M.C. Escher and the Impossibility of the Establishment Economic View

escher bernanke yellen elmendorf

It’s easy to show that public institutions such as the Federal Reserve and Congressional Budget Office (CBO) are routinely blindsided by economic developments. You only need to compare their past predictions to real events to see these organizations’ deficiencies.

More importantly, we can demonstrate that their struggles are all but certain to continue. This may sound like a difficult task, but we’ll argue that it’s easier than you think. Using historical data and basic economic concepts, we’ll explain not only why the establishment view is wrong but that the underlying principles are fundamentally flawed. The implication is that existing policies are destined to fail.

To make our case, we’ll start with the CBO’s current forecasts for real per capita GDP (economic growth net of inflation and population growth):

escher chart 1

Our regular readers already know that the CBO is abnormally bullish on near-term growth, based on its long-standing assumption that the gap between actual and potential output will swiftly close. But this won’t be our focus here. In fact, we’ll assume the CBO gets this part of its outlook right. We’ll be shocked if it does, but let’s pretend.

We’ll then examine the forecasted path for interest rates:

escher chart 2

The interest rate outlook is an offshoot of the policy establishment’s overall approach. Monetary stimulus is expected to be removed as it guides the labor market toward full employment, allowing interest rates to return to normal levels.  At that point, natural economic forces are believed to be strong enough to preserve a normal, healthy economy. Establishment economists have near complete faith that this is a sound and reliable process.

But closer examination reveals a few cracks. Consider that the chart above shows quite a jump in interest rates, which begs the question: How will the economy weather such a development?

We’ll look to history for possible answers. We calculated the change in rates on three month Treasury bills for every eight quarter period since 1953, which breaks down like this:

escher chart 3

We then reviewed past economic outcomes conditioned on the rate buckets above. Note that the forecasted 2015 to 2017 rate change of 3.2% (the leap from 0.2% to 3.4% in Chart 2) falls in the final bucket. Therefore, this bucket is especially relevant to the economy’s likely performance in the next rate cycle. We circled it in the charts below:

escher chart 4

escher chart 5

escher chart 6

While the results speak for themselves, I’d be remiss if I didn’t add qualifiers. For one, the sample sizes fall as you move from left to right across the charts. Moreover, history doesn’t always foretell the future; this time could be different.

But the thing is: the data makes perfect sense. Higher interest rates have obvious effects on risk taking and debt service costs. It stands to reason that the economy won’t just sail through the large rate hikes needed to restore historic norms.

If anything, the charts likely understate the future effects of rising rates, because today’s debt levels are far higher than average historic levels. Any normalization must also include a wind-down of unconventional measures such as quantitative easing, which presents additional challenges.

Yet, the official outlook calls for steady improvement both through and beyond the rate jump. As shown in Chart 1, the CBO predicts that per capita GDP growth will accelerate to over 3% before settling back to a trend rate of 1.2%.  Forecasts for 2018 and 2019 average a healthy 1.5%, despite the figures in Chart 5 showing virtually no growth after large interest rate increases in the past.

Here’s the corresponding outlook for employment, followed by two more reasons to expect forecasts to fail:

escher chart 7

escher chart 8

escher chart 9

(See here for background on the corporate leverage multiples and here for more on the stock valuation figures.)

In a word, the CBO’s projections are preposterous. They ignore effects that are clear in the data and obvious in real life. But the charts reveal more than just forecasting flaws at a single governmental institution. More broadly, the assumption of a smooth and lasting return to normality is standard practice for mainstream economists, particularly those at the Fed.

Essentially, economists are hardwired to focus on the near-term effects of policy stimulus, while overlooking long-term effects that are often far more important. Standard models fail to account for either natural cyclicality or the payback seen in Charts 4 to 6. Although establishment economists often speak about sustainable growth, they really mean any growth that restores GDP to where they believe it should be. They don’t seriously contemplate the unsustainable growth that occurs when the economy is over-stimulated through credit and financial asset channels. And the charts above demonstrate these deficiencies.

Worse still, this analysis doesn’t tell the whole story. We could have easily tripled the chart sequence with other indicators of Fed-fueled credit and asset market froth – from record margin debt to lax loan covenants to soaring public debt – that also show heightened risks of another bust.

We suggest giving some thought to the data shown above and considering its message for the future. Send it to the smartest people you know and get their opinions. In the meantime, here are our conclusions:

1: Even if the economy returns to full employment under existing policies, it won’t remain there after (and if) interest rates normalize.

2: Based on today’s debt and valuation levels (charts 8-9, for example), rising interest rates will have an even harsher effect than suggested by the 60 year history (charts 4-6).

3: Contrary to the establishment’s “sustainable recovery” narrative, the most plausible outcomes are: 1) interest rates normalize but this triggers another bust, or 2) interest rates remain abnormally low until we eventually experience the mother of all debt/currency crises.

Conclusion 3 restated: We’re stuck in an Escher economy (see below), thanks to the impossibility of the establishment economic view, and this will remain the case until the existing structure collapses and is rebuilt on stronger policy principles.

escher stairs

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6 Responses to M.C. Escher and the Impossibility of the Establishment Economic View

  1. CK says:

    Very good summary on something (economist projections) that continue to be way off mark year after year. You can point to how wrong all the economic predictions have been each year over the last decade (CPI, GDP, earnings, employment, etc).

    As another contradicting data point from a purely investment perspective a rising interest rate increases the discount rate, which makes the present value of all future cash flows assumed worth less than they would be otherwise. i.e. rising interest rates have a negative effect on valuations of all assets and is why stocks and housing will inevitably decline in value in such an environment, a contradiction to their projections. History has many examples of this (which is the exact opposite of what has happened since 1980 when assets had a strong tailwind of a declining interest rate to compete against). That wind is now changing and will be another major hurdle to reach all their projections.

    I don’t believe these projectors to be stupid and missing such large irregularities, though. They likely know the contradictions in their predictions but because of policies they must show such things as not to “rock the boat”. Perhaps an upcoming reporting change (A change to CPI, no more M3, etc) will help hide some of these issues with their models.

  2. Jim says:

    I have spent the past five years trying to wrap my head around U.S. economic policy, and how the Fed’s bond buying “QE” affects our economy now, and in the future.

    There is major doom and gloom when it comes to our economic future, and the options are “bad” or “even worse”.

    I want to lay out two scenarios and please tell me what the “real world” affects will be on the average American.

    Scenario 1. The fed tapers QE, interest rates rise to say 6% (I know your chart says 4%). What will this mean for the average person in terms of the costs of goods, etc.?

    Scenario 2. The Fed never tapers QE, the world loses faith in U.S. Bonds as a safe haven, and it all goes to he_ _. What would “going to he_ _” be like for the average American?

    I appreciate your feedback very very much.


    Jim in Arizona

    • ffwiley says:


      Unfortunately, I don’t have much to add to your scenario 1 is “bad” and scenario 2 “even worse.” Much depends on the rest of Washington. Spending, taxation, regulatory and what’s that fourth thing I was thinking – oh yeah, health care – policies can have huge economic effects.

      If Washington would stop making things more difficult for the private sector, pass major reforms to alter the debt trajectory, and be slightly less crony capitalist, then I think significantly higher rates could bring things back to normal with one bad recession, say a 1981-82 recession. That’s a lot of ifs. I think they become impossible, though, if the Fed doesn’t change, because the “Escher economy’s” booms and busts and malinvestment go hand in hand with bad fiscal/regulatory policies.

      • Jim says:


        I appreciate your response.

        My wife and I have two small children. Since they were born everything has become a lot more scary (this is what happens when we become parents I suppose?).

        This Recession is bad for many among us, yet the collective wealth on all U.S. Citizens has grown to close to $60 Trillion, or about $181,000 per U.S. citizen. This is about four times our current debt level (not counting future liabilities).

        History shows us, time and time again, that the idea of a middle class is a historical anomaly. Most societies throughout history consist of a wealthy few dictating the actions, or caring less about, the rest of the populations. This was even the case in the U.S. prior to 1900 or so. Some call this “freedom”, and it includes not just the freedom to succeed, but also the freedom to fail.

        Our Democracy is under attack and the Average Joe is no longer represented. Those who run large banks do most, if not all, of the legislating.

        Chile, Costa Rica, and Ecuador are starting to look like attractive places to raise my family.


      • Jim says:


        I guess my question originally was this: What would the economic landscape look like for the Average Joe Neighborhood/city under the worse-case scenario?

        Are we talking a country full of Detroits? Run away inflation like what was seen in 1930s Germany? Famine?

        Or, continued sluggish zero to no-economic growth for a decade or more?

        Seems the Doom-and-Gloom crowd see Doom-and-Gloom through the eyes of a soft American Life, when in reality 1/3rd of the world’s population are on the verge of total collapse, and experience famine and economic stagnation as a daily ritual.

        I spent years in some poor places in Central America, where people made $5 a day. But, I must say, their daily and family lives were quite nice.


        Jim in Arizona

        • ffwiley says:


          Thanks for your comments.

          IMO, the worst case is much more severe than a lost decade or two. Japan is in its third lost decade and we still haven’t seen the worst there – investors are holding government debt that’ll eventually be worthless or close to it. The U.S. worst case means much of the middle class slips into poverty as I think you’re saying, and also many more Detroits.

          As far as how it plays out economically, I think that depends on a small handful of elites, just like other big events in history. For example, if you could go back to pre-Weimar Germany and replace Havenstein with Schacht five years earlier, I think events would have played out completely differently. They would have still been very bad because of the WWI reparations, but it wouldn’t have been exactly hyperinflation then credit boom/bust then fascism. In the U.S., imagine swapping the terms of Volcker and Greenspan. Would Greenspan have been as successful killing inflation? How about Volcker and the housing boom – would he have let it happen?

          And you can play the same game with politicians – economic history would be completely different if you were to rearrange just a handful of the most impactful heads of state. (Think wars, especially.)

          Hopefully this explains why we haven’t come out with a specific vision for the “end game” – it’s very difficult to predict. We do think the worst case is extremely bad, though.

          But I like your last observation – even in the worst case people will find ways to cope and hold out until things get better. They may even realize that you don’t need flat screens and ipads to be happy. (I have neither, btw, and I’m happy enough, depressing blog notwithstanding.)

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