Let’s start by parachuting back to the beginning of 2023. We find central banks reeling from the terrible mistake of dismissing rising inflation as ‘transient’; yet economists apparently still feeling they need some sort of authoritative guidance to perform their jobs properly. It’s as if only in the commandments and teachings of central banks can they find the bedrock of ideas and thinking which will enable them to separate fact from fantasy, to know right from wrong, to be accepted as serious people. And so, we see economists and market strategists lining up in late-2022 to dutifully listen to Federal Reserve Chairman, Jerome Powell. He is warning that reducing the rate of inflation to acceptable levels could entail the loss of millions of US jobs. And so it was, 2023 opened with some 80% of economists forecasting an imminent US recession, slightly less than the 90% which predicted one in October 2022. 2023 wasn’t a fun time for believers, that recession never happened. Turning to the major Wall Street banks, at the start of 2023, they too stuck closely to central bank doctrines: major brokerages competed on the business airways to explain why large-cap US stocks were doomed. Goldman Sachs predicted that the lifting of Chinese Covid restrictions would power the Chinese economy and stock markets into the stratosphere. Almost everyone was convinced that Treasury yields would imminently tumble, the 10Yr US Treasury bond having closed 2023 at 3.5%. Each of these consensus positions proved disastrous. Chinese stocks collapsed, US large caps flew, and Treasury yields rose sharply to hit a peak of 5.02% on 22 October, their highest level since July 2007. Perhaps a little favoured by fortune, Eriswell either captured or avoided most of this mess. Not by being smart, but by sticking to a cold observation we made on 6 Jan 2023: “Following 2022’s ‘transient inflation’ fiasco, it is clear that pre-2008 economic theories and business cycle notions are no longer relevant, and that the econometric models based upon them now lie as relics to a pre-2007 productivity stalled world.” Central banks and their believers found this too extreme, arguing that a few tweaks to orthodox scriptures and all would be well. More a miracle than a tweak we replied: “One possibility would be to breathe new life into these old models by summoning the help of an Old Testament character like Ezekiel: In the story of the “Valley of Dry Bones”, Ezekiel prophesied there would be a "rattling" as the dead bones came together to be once again covered by flesh and skin. “As the story goes, that is exactly what happened. Then Ezekiel realised that God either hadn’t finished the job or hadn’t got it quite right. So, he exclaimed, “Come from the four winds, O breath, and breathe on these slain, that they may live”. The four winds obliged and the animals lived once more. “If this seems farfetched, another approach would be to simply accept the objective realties of zero-r* worlds and model them coherently.” Fun and games aside.... What concretely has gone wrong with mainstream economic models? Briefly: 1. For over a century now, economists have built economic forecasting models based on the expected actions of imaginary and perfectly rational individuals who possess infinite knowledge, supercomputer processing power, and who are on a mission to maximise their personal utility. To be fair, these idealised models worked reasonably well during periods of calm but were hopeless at identifying recessions, inflation outbreaks, and such like. In other words, they couldn’t tell you what you really wanted to know! 2. Next, introduce the possibility of imperfect information (hold that thought) and external shocks such as the 1987 stock market crash, the 2000 Nasdaq bubble, or the 2008 credit crunch. Econometric models adapted to what we can understand about the “real world” like this, can provide good ways to think about why such events happen. But their predictive power was degraded by excessive data fitting. In other words, they were better at understanding the past than predicting the future. Nevertheless, these were the econometric models of pre-2007 and while by no means perfect, they did a reasonable job. 3. Post-2007 however, things took a turn for the worse. Increasingly contorted to explain past events, the predictive power of these mainstream economic models fell to almost zero. While mathematically clever, they were built around assumptions of an idealised world which—if it ever existed—that had almost zero relevance to an environment where labour productivity growth had mysteriously stalled, and where the natural real rate of interest (r*) had fallen to zero or below. Their failure to predict the 2021-23 inflation firestorm, or even recognise it as it started to burn, is but one example. Last year’s erroneous forecast of ‘Serious Recession’ in 2023 is another. The truth is these ‘state of the art’ models have become about as useful as an army lookout who has forgotten to take the lens caps off his binoculars. The trouble central banks and economists faced from 2007 onwards was a significant shift within modern economies. Up until then economic forecasting techniques had got along more or less fine for decades by ignoring human psychology and the many observable irrationalities in the investment and consumption preferences of consumers and businesses. It is up historians to tell the story, but I would say that post-2007 central banks gradually recognised that inflation was very hard to create in zero-r* conditions. What they didn’t recognise was that low inflation world was but one semi-stable zero-r* equilibrium. Other equilibria existed which could—and ultimately did—blow them out of the water. To understand why this happens one must recognise and model the capricious and irrational human nature of behaviour. Human irrationality and zero-r* worlds We can see evidence all-around of how different societies shape economic preferences and human behaviour. Think about differences in the level of equilibrium savings rates in different countries. Far from being a function of some innate and predictable human behavioural response, we see that different societies actively shape household savings preferences. And these preferences can change over time. You can think of other examples. Enter an observation whose importance is impossible to overstate: these ever-present behavioural changes are normally slow moving and can therefore be ignored for forecasting purposes; they are what they are and will likely stay that way. And pre-2007 this assumption worked good enough. These behavioural patterns however become unstable and are magnified many times over when r* (natural real rate) falls to zero or below. Remember that, despite the ongoing inflation, r* remains firmly stuck at zero today. Few would dispute this point. It is as if being able to borrow money at zero real rates fundamentally changes how we think about ourselves. And so, if we wish to predict the post-2007 productivity stalled world, we must refocus and fundamentally retool what we are doing to incorporate the evolution of human behaviour. Right there we run into a problem: understanding how an individual’s preferences are shaped by society and how to coherently model them has long been the Holy Grail of economics. Nobody has come close to finding it. Yet, curiously, and thankfully, a zero-r* environment significantly simplifies this problem. It does so for an intriguing reason. Post-2007, and especially during the 2020 Covid pandemic, central banks enjoyed sky-high credibility and power over people and markets to a degree we may not see again for many a year. And, almost unprecedently, they chose to use this power aggressively to alter household and corporate behavioural patterns. To get the play here we must now step back into an almost philosophical discussion. Our Modern ‘Fair’ Meritocracy Ask yourself the first, or one of the first things you are likely to be asked these days upon making a new social encounter. What do you do? Followed perhaps by, where do you live? Why are we so obsessed with what people do these days? And why, when you answer that question, do people come to such a confident conclusion of who you are and how much you matter? The answer, we live in a world where financial wealth and the ability to accumulate it provide a gateway to the respect, and sometimes even the love we all need to be happy. Be seen as a financial whizz with a sports car, Rolex, and fancy clothes, and offers come aplenty. But perceptions of wealth matter beyond dating. They affect how your friends see you, the social circles you mix in, your ability to meet influential people, the job you are likely to get, and much more. Do you dimension people this way? You might do even if you wish you didn’t. Why has society evolved this way? One reason might be a diminution in the role of religion which left a vacuum that was filled by money and consumption. Another is certainly the collapse of the traditional class system in favour of a modern meritocracy. Now superficially meritocracies seem great; smart, hardworking, talented people can rise to the top no matter their social class, colour, or creed. Everyone is born to shine, or so they say. A world built around equality of opportunity, not equality of outcome. This is where the trouble begins. Take the rise of social media, a thoroughly modern business where everybody is free to have a go at being a star. Succeed and the world is your oyster. Don’t, and you get paid a pittance. In fact, social media revenues amongst so-called influencers are one of the most unevenly distributed of any industry. This metaphor for modern life takes us to a deeper problem: if the smartest, most talented, hardest working, and most committed people rise to the top, where exactly does that leave everybody else? It never really mattered in the old days when say a factory worker could look forward to nothing more than a lifetime of poorly paid toil, and his children the same. If that was your lot, so be it, it’s just the way life was. Not great for many, but nations and economies turned out to be surprisingly stable under such a system. Misery was of course everywhere, but it was entrenched and it certainly wasn’t your fault you weren’t as rich as the local squire. Now, I’m certainly not advocating to a return to such a system. But where does that leave the vast majority who fail to rise to the top of our modern meritocracy? The ‘obvious’ answer is that if the wealthy are wealthy because they are hardworking, talented, and clever, presumably people are poor because they are lazy, talentless, and stupid. This is certainly how lots of people view a lack of success these days, but it’s not at all fair. Because the fact is, one’s wealth and standing in today’s increasingly unequal world is largely a function of randomness. Of blind luck sometimes. An unfortunate injury can separate a £25m per annum footballer from a bricklayer. A capricious choice in childhood can separate a CEO from a schoolteacher, a brain surgeon from a County Council worker, a pilot from a bus driver. Whoa, just hold on there!, I hear you say. What is wrong with bricklayers, schoolteachers, bus drivers, and Council workers? Absolutely nothing. But as a friend of mine explained to me last week, the perception of status and power opens doors to a level of respect and access to things not enjoyed by many. It seems unfair but it’s true. You know it is. Enter that truly horrible modern word, ‘loser’. A label which is primarily applied to averagely or poorly paid younger folk who are earlier in their earnings cycle. In other words, the 90%, or perhaps even the 99% of them who don’t ‘make it’ to the top. Then we feign surprise at rising mental health problems and are shocked by that modern-day affliction, ‘young people suicide’. Which many disingenuously and appallingly dismiss as something to do with a snowflake generation which shuns hard work in favour of eating avocados. Or other such nonsense. Naturally, nobody wants to be labelled as a ‘loser’ a hurtful, nasty term which can inflict deep psychological harm on so-labelled individuals. A label which alienates them further from the images of monetary success we see all around us: on our phones, in newspapers, books, films, advertising, everywhere. Worse, this success has been achieved by people just like you, so if you’ve not made it, that’s entirely your problems. Or so the story goes. Now bear in mind that the urge to own, touch, and observe beautiful things is deeply rooted in the human psyche. Christianity alongside many religions has, for example, long recognised the importance of beauty and beautiful things; understanding that they can affect who you believe yourself to be and even who you are. The Catholic Church has for two millennia considered it important to spend vast sums of money on beautiful churches, paintings—think of Sistine Chapel—, and music, in the belief that it is going to affect the sort of thoughts you have. Ugliness by comparison is seen as bad which may pull you in the wrong direction, beauty as good which will pull you towards the path of virtue. This is one reason why advertising is so pervasive and so idealised. Enter a society where mass advertising promotes a ‘success is beauty’ culture which only a few can achieve. Now add to this curiously unhappy mix a stall in labour productivity and the easy money that comes with it. Post-2007: Central banks start to shape economic preferences Post-2007, central banks found themselves facing a stall in labour productivity growth largely without precedent since the Long Depression of 1874-96. The problem they faced was a chronic shortfall in aggregate demand within their economies. In such circumstances r* (the natural real rate) collapsed from its usual 3-4% range to zero or below. Nominal interest rates fell in tandem and it is easy to see why. If inflation is say 1%, and r* is 0%, then nominal interest rates must be set at 1% to deliver a 0% real rate (interest rates are equal to inflation). If the central bank wishes to stimulate the economy by say 3%, it can reduce rates to 0% but no more; in other words, 2% short of its desired stimulation. If inflation falls to zero and nominal rates are at zero, then if r* is also zero, there is nothing the central bank can do stimulate the economy. And so, from 2007 onwards, central banks gradually departed from ‘Scientist Mode’—how does this work, how to I fix it?—to what one might term ‘Preacher/Prophet/Politician Mode’. Under their new guise, central banks gradually shifted from analytical insights to preaching about how we should live our lives, prophesising what would happen in the future, and when their prophesies proved to be wrong—such as the ‘transient inflation’ fiasco—they would act in the manner of a politician to try and smooth over their mistakes. Post 2007, central banks began—even if not intentionally—to take advantage of contemporary feelings of ‘status’ or ‘consumption’ anxiety by providing a near-limitless supply of cheap money to all and sundry. It was a dangerous game and it went like this: make it cheap and easy for consumers and businesses to intertemporally forward-shift future spending and investment while preaching that this was a very smart thing for them to do. And prophesising that—despite one’s better instincts—inflation would remain low. The central bank sermon went like this: just spend spend-spend-spend, trust us, and all will be fine on the night. Whether that was on a personal, corporate, or governmental level. Aggregate demand will stabilise and inflation will remain low—i.e., "trust in us.” With the caveat that it fuelled rapidly rising levels of inequality, this policy largely worked from an economic perspective up until the Covid pandemic. When central banks got carried away and effectively went wild with easy money. To get the play here we must first forget about that fictional ‘all-knowing’, ‘super bright’, ‘utility maximising’ little creature who dominates mainstream economics. Social systems are in practice formed of thinking participants whose view of the world is always partial and always distorted. Central banks would begin to game this inherent distortion to create self-reinforcing positive feedback trends with the deliberate aim of shifting asset prices far from their fair equilibrium levels. The central banks’ goal was to either kick-start growth or create an upside inflation excursion which could be dismissed as ‘transitory’. Inflation after all appeared to be dead since 2008. Or so the central banks thought. Under either outcome, it made sense for households and businesses to borrow cheap money and reduce their cash allocations in favour of current spending. In effect, central banks were saying they would push nominal-GDP higher (inflation + real growth) whatever the real- growth/inflation mix turned out to be. It’s a complicated story, we wrote a series “When Reckless Turned Reckless” describing it, but we all know the ending. Inflation ran wild! Conclusion Pulling the strands together into a coherent forecasting model requires complex non-linear mathematical techniques which recognise that zero-r* worlds are comprised of multiple semi- stable equilibria. And all that jazz. But from a philosophical perspective what is happening today seems perfectly intuitive. Humans are profoundly relational creatures whose happiness and sense of community depends upon other people’s perceptions of them. For individuals and businesses suffering from ‘consumption’ or ‘status anxiety’—losers if you must—the advent of free money enabled them to spend down their savings and take on debt with no real cost to them. To temporarily feel like a ‘winner’ as it were. And I think that’s it, isn’t it? Not only was this money ‘free’, the central banks authoritative views on what’s right and wrong financially fully supported spending the stuff freely in 2020 and 2021. Which was great. Up until inflation spoiled the party. Central banks have, I think, in this way failed the nations whose prosperity was entrusted to them. It’s as if the people who were supposed to possess deep knowledge and a love of financial stability forgot the whole point of it. The truth is that between 2008 and 2021, they couldn’t properly explain to anyone why inflation had seemingly disappeared from the system. But they nevertheless remained confident it had gone for good. And so, despite the ‘transient inflation’ fiasco, between 2021 and 2023, economists, Wall Street banks, and professional investors, sat there listening deferentially to central bank sermons. In 2022, they ended up getting seriously burned by the sovereign bond collapse. Only to be badly burned again in 2023 by going short US stocks, long US Treasuries, and long Chinese stocks. The winners were those who simply got bored of the central bank charade and left to do their own thing. Now imagine a world where people increasingly lose faith in the central banks just like they have lost faith in the churches to which they once belonged. I guess this is my New Year Message—start thinking about exactly that! Mark Page