Warren Buffett Is Wrong; Macro Is Important Part 2

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In part one of our two-part series on macroeconomics we detailed why incorporating macroeconomics into your investment process is critical. A proper understanding of the macroeconomic environment can help you make better decisions when it comes to identifying attractive countries in which to invest and help you better project a companyAAAs future earnings. But understanding the macroeconomic environment can be difficult.

Just like with stock analysis the macroeconomic world is filled with people constantly offering their opinions. On top of that we are bombarded with a litany of economic statistics. Fed manufacturing surveys, jobless claims, PMI surveys, consumer confidence, freight car loadings, the Baltic Dry Index and on and on. So how can we make sense of it all?

Well, think of things the same way you do value investing. This site is called GuruFocus because it focuses on a group of highly successful value investors and the methodologies they use. The basic formula is a simple focus on buying good companies at attractive prices. We can do something similar and focus on two of the most important but misunderstood economic concepts: private sector debt and public sector debt. By understanding these two concepts properly we can make better macroeconomic predictions, and that translates into an important advantage when investing.

Understanding private sector debt

Perhaps one of the most misunderstood aspects of macroeconomics is the role of private sector debt. Almost all of academia uses whatAAAs called the AAAloanable fundsAAA model of the banking system. This model posits that private sector debt does not matter because deposits fund loans. In the model all bank loans are offset by corresponding deposits AAAAA a bank can only make a loan if it has a corresponding deposit. In this model banks simply function as financial intermediaries moving funds from savers to borrowers. The net amount of money in the economy does not change under this model.

Despite its widespread use the model is demonstrably false. Just go down to your local bank and take out a loan and ask the bank manager if the bank needs to find a corresponding deposit somewhere in the banking system before it will loan you money.

But you donAAAt even need to do that. The most recent organization to tell everyone in no uncertain terms that the banking system does not function this way was the Bank of England in this recent paper .

The paper says, AAAThe currently dominant intermediation of loanable funds ( ILF ) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist.AAA

DonAAAt believe the Bank of England? Well the International Monetary Fund said the same thing in this 2014 paper , and the Federal Reserve also released a paper back in 2010 disproving part of the loanable funds model.

Given how widely and thoroughly debunked the loanable funds model has been itAAAs exceedingly odd

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This article first appeared on GuruFocus .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Stocks
Referenced Symbols: ILF , MS , FOX , C , TOT

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