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Monday, February 13. 2012
The Fed has kept interest rates at an historic low in an attempt to help 'heal' the economy. Fed Governors have no fear of dead weight in assets, in the form of declining values and poor potential returns. The assumption is that with economic expectations so low, inflation is not a risk, and that rates can be used to 'fix' things by keeping rates low indefinitely.
This artificial approach to soothing our economic woes is a dangerous game. The economy has, in many respects, become unlinked from the stock market. In pursuing the current path, the Fed has gambled on some concepts which have been tried before, though in different conditions and with varying results.
Does this sound familiar? Because if it doesn't, remember that the current situation was caused, in part, by the creation of bundled mortgages, an existing tool which was utilized to try something new, with the assumption of safety baked in. In theory, the level of risk was limited. The problem with them was related to the nature of the individual loans themselves. Each bundled group offered had varying degrees of risk involved. Despite the levels of risk, many high risk assets were given very good ratings. In the end some failed, which put all at risk.
The issue the Fed faces is not a simple one, though they seem to approach it as if it is. To the Fed, keeping rates low and purchasing assets to keep the system liquid will offset any further damage to overall economic conditions. Things do seem to have stabilized, so there are varying degrees of opinions about how successful the strategy has been. The difficulty of saying whether or not it has been successful is that expectations for this approach were so much higher. In normal conditions, the economy should be booming. Instead, only the stock market is. What the Fed may not realize is the cure may be as dangerous as the illness, especially since one part of the cure has been a massive increase in 'crony capitalism', which has been codified by the Too Big To Fail policy. In addition, the Fed finds itself competing with investors rather than assisting them.
To get at the root of the issue, we have to look at Economics as a science. While other sciences have limited inputs, and can thus be relatively reliable as forecasting tools in experimentation, Economics has far too many inputs. In addition, there is no lab in which to test those inputs. Instead, the 'testing' is done in real time.
Economics often faces the conundrum described by Schrodinger's Cat. Checking on results alters the potential outcome. In collecting data for discussion, people tend to come to different opinions about what the data mean. So each person prepares and reacts a bit differently. Thus, a booming market tells some people the good times will continue, while it tells others to prepare for the bust. Eventually one side wins out, and the results with each iteration change, making predicitable outcomes unlikely.
Science is meant to explain, and predictive qualities are a sidelight. Economics is very good at explaining. For the most part, we know how and why certain events occurred in the course of our economic history. While economists may quibble over policy and details, the larger mechanics of the market are fairly well understood. But markets have a sensitive dependence on initial conditions, another way of stating the more commonly known 'butterfly effect'. Thus, details matter and the predictive capabilities of economics is limited.
Generally, economists know why the economy is in bad shape. The problem is that few know exactly what to do about it. Some, like Krugman, feel we need to spend more at the government level. Others feel it is enough to just leave business alone, as Bastiat would suggest. Still others feel we simply don't understand enough about how things work to make decent policy decisions.
I'm of the 'don't understand enough' school. In essence, the 'solution' this school suggests is to limit the impact of human intervention. That is, reduce government inputs, limit the impact of human interaction (like the Fed), and let people make decisions based on the things that impact them directly, allow markets to just do what they do without government policy impacting them. Like it or not, bond sales of government debt, even to the Fed, play a role in altering how the market operates.
In normal conditions, as the market was melting down and liquidity was drying up, interest rates would have risen. This would have increased savings and improved liquidity. In the short run, we'd have suffered terribly. You can be relatively sure that whatever we experienced was mild compared to what may have occurred. However, we wouldn't have fallen into a negative feedback loop that would have taken us ever deeper, as many on the Left suggest. No, the basis of interest rates would've been to increase liquidity naturally, and the economy would've turned around. It definitely would've taken some time, but by now we likely would be out of it.
This is my view, it's purely hypothetical, but previous situations in which the government did little (such as the 1921 depression) give some support to its effectiveness.
If we look at one of the primary causes of the collapse, the clearest single source is the Fed itself. From 2001 until 2004, interest rates were at all time lows. This caused a bubble in real estate, such that by 2007 interest rates were high again, having gone up by 200% in only 3 years. Within a year of 2007, interest rates were again at historic lows and falling. Today they are even lower. All things considered, we should be in the middle of one of the largest economic booms ever. But we are not.
Few have stopped to consider that the solution being applied is the original cause in the first place - artificially low rates. People are not being asked to save, they are being encouraged to borrow at a point in time when economic conditions suggest saving is the correct response. We have seen savings rates rise, primarily because people are intelligent and don't just react to economic signals like interest rates. But we have also not seen borrowing fall, as would be expected if interest rates were allowed to rise.
I hope the good times last. But I am not optimistic. It's possible I am simply a pessimist and things are improving. Personally, I know I'm better off now than I was 2 years ago and even 10 years ago. But my personal situation isn't an indicator of things in general. I also know more underemployed and unemployed people than I did 2 years ago. I'm not sure politics will provide a solution, though it certainly is part of the overall equation.
The Fed is playing a dangerous game, and for now it's making people think times are good or getting better. The stock market is 10% from an all time high, people are finding jobs (though not nearly at the rate we're told by the BLS), and the cost of living remains manageable, primarily due to mortgage refinancings. But many items have increased in price, such as gasoline (150% higher than the depths of December 2008), while food and clothing have been rising faster than the average rate, as well.
At some point the excessive liquidity will enter the real economy, not just the stock market. When it does, then the real effects of the Fed's policies will become very evident.
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Economics is a "science" only if you believe in zombies, vampires and Giant Flying Spaghetti Monsters.
The problem is that economics does not work in real time. It doesn't even work as a way to analyze historical trends. Every "economist" has an opinion on what cause which and which was what solved the whatever. Each side can develop the same data and reach different conclusions - that's not science - that's horse manure. Economics can fairly be described as "if you can't dazzle 'em with brilliance, baffle 'em with bullshit".
As to economics being very good at "explaining" - I defy you to actually read one of Alan Greenspan's Congressional testimonies and explain what he said. I don't think he can to be honest. I refer you to the dazzle/baffle concept in the preceding paragraph. :>)
You are right though that the real economy has disconnected itself from the stock market(s). I think a lot of that is trust in how the markets hve been corrupted - based on the various bubbles in the past ten years or so (tech/housing/oil, etc.) the average citizen now believes that they are powerless to do anything about their circumstances due to both economic dominance of "Big Whatever", Big Government, Corrupt Politicians and politics and a general sense of foreboding about the future.
What's the solution? Other than a complete revamp of how the economy works, a renewal in the concept of less government, the breaking up of Goldman/Sachs or a violent revolution, don't think there is much that can be done.
Just have to ride it out.
Most of what people call economics, isn’t. It’s sociology with dollar signs.
Economics is very much a science. The basic premises of finance were derived from engineering - hence the term 'leverage' for the use of debt.
The fact so many people don't understand how economics can and should be used is like saying people don't understand medicine, therefore it's not a science.
Economics can be utilized in many ways, quite usefully, particularly at the micro level. All the work I did in it has helped me understand how markets work so I can do my job more effectively.
There is an element of sociology, and there is an element of philosophy to the art of economics. The current trend is toward behavioral economics, which was more or less started with the Austrians (von Mises, Schumpeter, Hayek). Their view was that using static data to derive outcomes which are altered in real time is a misguided application. They are correct. Supply and demand curves are useful data, and are great at explaining why certain outcomes come to pass. But they won't tell you where you're going, and you have to realize that you are holding many inputs constant at that moment in time, so the data can change radically only moments later often in a way you didn't necessarily expect.
Behavioral economics has, in fact, been very effective in helping to develop policy. It's also been overused and misused. Arne Duncan has tried to use it to help guide educational policy, with very mixed results. Most of his successes, naturally, come from adhering to a solid understanding of its limitations. The failures, of course, are really a result of trying to impart a political outcome.
Alan Greenspan was, arguably, one of the finest Fed Chairmen. But, like anyone in a position of great power, he overstayed his welcome and overestimated his abilities based on his record of success. As a result, he eventually abandoned his better instincts and followed a more political than practical path.
Bernanke is a disaster, and I'm quite sure he knows it.
In the end, one has to realize that the practical application of economics as policy has to be based on a few simple rules. These rules have to engage respect for the natural rights of individuals, expect to only nudge behavior not guide or alter it, and maintain a solid financial approach of not spending more than you have available to you.
Debt is a tool, not a panacea.
Economics is very much a science. The basic premises of finance were derived from engineering - hence the term 'leverage' for the use of debt.
~~ cough ~~ bull ~~ cough ~~ shit ~~ cough ~~
Economics is not a science. Aristotle's definition of science states - "science" refers to the body of reliable knowledge itself, of the type that can be logically and rationally explained." There isn't anything that can be logically or rationally explained using "economics". There aren't any "schools" of physics or chemistry or mathematics - physics is physics, chemistry is chemistry, math is math.
Schools of economics: Islamic, Scholasticism, Mercantilism, Physiocrats, Classical political economy, American (National), French liberal, German historical, English historical, French historical, Utopian, Marxian, State socialism, Ricardian, Anarchist, Distributism, Institutional, New institutional, Neoclassical economics, Lausanne school, Austrian school, Stockholm, Keynesian, Chicago, Carnegie, Neo-Ricardianism and last, but not least Modern.
Now that is a "science". Pick your favorite explanation for life and universe and everything - something for everybody.
Further, the definition of economics brings it closer to the truth: "Economics: doing the same thing over and over again and expecting different results." Oh wait - that was Einstein's definition of insanity. Strange that huh? Because it perfectly defines what we're seeing now - by supposedly very smart people.
Originally, "economics" was called "political economy" because it was considered a "political/social" way to model and explain human behavior with respect to consumption, money and social behaviors. That changed somewhere in the very early 20th century when it was called economics - because it sounded more like mathematics, physics, chemistry, etc. Does that sound like a "real science" to you?
Economics is nothing more than a political tool for the current governments and politicians to use to explain away their behavior if it all goes south or brag if it all works.
Nothing more, nothing less. If economics was a real science, we wouldn't be getting into these social/economic messes every ten or so years.
PS: Leverage isn't an engineering term - it's a physical science term defined as "the action of a lever, a rigid bar that pivots about one point and that is used to move an object at a second point by a force applied at a third." The term leverage in the field of economics or finance is used differently and has multiple definitions in each field. That's not science, that's ~~ cough ~~ bull ~~ cough ~~ shit ~~ cough.
So Supply and Demand cannot be rationally explained, but quantum physics can be?
I'm sorry to disagree. Quantum Physics is based on statistical probabilities. It can't be rationally explained (yet). They are close, but they are not there yet.
The same is true of economics. You can build an input matrix which can basically tell you the price of any given good in a closed economy. The problem you're faced with is the term 'closed'.
Since all economies are open to some degree, the amount of inputs will usually exceed your ability to cover all possibilities. In addition, the nature of economics is one of new markets. This is another form of 'openness' which cannot be accounted for reasonably well enough yet.
Schumpeter did a remarkable job closing that with his work on entrepreneurialism, but it's work that received only partial attention since his timing just happened to coincide with the much more popular Keynes.
The other Austrians went further, but the Austrian School receives very little attention. Since Socialism or Mixed Economies have become popular and all the rage, their insight is usually pushed aside as meaningless (despite the great work they've actually done in the real world, when applied).
As for leverage, I'll admit your more precise 'physical science' attribution works, but the term was originally used by an economist (whose name escapes me at the moment) who, in studying physical leverage, realized he could apply the same concepts with debt. He recognized the value debt had within the world of economics and laid out many of the original foundations of stufy on debt ratios.
You can cough all you want, but I've met so many people who think they are smarter than the market itself because they don't value economics as a science, that they try to rig things in their favor. It can work temporarily, but when the market eventually tips back to right itself, they are pulling their hair out wondering why it all went wrong.
I know that never happens in a 'real' science (dripping with sarcasm).
I forgot to mention that the Economics does not do the same thing expecting different results. Had you paid close attention to what I wrote in the original post, you'd see that the nature of a market is such that you can have what seems to be the exact same inputs and get a different results.
It's called 'sensitive dependence on initial conditions'. I attended a conference on Complexity back in 1995, where I was very lucky to meet Murray Gell-Mann. Complexity is a scientific study and economics falls into this realm. In fact, a large portion of the 3 days was spent seeking (and finding) ways to take best practices from the world of physics and applying it to business and economics.
It was one of the most useful conferences I'd ever attended, and then my company decided that it was too arcane to send me back again the next year.
I believe these conferences still take place, they are run by the Santa Fe Institute. http://www.santafe.edu/
Emergent systems (essentially economics) are not a scientific study?
Not only do we lack understanding of the mechanisms, we lack understanding of individual preferences. Financial markets themselves are a distorting influence on the “real economy” of resource allocation. It’s as if we look in Schrödinger’s box via a play-by-play announcer watching an artist’s rendering of real events.
We still haven’t had widespread mark-to-market writedowns leading to a Great Repricing. It will look like healing until the next overleveraged artery bursts.
Part of the assumption behind the Fed's policies is that time can heal many things. In this, they are correct.
The problem is, time can only heal what is allowed to heal. You can't let debt 'heal' if you keep using it to buy up the garbage, store it in a closet, and wait for it the bubble to revive itself. All you'll do is pop the new bubble and start the process anew.
At some point, the political leaders will have to make tough choices, and the citizenry will have to accept a certain level of pain. There is no way to avoid it.
The FedRes, by its very nature, inhibits healing. They’re a non-market input on the price capital.
But then we have to take this up a metalevel or two. What is “healing”? The science of economics can only tell us what is likely to happen. It cannot tell us if that outcome is “good” or “bad”.
My utopia has everything priced by markets. Whatever happens under that regime is Eden.
We are in alignment.
That said, the real world still has a Fed to deal with. Since I prefer to work with the tools I have available, rather than the ones I hope to purchase, the question becomes something akin to:
"What can the Fed really do to make things better economically?"
The answer is simple. Let interest rates rise, and allow the economy to 'fix itself'. Or let them reach whatever natural rate they should achieve, rather than forcing them down by creating credit vehicles by purchasing bad debt, storing it, and increasing back reserves.
Theoretically, the purchase of debt and storage is allowing time to heal a 'broken' price mechanism. It's really just rigging the market.
Mark the shadow inventory to market and TBTF gets another shakedown cruise --