her next album is going to sound like.

Maybe a better test would simply be to see if inflation tops 10% at any time in the next decade.  Would that be a good test?

I've already explained that the bond markets would crash in that scenario because the Fed is buying virtually all the bonds right now. When (if) they stop, interest rates will have to rise substantially to induce people to put an additional $1 Trillion/year into purchases of bonds.

So we do have a test of competing theories then, if the Fed does stop buying: Austrian (bond crash) vs. MR (no bond crash).

[Gumby]

I've already explained that the bond markets would crash in that scenario because the Fed is buying virtually all the bonds right now. When (if) they stop, interest rates will have to rise substantially to induce people to put an additional $1 Trillion/year into purchases of bonds.

So we do have a test of competing theories then, if the Fed does stop buying: Austrian (bond crash) vs. MR (no bond crash).

And you're wrong, because MR already won this one.

When the Fed stopped buying bonds, after QE2 ended, rates declined.

Austrians have no explanation for why that happened. They were completely caught off guard.

[Gumby]

Anyone who understands MR knows that Fed purchases are just POMO (Permanent Open Market Operation) transactions. All POMO transactions do is add or drain reserves in exchange for government savings accounts (i.e. T-Bonds). They are just swaps.

[quote="Federal Reserve Bank of New York"]The purchase or sale of Treasury securities on an outright basis adds or drains reserves available in the banking system. Such transactions are arranged on a routine basis to offset other changes in the Federal Reserve’s balance sheet in conjunction with efforts to maintain conditions in the market for reserves consistent with the federal funds target rate set by the Federal Open Market Committee (FOMC).

[Libertarian666]

I've already explained that the bond markets would crash in that scenario because the Fed is buying virtually all the bonds right now. When (if) they stop, interest rates will have to rise substantially to induce people to put an additional $1 Trillion/year into purchases of bonds.

So we do have a test of competing theories then, if the Fed does stop buying: Austrian (bond crash) vs. MR (no bond crash).

And you're wrong, because MR already won this one.

When the Fed stopped buying bonds, after QE2 ended, rates declined.

Austrians have no explanation for why that happened. They were completely caught off guard.

I'm predicting the future, not the past. You can predict the past if you wish, but I'm afraid that doesn't count as much.

[moda0306]

Why don't we make this easier.  Will rates and/or inflation take off?

My answer is no. Most MR'ists would agree. Most Austrians would not.

Seems to me, since it's 2013 and we still have low inflation and low rates, that MR'ists are winning.

However, let's ignore the last 4.5 years of low rates and inflation.  We can start now.

I've already explained that the bond markets would crash in that scenario because the Fed is buying virtually all the bonds right now. When (if) they stop, interest rates will have to rise substantially to induce people to put an additional $1 Trillion/year into purchases of bonds.

So we do have a test of competing theories then, if the Fed does stop buying: Austrian (bond crash) vs. MR (no bond crash).

And you're wrong, because MR already won this one.

When the Fed stopped buying bonds, after QE2 ended, rates declined.

Austrians have no explanation for why that happened. They were completely caught off guard.

I'm predicting the future, not the past. You can predict the past if you wish, but I'm afraid that doesn't count as much.

A lot of Austrians predicted the past back when it was the future.  They got their asses handed to them. But we can forget that I suppose and move on from here.

[Gumby]

I'm predicting the future, not the past. You can predict the past if you wish, but I'm afraid that doesn't count as much.

That's laughable. You want a do-over because the Austrian predictions failed miserably the first time around?

Let's not forget that MR correctly predicted what happened after QE2 ended:

there will no concern about yields surging or bond auctions failing after June 30th.

MR already won this contest. It was 100% correct. You've offered no explanation why the next time would be any different.

[Pointedstick]

I've already explained that the bond markets would crash in that scenario because the Fed is buying virtually all the bonds right now. When (if) they stop, interest rates will have to rise substantially to induce people to put an additional $1 Trillion/year into purchases of bonds.

So we do have a test of competing theories then, if the Fed does stop buying: Austrian (bond crash) vs. MR (no bond crash).

And you're wrong, because MR already won this one.

When the Fed stopped buying bonds, after QE2 ended, rates declined.

Austrians have no explanation for why that happened. They were completely caught off guard.

I'm predicting the future, not the past. You can predict the past if you wish, but I'm afraid that doesn't count as much.

What Gumby is arguing is that the Fed is crowding out private market T-bond demand.

What you're arguing is that the Fed is propping up an artificial market for junk nobody in the private market wants to buy.

Gumby pointed to evidence of robust private demand for T-bonds at extremely low rates at the end of QE2.

Can you show me any evidence of private distaste for T-bonds, or any kind of reluctance to buy at today's interest rates?

Please don't say, "Yes, because the Fed is buying 90% of them right now," because the question at issue is whether that's true; it's not its own answer. We're trying to figure out if the Fed is propping up a dead market, or crowding out demand in a normally-functioning one.

[MediumTex]

I'm predicting the future, not the past. You can predict the past if you wish, but I'm afraid that doesn't count as much.

That's laughable. You want a do-over because the Austrian predictions failed miserably the first time around?

MR correctly predicted what happened after QE2 ended:

there will no concern about yields surging or bond auctions failing after June 30th.

MR already won this one.

I assume that he is saying that the Austrians will eventually be proven right, even if it takes 100 years or even 1,000 years.

Using this approach, I am certain that the U.S. will one day be viewed as an empire felled by hubris like so many others have been.

I enjoy visualizing the current Cowboys Stadium as future ruins similar to the Colosseum in Rome.

Think about how much fun future archeologists are going to have excavating all of the foam thumbs and plastic beer cups.

[Bean]

The thing that kills me about MR is its conflict with one of the most fundamental economic tools, the supply and demand curve.  It is suggesting that when demand is adjusted (Fed no longer buying bonds), no movement in the intersection of curves to establish a market price will occur.

Austrian logic is still sound, but when QE2 ended, it was not in a vacuum and other influences kept rates stable.  However, the noise will eventually lose to the inevitability of the market searching for a true equilibrium.

TL;DR  Austrian logic will eventually win, while MR propents will be muttering in the corner that there is no spoon. 

[MediumTex]

The thing that kills me about MR is its conflict with one of the most fundamental economic tools, the supply and demand curve.  It is suggesting that when demand is adjusted (Fed no longer buying bonds), no movement in the intersection of curves to establish a market price will occur.

Austrian logic is still sound, but when QE2 ended, it was not in a vacuum and other influences kept rates stable.  However, the noise will eventually lose to the inevitability of the market searching for a true equilibrium.

TL;DR  Austrian logic will eventually win, while MR propents will be muttering in the corner that there is no spoon. 

How much of your wealth would you bet on being right?

If you are that certain of your position, you should go out and buy the longest dated TLT puts that are available.

The thing to be careful about, though, are bond market influences and forces that have nothing to do with supply and demand, and which individual investors will never be privy to.  Your post-QE2 rate decline is a great example.  Why couldn't something like that happen again?

And then there is always the Japan experience, which seems to be completely at odds with Austrian economics.

[Bean]

How much of your wealth would you bet on being right?

If you are that certain of your position, you should go out and buy the longest dated TLT puts that are available.

The thing to be careful about, though, are bond market influences and forces that have nothing to do with supply and demand, and which individual investors will never be privy to.  Your post-QE2 rate decline is a great example.  Why couldn't something like that happen again?

And then there is always the Japan experience, which seems to be completely at odds with Austrian economics.

This is why I like the PP, I believe it will happen, but honestly have no idea when.  So I guess my answer would be 25% for gold and to a lesser degree 75% depending on how successful the bond barbell and stocks in the PP react when/if rates go parabolic.

[Libertarian666]

I should have known better than to engage fanatics. Never mind.
In fact, I'm out of here. The arrogant attitude of people with "no emotional investment in their theory" is not worth the trouble.

[Bean]

I should have known better than to engage fanatics. Never mind.
In fact, I'm out of here. The arrogant attitude of people with "no emotional investment in their theory" is not worth the trouble.

Don't do that 

I do have a counter challenge to the MR folks here.  If the Fed buying means nothing, why hold 25% gold?

[Gumby]

I should have known better than to engage fanatics. Never mind.

Fanatics? All we've done is offer evidence and examples to explain the operational realities of our monetary system. All you've done is put your head in the sand.

[Pointedstick]

I should have known better than to engage fanatics. Never mind.
In fact, I'm out of here. The arrogant attitude of people with "no emotional investment in their theory" is not worth the trouble.

Don't do that 

I do have a counter challenge to the MR folks here.  If the Fed buying means nothing, why hold 25% gold?

In case we're wrong! 

Also to profit from negative real interest rates and levels of inflation that are moderate to high, but not yet currency-destroying.

[MediumTex]

I am enjoying the spirited exchange, but I think some of us are starting to talk past one another.

Regardless of who may be right or wrong (or whatever), let's be civil please.

***

Libertarian666, please stick around.  We get worked up sometimes, but things are cool around here most of the time.

If there is no one to make arguments that some of us may disagree with, there is no way to test our beliefs against other ways of thinking.  Remember, too, that people always think that their way of thinking is correct, whatever that way of thinking may be.  Like I said, just be civil.

[MediumTex]

I should have known better than to engage fanatics. Never mind.
In fact, I'm out of here. The arrogant attitude of people with "no emotional investment in their theory" is not worth the trouble.

Don't do that 

I do have a counter challenge to the MR folks here.  If the Fed buying means nothing, why hold 25% gold?

Gold is an excellent hedge against negative real interest rates, which the Fed has succeeded in creating.

[Gumby]

The thing that kills me about MR is its conflict with one of the most fundamental economic tools, the supply and demand curve.  It is suggesting that when demand is adjusted (Fed no longer buying bonds), no movement in the intersection of curves to establish a market price will occur.

Nonsense. The Fed is buying bonds on the secondary market that have already been purchased by the private sector. The private sector would buy these bonds even if the Fed wasn't buying them because that's how the private sector saves the cash that comes from deficit-spending.

In other words, deficit-spending creates excess reserves and T-Bond auctions drain those reserves.

Obviously POMO transactions as purchases by the Fed can crowd out access to those T-Bonds — which can make them more scarce (yes, increasing demand). But, that's the whole point of POMO transactions. No one ever complained about them until the Fed started calling them "QE". The Fed has always done POMO purchases to target interest rates. They are nothing new. When the Fed stops POMO transactions, bond auctions don't fail because people still have a desire to save. The rates just moves to whatever the Fed wants them to move to.

[MediumTex]

The thing that kills me about MR is its conflict with one of the most fundamental economic tools, the supply and demand curve.  It is suggesting that when demand is adjusted (Fed no longer buying bonds), no movement in the intersection of curves to establish a market price will occur.

Nonsense. The Fed is buying bonds on the secondary market that have already been purchased by the private sector. The private sector would buy these bonds even if the Fed wasn't buying them because that's how the private sector saves the cash that comes from deficit-spending.

In other words, deficit-spending creates excess reserves and T-Bond auctions drain those reserves.

Are you saying that the Fed's bond buying has not pushed down yields at all?  I thought that was the Fed's stated purpose in doing it.

[Gumby]

Are you saying that the Fed's bond buying has not pushed down yields at all?  I thought that was the Fed's stated purpose in doing it.

No. POMO transactions "crowd out" access to T-Bonds. So, it certainly does make T-Bonds more scarce for the private sector (increasing demand). I totally admit that.

However... There will always be demand for T-Bonds since people always have a desire to save. And even if there weren't, Primary dealers are also required to participate in all auctions of U.S. government debt. Even if nobody showed up to the auctions, the Primary Dealers are ready, willing and able to take down the entire auction at a reasonable rate. And in fact, they want to take part in these auctions so that they can drain their excess reserves.

In other words, there will always be a healthy demand for T-Bonds, so long as people are willing to save their cash — even if the Fed isn't buying them. Did QE artificially push those yields down even more? Yes, of course. But, let's not pretend that bond auctions will fail and the market will crash if the Fed isn't crowding people out. There's no evidence that would happen. The Fed sets the rates exactly where they want them. If the Fed wants the rates to rise, they just tweak their POMO purchases. That's the whole point of POMO and the market front-runs and obeys every time because they know the Fed has unlimited firepower.

[Bean]

Nonsense. The Fed is buying bonds on the secondary market that have already been purchased by the private sector. The private sector would buy these bonds even if the Fed wasn't buying them because that's how the private sector saves the cash that comes from deficit-spending.

In other words, deficit-spending creates excess reserves and T-Bond auctions drain those reserves.

So is the Fed not a part of the demand curve for overall T-Bond market?  Also, saying that my comment is nonsense because the primary auctions are not swayed by the most liquid and vast secondary market in the world has me really confused.

I guess if I translated what you are saying into my slower thought process, it would be like saying the used car market has no impact on the new car market. 

[MediumTex]

In other words, there will always be a healthy demand for T-Bonds, so long as people are willing to save their cash — even if the Fed isn't buying them. Did QE artificially push those yields down even more? Yes, of course.

Well, that may narrow the area of disagreement a bit.

Now it's just a matter of determining the scale of yield suppression that the Fed's activities have created.

My own opinion is that the Fed has probably suppressed the yield on the 30 year bond by 100-200 basis points (at the most).  Others probably think it's a lot more than that, but I would say look at other bond markets around the world if you think that the U.S.'s current rates are unusual.