Economists | - Part 2

When Models Trump Common Sense

More evidence that U.S. economists are particularly ill-suited to run the U.S. economy comes via the fascinating exchange in recent days between St. Louis Federal Reserve President James Bullard and a small army of bloggers with PhDs in economics, nearly all of the latter ganging up on Bullard after he suggested that the “output gap” theory for what ails the U.S. economy may be fundamentally flawed and that attempts to boost overall demand to close that gap through freakishly low interest rates and other super accommodative Federal Reserve policies might end up doing more harm than good.

Bullard threw a cat amongst the pigeons in this speech(.pdf) when he noted the following:

The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation. We may do better to replace it with the notion of a permanent, one-time shock to wealth.

Recall that I’ve railed on this subject a number of occasions over the years, the last time being this offering from about six months ago when it was noted:

The theory posits that it is not important what level of overall demand an economy has reached or how it got there, but that, when all the wheels fall off the wagon as they did back in 2008, the imperative is for the government to somehow restore that level of demand. Otherwise, you get another Great Depression.

It makes no difference if, back in 2005, people making $40,000 a year were buying no money down $500,000 homes and then, after the home’s value went up to $600,000 in 2006, pulling out their $100,000 in brand new home equity to put in a pool, buy a motor home, and install big screen TVs in every room of the house because, once you reach a certain level of demand and it begins to drop like a rock because everyone has become indebted up to their eyeballs, it must be restored.

At that point, it simply becomes a question of how much taxes must be cut or how much money must be borrowed or printed to accomplish that goal.

Of course, I don’t have any models to back up the contention that an unusually large portion of economic output we saw in the middle of the last decade was “artificial” due to the housing bubble, but economists do have models, and that’s the crux of the problem.


A couple of items related to yesterday’s Bernanke’s Disingenuous Message to Savers come via this Reuters report that chronicles the difficulty older, fixed-income investors are having under Fed Chief Ben Bernanke’s policy of freakishly low interest rates and this item at The Aleph Blog that captures my sentiments fairly well.

Bernanke Does Not Understand Savings
Twice in his press conference yesterday, Bernanke showed that he was out of touch with average Americans. He argued that average people could keep up with a 2% increase in the price level by investing in stocks and (presumably short-term) bonds.

(Speaking to The Bernank)

I’m sorry, Ben, but ya gotsta come down from the uneducated ivory tower and wallow in the mud wit da restov us. There are three problems with what you said:

- It’s hard to earn 2% (after-tax) consistently when the Fed funds rate is zero.

- Only the top 20% of the wealthy have enough assets to keep themselves afloat using the asset markets. Most people would like to do something to protect themselves from inflation, but lack the means to do so.

- Average people do not invest, they save at financial intermediaries like banks, S&Ls, and life insurers. Fed policy kills rates for savers. They will not become investors, because they lack the knowledge to do so.

I am again sorry, Ben, because your policies discriminate against the poor, and the lower middle class. Yes, the rich and the upper middle-class clever can escape the penalties stemming from your policies, but the lower-middle class and the poor can’t.

Think of it this way: your policies are making it more palatable for average people to buy gold, because the alternatives in savings are lousy. If there is no income, why not grab safety from inflation?

Author David Merkel then suggests a comparison to Arthur Burns, one of the worst Fed Chairman ever, a subject that will be taken up in the next item that appears here.

Bernanke in the Shower

Repercussions of yesterday’s Fed meeting continue to be felt as the gold price has now risen about $80 since the central bank announced an extension of its low interest rate forecast and more than a few columnists are taking issue with this approach. Bloomberg’s Caroline Baum chimes in with this commentary today.

What the Fed is saying, in essence, is that as the economy improves, it’s appropriate to provide as much stimulus, or support, as it did in late 2008, when the economy was contracting and the financial system was imploding.

This is a dramatic shift. Given the long and variable lags with which monetary policy operates, past Fed officials at least paid lip service to the notion of acting preemptively: withdrawing excess stimulus — a fancy way of saying they will raise interest rates — as the economy improved.

Not so the current committee, which is tilted toward doves after the annual rotation of voting members. This group seems to think it should “continue to ease as long as there is economic slack,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. “It’s a classic, elemental mistake,” he said, one described by the late Nobel economist Milton Friedman as the “fool in the shower.”

The fool turns on the water in the shower, steps in and finds that it’s still cold. So he turns the knob all the way to hot, only to get scalded when the water heats up with a predictable lag.

Given the uber-dovish FOMC voting members this year we’ll probably start hearing discussion about “when the chain catches the sprocket” again in 2012, particularly if oil prices begin to rise. In the end, we are likely to look back at this period later in the decade and conclude that the Fed held rates “too low for too long”.

What’s that old saying? Those who don’t learn from history are doomed to repeat it.

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What Happened at the FOMC Meeting?

I’m not around at the moment to comment on the results of today’s FOMC (Federal Open Market Committee) meeting that concluded a few minutes ago, likely to have resulted in some sort of announcement about the central bank’s communication policy and an enhanced economic/policy forecast, but, when I’m able to catch up on this and Fed Chief Ben Bernanke’s press conference, I’ll try to put something up later in the day.

Based on what I’ve been reading about an extension of the Fed’s freakishly low interest rate guarantee, we’re probably looking at the situation to right.

This is not going to make savers happy, but, if you like to borrow money, you’re likely to get lower rates for a while longer.

Come to think of it, those low-rate credit card offers could be arriving in our mailboxes for the rest of the decade.

Anyway, I’m hoping that someone asks Bernanke about the 2006 FOMC meeting transcripts and how the nation’s brightest economists could have been guffawing all year long when they maybe should have been looking at the rapidly inflating housing bubble that would burst a year or two later.

See The Fed’s Housing Bubble Laughter from the other day for the particulars about this.

How to Save Economics?

Following yesterday’s generally well received diatribe about the shortcomings of  the world’s economists, this Time Magazine commentary was stumbled upon that makes some of the same points, absent what I thought were important references to The Shining.

After the financial crisis of 2008, the Queen of England asked economists, “Why did no one see the credit crunch coming?” Three years later, a group of Harvard under­graduate students walked out of introductory economics and wrote, “Today, we are walking out of your class, ­Economics 101, in order to express our discontent with the bias inherent in this introductory economics course. We are deeply concerned about the way that this bias affects students, the University, and our greater society.”

What has happened? Rebellion from both above and below suggests that economists, who were recently at the core of power and social leadership in our society, are no longer trusted. Not long ago, the principal theories of economics appeared to be the secular religion of society. Today, economics is a discipline in disrepute.

First, economists should resist overstating what they actually know.

Second, economists have to recognize the shortcomings of high-powered mathematical models, which are not substitutes for vigilant observation. Nobel laureate Kenneth Arrow saw this danger years ago when he exclaimed, “The math takes on a life of its own because the mathematics pushed toward a tendency to prove theories of mathematical, rather than scientific, interest.”

Financial-market models, for instance, tend to be constructed with building blocks that assume stable and anchored expectations. But the long history of financial crises over the past 200 years belies that notion.

And that is why few economists saw the financial crisis coming – because they had their noses buried in models that failed to properly reflect what was happening in the real world.

I’ll never forget former Fed Chief Alan Greenspan’s remarks before Congress in 2004 or 2005 when he said there was virtually no stress in the banking system when, at the time, the real action was in the now-defunct  “shadow banking” system.

Apparently, Fed economists didn’t see the need to model that.

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