Decoding The NY Fed’s Latest Paper On The Equity Risk Premium

I read academic research papers so that you don’t have to. The NY Fed has recently released a working paper on the ERP. This paper follows a previous paper published last year, which reached similar conclusions. Both papers conclude that the ERP was at an historically high level in 2013. Further, the authors conclude that the ERP is a valid tool for estimating equity market value, and that ERP tools are superior to PE-related tools such as Robert Shiller's CAPE.

You really can’t value stocks through the cycle without reference to bond yields. Otherwise, we would just be looking at PE ratios and be thinking that stocks were expensive when rates were low (2002, 2009, 2012, 2013, 2014). Bottom line: ignore the PE and ignore the cyclically-adjusted PE (the CAPE). Only look at the ERP (earnings yield minus the risk-free rate) or--my preferred index-- the ratio of the ERP to the risk-free rate. Equities can only be valued by reference to interest rates.

If you agree with me, and accept that the ERP/RFR ratio is THE index*, then you should sell everything you own and put it into equities. If you were a real hombre, you would also borrow up to your debt capacity and buy stocks (please don’t do that!). If you accept the internal logic of the ERP/RFR ratio, then you should be overweight equities. Below I have excerpted from the NY Fed’s most recent paper on the ERP, and have provided my parenthetic exegesis. The NY Fed’s words are italicized.

There is broad agreement across models that the ERP has reached historical heights [as of mid-2013] even when the models are substantially different from each other and use more than one hundred different economic variables. Our preferred estimator places the one-year-ahead ERP in July 2013 at 14.5%, the highest level in fifty years and well above the 10.5% that was reached during the financial crisis in 2009.

Translation: The best time to buy stocks in our lifetimes was last summer. If you mentally adjust the ERP to reflect the subsequent market appreciation, we are still in historic territory.

The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities.  In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat.  Current and expected future dividend and earnings growth play only a minor role.

Translation: The reason that stocks are a buy is that bond yields are at deflationary levels.

A high ERP caused by low bond yields indicates that a stock market correction is likely to occur only when bond yields start to rise.

Translation: Unless something happens to upset current inflation expectations, the ERP will remain elevated into the foreseeable future, making stocks a compelling investment.

Another implication of a bond-driven ERP is that we should no longer rely on traditional indicators of the ERP like the price- dividend or price-earnings ratios, which all but ignore the term structure of risk-free rates.

Translation: Shiller’s CAPE and similar crude valuation measures are flawed because they ignore the expected returns from alternative investments. When rates are low, PEs are high. That doesn’t make stocks expensive. We should compare the PEs of stocks with the PEs of bonds. Right now the 10-year PE is ~35x--and bond yields can never rise.

The current high levels of the ERP are unusual in that we are not currently in a recession and we have just experienced an extended period of high stock returns, with 60% returns since July 2010 and almost 20% since the beginning of 2013. During previous periods, the ERP has always decreased during periods of sustained high realized returns. It is unusual for the ERP to be at its present level in the current stage of the business cycle, especially when expectations are that it will continue to rise over the next three years.

Translation: We are living in a period of unprecedented prospective equity returns. This an historical opportunity to buy stocks.

Our analysis provides evidence that is consistent with a bond-driven ERP: expected excess stock returns are high not because stocks are expected to have high returns, but because bond yields are exceptionally low.

Translation: You should only be bullish on stocks if you are also bullish on bonds. That requires an opinion that the FOMC will continue to be unable to raise inflation and inflation expectations.

There was a moment when I thought that Yellen would be the catalyst for higher inflation expectations; I was wrong. She is a catalyst for nothing. We should expect low inflation, low bond yields, and an attractive equity yield premium until stock prices go much higher. Investors who currently hold metals, cash and bonds will look back on 2014 and regret it. Where we are today is 1933, 1974, 1980, 1987, and 2009.

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* It was subsequently explained to me (at Seeking Alpha) that the ERP/RFR ratio is unreliable because of its sensitivity to small changes in the RFR when the RFR is very low. Consequently, I suggest that we focus on the ERP itself.

Valuing The Bull Market

• PE measures suggests the market is overvalued.
• ERP measures suggest that it is undervalued.
• A lot depends on the outlook for bond yields.

Earlier this month, the Post-Crash Bull Market turned five years old, which some people think is close to its expected life span. Everyone has an opinion about whether it is now time to sell or to hang in there. As readers know, I am in the latter camp.

Serious investors need a sophisticated understanding of the tools available to judge whether the stock market is over or under valued. Such a judgement is highly actionable from an investment perspective, unless you still believe in the EMH and the tooth fairy. You can’t look at the market over the past decade and say that market-timing doesn’t matter. If you bought in 2007 and sold in 2009, it mattered. If you bought in 2009 and have held on, it mattered. The market is volatile and inefficient.

Given just how highly actionable market valuation tools are, you would expect Wall Street to be falling all over itself to publish research and data on the subject. But, because the data is so valuable, they don’t. 

The Street is very close-mouthed on this subject. The ignorant blather on TV about the stock market never goes near a discussion of valuation techniques. To get the data you need to calculate it yourself (no thanks!) or go to academia. There are two schools in academia in this discipline:

The PE School: Bearish

One school believes that equities can be valued without reference to bond yields, or argues that the Fed has used QE to artificially depress bond yields below their natural level. This view has particular appeal to those who believe that QE has artificially held down bond yields since the crash. This school, let’s call it the PE school, makes adjustments to the  reported PE ratio in order to smooth out earnings and inflation noise. For example, Prof. Robert Shiller at Yale calculates a cyclically-adjusted PE ratio, which uses averaged earnings and constant dollars to calculate the CAPE. Shiller’s index indicates that the market is substantially overvalued in a historical context. The current CAPE is 25.5%, versus an historical mean of 16%. That means sell, unless you are very bullish about earnings growth--which I am not.

The ERP School: Bullish

Another school believes that equity yields, meaning the reciprocal of the PE ratio (the EPR), should be be compared with  the risk-free rate (RFR). This makes sense to me because, historically, the EPR has been correlated with interest rates: when interest rates are high, so is the EPR: the higher the bond yield, the higher the premium demanded by investors to hold stocks. There is therefore a need to abstract from the level of interest rates in order to measure the equity yield. Hence, this school looks to the equity risk premium (ERP) as a measure of  the yield premium offered by stocks over the RFR. This school, which I will call the ERP school, seeks to adjust the earnings yield to reflect the level of long-term interest rates. This can be done in two different ways: (1) by subtracting the RFR from the EPR which leaves the ERP; or by dividing the ERP by the RFR, the ERP/RFR ratio. (We could also divide the EPR by the RFR, but no one does that.) Intuitively, both measures look useful to me. I want to know how big is the premium that I am being paid to own stocks, and I want to know how big the premium is in relation to the RFR. Luckily, both measures are calculated and published by Prof. Aswath Damodaran at NYU.

Damodaran calculates the ERP from 1961 until now. The historical range has been from 2.7% in 1972 to 6.5% in 2009. The median is 4.0%. As of March 1st, Damodaran calculated the ERP at 5%, which is 25% above its historical median, and is comparable to the elevated levels of the 1970s, when inflation was out of control and bond yields were in the double-digits. This measure suggests that today’s S&P is very undervalued, unless you think that bond yields are artificially depressed and/or are likely to go much higher--which I don’t believe.

Damodaran also calculates the ratio of the ERP to the RFR for the period 1961 until 2013. Over this period the minimum observation was .32% in 1999, and the maximum was 3.3% in 2012. However, the data stayed within a narrow range for 30 years, from 1962 until 2001, when the median was around .5%, and the range was .4% to .9%. Then something happened in 2002: the ERP started to climb out of its historical range to a level of 1.1% between 2002 and 2007. Since the crash, the ERP has been literally off the charts, reaching an all-time high of 3.2% in 2011 and 2012. Since then it has declined to the region of 1.6-1.8%, far below its post-crash high, but far above its historical range and median. Using this ratio alone, it appears that the market is still very undervalued. If this ratio were to return to its pre-crash levels, the market would be twice what it is today, ceteris paribus. That makes today’s stock market an historical investment opportunity--unless you believe that the price of Treasuries has been artificially inflated by the Fed, which I don’t.

Bond Yields Are Not Artificially Depressed

A word on bond prices and yields. I don’t think that bond yields have been artificially depressed by QE, or at least not by much. Bond yields have been depressed by very subdued inflation expectations (which logically should have risen due to the Fed’s “massive monetary stimulus”). The Cleveland Fed calculates an estimate of the market’s 10-year expected rate of inflation. Despite the Fed’s massive monetary stimulus, expected inflation has declined over the past five years, from above 2% to below 2%. This might be because inflation under QE has been considerable lower than it was pre-crash. Before the crash, core inflation was consistently above the Fed’s 2% target; since the crash, it has been consistently below the 2% target, and has lately been bouncing around 1.1%, which is about half of its precrash level. Therefore, the reason bond yields are low is not because of QE, it is because of declining inflation and declining inflation expectations. There is nothing artificial about today’s 2.8% yield. And I would add that today’s yield is much higher than it was in mid-2012. The bond selloff has already happened--and is baked into the current ERP.

Conclusion

The age of the bull market and the level of the S&P are meaningless data. The market must be objectively valued. By one measure it is overvalued, while by another it is undervalued. I find the latter measure to be more congenial intellectually, and also more predictive historically. Hopefully some smart Ph.D. candidate will someday run the regressions and tell us which is the most predictive valuation measure.

Decoder:

EMH: The efficient market hypothesis, which holds that the stock market efficiently incorporates all of the knowable data and is the best estimate of future market value.

QE: Quantitative easing, the Fed’s policy of buying Treasury bonds.

PE: The ratio of the price of an equity or equity index to annual earnings.

CAPE: Robert Shiller’s cyclically-adjusted PE ratio.

EPR: The ratio of earnings over price, the reciprocal of the PE ratio, also known as the earnings yield.

RFR: The risk-free rate, a proxy for which is the 10-year Treasury bond yield.

ERP: The equity risk premium, which is the EPR minus the RFR; in other words, the premium of stock yields over bond yields. (Think of it this way: the inverse of the RFR is the bond market’s PE, which today is 36x).

How To Fix Income Inequality

• Rising income inequality in the US is a result of a broken educational system, an open border with Central America, and Chinese mercantilism.
  
  
• The price of unskilled labor has become globalized at a low level.
  
  
• The American education system overproduces unskilled workers.
  
  
• If the Left is sincere about raising the living standards of the working class, it will close the Mexican border and impose tariffs on Chinese manufactured goods.

"People who work hard deserve a living wage."

--President Obama

A major political issue on the Left is “rising income inequality”, pointing to the growing income disparity between the rich and the poor since 1970. This disparity is attributed to nefarious activities by “the rich”, and is blamed for all that is wrong with the US economy. A common refrain is that the current sluggish growth is attributed to income inequality, often using the “underconsumption” theory once espoused in the 1930s to explain the Depression. Obama again:

“When families have less to spend, that means businesses have fewer customers; meanwhile, concentrated wealth at the top is less likely to result in the kind of broadly based consumer spending that drives our economy.”

I could argue that income inequality is as old as society, and is an artifact of capitalism and competitive labor markets. But that does not address three inconvenient facts: income inequality is growing; real median household income has been declining since 2006; and real wages for unskilled labor are declining (as measured by the real minimum wage) . It would be one thing if income inequality were widening at the same time that income levels for the the lower cohorts were rising--a rising tide lifting all boats. But it is another thing when widening income disparity is accompanied by declining median income and declining living standards for the working class.

Personally, I don’t care about the GINI ratio, because it does not speak to the living standards of working Americans; American workers are not injured by the income levels of the rich. A society without rich people is very poor indeed, as any 16th (or 21st) century artisan will tell you. No rich, no Michelangelo or Shakespeare. A better measure of economic justice is real income by cohort, which paints a dispiriting picture today, particularly for the working class. So, to me, the problem is the real income of the working class, not the real income of the rich. Envy is a political problem, not an economic one. (Another important measure is the cross-national standard of living of the bottom rung, which is for another post.)

The Problem Of Declining Real Wages

The explanation for declining blue collar wages and living standards in the US in 2014 is that the combination of free trade with China and unrestricted immigration has globalized the price of unskilled labor.

The golden age for income equality in the US was the postwar era (1945 to 1980), when the American economy was closed, almost autarchic. The laboring classes faced little competition from cheap manufactured imports, and immigration only affected the price of agricultural labor. Today, three decades later, America’s blue collar workers must compete with less expensive immigrant labor, of which the supply is virtually unlimited, and with highly productive foreign workers making much lower wages, particularly in China which has an unlimited supply of cheap labor from the provinces. 

Today's unionized blue collar worker with a house, a family, two cars and a mortgage can’t compete with penniless Honduran immigrants living ten to a room, nor can he compete with Chinese teenagers living in a dormitories adjacent to their employer's factory. Unfortunately for President Obama and his aspirations, America has no monopoly on people who work hard (quite the contrary), and no control over what Chinese factories pay their non-unionized workers (a lot less than $10 an hour). And yes, China also has a nasty income inequality problem, with some of the poorest workers and richest elites in the world. China is a fascist plutocracy run by the 1%. The CCP is far to the right of the GOP: just try organizing a labor union or organizing a strike. China is America in 1895, minus the philanthropists.

Globalization has many positive attributes, such as cheap consumer goods which allows everyone to afford state-of-the-art TVs, but it is very damaging for the American worker. America is increasingly uncompetitive in manufacturing, resulting in the heart-breaking decline in manufacturing employment since 1980. Most of the job categories that are growing are in the service sector and either pay low wages or require post-secondary education. The spread between the minimum wage and the median income is growing, while the median income is declining. The employment and wage prospects for high school graduates (and dropouts) now is as bad as they were in the 1930s.

Unemployable Workers

America’s ridiculously wasteful educational system produces millions of young adults without the education necessary to be able to acquire marketable skills. This is our greatest social injustice. Illiterates cannot become skilled laborers. There is no reason to believe that anything the Department of Education can do will change the fact that American schools and colleges produce a surplus of unemployable workers. The defective American educational system won't change no matter how many billions the federal government spends on “education”. Illiterate teachers beget illiterate students. China is so far ahead of us in basic skills.

The Left believes that the problem of declining blue-collar living standards can be addressed by forcing hard-pressed employers in low-margin industries to pay workers higher wages (including subsidized health insurance). Such misguided policies raise the price of unskilled labor, which creates incentives to for manufacturers to manufacture offshore and for service industries to replace unskilled labor with capital goods. There is a belief on the Left that forcing McDonald’s to pay its workers $10 an hour will raise its workers' living standards. Their living standards would indeed rise--but only until McDonald’s automated its restaurants, which it is already doing in Europe. There is no job in a fast food restaurant or a warehouse that can’t be automated and, if trends continue, won’t be automated. Robots don’t need healthcare or pensions, and don't need a "living wage". The terms of trade for the American blue collar worker will continue to worsen unless something radical is done to correct this trend. And there are no radical policies coming from the Left.

What Can Be Done?

There are indeed radical policies which the federal government can implement to raise the real wages of blue collar workers. Most crucially, the working class would benefit by reduced competition from unskilled immigrant labor. The best way to impoverish the American working class and to maximize income inequality is to maintain an open border with the penniless peasants of Central America. That way, the bottom rung of society will always be replenished with millions of new uneducated poor people. Organized labor used to understand this, but no longer does due to pressure from immigrant members. Now the SEIU and other unions are actively encouraging Central American immigration, and an end to deportations of illegal immigrants. The SEIU is an enemy of the white working class, and the white working class knows it. This is the central conundrum of the Democratic party.

The American worker of today is competing with millions of undocumented Central American immigrants who are driving the price of unskilled labor to Central American levels. Until the wages of American workers are driven down to Guatemalan levels, the supply of eager Guatemalan workers will continue unabated. The US simply cannot have income equality and an open border.

Does the hard-core Left understand the contradiction between its pro-labor posturing and its anti-labor immigration policies? I think it does because the hard-core Left is not interested in working class living standards. What the Left desires is a large and impoverished state-dependent proletariat that votes Democrat. The combination of impoverished immigrants and impoverished native workers creates a natural dependent constituency for the Democratic party (or so they believe). A large, prosperous and non-dependent middle class is an enemy of the Left, which Marx and Mao understood. (Hence, the marxist need to liquidate rich peasants and the petit bourgeoisie.)

When Thomas Frank, Joan Walsh, Paul Krugman and others argue that the white working class "votes against its economic interests", they reveal their misunderstanding of the working class's actual economic interests. The white working class lives on the front line of leftist immigration and racial-preference policies, and understands its economic interests much better than its friends in Manhattan and Cambridge. 

The reason that the white working class has become conservative is not because they are stupid; they have become conservative in reaction to unrestricted immigration, the aristocracy of federally protected ethnic groups, and the growth of state-dependent classes who don't pay taxes. The difference between the Democratic coalition and the working class is that the working class actually works for a living in the private sector. White blue collar workers now vote Republican, something that Harry Truman would have real trouble understanding.

The Left has no understanding of how labor markets actually work, and what that means in the lives of actual working Americans. The Volvo community are still playing Pete Seeger records and watching Oscar-winning movies about Nelson Mandela and Cesar Chavez. They don't understand that it wasn't the capitalist class which voted for George Wallace, and it wasn't the working class who voted for George McGovern. The working class always and everywhere hates enforced "equality". Just ask the Poles, the Estonians, the Cubans, the Slovenians, or the Ukrainians. No workers want state-imposed "equality".

Globalization Of Manufacturing

Another policy change that would materially help the American worker would be to give up on "free trade" with China and impose tariffs and other trade barriers on its manufactured goods until it ends its mercantilist currency policy and allows the bilateral trade account to balance. The US needs to do to China what it did to Japan in 1971 and 1984--force it to appreciate its undervalued currency. China's one billion potential workers pose a mortal threat to every person working in manufacturing in the industrialized world. China has hundreds of millions of penniless peasants who are not yet employed in manufacturing, but who will be soon enough. The productive capacity of these potential workers has the potential to wipe out millions of jobs in the West.

In an earlier post about the Chinese threat, I wrote:

China’s manufacturing potential is so huge that within a few decades its output could exceed that of the the rest of the world combined. The world's central problem is that China is simply too big to be neatly inserted into global trading system. When countries like Guatemala or Bangladesh seek to grow exports, they can do so without affecting markets or hurting competitors. By contrast, China at its full potential is a Panzer tank at Tiffany’s. For China to succeed in implementing its development plan, it will have to destroy the world. China’s national development strategy compels it to wreck everyone else’s manufacturing economy. This is economic warfare, with Chinese characteristics.

I will note that, despite its promises to revalue the yuan, China’s latest currency "reform" has depreciated the yuan, which cheapens further its already cheap exports. So much for its empty promises to appreciate the yuan. It has been well reported that China exerts political influence in the US by funneling money to friendly politicians in both parties. This helps to explain why Congress has helped China to destroy America’s manufacturing industry. (Just imagine how things would be if Ambassador Huntsman had been elected president!)

If President Obama wants to do something to improve living standards for the working class, he will follow Mitt Romney’s advice, declare China to be a currency-manipulator, and ask Congress to impose countervailing tariffs. It should be just as easy for Chinese companies to export their manufactures to the US as it is for American companies to export manufactures to China--i.e., impossible. Ask Apple how many Macs it has sold in China.

There are elements on the Left, particularly the manufacturing trades, who understand the corrosive effects of one-way free trade with China. Many politicians in both parties will freely admit that China flouts its treaty obligations under WTO. Some courageous senators (Chuck Schumer and Lindsey Graham) have gone so far as to actually introduce punitive tariff legislation, but their bill was killed by the Bush administration*. Such a bill should be revived and enacted and should be labelled "The American Working Class Recovery Act".

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*AP, 9/28/06: "Two U.S. senators said Thursday that they will abandon legislation that would have punished Chinese goods with steep tariffs. The lawmakers promised, however, to renew efforts next year meant to spur Beijing to change currency policies they say cost millions of American jobs. Sen. Lindsey Graham, a Republican, said President George W. Bush met with the lawmakers Thursday, asking them to scrap this week's vote on a bill that would have imposed a 27.5 percent tariff on Chinese products coming into the United States unless China went further to revalue its currency. Bush, Graham said, wanted lawmakers to give new Treasury Secretary Henry Paulson more time to persuade China to take steps to allow the yuan to strengthen against the dollar. Critics say China's currency is undervalued by up to 40 percent, making Chinese goods cheaper for American consumers and U.S. products more expensive in China. Chinese leaders have said they plan eventually to let the yuan trade freely on world markets, but that doing so immediately would cause financial turmoil and damage the Chinese economy. The senators have expressed hope that Paulson's personal connections in China can resolve a three-year-old impasse that his predecessors at the Treasury Department could not fix. Paulson made some 70 trips to China while at Goldman Sachs to drum up business for the investment firm."

The Outlook For Stocks And Bonds: Still Bullish

Let’s begin with the meta-phenomena: money and credit growth. At present, both are quite weak. Money is growing at 6% which is too slow, given the current rates of inflation and nominal growth. Credit growth, which was contracting for a long time after the crash, has finally turned positive at an anemic 3.5%. Household credit growth has turned the corner and is now growing at 1%, which doesn’t cut it, while business credit growth is doing well at 8.5%. Federal credit growth--which sustained the economy during the recession--has now declined to 6.5%, which is still supportive. The weak link is household credit, which reflects the wounded housing market. The picture is therefore one of positive but weak money and credit growth.

Next, the outlook for bonds. Bond yields have risen sharply since 2012 (from 1.5% to 2.8%), despite a decline in inflation from 2% to 1.1%. The bond market appears to have mistakenly assumed that QE would accelerate money growth, which it has not. Money growth has been steadily declining since QE3 was announced in September 2012. I see no reason for bond yields to rise any further, and I think that yields are vulnerable to negative shocks, such as weak employment or nominal growth. Consequently, I am bullish on bonds, which translates into being bullish on stocks.

Stocks are no longer the screaming buys that they were when the Dow was at 11,000 in October, 2011. The equity risk premium has declined as prices have risen by 45% since then. But stocks are still more rewarding than the alternative asset classes: bonds, cash, metals. Stocks still have an attractive forward earnings yield (6.3% on the S&P), which compares favorably to bonds (2.8%), cash (0%), and metals (0%). As corporate earnings continue to grow (in the single-digits) and bond yields decline, the equity risk premium should widen, making equities a bit more attractive. The Fed is still paying investors to hold stocks and penalizing them for holding cash, bonds or metals.

I don’t expect robust earnings growth this year, given 4% nominal growth. But I do expect some EPS growth, especially for those companies using free cash flow to shrink their float. While topline growth may be slow, overall profitability is high, which leaves plenty of room for return of capital to shareholders.

When the Dow was at 13,000 in December 2012, I said that it would go to 15,000 by yearend; in fact it overshot my forecast and went to 16,000. For 2014, I expect the Dow to close the year about a thousand points above where it is today. That would be in the range of 17,000 to 17,500.

I see nothing coming out of the Fed in the near-term that would change this calculus. Although Yellen is a dove, there is no evidence that she plans to shake things up. Like Bernanke, she will seek consensus and do nothing radical. Money growth, inflation and nominal growth will remain subdued. The real funds rate will remain higher than it should be. Nonetheless, the business cycle is on the upswing.

The Unsound Doctrine Of Sound Money

There is a dangerous economic philosophy which threatens both capitalism and freedom. Like most isms, it is not the product of centuries of encrusted tradition, but is instead, like communism and fascism, based upon a radical philosophy which casts aside most of human learning and seeks to restore an imaginary golden age.

The Austrian School

This philosophy is called Austrianism, or the Austrian School, after Ludwig von Mises, Max Weber, Murray Rothbard, and other ultra-libertarian economists (but not Milton Friedman, a monetarist). Austrianism can be described as radical libertarianism, the antithesis of marxism (in fact it is a reaction to marxism). It is predicated on the notion that markets are perfect, and that government intrusion is always an error from both an economic and moral perspective. It is extreme capitalism, what was known in the 19th century as liberalism.

One of Austrianism’s chief tenets is that fiat-money central banks are among the most pernicious aspects of government intervention, and should either be abolished or replaced with the gold standard, private currencies (Bitcoin) or, as a last resort, a zero-discretion policy of price stability (e.g., the ECB). In the Austrian view, discretionary fiat money central banks are the cause of economic and financial instability, not their solution.

Austrianism turns Anglo-American economics on its head. Austrians believe that everything that Anglo-American economists (Fisher, Keynes, Samuelson, Friedman, Krugman) have learned and taught about money policy over the past 80 years is wrong. The edifice that is the modern financial system--a central bank which controls the money supply, a regulated banking system, the financial safety-net, deposit insurance, moderate inflation--is rejected.

The Austrian golden age was the period before central banks and deposit insurance. Such a golden age was 19th century America, when the dollar was bimetallic, bank charters were sold like lottery tickets, deposits and bank notes were understood to be risk assets, the money supply was determined by the credit cycle, and the only role played by government was the minting of bullion into coins of a specified metallic content.

The Business Cycle Is Prophylactic

Less extreme Austrians, today’s sound money community (see: Bundesbank, WSJ, Rand Paul) accept much of the architecture of today's  financial system, except for the notion that an appropriate role for the central bank is to encourage growth, employment or financial stability. The sound money community argues that price stability maximizes long-run growth and employment, and that the business cycle (including financial crises) is natural, prophylactic, and necessary: the instrument of Schumpeter's creative destruction. The business cycle is seen as an essential element of capitalism. (Marx saw the business cycle as an inherent contradiction of capitalism: the periodic instability and depressions which impoverish the proletariat.)

In the realm of abstraction, I am agnostic on the sound money question. I understand the rationale, that the business cycle is necessary and prophylactic. How can I say such a thing, given what happened under Hoover? Because the US operated successfully with a hard money system from 1791 until 1933 (excluding the Greenback Era). From 1791 until 1933, the US experienced price stability (the dollar price of gold remained unchanged at $20) and also brutal decennial "business depressions". Despite these depressions, average economic growth rates were very high by any historical measure.

Those periodic convulsions were prophylactic, purged the system of inefficiencies, and made room for innovation and efficiency. Impoverished workers were the necessary collateral damage. Wages and prices were flexible, employment was volatile but tempered by wage flexibility. Instead of starving, workers worked for less. Victorian liberalism.

Of course, much of the growth of the US economy over this 140-year period can be attributed to immigration, continental expansion and the industrial revolution. But the fact remains that the US enjoyed strong growth in the face of hard money and periodic deflations. Real growth often exceeded nominal growth, something unimaginable today. The golden age of hard money really did exist. It wasn't a golden age if your family starved to death (as many did in the 1870s and 1890s), but society as a whole prospered.

Democracy And The Business Cycle

The problem with the golden age of sound money is that it was accompanied by increasing universal suffrage: the masses were increasingly allowed to vote, and they voted for inflation, wage stability and job security. By the mid-20th century, the masses had won almost all of their demands: a dual-mandate central bank, counter-cyclical monetary and fiscal policy, the right to bargain collectively, unemployment insurance and wage stability. American capitalism accommodated itself to the democratic revolution by producing the New Deal, which went a very long way towards addressing the marxist critique of capitalism, and staving off the communist alternative.

In 1947, Congress passed the Employment Act which ultimately led to the dual mandate for the Fed: not only price stability, but also economic growth (full employment). That is how we got to where we are today, when we expect the Fed to smooth out the business cycle and prevent depressions. Anglo-Americans live in a world in which the Quantity Theory is a given: by controlling the money supply, the central bank can determine the rate of nominal growth. All English-speaking central banks believe this.

Keynesians like Krugman, Summers and Obama believe that fiscal policy is an indispensable partner for monetary stimulus, but they do not discount the importance of monetary stimulus. Austrianism is almost nonexistent within the US economics profession, and--aside from a handful of Paulistas--almost nonexistent in Congress. The American debate is between the Keynesians (fiscal + monetary) and the monetarists (money alone). No one in America, besides the Austrians, is arguing for a single mandate which ignores growth and employment. To paraphrase Richard Nixon, "We are all monetarists now."

Germany Is Austrian

In Germany, it's different. In Germany, both monetarism and Keynesianism are not only discredited, but seen as heretical. Most German economists and politicians--on both the right and left--are Austrians. They believe that price stability (the hard Deutschmark) was an essential component of the postwar wirtschaftswunder, and that price stability will--over time--bring the rest of Europe up to German standards of discipline and prosperity. The Germans believe that what is happening in the eurozone is prophylactic, that the excesses of undisciplined fiscal and monetary policies are being squeezed out, and that the faster they are purged, the sooner Europe will start growing again. Hence Draghi's constant refrain that the resumption of growth depends on deeper structural reform.

What Germany wants to do is to to usher in a new golden age of sound money in which the business cycle is allowed to operate, wages are flexible, and parasitic state-dependency is abolished: Mellonism.

Andrew Mellon, Hoover's economist, saw the Great Depression as necessary and prophylactic, and saw no reason to interfere with it. The millions of unemployed were necessary to drive down wages (now termed “labor market flexibility”). Mellon may not have been aware that the US money supply was contracting on his watch, but he would have agreed with the Fed that this was a natural consequence of the cycle: there is less demand for money during a depression.

Our interwar experience was the opposite of Germany's. Germany experienced hyperinflation, while we experienced deflation. (Germany experienced deflation too, but doesn’t choose to remember it; it was deflation that destroyed Weimar, not inflation.) Hence, Germany is Austrian, while we in the Anglosphere are all monetarists and/or Keynesians.

The Anglos and the Teutons approach the macroeconomy from such different perspectives that we can barely talk to each other. Our universities teach economics differently, and we don’t translate enough literature into each other’s language. Germans don’t use our textbooks and vice versa. Bismarck was right about the language barrier.

The Fed's mantra is that it is doing everything it can to stimulate growth and employment, while the Bundesbank's mantra is that any attempt to use monetary policy to address the  current eurozone depression is dangerous and will destroy the progress that has been made and remains still to be made. Imagine Janet Yellen explaining to Congress that high unemployment is a necessary feature of her monetary policy! Weidmann and Draghi have no problem explaining that high employment is a necessary consequence (or predicate) of structural reform. Our economists inhabit different planets and respond to very different public expectations.

I won't say that Austrianism is wrong, per se, because it worked in the past and actually functions today in Hong Kong. What I will say is that, after the experience of the Thirties, those who desire to preserve capitalism and free markets must oppose Austrianism because it is the handmaiden of welfare socialism (Obamaism). Andrew Mellon thought that he was restoring the golden age, when what he was really doing was forcing the proletariat to choose between welfare socialism and starvation. The masses chose welfare socialism by a landslide, in five consecutive presidential elections.

The Anglosphere has learned the lesson that depressions feed welfare socialism; Europe hasn’t. Free market capitalism is being discredited in Europe today, as the masses are forced to endure penury in pursuit of “structural reform” and "labor market flexibility".  The ECB's debt-deflation policy is a very blunt instrument to use against market rigidities and fiscal indiscipline. Fiscal austerity and structural reform--if they are really needed--must be offset by strong monetary stimulus, such that NGDP and employment continue growing. (The higher the rate of inflation, the less fiscal austerity is required, which no one on either continent understands.)

Europe is (or should be) slowly learning what the Anglosphere learned 80 years ago: democratic capitalism requires prosperity and and a dampening of the business cycle. That means competent monetary policy which delivers moderate inflation and moderate nominal growth. Price stability in an environment of sticky wages is deflationary and leads to depression and welfare socialism.