The Arrogant Conceit of Modern Planners

In the course of combating the Great Recession, radical sounding policies were enacted with the expressed intention of easing the economy's slump and helping it transition smoothly and successfully to the next growth phase. Markets, we were told, had failed and needed to cede more control to the experts and their centrally dispensed scientific wisdom. It all sounded so easy, that once the markets stepped aside the planned recovery would spring forth as if it were some irresistible inevitability.

These were tremendous leaps of faith that the experts were willing to make. Of course, it was never sold that way. What we heard was that the "best and brightest" had been recruited and, even though their proposals and cures were on a massive scale, they would be administered with methodical precision backed by sound scientific principles. The cocksure displays were enough to obtain the benefit of the doubt from a public shell-shocked by financial and economic calamity.

As much as I might like to kick the dead jobs market horse some more, especially with the revelation that the American Reinvestment Recovery Act cost taxpayers at least $278,000 per job (before assuming any job destruction caused by the same act), there is an even larger unease to this fiasco. All that supreme self-confidence emanating from fiscal and monetary experts was based on pseudo-science. We would be in much better shape today had Chairman Bernanke admitted in 2009 (rather than $1.9 trillion later) that he really didn't know how "stubborn" the economic headwinds were, or if President Obama and his brightest advisors had thought a little harder about the science behind "shovel ready".

I often laugh to myself as I think about what is written on my Bachelor's Degree from Canisius College (this is nothing against the good folks at Canisius, they are simply following standards). Signified in the middle of the document, my alma mater has conferred upon me the honor of Bachelor of Science . The course of "scientific" study that led to that conferment was "finance".

To this day I often wonder when and how the study of essential human interactions became a science. Nothing about economics or finance can be rightly classified as scientific. The very basis of humanity and its constantly changing nature renders scientific objectivity utterly impossible.

Instead, what we see is a veneer of science espoused through increasing complexity. It is through adherence to mathematical constructs that this unearned hubris has spread. The cloak of Byzantine equations (that are admittedly very elegant) is enough to deter a wider, more penetrating consideration of the mainstream economic canon. It is enough, apparently, to be impressed by the considerable intricacies and complications of the mathematical models to defer all judgement to these "best and brightest" that scripted them in the first place.

"The modern New Neoclassical Synthesis (or New Keynesian) consensus macroeconomic model of monetary policy is a dynamic general equilibrium model with a real business cycle core and costly nominal price adjustment...There is a ‘forward-looking IS function' in which current aggregate demand relative to potential output depends positively on expected future income and negatively on the short-term real interest rate. It resembles the original Keynesian IS function except for its reliance on expected future income...There is an "aggregate supply function," also called a price-setting function, that relates current inflation inversely to the current markup (or output gap) and expected future inflation. This aggregate supply function can be derived directly from Calvo's (1983) model of staggered price setting and is closely related to the pioneering work of Stanley Fischer and John Taylor...The modeling of expected future income in the IS function and expected future inflation in the aggregate supply function reflects the introduction of rational expectations into macroeconomics by Robert Lucas in the 1970s...By solving the IS function forward, it is possible to express current aggregate demand relative to potential in terms of the expected path of future short-term real interest rates and future potential output."

This impressive, precise sounding description of the basic monetary model still in use by the Federal Reserve comes from a 2005 research paper published by its St. Louis branch. That paper expounded on the purported monetary lessons learned since 1979, and how they have been incorporated into the scientific study of economics and monetary finance.

That corpus is embedded within the very mathematical models that govern all monetary policy decisions. Unfortunately, by solving these equations in the manner prescribed, monetary policy created the largest asset bubbles in the history of mankind. Not only that, the Federal Reserve was completely surprised by their subsequent collapse, and even further surprised by the widespread economic damage. For all their mathematic and statistical complexity, the panic of 2008 was a ten-sigma event for these models, a statistically impossible possibility.

Math is not science no matter how complex it becomes. Math itself may be objective, but the assumptions that must go into it each and every statistical function and the ultimate applications of their conclusions are subjective. These models are simply classroom academic exercises that have to pare down the real world to manageable size. In order for the math to make any sense or salvage any information of even dubious value, its practitioners must make shortcut assumptions about basic human behavior.

Take the rational expectations theory, for instance. It sounds reasonable that economic actors would use their current expectations as a template for the future economy. This theory essentially assumes that if the public expects inflation in the future, for example, they will prepare for it now. Much of current monetary thought is centered on this idea of influencing current expectations with the intention of creating an economic future identical to those influenced expectations.

As much as that solves a modeling problem for economic theory, it is a foolish invitation to straight-line extrapolation. But beyond this inherent weakness, it demonstrates exactly how economics is not science. The rational expectations theory is, unambiguously, an assumption . It is a leap of faith, not a product of empirical and repeatable observations. As much as the attachment of mathematics to the study of economics seems to add the weighty element of objectivity, there will always be subjective predilection to how it is applied.

For all the empirical results (asset bubbles, panic, commodity prices, an eleven-year dollar devaluation, no sustainable economic recovery after more than two years of heavy intervention, etc.) that run contrary to monetary and economic science, its practitioners fail to alter their methodology. "Aggregate demand" or economic potential is still believed to be the sole province of an inflation/employment tradeoff, basically unchanged since 1979, despite the body of evidence gained over the past forty years. Empirically, we have seen enough dramatic divergences in the historical record to show that consumer inflation and unemployment are not mutually exclusive.

We have also seen that asset inflation, commonly known as bubbles, can take the place of consumer inflation during the periods of gross monetary imbalances. Had monetary scientists made the subjective decision to include asset inflation within the core objective functions of monetary modeling, the Fed may have altered its monetary trajectory long before household and government balance sheets were extensively, and for many irreparably, damaged. Instead, it made, and continues to make, the conscious, subjective decision to exclude asset inflation as even a small variable within its dense equations of economic potential and the output gap.

In November 2009, the Fed published a paper ironically titled "Monetary Policy and the Housing Bubble". Among its chief conclusions were:

"...our review suggests that the course of policy during the first half of this decade accorded well with conventional prescriptions."

and,

"We do not believe that the accommodative monetary policies of the period played a large role, although it is possible that the shifts in housing finance we discuss may have interacted with monetary policy in ways that are not captured by the historical relationship embedded in our macro-based approach."

The best that can be said of these core monetary beliefs is that they are at least selectively grounded in recent historical events. However, these statements reflect the kind of subjective narrowness that continues to plague monetary decisions.

In reviewing its own actions, the Fed essentially admits that it only contemplated "conventional prescriptions" in countering the dot-com bust. And those conventional measures were taken because the Fed expected them to act according to the established "historical relationship" described by its mathematical calculations of the most recent chronological data series.

The Fed knew that housing-related GDP was at the extreme "upper limit" of the historical range, quantified in the paper as two standard deviations off the historical baseline, yet it never made a serious effort to quantify real estate prices and connect the dots. GDP was part of the monetary equation; house prices, no matter how "frothy", were subjectively left out.

Any discipline of study that cannot move beyond itself falls far outside the bounds of scientific seriousness. There is no good reason to expect that tomorrow will always look like yesterday. Until 2009, the Fed still operated under the assumption that credit production was primarily based on the actions and reactions of depository institutions. That was not empirical study; it was blind faith.

Any observation of the actual financial system revealed the growth and dominance of both investment banks and their related shadow banking systems. It was a colossal mistake to believe that balance sheet incentives and leverage applications from the investment bank perspective would follow the same systemic behaviors that depository institutions had in the past. Whether that blindness was willful or not may never be settled.

In the end, mainstream economics and finance are not scientific endeavors, they are ideological expressions. That is the only way to explain both their immense mistakes and unwillingness to adapt to empirical observation.

Fiscal stimulus and monetary interventions are essentially different sides of the same central planning coin. The only way to rationalize succumbing to central planning at the expense of market-based decisions is to fully believe that central planners know better than markets. For that to be the case, there has to be both precision of information and theory. It is much easier to sell this transfer of power if it is framed as the only choice between unruly, dangerous capitalism and scientific, objective monetary and fiscal management.

This is not to say that capitalism and markets are perfect, nor is it an endorsement of unregulated markets - I would gladly accept a reinstitution of Glass-Steagall. I am simply trying to gain wider acceptance of the idea that economics is an art form and the implications that must follow from that. It makes little sense to converge theory and decision-making within the realm of a pseudo-science that mistakenly believes it can achieve precision, and therefore proclaim any universal economic truth.

The "experts" in Washington and New York have concentrated economic and financial power solely because they have associated themselves with mathematical objectivity and complexity. Just because they appear to be the "best and the brightest" does not mean they will always be correct, and it is surely no guarantee that they will act with benevolence (see stimulus and TARP beneficiaries). To allow such power to continue in so few hands is an anathema to free markets and freedom itself.

Even at $278,000 per job the central planners still cannot buy a recovery. We need to move past the idea that a recovery can only spring from Bernanke and Obama (or Bush or whatever president resides in the White House). Reverting back to true capitalism and unfettered price discovery, away from monetarism and central planning, is the answer to what ails the economy. We would do well to wrest back control before the central planners once more unleash their scientific prowess to determine that the dollar figures need to be exponentially bigger.