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Profiting from Monetary Policy: Investing through the Business Cycle - An interview with Thomas Aubrey

Thu, 14 Mar 2013 05:25:00 GMT



In this second interview in a new series with Authors about their recently published books, I talk to Thomas Aubrey about his new title: 'Profiting from Monetary Policy: Investing Through the Business Cycle'.

In a wide-ranging discussion we talk about the flaws in modern macroeconomic theory, the idea of consensus in economics, the credit-based theories of Wicksell and Hayek and much more.

Thomas was a business consultant before moving into running economic and credit analytics businesses. He is the former Head of Datastream, Economics & Fixed Income at Thomson Financial and more recently was the Managing Director of Fitch Solutions.

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Jacob Bettany: Thanks very much for joining us Thomas. Could you begin by telling me a little about your background and what motivated you to write the book?

Thomas Aubrey: Well my academic background has been a combination of studying the history of economic and political thought in combination with mathematical economics. What has always driven me though in my studies has been trying to understand the internal dynamic of capitalism and I don’t think that can be well understood if you just study economics. There are too many other forces and factors impacting the development of society even from the economic standpoint. After I left graduate school pretty much all of the career decisions I made have given me a different perspective on the nature of capital, whether it’s turning around failing businesses as a consultant or running economic and credit analytics businesses. And I’ve always been interested in thinking about how these experiences provide different insights into the dynamic of capitalism.

The genesis of the book itself goes back to 2002 when I spent a year or so researching and modelling the volatility of the UK housing market. The model I’d developed was signalling that during 2003 the UK market was overvalued and was ready for a correction. But of course the market kept going up and I realised that something was not quite right with the standard approaches to economic modelling. As part of this research I did spend quite a bit of time looking at Wicksell and Austrian business cycle theory to help explain the volatility of the UK housing market, but I didn’t use the ideas of Wicksell and Hayek in any empirical way. That’s mostly because both Wicksell and Hayek were pretty negative about their theories being empirically tested.

In 2006 with house prices still rising I thought there must be something that I can test based on the credit theories of Wicksell and Hayek. And that’s when I started to think how I might be able to use company fundamental data to indicate what a natural rate of interest for an economy might be. That led on to a lengthy period of research, which eventually turned into a series of articles published by Thomson Reuters. That research provided me with some initial estimates that throughout the period of the Great Moderation most of the developed markets had actually been in a state of substantial disequilibrium when looked at from a credit perspective.

Clearly that was a completely different result from the standard macroeconomic modelling approaches that the central banks had been using. Central bankers had been arguing right up until the cusp of the crisis in 2007 that the economy was oscillating around equilibrium as they had successfully minimised fluctuations in output and inflation. However in reality most advanced economies were seeing a substantial disequilibrium effect right through the period.

As for why I decided to write this book, there were a couple of triggers. The first was definitely reading Willem Buiter's superb FT blog, maverecon. He wrote a brilliant article ‘The unfortunate uselessness of most ‘state of the art’ academic monetary economics’. So here was a renowned monetary economist stating publicly that the underlying macroeconomic theory was fundamentally flawed.

The second thing was seeing the huge negative impact on pension returns due to the crisis. Clearly there was a cause and effect happening here, where investors were dependent on a fundamentally flawed macroeconomic framework, which in turn led to massive losses. So it struck me that what was required was a more detailed exposition of Wicksell’s theory and how investors could use it to prevent capital destruction. It probably took just over a year to get all the data together as well as going back to my initial research on Wicksell and Hayek. Then I put pen to paper.

JB: In terms of the structure of the book – how did you go about organising it?

" its heart Austrian theory is about capital. It’s not about whether the state is big or small. I mention in the book that the debate we’ve had for the last four years of austerity versus stimulus is just extremely unhelpful. It totally misses the point because what matters is capital..."


TA: The core of the book is really the development of the neo-Wicksellian model and all the empirical analysis to validate it – that’s all in chapters five and six. Some of this material had been partially sketched out in the series of articles. However I think with any theoretical work which is empirically substantiated, it’s important to highlight to practitioners’ why the existing framework that they are using is in fact flawed – that was really the focus of the first couple of chapters. Clearly the fact that these models ignored credit, which in many respects is a shocking omission given the importance of credit in the modern economy, suggested that credit-based theories may be a far more appropriate foundation for the way we should think about the economy and the investment of financial assets. More importantly there is a very deep intellectual heritage of credit-based theories which ended up providing an alternative system to the Walrasian General Equilibrium Model. However much of this rich body of thought is mostly forgotten today, so it seemed important to highlight that there is a substantial body of work to back up these ideas.

Obviously at the end of the book there are some implications of this model for investors and how they can avoid capital destruction in downturns by analysing the nature and dynamic of capital. Some of the issues surrounding capital are more medium term related to the economic superstructure, but the crux of the argument is that what matters is the nature of capital and the relationship between credit and capital. This approach is of course largely ignored by investors. However, it is becoming abundantly clear that if you are using a fundamentally flawed theoretical foundation for an investment framework, then you are going to have very volatile returns due to the periodic destruction of capital.

JB: That does bring me rather neatly on to the next question, which is about how this came to be? The idea of a consensus does seem somewhat laughable in economics, so how it is that the prevailing view you describe came about?

TA: That’s a great question and I don’t really have any great insight or answer to that! I think that for me Axel Leijonhufvud at UCLA highlights the problem very eloquently. He argued that economics is just very poor at eliminating errors and he uses a great analogy for economics which is of a very ugly bush, with sap running in unlikely places, whereas the natural sciences tend to be much better at eliminating errors and so you get something resembling a tall redwood!

If you look back at the last sixty years of the history of macroeconomic thought, you see a theory is postulated and then validated by some data. However each time there are anomalies in the data which are apparent but they get ignored. Then of course every so often those anomalies become too significant to ignore and we see the breakdown of the theory itself. The Keynesian models led to rising inflation; the experiment with Friedman’s monetary growth targets didn’t work either, and then we move on to inflation targeting and the theory behind the Great Moderation. In many respects this epitomises the problem where central bankers claimed that it was their management of monetary policy that minimised fluctuations in inflation and output. Of course this theory broke down just like all the others have. Interestingly the Harvard economist Greg Mankiw pointed out back in 2006 that inflation also fell in countries where there was no inflation targeting suggesting that the fall in fluctuations of output and inflation had less to do with how well central bankers were managing the economy.

The real problems then start when the facts no longer fit theory. The challenge is that even if a theory has been invalidated it’s not always clear that one should abandon it completely until there is something else to replace it with. I have used the analogy with Newtonian Mechanics quite a lot. His laws of gravitation did a pretty good job of predicting the path of the orbits of the planets around the sun. However in the mid-19 th century an astronomer looking at Mercury and found that it didn’t follow its predicted trajectory. Astronomers and physicists then spent the next fifty or sixty years trying to demonstrate why Newton’s theory was right. The best explanation they could come up with or the best theory was that there must be some dust between Mercury and the sun which was causing it to move off its projected trajectory. Of course it wasn’t until Einstein’s Theory of Relativity, that in fact Mercury’s trajectory could be properly explained. So until a new theory is in place it is pretty hard to let go of the old one. Better the devil you know than the devil you don’t.

There are lots of examples of economists and investors criticising some of the flaws in the prevailing models, and probably the most interesting contribution has been from George Soros – who has made a lot of money by ignoring the general equilibrium framework. For the last twenty years he has been very open in criticising modern macroeconomic theory. His criticisms however have largely fallen on deaf ears. Perhaps one of the potential issues with his criticism is that his theory of reflexivity isn’t substantive enough to act as the foundation for a major shift in macroeconomic theory.

It is also possible that economics faculties are guilty of group think too. I often go back and look at the work of the psychologist Irving Janis and his research on the failure of US foreign policy in the 1960s. He introduced the idea of group dynamics whereby a group of very highly educated and intelligent people got things wrong because of a need to eliminate signs of tension in the group. You get these problems in science as well, and not just with respect to the whole shift of the Copernican revolution but also in the 20 th century. For instance in Quantum Physics there continues to be a debate about hidden variables. De Broglie the French physicist in the twenties proposed that hidden variables that were non-local could explain a deterministic view of quantum mechanics. Von Neuman, probably the first econophysicist, attacked this theory and said that this wasn’t possible. It wasn’t until the sixties that Bell actually highlighted that there was a flaw in Von Neuman’s arguments, so I think these things happen quite a lot.

The challenge it seems to me, is to get people thinking more clearly and carefully about methodology when it comes to economics, and probably this is where the difference is between social and natural sciences: The methodologies in natural sciences are clearer, and without a doubt one problem you have in economics is that too many economists impose their political ideology on economics. Ironically it was Hayek who was very concerned about this issue despite the fact that many modern Austrian theorists impose Hayek’s political ideas on an “Austrian” analytical framework. I think that’s one of the reasons why Austrian business cycle theories haven’t really been taught in many faculties which is a shame, because at its heart Austrian theory is about capital. It’s not about whether the state is big or small. I mention in the book that the debate we’ve had for the last four years of austerity versus stimulus is just extremely unhelpful. It totally misses the point because what matters is capital and neither of those things actually addresses the issue of capital at all.

So I think that with the propagation question, methodology is definitely a key issue but I don’t see any reason why a consensus couldn’t develop in the future but those methodology issues do need to be looked at in more detail.

JB: Thank you. I guess it’s probably worth talking about the nature of the Wicksellian approach that you are advocating. Can you outline your views and explain why they might be considered controversial?

TA: It’s interesting in a way, because these credit-based frameworks have been around for a long time but they have been ignored by the current monetary policy establishment. I think the main focus of the book was really just to develop an empirical framework, based on this theory that would allow the extent of credit disequilibrium to be measured, which would provide quite dramatically different signals about the state of the economy.

The basic insight of Wicksell’s ideas, which was further elaborated by Hayek and then Myrdal isn’t really controversial at all. Their point is that what really matters in a credit economy is the difference between the natural rate of interest and the money rate of interest. As the natural rate or return on capital increases, the increased profits stimulate demand for credit, which in turn drives further expansion. This of course drives up asset prices through a reflexive process which is what Soros has been talking about for decades.

I think that where it becomes potentially controversial is that banks are central to the process; they are not intermediaries as modern macroeconomic theory argues. Indeed central bank models do not take the instability of the banking sector into account at all which is clearly problematic. The Bank for International Settlements has highlighted this, time and time again, but it’s not clear how you might be able to model such instability within the current framework. Banks can and do generate credit, so this means that the fundamental identity that most economics students are taught between savings and investment, makes no sense whatsoever in a credit economy.

I think the other potentially controversial issue is about how we understand inflation. Most asset bubble models, including those of Hyman Minsky and Charles Kindleberger all assume that inflation is endogenous. This goes back to Irving Fisher, who influenced Minsky, but is central to Milton Friedman and more recently to John Taylor’s ideas. All of these theorists argued that any kind of credit bubble will reveal itself in rising inflation because of the endogeneity of inflation itself. Now, given that we have had quite a few asset bubbles where that didn’t occur, those models are clearly invalidated – it happened in the 1920s in the US, it happened in the 80s in Japan, it happened again in the 2000s in the US. The reality is that inflation and deflation can be both endogenously and exogenously determined and that makes the traditional approach to macroeconomic modelling more complicated without doubt.

There was always the view that came from Friedman’s quantity theory of money which asserts that exogenous impacts on inflation don’t have any impact on expectations, but it’s very hard to maintain that stance. There have been a number of central banks in emerging markets that have raised concerns about non-core inflation. Things like food prices and energy costs. If those factors are rising continuously, it’s hard to see how that couldn’t have an impact on people’s expectations of inflation.

And then of course there is the whole concept of the output gap which I wouldn’t say is meaningless, because I think theoretically it’s a nice idea, but it’s extremely challenging to estimate and more likely, therefore, to generate to misleading signals.

So in many respects the controversy is more around the existing known problems within general equilibrium models rather than the use of credit- based theories. However, on the credit-based theory side there has always been a gap between theory and practice. You have the major proponents of theory suggesting that it’s not practically possible to measure the natural rate of interest which has meant there have been fewer people looking at it. But a great deal of progress has been made, particularly by Myrdal and the Stockholm School. Unfortunately, this whole movement came to an end with the revolution in Keynesian economics post 1945.

In my book there’s a great quote from David Laidler which I think explains why:

“The contrast between the simplicity of the Keynesian message that movements in output and employment were themselves equilibrating mechanisms, a message readily summarised in a diagram that could be embossed on the cover of a text book’, versus the Stockholm school’s complex approach which demonstrated that almost anything could be the outcome of a dynamic sequence is a telling one”.

When the standard neo-Keynesian models were developed, economists thought this approach was a very simple way of beginning to model something very complex. Of course the reality is that the economy is an incredibly complex system and simple models can’t model it, and more importantly complex models can’t model it either!

All you can hope to do with any complex dynamic system - and I think this is the key insight of Mandlebrot from the perspective of statistical physics - is to see what’s coming in and what’s going out of the model, but not really what’s happening inside. This is a key methodological issue that I think economists do need to be prepared to accept.

So my book proposes a practical way of measuring these rates of interest permitting the measurement of the extent of credit disequilibrium. Of course there are challenges with the methodology itself in terms of estimation, particularly for smaller economies due to data limitations - but in larger economies it does provide a reasonable proxy for the two rates. The challenge in the end is that although practitioners do a good job of understanding what’s wrong with their systems and their models, it’s a different exercise completely to bin them altogether.

JB: In the absence of an alternative it makes it harder to switch your basis?

TA: Yes, but there are alternatives within monetary economics. – For instance there’s potentially enough data around to look at implementing a credit based system based on the productivity norm. The productivity norm, which was promoted by Hayek and Myrdal and more recently by the economist George Selgin is a much more sensible way of thinking about the equilibrium of an economy. But given the critical flaws we’ve had over the last fifty or sixty years, I think a lot more research is going to have to go into any new monetary framework. Moreover, it’s going to be hard for the current generation of economists to completely change what they’re doing and start using something else. Perhaps in the next ten or twenty years we might see a very slow shift towards a focus on credit but I don’t see there’s much appetite for a big change despite what happened.

JB: The title of the book is ‘Profiting from Monetary Policy’ which suggests that, irrespective of any new model one might hope to implement, it’s possible to make money from the old model? Are you saying the fact other people are using the old model means that there’s an opening to exploit it?

TA: Yes. Lots of people have commented on the interventionist nature of monetary policy as causing problems and therefore opportunities. The Greenspan Put is clearly one of those. But I think the heart of this issue really goes back to the question what should be the role of monetary policy?

I think Friedman was right in his ’68 paper that it ought to be neutral because as far as he was concerned monetary disturbances are a bad thing. The problem is that if you look back over the last sixty years of monetary policy, the policies pursued haven’t been neutral at all. They have all created this disequilibrium effect rather than an equilibrating effect and this disequilibrium is therefore creating the opportunity for investors. So it’s pretty clear that this interventionist monetary policy has been fuelling boom and bust. I think that’s partly because, whether anyone would like to admit to it or not, monetary policy is fundamentally politicised. The fact that in a downturn governments look to monetary policy to try to stimulate the economy is clearly backing up that case.

There may well be arguments that monetary policy shouldn’t be neutral and that Friedman was wrong but I think the reason why Friedman argued this in the first place was that he felt it was very hard to predict the impact that interventionist monetary policies might have, such as rampant inflation or huge credit bubbles.


For me this really highlights that as long as investors are aware that monetary policy almost by definition is creating this disequilibrium effect, as long as they are looking at the right indicators they can make the appropriate investment decisions. I think that what happened throughout the great moderation was the view that monetary policy was in fact neutral. Take something like the Taylor rule and that by minimising fluctuations in output and inflation the economy would be oscillating around its general equilibrium. If that were the case then clearly a Buy and Hold strategy would have been perfectly sensible but of course what this missed was the huge build-up of credit. If you had been looking at that, you would have seen that pretty much the last thirty years of monetary policy has been highly interventionist, so investors who did think about the nature of credit disequilibrium have done a fantastic job of generating robust returns for their clients. Unfortunately if you look at the OECD Pension returns data for the last decade, most investors have hardly generated any returns at all. That’s because investors believed that central bankers by minimising the fluctuations in inflation and output, the economy was operating around equilibrium, therefore future returns should be the same as historical returns.

JB: So in this case people were lulled into a false sense of security?

TA: Exactly. To me the main issue is that you don’t have to lose your money just because of what central banks are doing. In reality we are dealing with a complex system but there are usually general trends that can be observed, and the fact is that by looking at credit, investors have been able to consistently beat the market by a substantial margin for the past forty years. This shows there are ways of doing it, but you are less likely to find those ways if you don’t understand the nature of credit.

JB: You advocate what you call low cost business cycle tracker funds, which you describe as an index fund based on a foundation of dynamic disequilibrium. Could you just briefly describe what you mean by that? And what the immediate impacts would be in your view?

TA: The product concept is just a very simple asset allocation switching strategy based on the ex-ante natural rate of interest, the expected return on capital. That’s obviously very closely linked to the rising demand for credit, which is therefore providing a proxy for profit expectations and good for equities. Falling profit expectations are going to be better for bonds or cash if you expect yields to jump dramatically. Now sometimes actual prices do become disconnected from fundamentals, so I am not arguing that this is going to be the most profitable strategy, but what I think is important about this investment strategy is that it will indicate when to move out of equities before a big downturn and therefore reduce the volatility of returns for investors like pension funds. If you look at where the vast bulk of pension assets are invested they are mostly in buy and hold funds benchmarked against an equity or bond index. Unfortunately this approach has not been able to mitigate the effects of massive volatility. Although active investors who use credit-based frameworks can continue to generate large profits, if the market did move towards such an approach in large numbers there would of course be some impact on the dynamic of the market itself.

I’d expect to see the wilder gyrations of equity market highs and lows curtailed. As falling profit expectations are signalled, investors would begin to switch out so there would be less pressure to drive a bull market to its excessive highs. As a consequence the falls wouldn’t be as large either. But I think within these narrower constraints, it would create more price volatility. This is just a function of the fact that if you have more funds being active when it comes to asset allocation there would be a bit more volatility.

JB: In the book you talk about the fact that some of the most successful investors in the last twenty years have been somewhat heterodox. If the approach you are advocating was taken up, and became more mainstream, would that reduce the returns for those investors employing it?

TA: I don’t think so. The main aim of the book was to provide a framework for low volatility funds for pension schemes that offer reasonable returns by permitting the broader market to reduce the exposure to such catastrophic falls. These are investment strategies that are never going to generate the kind of returns that one sees from the likes of Bridgwater and Soros Fund Management. I don’t see that active investment strategies would necessarily be that impacted. Maybe to the extent that you wouldn’t get such highs and lows in the equity market and for those who are able to pinpoint those turning points more accurately, then sure returns may fall slightly, but there’s still a lot of money to be made by active investors that can use leverage and those managers who can get closer to those turning points. Moreover, the risk return profiles of savers are going to be different. Some may not want to have a fund which is generating 7-8% year in, year out; that may not do it for them. So I think that there is always going to be an array of different kinds of funds to accommodate those profiles.

JB: One final question. How hopeful are you that some of the approaches outlined in the book might be taken up? Are other people thinking about them?

TA: Starting with the monetary policy issues, I don’t really see anything changing much there. The Bank for International Settlements has been highlighting these issues for over a decade and there are few if any signs of change. The latest fad of NGDP targeting almost takes us back to a quasi-Keynesian approach, which, in inflation-prone economies like the UK are not going to help in anchoring inflation. Charles Goodhart has written about that quite extensively. Realistically, the political pressure on central banks to stimulate the economy to make up for the failings of government policy will mostly cause further credit disequilibrium so I think in terms of a macroeconomic policy I am very doubtful that anything will change in the medium term.

So it comes back to the issue that if we are likely to get more credit disequilibrium – which we are – how are investors are going to take advantage of that?

I think what’s been missing for a large portion of the industry has been a more detailed theoretical exposition of why credit based macroeconomic theories can be helpful. When most people study finance 101 they learn about the capital asset pricing model, which is entirely based on general equilibrium - so pretty much most of the current investment framework is based on a macroeconomic model that is fundamentally flawed. As such investors are going to have to be comfortable with credit-based theories before they are going to make any major shift. However fund management companies are constantly looking at how they can build new products that can offer more appropriate risk-return profiles to the asset owners. Indeed, new product ideas may well become increasingly important to attract new clients given that the last decade of returns has been so poor. In this sense I don’t think there’s any reason why some of the larger relative index-based fund companies like Vanguard, Blackrock or PIMCO couldn’t start developing these kinds of funds. By the same token there’s no reason why some of the very successful global macro hedge funds couldn’t enter into the low cost business cycle tracker funds as well.

To be frank, I think the real challenge is going to be with pension fund trustees and for them to accept that buy and hold isn’t going to provide them with the returns they need just as active stock selection strategies have mostly failed. The key to returns has always been around asset allocation but it may take another crash in the value of capital before pension fund trustees make that decision and change. This is a conservative industry and rightly so, but at times it does need to reflect more and think about whether the traditional approach to investing remains appropriate for the vast bulk of savers. And that debate does need to take place. In the short term I think it is unlikely that we will see business cycle tracker funds taking in a large amount of assets in. Having said that I think in the medium term there will be a shift in thinking away from these general equilibrium models towards a credit disequilibrium approach. Pension fund trustees will eventually realise that there is a different way of thinking about financial markets and investment theory. This flow of assets will then permit the fund provider’s products to become more profitable for them to run which should lead to lower fees. But it will take time.

JB: I guess it’s a question of demand, isn’t it? Once you’ve got pension funds that are recognising the value of the product, which may be hypothetical at this point but which is potentially useful, then people will start providing that product.

TA: Exactly, yes.

JB: Thank you very much Thomas. It’s been great to talk. All the very best with the book and your future activities.

Profiting From Monetary Policy


“This book is learned, witty and convincing. Mr Aubrey draws adroitly from historical data and the history of economic thought to discredit much of ‘modern’ macroeconomic thinking. Rather, he supports a ‘Neo-Wicksellian’ view that puts credit and leverage at the heart of serious economic downturns. His practical guidance to asset managers, hoping to profit from identifying emerging disequilibria, is an added bonus.”

Dr. William White, Chairman of the Economic and Development Review Committee, OECD and former Economic Advisor for the Bank for International Settlements

“Thomas Aubrey has done an impossible thing. He has used good but somewhat forgotten theory to the practical purpose of telling people who may wish to invest how to avoid the pitfalls of boom and bust. His book is readable and useful and he argues his case convincingly. Read him and you may learn more than just good economics.”

Professor Meghnad Desai, London School of Economics and Political Science

“The ideas of Knut Wicksell – Sweden’s most famous economist – have come to play a central part in modern economists’ understanding of the business cycle. In Profiting from Monetary Policy Thomas Aubrey performs the much-needed service of bringing those same ideas to the attention of investors, so as to better enable them to anticipate, withstand, and even profit from, financial booms and busts.”

George Selgin, Professor of Economics, University of Georgia and Senior Fellow, The Cato Institute.

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