Greenspan’s Defense

I just finished reading Alan Greenspan’s latest book on the financial crisis called The Map and The Territory. I really was hoping that the book would be his confession that flawed monetary policy led to a global financial crisis and how he learned all sorts of interesting things about interest rates in the process.. Unfortunately it reads more similarly to Hank Paulson’s memoir On the Brink for his unwillingness to take any responsibility for his decisions and for the absurdity of the excuses he offers.

In Paulson’s book he argues that it would have been illegal to have bailed out Lehman Brothers because they had capital rather than liquidity problems even though he had no problem bailing out AIG with bigger capital problems weeks later. Paulson’s memoir was at least so absurd that it was funny because it was filled with quotes like this:

“On October 30, I took the opportunity to deliver a pep talk to my staff , just before we began a lengthy strategy session in which I would lay out the assignments for the next few days. And of course everyone already expected they they were going to work all weekend. That’s what we did. I had to fly to Chicago with Wendy to babysit our granddaughter – but I, too, knew I would spend most of the weekend working.”

Greenspan didn’t even have funny tidbits about highly important babysitting gigs and fishing trips that required his attention in the height of the financial crisis. Greenspan directs most of the blame for the crisis on the chinese for saving too much money and driving down long term interest rates.

“In short, geopolitical events ultimately led to a fall in long-term interest rates and the mortgage interest rates which they were tied. That led, with a lag, to a global boom in home process”

Unfortunately he argues, there was just nothing he could have done about it.
“Some academics favored an incremental defusing of the bubble through a gradual tightening of monetary policy, but such incremental policies have never appeared to have worked in the real world. Even had we had the official data from 2005, there was little the Fed could have done to contain the rise in home prices”

It’s hard to imagine that higher short term interest rates wouldn’t have reduced the severity of the crisis. Much of the sub-prime mortgage mess is attributed to variable rate mortgages whose attractiveness was largely attributed to low short term interest rates. The share of adjustable rate mortgages in the total value of first mortgages sub-prime origination soared to nearly 62 percent by the second quarter of 2007. There is also the simple fact that low long term interest rates (which Greenspan says caused the housing bubble) are affected by the yield on short and medium terms bonds.

Greenspan should have rested his case with his hit track on Recession Sessions.

Economics as Science

Caroline Blaum wrote a recent piece for Bloomberg arguing that economists should stop pretending to be scientists. Or, rather, that they should acknowledge that what they practice isn’t science. If science means accruing knowledge through experiment-based discovery, economics (or at least 99% of it) surely isn’t a science.

However, Blaum’s article illustrates a tendency to put science on a strange pedestal. To be sure, the scientific method is the greatest cognitive tool ever created. But in trying to dismiss a field by saying it’s not science, we aren’t being honest about other methods of knowledge-accrual.

Blaum lists many questions whose answers are either currently unknowable or at the very least don’t enjoy consensus among experts.

1. What is the expected rate of economic growth in conjunction with a 4 percent federal funds rate?
2. What is the effect on inflation of a 300 percent increase in the monetary base?
3. What is the effect — the multiplier — of a $1 increase in government spending on output?
4. What is the nonaccelerating inflation rate of unemployment, or the jobless rate that triggers rising prices?
5. What is the wealth effect from a 20 percent increase in the major stock indexes? What about a 100 percent increase?

The answer to all five questions is, it depends. And that’s one of the main reasons that economics isn’t, and will never be, a science.

We know the physics behind a baseball very well, but a physicist couldn’t tell you exactly where a given fly ball will land at the moment it’s hit. This is what we’re expecting of economists and it’s unreasonable. Of course “it depends”. That phrase is really just an acknowledgement that the question asked doesn’t contain enough detail to have only one answer, and I’d wager “it depends” is the same answer a physicist would give to a fly ball question without more information about the system involved. A model insufficiently detailed for reality is an insufficient model to predict reality.

Isaac Newton, the English physicist, mathematician and philosopher, pretty much explained the fundamental difference between economics and the hard sciences more than 300 years ago. With the physical sciences, we observe what happens in nature. Then we try to quantify it. An apple falls from the tree to the ground with increasing velocity.

Notice the opaque phrasing of the famous falling apple example, boiling it down to its most basic point. Newton, after all, got the details wrong. Newtonian physics are a nice approximation of reality but really only apply sufficiently to mundane problems. Eventually, humans started operating on scales of time, space, and precision that showed a more complex picture. Today, numerous technologies we interact with daily wouldn’t be possible without an understanding of relativity and quantum mechanics. Obviously, knowledge in any field is cumulative, which means that at any snapshot in time it is never complete.

The examples that Blaum uses are attempts to generalize incredibly complex systems, and it’s understandable for that to be problematic and open to multiple interpretations. Even the best natural experiments that economists can use are only approximations of what they’d like to design in a lab.

Time matters in experimentation. Whereas with physical sciences a given experiment can be run again and again, economists tries to explain actions and behaviors on a time scale that prohibits this and about a system that is unimaginably complex. Economists are also part of the systems they try to explain, which is bound to lead to some odd self-referential system effects.

Such systems require exponentially more work to understand than simple systems. A physician would be helpless in answering any of her economics questions despite every interaction conceivably relevant to the question involving simple physics between simple particles. It would be too complex for any science to answer.

Economics isn’t a science, but that doesn’t mean that there isn’t an accrual of knowledge. There is a good amount of consensus on, granted, pretty basic points. For example: when a good increases in cost, customers demand less of it. To me, that sounds a lot like “an apple falls from the tree to the ground with increasing velocity”. Give economists time to work out the details.

The Rational Actor

Last night I had the opportunity to hear Greg Ip, US Economics Editor of The Economist, speak at the Chicago Council on Global Affairs. He had some great insights on the current state of the US economy and what that might mean for globalization in the coming years. He seems to hold some refreshingly idiosyncratic views of the causes of and lessons learned from the Great Recession, and while I don’t agree with all of his conclusions he was a very articulate and engaging speaker.

One issue that I think he and many others unfortunately get wrong revolves around the economic concept of the rational actor. In many people’s telling, neoclassical economics stands or falls on an idea of market participants making completely logical decisions. Since humans clearly aren’t logical, standard neoclassical economics, if not all of economics, must be wrong from the starting gate. Mr. Ip took the recession to demonstrate that actors aren’t rational, and also that the recession itself stemmed from this irrationality.

Firstly, in economics, “rational” doesn’t mean the same thing as “logical”. To assume that people act rationally merely means that we can assume that they make choices, based on the information that they have, that increase whatever resource they want to increase. It isn’t a claim that Vulcan-like disinterested logic rules the day, which would be absurd on its face. Unfortunately, the idea of a rational actor tends to be a flimsy straw man that serves no real purpose above a cheap joke against economics. Mr. Ip knows this, and I don’t think it was really the point he was trying to make, but since so many people do try to make this argument, it’s worth stating.

What Mr. Ip does miss by blaming the crisis on irrationality is a more profound and perhaps more sobering picture of what we can learn from the recession. I think it is naive to pin the recession on people acting stupidly. It can make you feel good, pointing to the stupid people in hindsight, and feel confident that you would never make what in hindsight turned out to be bad mistakes. Similarly to blaming violent crime on “monsters”, blaming the recession on irrational actors really just serves to create an “other”, where if only it weren’t for that “other” nothing bad would have happened.

The crisis, instead, happened despite people acting rationally. It is rational (in an economic sense) for a potential homeowner to purchase a house with no money down if a bank will cover the mortgage. It is rational for a bank to give more and more risky loans if investment banks are willing to get them off their books in return for a nice fee. It is rational for investment banks to be willing to buy more and more risky and complicated assets if they can be pretty sure that they won’t be the ones holding the hot potato when the game is over. And it certainly is rational for investors of all stripes to assume more risk if there is a reasonable expectation that the government will socialize any major losses that occur.

The real danger with our current economic system isn’t that it allows irrational people to make bad decisions, it’s that enormous crises can result exactly because it’s in everyone’s interest to keep the party going, enjoy the ride, and allow the taxpayer to clean up afterward.

Who Else Could Ever Ease As Quantitative As Me?

When the Fed launched its first episode of quantitative easing in November 2008 (1.25 trillion in MBS purchases and 175 billion in agency purchases), investors largely embraced it and considered it a necessary move given the ongoing panic in credit markets and the threat of deflation. The second round of Quantitative Easing (600 billion in long term treasury bond purchases) in November 2010 was more divided since financial markets and the economy had rebounded and deflation was no longer considered a major threat. The Fed justified its action by stating that core inflation (different from headline inflation which includes energy and food prices) was running below its desired levels and unemployment was still unacceptably high. This third round of QE (open-ended purchases of $40 billion of mortgage debt a month) has seen far more critics than supporters given that the majority sentiment among investors before QE3 was that monetary policy was already overly stimulative.

The tools that Bernanke has used to stimulate the economy have been very unconventional. Without any precedent it is very hard to tell if Bernanke is leading us down the road of recovery or high inflation but it is clear that there is a high degree of concern that it will be the latter outcome.
When the picture becomes clearer he will likely either be boasting as he did in our hit track QE2 or making excuses for providing excess liquidity like Greenspan did in Greenspan’s defense

Pistol Pete

I recently had the opportunity to hear Pistol Peter Schiff speak on the economy. His speech rehashed his major talking points over the past several years but it was fun seeing him in person. Here were some of his major points:

1. There is already substantial inflation that exists in most major developped economies. He believes that oil prices are the perfect example of this. The demand for oil is at a recent low while the supply has simultaneously reached a high but the price is still at $110 which has been entirely caused by his defintion of inflation ( the increase in the money supply). When pressed about why inflation hasn’t showed up in more tradional measures like the personal consumption expenditure index, he said that much of it has to do with the effect of subsitution. This means that if people were previously eating filet mignon, they might now be substituting towards a cheaper product like hamburger meat and thus PCE will not record inflation. He thinks that by the time measures like CPI, PCE start recording substantial inflation, that real inflation in the economy will already be out of control.

He also thinks that people aren’t more concerned about the inflationary impact of quantitative easing because the government created a good term from a marketting standpoint. He asserted that “Quantitative sounds smart and easing sounds pleasant”. He thinks if they called it what it actually is (debt monetization) people would be more concerned.

2. One conclusion from the inflation we are creating through low interest rates and quantitative easing is that interest rates are bound to rise. At that point he believes both the government and the banks will become insolvent. He says that the banks are borrowing money at practically zero interest rates and reinvesting in slighly higher yielding treasuries and mortgages. Once interest rates rise, the spread will turn negative and they will become insolvent. Concomitantly, the goverment will find it impossible to service the interest on their debt once interest rates rise.

3. He thinks that the dow and gold will converge to a 1:1 price ratio. He says this has already happened twice in history (in the 30’s and in the 80’s) and the economy wasn’t nearly as bad then. He didn’t want to speculate whether the prices will converage at the dow’s current price of 13,000 or gold’s 1,800 or somewhere in between. Other than his bullishness in commodities, he is much more bullish on emerging market stocks that pay a solid dividend. He thinks that the only thing that is worse than holding US dollars are US bonds (a promise to be paid US dollars in the future). He seems to be in agreement with Warren Buffet who recently wrote an op-ed on the toxic nature of US bonds.