by Christopher Casey of The Mises Institute
Fans of HBO’s hit series, Game of Thrones, know well the motto of House Stark: “Winter is Coming.” This motto warns of impending doom, whether brought on by the Starks themselves, devastating multi-year, cold weather, or something far more ominous north of the Wall.
At least since Soviet economist Nikolai Kondratieff wrote The Major Economic Cycles in 1925, recessions have been associated with winter weather. Although Kondratieff’s theories contained as much fantasy as Game of Thrones, using seasons as an analogy for the stages of a business cycle is intuitive. If spring represents recovery, and summer the peak of economic growth, then the U.S. economy may well be in autumn. All should be as wary as the subjects of Westeros (the realm of focus in Game of Thrones).
Few mainstream economists currently foresee a recession. They cite “strong” (a new-found, favorite term in Federal Open Market Committee minutes) economic statistics, a “healthy” stock market (despite gains highly concentrated in the so-called “FANG” stocks), and few warning signs among the “leading indicators.” But the same exact sentiment existed before the last recession. Most infamously, then-Federal Reserve Chairman Ben Bernanke stated in January 2008 – exactly one month after the recession technically began: “the Federal Reserve is not currently forecasting a recession.”
How could Chairman Bernanke have been so wrong then, and why may mainstream economists be likewise wrong today? The answer lies in their erroneous business cycle theories. Without a theory which accurately describes recessions, watching leading indicators or other signs of a slowdown are as effective as reading tea leaves. One can only predict by first understanding causality.
The Austrian school of economics explains business cycles, for it describes their phenomena (e.g., the “cluster of error” exhibited by businesses and economic actors), why they are recurring, and why they first repeatedly appeared in the 19th century (with fractional-reserve banking and/or central banks). In short, when the money supply is artificially increased, interest rates are decreased and distorted. As interest rates are a universal market signal to all businesses and economic actors, investments and purchases which previously appeared unprofitable or untenable now seem economically profitable or reasonable. However, these expenditures are actually “malinvested” relative to the natural level of interest rates. When interest rates revert to their natural level and structure, a recession ensues. Recessions are an inevitable condition which corrects malinvestments by returning capital to rightful purpose.
What causes the artificial boom to end and the winter to begin? Ludwig von Mises offered a succinct explanation:
The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market.
In the U.S., the growth rate of “additional quantities of fiduciary media” has flatlined (as represented by the red line below). The most relevant monetary metric to analyze is the Austrian definition of the money supply known as “True Money Supply” (“TMS”). Developed by Murray Rothbard and Joseph Salerno (and frequently commented upon by Ryan McMaken of the Mises Institute), TMS more accurately captures Federal Reserve activity than traditional measures such as M2. Since March 2017, it has averaged a mere expansion rate of just over 4%.
Since Austrian business cycle theory describes the impact of monetary expansion and contraction upon interest rates which, in turn, impacts the economy, are interest rates likewise signaling a possible end to the current, artificial economic expansion?
When Winter is Coming
Interest rates have certainly risen. Since breaking below 1.4% just over two years ago, the 10-year Treasury has traded with a yield close to 3.0% for the majority of 2018. But in forecasting a recession, timing and probability are better served by analyzing the structure of interest rates (known as the yield curve) rather than the overall interest rate level.
The yield curve represents a graphical depiction of fixed-interest rate security yields plotted against the amount of time until their maturity. Various methods of measuring the “flatness” of the yield curve exist, but one of the most popular is the yield on a long-dated bond (e.g., the 10-year Treasury) minus the yield on a shorter-term bond (e.g., the 2-year Treasury). Based on this methodology, the yield curve has flattened extensively over the last several years to levels last observed just prior to the Great Recession.
Historically, a yield curve which flattens enough to become inverted; that is, when short-term interest rates are higher than longer-term interest rates, a recession typically follows. An inverted yield curve possesses a unique power of predictability.
As explained by economist Robert Murphy, in foreshadowing every recession since 1950:
Not only has there only been one false positive (which even here was still associated with a slowdown), but every actual recession in this timeframe has had an inverted (or nearly inverted) yield curve precede it. In other words, there are no false negatives either when it comes to the yield curve’s predictive powers in the postwar period.
The acknowledgement of the yield curve’s prognosticative capability extends beyond Austrian school economists such as Dr. Murphy, for numerous studies – many by Federal Reserve economists – cite this phenomenon. The Federal Reserve Bank of New York, in introducing some of this research, recognizes “the empirical regularity that the slope of the yield curve is a reliable predictor of future real economic activity.”
Recognition is different from understanding as mainstream economists are largely unable to offer an explanation. However, yield curve recession signals adhere well to Austrian business cycle theory which demonstrates the importance of banks in creating money and lowering interest rates (which steepens the yield curve as most of their influence resides with shorter maturities). It is the reversal of money creation – and the impact of banks on interest rates – which causes shorter-term interest rates to rise disproportionately (the typical fashion by which the yield curve flattens).
In addition, if the artificial boom ends when interest rates are no longer artificially depressed, then it stands to reason the structure of interest rates will also revert to its natural state. A flatter yield curve comports with the natural structure of interest rates expected in a free market. The Austrian-economist Jesús Huerta de Soto described the underlying reason free markets generate flatter yield curves:
…the market rate of interest tends to be the same throughout the entire time market or productive structure in society, not only intratemporally, i.e., in different areas of the market, but also intertemporally… the entrepreneurial force itself, drive by a desire for profit, will lead people to disinvest in stages in which the interest rate…is lower, relatively speaking, and to invest in stages in which the expected interest rate…is higher.
In short, the predictive power of the yield curve is matched only by the explanatory power of Austrian business cycle theory. If it continues to flatten and invert, a recession will likely follow as the previously created malinvestments are exposed.
But rather than wholeheartedly embrace yield curve analysis, high-ranking Federal Reserve officials consistently waffle at its utilization. Like Westerosi maesters in conclave to determine the advent of winter, they frequently recognize recessions only after their onset.
The similarities between the climate in Game of Thrones and the state of the U.S. economy are eerily similar. Prior to the recent beginning of winter, Westeros experienced an unusually long time since the last winter. Likewise, according to the National Bureau of Economic Research, the current U.S. expansion is the second longest ever at just over nine years (110 months).
Also, just as recessions are not phenomena endogenous to free markets (but rather, as discussed above, caused by an artificial expansion of the money supply typically produced/coordinated by central banks), so too the winters in Westeros appear to be generated from an artificial, exogenous source. As protagonist John Snow explained in describing the supernatural White Walkers: “the true enemy won’t wait out the storm. He brings the storm.” The Night King is the Westerosi version of the Chairman of the Federal Reserve (with the primary difference being the Night King purposely brings about winter).
Finally, like the next winter in Westeros, the next U.S. recession may prove unusually severe by historical standards. In Game of Thrones, many characters (at least the peasants) believe this winter will be the worst in 1,000 years. Given the Federal Reserve’s unprecedented monetary machinations since 2008, the next recession may well prove worse than the last one, and potentially as devastating as the Long Night.
Approximately one year ago, speaking as confidently as a Red Priestess of R’hllor, then-Federal Reserve Chair Janet Yellen believed the next recession-driven financial crisis may be averted for at least a generation or so:
Would I say there will never, ever be another financial crisis? …Probably that would be going too far. But I do think we’re much safer… and I hope that it will not be in our lifetimes, and I don’t believe it will be [emphasis added].
You know nothing, Janet Yellen. Winter is coming.