A Song of Ice and Fire
Epsilon Theory
May 27, 2019·13 comments·Money
Central banks have spent a decade assuming that lower interest rates work the same way at 0.5% as they do at 5%. But something changes when the price of money gets cold. Rational investors stop building factories and start buying back stock. The theory that guides policy says this shouldn't be happening. The economy suggests otherwise.
- The linear assumption is breaking. Central bankers expected ultra-low rates to spur risk-taking and inflation the way lower rates always had. Instead, each rate cut is met with the same result: nothing moves.
- Behavior flips when rates approach zero. Investors who would rationally borrow and spend at 4% stop doing so at 0.5%. They're not being irrational. They're responding to what zero rates actually signal about growth and the future.
- The economy has shifted to financialization instead of production. Stock buybacks, profitless revenue, and oligarchification have replaced investment in property, plant, and equipment. This isn't a market choice. It's the rational response to a broken theory.
- A macro theory of money is running into the limits of how it works. Like the physics of water itself, money has properties that don't follow the expected rules at extreme conditions. Macroeconomics can't see them because it operates at the wrong scale.
- The gap between what policy assumes and what actually happens is widening. Until the underlying theory changes, central banks will keep lowering rates and keep wondering why nothing works. What breaks first: the theory or the economy?
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Comments
Loved it Ben !
Great note - thanks.
And this is why I subscribe to, read, and re-read Epsilon Theory.
Elegant writing. Here in the UK we are fighting Yay, Europe!
Really smart stuff. I’ll probably have more of my, as always, not-nearly-as-smart stuff to say after I’ve read it again / studied it, but even the first time through, you know this one is special.
Quick thoughts:
I feel really bad about the bees (an early ET piece turned me into a huge bee fan)
Good for the goldfish / what did they eat all winter?
Love the macro clockwork machine versus bonfire analogy
Brilliantly developed and argued, but the non-linearity of money should be obvious to the Fed by now or, at least, it should get that funny things happen around zero rates (like Newton’s laws in the subatomic world)
I’ve seen change happen in the corporate world the way you describe it - it can happen, but as you note, it needs a high-level advocate and time.
Agree with you Mark - I also felt pretty sad about the bees…
Great piece, Ben! Non-linearity and the fallacy of extrapolating the present indefinitely into the future are like pride in a Greek tragedy. Felt like a mini-reread of “Ubiquity, Why Catastrophes Happen”. I’m reminded of the 1800s futurist who predicted that there would be 4 feet of horse dung in the streets of NYC by 1945 based upon population growth, need to move foodstuffs and waste around, etc…totally missing the invention of car/truck. Nuf sed.
I differ with your statement re low risk re stock buybacks versus investing in plant and equipment. It only looks risk-free/lower risk NOW because the consequences have as yet been realized. Here too, the non-linearity that is the unwind of bovine investor herding, complacency, lack of volatility, passive indexation, lulling of investors by way of political utility, etc. will eventually kick in an manifest itself in super-geometric fashion via the explosion of risk aversion…the equivalent of yelling “fire” in a crowded theatre. Haul-ass, bypass, and Re-gas!
Beautiful, very well written. The only macro/economic writing I read that stirs up real emotions.
Am I wrong to be troubled by how much sense this well-developed line of thinking continues to make, and how little our current reality and predictable (such as it is) future does?
Rhetorical question, of course.
Please keep up the excellent work, Dr. Downer, and I’ll keep reading.
I loved this piece and as usual it has me staring out across the irish countryside wondering what other stories and narratives are gestating as suitable metaphores for our human reality. And then I realise, of course (Duh! as the two generations below me on the ladder might put it) that all systems are organic and bio-dynamic and we should never be surprised (Duh!) that life behaves according to the non-linear determinations of the natural world - with all its extraordinary potential for surprise, decimation and regeneration. Just ‚coz we don‘t understand it doesn‘t mean it ain‘t so. Or words to that effect.
One quibble: Tithes can‘t be extracted. They are always volontary. That is the point of them. Taxes, penalties, fees, fines, levies and even seigniorage can be demanded and extracted by force, but not tithes.
Best wishes and as always thank you for your service to the cause of truth-seeking.
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