This is something written by Eric Sprott in 2002. It reads like a prophecy.
http://www.sprott.com/docs/MarketsataGlance/10_2002.pdf
MARKETS AT A GLANCE ECONOMIC MODELS: WHO NEEDS THEM?
By now it should be obvious to everyone that the economists got it wrong. Worse yet, they keep getting
it wrong. Yes, these are the people with a decade worth of higher education and a veritable alphabet of
credentials after their names: CFA’s, CA’s, MA’s, MBA’s, PhD’s, etc. Very intelligent people, to be sure,
but they were almost all wrong. For the past three years, the vast majority of them have been predicting
that an economic rebound is just around the corner. How many times have you heard about the everelusive
second half recovery? The answer is three years and counting. The vast majority have also been
predicting an imminent rebound in the stock markets, and coaxing you to buy on every dip. Once again,
they have been wrong. We don’t want to demean these well-educated and intelligent people. But what’s
going on? Why are the economic models not working? Even economists from independent think tanks
(i.e. not employed by investment banks) have, almost to a man (or woman), been erroneously bullish.
Clearly, something is amiss with the models.
We are not so arrogant to think that we can produce the be-all, end-all model that would explain
everything in the world with precision. Such a task would be impossible. There are too many variables in
this world of ours and the number of combinations in which they can interact approaches the infinite.
What we can do, however, is offer an insightful critique of why the output of these tried and tested
models can be precarious at best, especially in times like these when, in many ways, we are all
experiencing once in a lifetime circumstances. We cannot overemphasize that this is not merely a
downturn in a normal business cycle. The problems go much deeper than that. So we will offer up an
alternative way of thinking about the economy, one that deviates substantially from the mainstream of
economic thinking (as expounded by Keynes, monetarists, and others). It is called the Austrian School of
Economics.
But first, our promised critique of modelling in general. A model is a “black box” in which relevant
variables are measured and put into the box, in the hopes that the output from the box will be a fair
predictor of what can be expected to happen in the future. Such relevant variables may include things like
interest rates, inflation, inventory levels, the unemployment rate, etc. The black box spews out a
prediction (GDP will grow 3.5%, for example) and the economists all go with it, no questions asked and
very little is done in the way of creative thinking. After all, these models have normally worked fairly
well in the past. But alas, these are not normal times!
Today, so many factors are “in play” that barely registered on the radar screen in times past. How do
these models, for example, take into account the record levels of financial leverage (debt) of both
corporations and individuals? Or the fact that we just came out of one of the biggest financial bubbles of
all time? How do the models account for rising government debt? Do they take into consideration how
plummeting stock markets around the world impact the behaviour of businesses and individuals? How
about the prospect of skyrocketing pension plan deficits in this adverse investment climate? How about
wars? How can models factor in corporate corruption and the insatiable greed of managers? What about
investor confidence? All of these are nontrivial factors that loom large today. Yet the models surely miss
them all.
Eric Sprott (416) 943-6420 Investment Strategy
Sasha Solunac (416) 943-6448 - 2 - Insight Oct. 4/02
And what about the rising price of oil? At around $31 today, it is the highest it has been in well over a
year. During the bubble, the economists shrugged off the high price of oil as being no longer relevant in
the “New Economy”. After all, in the age of the internet and lightning-fast telecommunications, what
purpose is to be served by such an “Old Economy” commodity like oil? Alas, the new economy has come
and gone, and the world is back to its old economy ways. Yet the economists still aren’t giving much
credence to the negative economic consequences of high energy prices. What’s that about? Surely some
of these bullish models factor in the price of oil? Or is everyone still using the same models they had at
the peak of the bubble? Like old dogs, today’s economists cannot seem to learn new tricks.
It’s time to throw this “black box” out the window and learn to think “outside the box”!
We are of the opinion that investing is more of an art than a science. To be sure, one still needs to be
logical. But the practice of adhering to dogmatic principles is proving to be debilitating indeed. When
times are abnormal, we need to think unconventionally. Sit back, look at what’s going on in the world,
and draw your own independent and logical conclusions. There is no magic black box that will explain it
all. Every time you hear a conclusion that was derived from some economic model, step back and think
about whether or not it makes sense in light of what you see happening around you. Take nothing as a
given!
Perhaps one of the flaws of today’s economic models is that too much is taken as a given. The virtues of
our current financial system, one that is based on fiat money and the unlimited power of central banks to
print more of it out of thin air, is unfortunately taken as a given. Outside of a rare few in academic circles,
almost no modern economist questions the foundations of this thinking. This foundation is based on the
works of Keynes and monetary theorists who expound that the economy can be “managed” by
governments in general and central banks in particular. Any economic mishap that occurs (such as a
recession, for example) is a fault of policy implementation, and not a fault of the system. (This situation
is not unlike the sentient, intelligent, and “infallible” supercomputer in science fiction movies who
commits a fatal blunder and then blames it on “human error”.)
Mainstream economists may question Greenspan, but they do not question the role of the Fed. They may
question the “irrational exuberance” of the bubble (always in hindsight, of course), but they do not
question the system that allowed this bubble to come about in the first place. Perhaps this is what is
wrong with today’s models. They are not seeing the forest for the trees. But if the foundation is flawed,
then the models will also perforce be flawed.
There is a school of economic thought called the Austrian School of Economics. Because they question
the unquestionable, they are considered “fringe” by most of the economic intelligentsia. Be that as it may,
their thinking provides valuable insights into what’s been going on in the world, and why the mainstream
is getting it wrong. Perhaps years from now, after time takes its course and painful lessons are learned,
this fringe will become the mainstream.
At the crux of their thinking is the notion that the central bank, with its unbridled ability to print paper and
offer unlimited credit into the banking system, creates distortions in the financial markets – distortions
that cause economic agents (businesses and individuals) to behave in irrational ways. In our capitalist
society, free markets are generally encouraged. Only in a free market, after all, can the optimal allocation
of limited resources be achieved. But for some reason, our financial system is such that market forces are
not being allowed to determine interest rates. Rather, interest rates are to be “centrally planned” by
politicians. So rather than letting borrowers and savers determine what should be the price of money (i.e.
the interest rate), it is incumbent on the central bank to do this for us.
Eric Sprott (416) 943-6420 Investment Strategy
Sasha Solunac (416) 943-6448 - 3 - Insight Oct. 4/02
The problem with any type of central planning is that a disconnect often occurs between what the central
planners want (i.e. politicians) and what is happening on the ground (i.e. reality). Incentives get created
that cause people to behave in less than optimal ways. The distortions can exacerbate themselves, thus
creating a bigger problem in the end – one that will require great pain to correct. The problem would not
have gotten so large if market forces were allowed to act. (This problem, as it pertains today, is excessive
debt.) So state the Austrian economics – the system is flawed.
We need not argue the point that this type of irrational behaviour, incentivized by the central bank, was
running rampant during the bubble. That much is obvious to everyone. Corporations overborrowed and
overspent on projects with dubious investment value, which eventually was shown to be what it is and
this led to the inevitable bust. Valuations plunged and bankruptcies ensued. But what about now? Are
things back to normal? Hardly. The Fed has continued to create conditions for even more irrationality
today, except this time the grieved party will be the consumer.
During times of financial fallout, it is normal (and rational) to adopt a defensive stance. What this usually
means is save your money for a rainy day, only spend money on what you need, and keep your borrowing
to a minimum. But if you look at what’s happening around you, this is hardly the case. It is irrational
exuberance, part two. People are borrowing and spending like there’s no tomorrow. They are being
“pushed” to act against their better interests. Granted, nobody is putting a gun to the head of the
consumer, but incentives (market distortions) are being created by the central bank to coax you into
behaving in this irrational way. Borrow and buy a new car, even though the one you have now is perfectly
fine. Mortgage whatever equity you have in your home so you can spend it frivolously to “help the
economy”. Forget about all the money you lost in the stock market. Forget about the weak economy.
Forget about all the layoffs. Borrow and spend, borrow and spend… declare bankruptcy later. The sense
of overconfidence that existed during the bubble still exists today. People still believe that the system
cannot fail. Stay tuned.
According to the Austrian School, it is the central bank, and only the central bank, that creates boom/bust
cycles through the manipulation of money and credit. Furthermore, everything that goes up must come
down. Everything that inflates must eventually contract. To borrow an analogy from the laws of physics,
every bubble must be followed by an equal and opposite bust. It is this logic that the bullish economists,
and thus many individuals, are missing. In spite of the economy coming out of one of the biggest
financial bubbles in the history of mankind, they still think that by manipulating interest rates everything
will be set right. This is just wishful thinking. A whole lot of pain needs to happen between now and then.
All we’ve felt so far is a pinprick.
When you think about it logically, the whole notion that economic prosperity can be created from ever
mounting piles of debt is seriously flawed. A key fact appears to be forgotten: All debt must eventually
be repaid! Loose money policy on the part of the central bank is not a sufficient condition for real
economic growth. When all is said and done, it is savings that create the real productive opportunities in
the economy, not leverage. It is real savings, not money created from a printing press, that creates real
productive capacity. The world eventually becomes wise to what is real and what is artificial. This is why
Fed policy, and the models that depend on it, are not working. Saving is good. Reckless spending is bad.
It sounds obvious – but politicians, central bankers included, would have you believe otherwise.
As a final point, American economists like to proclaim that things will be different here than they are in
Japan. Monetary easing is being done more aggressively here, they claim, while the Japanese have been
committing one policy blunder after another for the last 13 years. We should give the intelligence of the
Japanese more credit than that! Truth be told, Japan has been pumping money like crazy. With interest
Eric Sprott (416) 943-6420 Investment Strategy
Sasha Solunac (416) 943-6448 - 4 - Insight Oct. 4/02
rates close to zero, monetary policy is about as easy as it gets! Furthermore, they have been propping up
their banking system with tremendous amounts of money, causing the government of Japan to be one of
the most heavily indebted in the world. Alas, it didn’t work. They are stuck with the same central banking
system that we have, and it is flawed. By artificially trying to prevent the inevitable contraction from
taking place, all they ended up doing was prolonging it. To claim that the US is going to be any different
appears naïve, to say the least.
The economists don’t get it. The central banks don’t get it. Governments don’t get it. And the pitiable
consumers don’t get it. It just ain’t working.
Sprott Asset Management Inc. is the investment manager to the Sprott Canadian Equity Fund, Sprott Gold and
Precious Minerals Fund, the Sprott Hedge Fund L.P. and the Sprott Hedge Fund L.P. II. Important information
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and/or offering memorandum. Please read them carefully before investing. Mutual funds are not guaranteed; their
unit values and investment returns will fluctuate. Performance data represents past performance and is not
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