Welcome to the Long Run: For Good or Bad We're Not Dead
In another week where "outflows" from China show up across the globe as also "outflows" everywhere else, it might seem difficult to be able to untangle the various threads of disorder as they radiate out from a central axis equally undiscernible. For one, the central bank in China spent last week projecting growing desperation and then followed it up this week by intentionally spiking a liquidity market of its own creation. To gain control over yuan, the PBOC destroyed, for one day, trading of yuan and all in the name of regaining stability.
It truly is absurd as it sounds, though maybe just a little less so if you appreciate the distinction of yuan onshore (CNY) against yuan (offshore); all of which are really supposed to be renminbi, though that is just semantics (renminbi is the name of the currency, "the people's currency" in Mandarin, while yuan refers to the unit of account). The PBOC first allowed yuan trading in Hong Kong (CNH) as a means toward more liberalization of the financial system, so when overnight HIBOR spiked to 66.815% on Tuesday, all at the behest of the PBOC "requesting" Chinese state banks "buy up" all the offshore CNH they could find, it appeared more than a little odd. Liberalization and greater market forces were once to be courted, but now to be snuffed out and with great vigor?
At issue are "speculators", those loathsome creatures that only seem to show up when the most awful conditions are presented. Given the way the official sector treats them, and more importantly exactly when they get to publicly hating them, you would think them some sort of cabal of evil geniuses biding their time in order to strike only at the weakest points in order to sow chaos and confusion to make their ill-gotten gains. The bastards seem only to make money from our general misery.
That, of course, is utter nonsense. Speculators are not just evident every single day but a fruitful part of the balance of forces that keep economics and financial markets as efficient as possible. This is totally distinct from the "efficient market hypothesis", rooted in rational expectations theory, that central banks and orthodox monetary economists now use against speculation. This idea of efficiency is at the very root of everything that is wrong now, and the distinction between free market efficiency and what central banks are trying to cajole and force is not trivial.
To see why, we need only appreciate a simple experiment. In the 2011 BBC documentary mini-series The Code, mathematician Marcus du Sautoy demonstrated what is known as the "wisdom of crowds" through nothing more than a jar of jellybeans. We have all seen these guessing games at various places, so it is easy to appreciate the difficulty in trying to venture just a ballpark estimate. In the third episode of the series, he placed 4,510 jellybeans in a jar and set out to ask 160 people for their guesses. They were, predictably, all over the place and only four were actually close (the show didn't disclose how close). One lady guessed 80,000 first before settling on 50,000 as her try.
However, in what seems like a magic trick, the crowd got it almost exactly right (obviously, not all the guesses were shown on camera so we have to assume that the numbers presented were faithful). The total guesses of all 160 people added together summed to 722,383.5; someone even presented their turn with, apparently, half of a jellybean in his/her total. Divide that sum by 160 and you get 4,514.89688, or so close to 4,510 as to be eerily unrealistic.
This is fractal geometry, which in this context demonstrates a great truth, perhaps even noting something of truth in the Platonic sense (which was the entire point of The Code). There is value in error; vital information that subconsciously or in subterranean fashion becomes a profitable part of the information stream that produces the most efficient results. The more complex the system, the greater the difficulty in defining and seeing error from whatever is not error.
We can even grasp that point in the very humble example provided by Marcus du Sautoy and his jellybeans. Clearly, the woman guessing 50,000 (first 80,000) was way, way off; it was a ridiculous guess by any standard. But what happens when we assert our bias in that fashion and "righteously" exclude her imprint on the system? Subtract 50,000 from the whole to get 672,383.5 and divide by 159 to arrive at 4,228.82704. The original answer was off by 0.108%, but by excluding an error that was very clearly wrong we are now farther away, deviating to 6.2%.
That is what statistics, as a practical discipline, in especially economics does. It attempts to define errors for us as if they were more than useless, even harmful. A statistical model, by definition, is an unnatural subset of reality or the comprehensive state. The statistician must make simplifying assumptions about what to include as defining variables. It is physically impractical to do otherwise even where a mathematician or economist, in particular, might actually appreciate the bias. To truly predict the weather, for example, would require measuring every single molecule in its current state and as it changes, and then making real-time calculations about all of them; an impossible task. Meteorologists have no ability to even undertake such an effort, so they are left defining (and arguing about) shortcuts in how to measure, calculate changes and then, maybe more importantly, interpret their own systemic shortcomings in a useful way. The TV weatherman has a literally impossible job.
The genius of Benoit Mandelbrot was realizing that there is important information outside of those artificially constructed boundaries. What seem to us as obvious errors, even ridiculously so, cannot and should not be isolated and treated on those terms. We know this point intuitively as "trial and error", where error performs the very function of societal progress and innovation. That used to be the very standard of science itself, which has somehow been supplanted as "science" of statistics.
Statistical processes assume that their modeled reality are close enough because they set aside "errors" that appear to be random, and thus unhelpful. In increasingly complex systems, the ability to make such a guess about randomness becomes exponentially more difficult; yet they do it anyway. Again, errors may only seem useless or harmful in isolation only because we choose to view them in that isolation. We have no ability or functional method by which to distinguish how any error might further affect the complex system, including in positive fashion and ultimate outcome; that was the whole point of chaos theory (which is nothing like what was described in the movie Jurassic Park).
Chaos theory starts from the point of sensitivity to initial conditions. In other words, the smallest of variations produce monumental changes the further you go. That was demonstrated in the seminal 1975 paper Period Three Implies Chaos, where authors Li and Yorke showed that "any one-dimensional system which exhibits a regular cycle of period three will also display regular cycles of every other length as well as completely chaotic cycles." The information supplied by even ridiculous guesses might somehow inform someone else about which way to arrive at the "correct" answer; eliminated that guess might produce unpredictable consequences, even disastrously so. To know how that information is both supplied and applied is a practical impossibility.
So it is with economic and financial systems, with trillions of transactions and perhaps quadrillions (or more) of data pieces and points all being subjected to translations and imputations that we cannot possibly imagine. And in that mix are errors; lots and lots of errors. In fact, that is why economics and finance are often described in terms of winners and losers, not just because of the often massive egos involved but in how losers help us define everything. Thomas Edison famously took 1,000 (or 10,000) tries to make the carbon filament light bulb, to which he supposedly responded, "I have not failed. I've just found 1,000 ways that won't work."
He also said, "To invent, you need a good imagination and a pile of junk." In financial terms, central banks are dedicated to eliminating both imagination and the pile of junk. They have judged "error" to be identifiable in the terms they themselves have narrowly chosen, and taken to task in eliminating them. In reverse Platonic fashion, economics seeks to prevent and reduce the forces of crash and recession as if there were no redeeming qualities in systemic resetting. On the surface, these seem noble and enlightened goals but it isn't long before you realize that this is no different than assuming the 50,000 jellybean guess has no systemic value, and therefore worthy only of removal (and, of course, being totally surprised at arriving at a worse result for the trouble). How can a system truly evolve if it is skewed artificially from all possible informational points?
This, too, isn't very difficult to demonstrate as all one has to do is point to the serial asset bubbles with which the world is all-too-familiar with at this point (and becoming so yet one more time). In one respect, asset bubbles are rationalized behavior centered around that skewed distribution. Because the central bank has dedicated itself to reducing or eliminating "risk" in very vague terms, no less, speculators indulge in all manner of imprudent behavior. In the end, however, the central bank guarantees the outcome they are seeking to avoid because they have eliminated the information feedbacks that allow the free markets to define and learn what is and is not "imprudent."
There is efficiency in seeming randomness. In the natural world, there is tendency for physical forms to find the most efficient shapes possible. The sphere, for example, is the most efficient distribution of forces which the material in it can displace maximum volume for finite quantities. The soap bubble is a perfect example of that. Economies and other complex systems are in many important ways similar; always searching for the most efficient manner of distribution given finite quantities of everything. There is no way to find such efficiency and thus true progress at the direct exclusion or dismissal of error. The Federal Reserve, had it existed in 1879 and assigned itself the task under its current rules, would have told Edison to stop after only a few tries at the light bulb and instead use whatever he had at that point. In other words, monetary intrusion is a purposeful deformation of the efficient shape because economists have assumed they can, with no wisdom of the crowd, define better what is and is not error and prudence.
That is the point of speculators as a general class, full of imagination and seeking to find piles of junk with which to mine gold. We only subject them to great scorn where they, again, appear unbridled and overwhelming (unfettered greed is usually how it is termed). But how are any of those terms defined? The damned speculators of the great crashes are treated as if they are the error, when in fact the possibility that speculators are instead revealing it is never contemplated.
In many ways, economics has recreated Triffin's Paradox from the 1960's because economists never saw how it was never really a paradox to begin with. Robert Triffin proposed that the US dollar dilemma at that time was due to gold restraint; the US "had" to expand the money supply for use as the global reserve currency, especially with the co-reserve British pound in full-scale retreat through repeated crisis, but in doing so that only created the inevitable end of the process since foreign dollar holders would see the discrepancy and demand, increasingly, conversion of paper dollars into gold. The more the US expanded, the more paper converted to gold, further and further fatally undermining the "necessary" monetary expansion. Economists, as they had done of the 1930's, treated gold and the negative forces gold proposed as "the error."
In fact, as the Bretton Woods standard was increasingly undermined throughout the 1960's, we see in the Great Inflation that instead gold was revealing the error all along - the error was economists who thought they could define what were and were not errors. In fact, an objective view of the 1920's showed that same discrepancy, as the Great Crash starting in 1929 wasn't related to the gold standard but rather central banks that had taken great pains to circumvent it ("sterilize") throughout the 1920's; once the traditional gold standard was removed in WWI, economists in the Progressive Age were first "allowed" to experiment in greater and greater fashion not on market efficiency but on their own methods of overruling them. Every time, it seems, the global financial system moves away from a hard monetary anchor it ends so very badly; and each time those responsible for declaring "what went wrong" are those that advocated against the anchor in the first place. That is the true paradox of the modern economy; those that mistake themselves as capable of defining errors in complexity are the very people that seek no appreciation for them.
That is what hard money actually meant in terms of a complex system. It was the bearing and orientation, the focus of trial and error that revealed in non-specific terms the "temperature" of the wisdom of the crowd. A strong dollar was one in which convertibility, of paper to hard money, wasn't going to be a problem. No matter the economic or financial errors that combine and approach every single day, the economy seemed in relatively efficient operation - if not the sphere than at least moving toward it. It was gold and hard money that allowed us to see the "shape"; to be reasonably assured that errors were treated not as random noise but as the very basis for messy but positive progress. When natural error accumulated too far, it was gold that, through crash or recession, brought it all back in line of efficiency. That is why recession cycles used to be short and quick; not the long and extended "jobless recoveries" (a term first proposed after the 1990-91 recession) that we have now, including the very new and alarming recovery-less recovery.
In the post-Bretton Woods era (and really starting more than a decade before Nixon's 1971 default), there is no monetary anchor leaving only seeming randomness. The eurodollar and various money markets that developed through the last decades of the 20th century were treated as a singular, monolithic process with the Federal Reserve's ephemeral "windows" standing in for a monetary anchor. It was no such thing, a fact revealed starting August 9, 2007. Paradoxically, the Fed then acted as though what was really the error was instead the goal, and that the means in process of revealing that weakness were instead the error. In other words, the Fed sought to recreate the eurodollar system as if it were a stable state worthy of being the permanent monetary baseline when in fact it was the definition of instability due to the lack of perception about systemic inefficiencies it had created all along (it was nothing like an efficient sphere, but without a true monetary anchor along the way there was no way to prove it, though many, many people contemporarily warned about it long before 2007).
In fact, that is what we increasingly see even today; that money markets are still fragmented and unapproachable under this common conception because there is no money in any of it. The world's money markets are under desperate pressure because central banks refuse to accept the complex pronouncements of modern money trial and error - that they, central banks and economics through econometrics, are and have been the error. If there is so desperate a monetary state in offshore CNH as to make the PBOC undertake such drastic action as seen this week, it can only be because "speculators" are attacking the systemic impossibility of the artificial nature of the system the PBOC has itself created and nurtured all along.
Despite somewhat popular perception, particularly among people predisposed to confusing central control with efficiency, the Chinese economy is a tangled mess of inefficiency. That fact is what the crash is trying to reveal, that the economy and its financial system are so warped as to be nothing like a sphere. The only reason it has gotten this far is that without true money there was no way to separate and conclusively define the economic shape. Prices matter, and artificial prices matter more so in enforcing great and extended inefficiency.
And while that seems like an unfortunate problem for the Chinese to try and handle, and for the rest of the world's central banks to limit the fallout, that, too, is an as-yet proved error. The great inefficiency of the Chinese economy is and has been predicated on the eurodollar and the eurodollar alone. The eurodollar built China. Every time over the past few decades, including 2008, that the true market forces of crashing attempted to signal, demonstrate or prove the inefficient artificiality to all of it, the world's central banks combined and colluded to view instead the crash as the error to be overcome rather than the markets incorporating central bank errors into defining the actual, efficient path forward - even if that required great short-term devastation to accomplish.
The global crash in 2008 was just that but "monetary stimulus" was the equivalent of removing the 50,000 jellybean guess. That is why the global economy never recovered, itself a singular act of incongruity that stands out and demands recognition in just these terms, and why in many ways what the rest of the world is experiencing right now is worse than the Great Recession already. Markets even here, especially junk bonds already nearing or at 2008 levels, are starting to get that sense; that 66% money market rates are not at all random, but indicative of a deeper fissure or "the code" behind it all. The Great Recession was not a temporary cycle deviation from a fruitful and efficient track or trajectory, it was the first attempt revealing that the artificial and inefficient structure of the economy and global financial system under the eurodollar had reached its end.
All the signs and indications of that as it was building were treated as unimportant randomness. Now, there is regularity to disorder (so much for "transitory") that leaves little doubt as to deeper meaning, even if central banks still refuse to entertain even the slightest thought of it. You can start to appreciate their impotence, because for them they truly see it as all random; as if the events of August are unrelated to our current circumstance; and the events of earlier in the year unrelated to August; and the events of October 15, 2014, unrelated to the events of January 2015; etc., etc. What economists self-select as nonsense to be avoided and dismissed may be vitally important in the long run. Welcome to the long run.