Death Is the Only Difference Between the Fed and the FAA

On May 11, 1996, ValuJet Flight 592 departed Miami International on its scheduled route to Atlanta’s Hartsfield-Jackson Airport. Only eleven minutes into the flight, the McDonnell-Douglas DC-9 crashed in the swampy Everglades west of the city. There were no survivors among the 110 people on board.

The investigation into the crash subsequently revealed a fire had started in a cargo compartment. The pilots had no idea since smoke detectors weren’t required by the Federal Aviation Administration (FAA). By the time they saw smoke in the cockpit, it was far too late to save the aircraft, and the lives aboard.

The National Transportation Safety Board (NTSB) had recommended that smoke detectors, as well as fire extinguishers, be mandated for all passenger jet cargo holds – in 1993. The FAA rejected the advice on the grounds of its cost-safety benefit analysis. The risk of loss of life was low, in the agency’s view, because there hadn’t been any fatalities due to cargo hold fires in a very long time.

Testifying before Congress in 1997, the former Inspector General for the Transportation Department, Mary Schiavo, told Members the blunt truth. “Our safety agency is called the tombstone agency…because they wait for major loss of life before they make a safety change.” The NTSB’s Bernard Loeb echoed similar concern. “Now they’ve got their tombstones, now they can act.”

Not that the FAA didn’t deserve its vilification, but this is an all-too-common human frailty. Institutional inertia is an inherent attribute found in every organization, down to the smallest one-man shop. Recency bias is rampant as a matter of our own psychological makeup – we believe nothing bad can happen when nothing bad hasn’t for a long time. It can, if unchecked, progress into pure rationalization; that nothing bad can ever happen.

In modern times, that point is pressed further into the foundations of many systems by their overdependence on probability statistics. By their very nature, regressions and dynamic statistical modeling haven’t yet solved the problem of “tail risk.” A tail risk is, as the term denotes, the assumed probability of an extreme event, the computed size of the small area contained in each tail (left and right) at opposite ends of the bell curve. An airplane crash certainly qualifies, as does a market crash.

The technical term for attempting to quantify the tails in any probability distribution is kurtosis. One calculated as being subject to fewer extreme or outlier events (tail risks) is classified as platykurtic. That is, its kurtosis is found to be less than 3 (the number of any univariate normal distribution). Those with a kurtosis of more than three are said to be leptokurtic, prone to more frequent extreme cases.

In 2004, his reputation only slightly tarnished by the dot-com bubble, then-Federal Reserve Chairman Alan Greenspan spoke about the regime change that at the time he and many others believed had ushered the US economy into a Great “Moderation.” The evolution of econometric models, particularly those of the dynamic stochastic general equilibrium (DSGE) variety, had allowed central bankers essentially a choice. They could, given the monetary world’s parallel evolution, place greater emphasis on forecasting.

“Given our inevitably incomplete knowledge…a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy.”

Monetary policy had come into the age of lags, or so it was believed by the eighties. Because of better understanding of feedbacks, or the studied limitations policymakers felt with regard to rules-based policies, the time frontier for any policy choice was pushed over the horizon. The central bank under this doctrine must predict, not react.

That, obviously, places a great burden upon policymakers’ collective ability to forecast. In 2004, that didn’t seem like much of a problem. In fact, at that time they were all riding high believing themselves the epitome of technocratic competence.

Ironically, the collapse of the dot-com bubble added to the hubris. It was a major stock market event, to be sure, but ultimately it amounted to very little in the real economy. The 2001 recession was the mildest ever recorded, a fact from which Federal Reserve officials made good use. Attributing it to their own skill, especially in foreseeing the “distribution of possible outcomes”, they could dismiss the stock bubble as an exogenous factor while at the same time claiming a whole lot of “jobs saved.”

The primary appeal of that doctrine was in kurtosis. Unlike the FAA, the Federal Reserve was determined to not repeat the mistakes of the past. They had erred in the early thirties, in the manner Milton Freidman described later, and they were determined never to do it again. As Ben Bernanke said also in 2004:

“However, in practice, policymakers are often concerned not only with the average or most likely outcomes but also with the risks to their objectives posed by relatively low-probability events. For example, although the probability last year of a pernicious deflation in the United States was small, the potential consequences of that event were sufficiently worrisome that the possibility of its occurring could not be ignored.”

He gives here the impression that the ever-vigilant central bank lowered the federal funds rate to a then-unheard of ultra-low 1% on the concern over tail risk. This is the dint most people have at least with regard to the central bank model before 2008. In it is contained the so-called Greenspan put, the idea long ago derived from just this sort of policy intent.

Bernanke’s discussion, and Greenspan’s, in 2004 all hold to the wrong timeline. That much would become all-too-apparent by late 2007. It’s all well and good that any central bank might stand at the ready for heavy policy action when confronted by a tail risk, but what good might that be if the same central bank cannot actually predict one?

To put it into technical terms, the Fed is using a model of markets and the economy that is in practice platykurtic. And one of the reasons they do so is their assessment of themselves. In other words, as Bernanke was describing with regard to the dot-com bust’s potential to unleash deflation, it didn’t because monetary policy was right on it. The true tail risk in his scenario wasn’t the stock reversal but any severe economic backlash that might result from it.

It’s a formula that he had been using for years, one widely shared by FOMC officials as well as other authorities at central banks around the world. At the Kansas City Fed’s Jackson Hole Symposium in August 1999, right at the very top of the dot-com mania, Bernanke presented one of his papers (co-authored by Mark Gertler) to assembled central bankers and Economists.

“The principal conclusion of this paper has been stated several times. In brief, it is that flexible inflation-targeting provides an effective, unified framework for achieving both general macroeconomic stability and financial stability. Given a strong commitment to stabilizing expected inflation, it is neither necessary nor desirable for monetary policy to respond to changes in asset prices, except to the extent that they help forecast inflationary or deflationary pressures.”

In layman’s terms, he was saying that the Fed will easily handle any fallout from an asset bubble (what he obliquely refers to as “changes in asset prices”) going in reverse. In FAA terms, he was denying any need for smoke detectors in cargo holds. It was, in short, the tragic legacy of the maestro. They really believed in their own press.

So, it became circular of sorts. The Fed grew confident in part on what the media was writing about it, and the media believed in the Fed’s confidence.

At the dawn of the next crisis, which would prove to be the real deal, the press was in overdrive in its fawning coverage. The media in this country, as around the world, shares a similar vision to that of the Federal Reserve. In the end, both attempt to drive things toward technocracy, the idea that human systems largely predicated on “scientific” statistics can pre-determine “optimal” outcomes. The power of government, or as was assumed in the case of the central bank, the power of the printing press, gave these enlightened few the power to carry out their good work on all our behalf.

In January 2008, The New York Times Magazine published an extensive and glowingly positive portrayal of the Fed Chairman at seemingly his moment. His friend Mark Gertler was quoted in it as describing Bernanke’s drive, saying “he wants to be known as a great central banker.”  Greatness is so often a combination of talent, skill, and ultimately opportunity. Wisdom, however, as Socrates took great pains to describe (via Plato) was in knowing what one did not know.

For the newspaper, there was no better man alive to be in his position at that particular moment.

“On virtually every topic of significance — how to prevent deflationary panics, for instance, or to gauge the effect of Fed moves on stock-market prices — Bernanke wrote one of the seminal papers…And having devoted much of his career to studying the causes of the Great Depression, Bernanke was the academic expert on how to prevent financial crises from spinning out of control and threatening the general economy.”

How could the absolute perfection of modern monetary technocracy thus fail so spectacularly? In a word, kurtosis.

At every crucial moment, Bernanke and his FOMC compatriots overvalued their own contributions and undervalued the degree of difficulty and dysfunction. There are far too many examples to cite efficiently (as I will once again urge everyone to read through the FOMC transcripts not just in 2008, but also 2007 as well as 2011), so I’ll use just one.

The following was taken from the transcript of the FOMC’s emergency conference call held on March 10, 2008. The worst sorts of funding strains had re-emerged and intensified beyond anyone’s prior imagination, a ratchet effect that should have been clear for what it signaled – the markets would get worse, the Fed response would be bigger, and the market would get even worse. They were proving to the world they didn’t know what they were doing, and by doing so they had fattened the tails into hyperleptokurtic disaster.

“MR. LACKER   I think the burden of proof ought to be on those who are advocating such measures to provide evidence of some sort of market failure. I have yet to see a plausible case for market failure that would warrant such intervention by a central bank here. In this case, I don’t think the concerns raised by the New York staff memo really come close, and it strikes me that they could equally well rationalize buying tech stocks in late 2000.”

Richmond Fed President Jeffrey Lacker would get his tombstone, metaphorically speaking, just days later in Bear Stearns. The reference to the NASDAQ equally apropos as it signaled the widespread belief in Bernanke’s view of kurtosis as being a function of monetary policy as much as anything else. The Fed didn’t need to buy stocks back then because it could handle all economic considerations downstream, so they didn’t really need to bail out the markets again starting in 2007 because federal funds cuts would cushion any blow to the economy.

Or maybe not.

They really took the wrong lessons from the dot-coms, and it burned them, and the rest of us far more severely, in 2008. Paul Volcker, the former Federal Reserve Chairman from 1979 to 1986, was one of the few quoted in that New York Times Magazine piece politely protesting so much undeserved confidence.

“I think Bernanke is in a very difficult situation. Too many bubbles have been going on for too long. The Fed is not really in control of the situation.”

Nobody listened because nobody wanted to. Especially the media, for to do so would have meant dismantling even in part the technocratic ideal at least in its contemporary format. So, they’ve pretended for a decade that 2008 didn’t matter since what did was that 2009 didn’t end up like 1933. From there, we’ve heard about a recovery in name only.

That’s where we still are in 2018, only now the tails are fatter still. We worry not just about market extremes but political as well as social extremes, the hyper-hyperleptokurtic.  To counter the growing backlash, we’ve entered an age of almost pure insanity.

At the front end of it is, no joke, the idea that the Federal Reserve can accurately forecast “the most likely future path for the economy but also the distribution of possible outcomes about that path” as if everything over the last twenty years or so never happened. Right now, we are gripped by inflation hysteria predicated on only that.

The US CPI this week was reported to have gained 2.07% year-over-year in January. That’s slower than 2.11% in December and 2.20% in November, as well as the high of 2.74% last February. From that deceleration comes widespread commentary of “hot” inflation proving the Fed’s predictions and thus policy action correct if not in danger of being slow.

At the same time as the CPI, the Census Bureau also this week reported falling retail sales while the BLS produced estimates for real average hourly earnings that are lower in January 2018 than in January 2016.  Those are far more consistent with last year’s labor market that was simply awful no matter how low the unemployment rate fell, or how often the estimated addition of 2 million jobs is characterized as strong and terrific (it’s not even close).

While it may not seem this way, at the forefront is political rather than market kurtosis. Sure, the Dow got hammered for a time and global stocks retreated in liquidation just recently. Valuations being stretched as they are, the idea of a bubble and its possible downside are suddenly more plausible (as if they weren’t before).

That’s not what’s driving the utter certainty in commentary about the optimistic economic future, the hope to avoid another bust. Though that’s part of it, ultimately it is about the fate of technocracy and one of its most important projects – globalization.

Despite the overflowing catalog of moribund economic statistics, The Economist as one of its most vocal proponents saw fit to describe the US economy as “Running Hot” right on its most recent magazine cover. Is it, or is that outfit fearful that if they don’t claim it is they might risk more people turning against globalization? It was in these same (virtual) pages where last year was written another certainty, “Globalisation has retreated before. The results were disastrous.”

It is a titanic struggle of interpretation. On the one side are the populists who see stagnant wages and atrocious labor growth as a failure of the status quo technocracy, including globalization as well as various outlets of authority like the Federal Reserve that can’t do anything right. On the other is the so-called establishment who wishes at the very least to keep with the current order. To try and address worldwide political unrest, this side maintains simultaneously illegitimacy on the populists’ part (racism, xenophobia, even laziness) as well as admitting that maybe globalization didn’t benefit everyone uniformly.

The political results especially in 2016 and 2017 (Brexit, Trump, Germany, etc.; with Italy next?) showed that there might be something to this dissatisfaction after all, and worse, that it might not be limited to a small historical window. In desperation to undercut it, the economy is more and more described by intentional hyperbole; the economy is so awesome, you have to be clinically stupid or hopelessly biased not to realize it. The alternate from this perspective is to admit that the racists have a point, and it’s not racism.

Deep within the recesses of ferbus and the other DSGE and non-DSGE econometric models, what I’m describing here doesn’t rate even under the broadest measure of kurtosis – and even though it is the ultimate tail risk. We know they don’t consider it because not even 2008 was thought possible in their math, and yet it happened and maybe was inevitable (Volcker, of all people, sort of seemed to hint in that direction).

This is ultimately the difference between the Fed and the FAA. The latter has been repeatedly forced by literal death and destruction to change its ways, to alter its outlooks as well as procedures. Because the former has achieved only figurative losses no matter how grave and substantial, it can go on and on pretending that nothing different needed to be done, or needs to be done now.  The status quo can only then be maintained.

Inflation had better show up, and real growth with it, otherwise tombstones. Unfortunately, betting as many are on the Fed’s competence in forecasting and beyond, that’s the real tail.