Econometrics Hide the Depressed State of Nature

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It's hard to know for sure how much is just raw human nature, but there is perhaps more of a pervasive expectation for linearity, an almost bimodal outlook applied to everything. In general terms of economies and markets, if something isn't getting worse, it must be getting better. There is no account for how these things actually go, where no trend ever moves so straight a line. Something will always look better before it gets worse, and vice versa, usually several times over.

The proliferation of econometrics is, I believe, one of the biggest impediments to realizing this true state of nature. Statistical models are not truly all that sophisticated in their predictive states; if the modeler judges that, in this bimodal assumption, the state of the world isn't getting worse then the model will run forward as if that is always true. There will be calculations for downside risks, of course, some small percentage of Monte Carlo simulations falling toward what is judged a worst case, but the "central tendency" will plot along this dichotomy.

It is, however, at best confirmation bias, which is especially strong given that primary assumptions in every econometric model are bent upward to begin with. Economists assume "stimulus" works; therefore the level of nonconforming incoming data that economists require to overcome this bias is, for them, enormous. On the flipside, the lack of further negativity, even if temporary, is given inordinate weighting and often considered dispositive proof.

On August 7, 2007, the Federal Open Market Committee gathered as usual for its regular policy meeting. The flow of the meeting, however, was far from typical. The year started out in "unexpected" turmoil, and not just in subprime mortgages, though those held most of the attention. There was economic weakness, too, suggesting perhaps a little more than just cooling of the housing sector. On February 27, the stock market experienced a sudden and out-of-proportion (for that time) shock; the Dow fell 416.02 points, 3.3%, as foreign markets were weak but primarily because durable goods orders fell sharply. The implication was obvious, that perhaps there might be more to this housing thing after all.

The stock market played an outsized role in policy discussions, a factor that won't be of any shock to any observer, policy or "market." Economists particularly under rational expectations and efficient market theory believe that there is discounted future information in stocks beyond what might be found in other markets. I have always found this fondness and deference curious, as funding and credit markets are orders of magnitude larger, deeper, and more closely tied to fundamental balances (and, as the case may be, imbalances).

By early August 2007, however, stocks had shaken off their early year worries and rebounded nicely. There were more than few sighs of relief expressed at the May 2007 FOMC meeting, as Bill Dudley, manager of the System Open Market Account at FRBNY declared at its outset. "The market turbulence that began in earnest on February 27 is now a distant memory. Risk appetites have recovered, volatility in the fixed income and equity markets has declined, and the U.S. equity market has climbed to a new high." That attitude spilled over in the June meeting and then again in August.

It was in some ways contradicted, indeed had been contradicted, by other markets through the whole of the year to that point. Whereas the FOMC had expressed more of an academic attitude toward the events earlier in the year as almost outsider curiosity, the rest of the world was increasingly uneasy.

St. Louis Fed President William Poole asked Bill Dudley two questions about this disparity, particularly as they related to what seemed hardening in these diverging perceptions. "First, does the New York Fed have what I might call material nonpublic information about firms that would suggest that there is more difficulty than we see in the newspapers?" It was a very telling moment, an introduction of tension that is palpable even in the dryness of the sea of words that is these transcripts. President Poole, paraphrasing in my own words, was asking whether there really was something there given that the past two FOMC meetings had come to the conclusion there wasn't.

Dudley's response is Hall of Fame level famous last words.

"As far as the issue of material nonpublic information that shows worse problems than are in the newspapers, I'm not sure exactly how to characterize that because I guess I wouldn't know how to characterize how bad the newspapers think these problems are. [Laughter] We've done quite a bit of work trying to identify some of the funding questions surrounding Bear Stearns, Countrywide, and some of the commercial paper programs. There is some strain, but so far it looks as though nothing is really imminent in those areas." [emphasis added]

Just two days later, the entire global monetary system ruptured - irreparably. And it was none other than Countrywide who kicked off the day, admitting, finally, what everyone had suspected. The company had denied all year that they were experiencing, or would experience, liquidity issues; on August 9 they finally came clean with a press release that sent shock waves throughout the globe. What followed was a cascade of negativity, severe shifts that proved impossible to come back from. Even the FOMC was forced to hold an emergency conference call on August 10, 2007, not even half a week after Dudley confidently assured the Committee "nothing is really imminent." Northern Rock CEO Adam Applegarth, after his bank became the first major victim of rising systemic illiquidity, said it best later in 2007:

"The world stopped on August 9. It's been astonishing, gobsmacking. Look across the full range of financial products, across the full geography of the world, the entire system has frozen."

Bill Dudley was no empty suit; he couldn't be. The Open Market Desk, unlike many of the voting memberships, commanded real technical knowledge. Why had the Fed been so mesmerized by the stock market when they had in their hands contrary evidence of a much more consistent and compelling contrary case? In fact, it was William Poole's second question to Bill Dudley that provided just that kind of summary.

"People are trying to shore up their liquid assets in case they have to sell some stock into the market, so they are trying to hold more of that. But there is no easy way for those on the other side of that market to go short and push that yield back to where the best-informed people think it will be once we are past this turmoil. So what we may be seeing is less a reflection of expectations about future policy actions than a flight to liquidity as a desperate effort- "desperate" may be too strong-to shore up the liquidity of a balance sheet, and there is no easy way for people to go on the other side."

What he wanted Dudley to address if not answer was where all those "other side" traders were if the Fed was right. Specifically, the FOMC had been talking about eurodollar futures, a topic that suddenly became important back in the early part of the year when the FOMC first began to discuss potential scenarios. Eurodollar futures were plotting serious and growing chances of rate cuts, and many of them, especially in 2008. To that point, neither the FOMC "stance" nor mainstream economic forecasts were even hinting at the possibility.

Poole, however, essentially answered his own question; "we may be seeing less a reflection of expectations about future policy actions than a flight to liquidity as a desperate effort." Though he hedged on "desperate", again just two days later that word would instead prove inadequate. The wider FOMC was channeling funding markets through their own centrality, as if eurodollar participants were exclusively concerned with what the Fed would do or would not do in terms of the federal funds target policy lever. That was a huge blind spot, perhaps the fatal one.

It also assigned a damaging conceit: money market rates had to conform to Fed policy targets, and thus that Fed policy targets were the only meaningful translation of economic prediction.

Rather than heed Poole's more comprehensive assertion for money markets, the Committee, because they believed that eurodollar futures and other money rates were only a reflection of themselves projected into the future, easily dismissed other possibilities such as liquidity concerns. They didn't believe they would have to reduce rates, so the eurodollar futures market must be reflecting some temporary irrelevancy.

This was something that was discussed back at the March 2007 gathering. Richmond Fed President Jeffrey Lacker zeroed in on the discrepancy, again in a question directed at Bill Dudley.

"I look at Eurodollar futures every day. You're an experienced, savvy market guy and I want to learn how to understand these markets. My presumption would be that, if that takes place, there's something limiting the capital of people who could take the offsetting position. How could markets be so out of whack for so long?"

The difference at that time was even more puzzling. Though the stock market had rumbled on February 27, nobody was expecting serious dilemma. Of that "nobody", the FOMC placed high value not just on stocks but more so economists and their forecasts which stock prices (always) seemed to confirm. Lacker's idea of "out of whack" was directed at this difference - forecast models, particularly those made by the primary dealers themselves, whom the New York Fed regularly surveyed (and still does, the results now being public), showed no tendency at all for lower rates in the coming year or years. Why would traders, including those at these very same primary dealers, be acting contrary to their own forecasts?

What specifically elicited Lacker's question was Dudley's prior attempt at an answer, "Well, another explanation is that the economists who make the dealer forecasts are not the traders who execute the Eurodollar futures positions." In other words, the FOMC was taking the side of the economists. This is disturbing on so many levels, to discount very good market information in favor of econometrics, and to so in blanket fashion. As Poole in August, Lacker in March even pinpointed the key inequality; "there's something limiting the capital of people who could take the offsetting position." If economists were so convincing, where were those "other siders" who should have been falling all over themselves to take the arbitrage opportunity?

Lacker, as it turned out, was absolutely right. Capital constraint was the primary symptom of the looming eurodollar disaster. Eurodollar futures were pointing in that direction very early on in the crisis, yet because economists weren't seeing it that way the problem wasn't taken seriously enough. Policymakers defer to markets only when they seem to be confirmation of econometric models; contradictory market condition is left as just emotion or overdone concern. These are the functional differences between how economists see the world and how the world actually operates, a philosophical gap Milton Friedman once warned of.

One of these divergences is certainly the problem of money. Because economists and policymakers operated on assumptions that earlier committees even admitted were outdated, the fundamental flaw in their analysis of monetary policy and liquidity was not understanding money and liquidity. To economists, money is money, devoid of interesting and useful characteristics rendering it not worth further study. To markets, the nuance and texture of modern, wholesale money is everything. It begins and ends with balance sheet capacity.

President Lacker further pressed Dudley on the matter, going so far as to call him out for so discounting eurodollar futures as in "disequilibrium."

"No, he [Dudley] said that people told him not to take the Eurodollar price as indicative of the expected value of the Eurodollar rate at that date. Is that what you were saying? You said ‘disequilibrium.' I'm trying to understand how financial markets work here."

Dudley's response was representative of the fundamental problem of orthodox monetary economics. "When people are in risk-reduction mode, they don't want to take on more risk." It was a tautology of a rationalization, if not complete circular logic, that there was no one on the other side of eurodollar futures to push them back in line with economists' forecasts because anyone who might was reducing risk. If it was an arbitrage worth taking, there is no risk. What Dudley really meant, then, was what Lacker suggested before, "something limiting the capital." He never answered Lacker's question because he couldn't; it might have looked to these economists as agents reducing risk, but functionally it was the same as reducing global, systemic liquidity, really money supply.

Reducing risk was just a euphemism the FOMC conjured to translate functional money contraction into their Fed-centric, 1950's monetary worldview.

It proves yet again what I call math-as-money, where balance sheet capacity as determined by various mathematical factors including capital ratios, leverage ratios, and risk ratios, as well as external factors such as credit default swaps and hedging (traded risk liabilities) are what actually count in "dollar" liquidity (thus the quotation marks). Policymakers should have ignored stocks and started listening to their own closer constituents; "dollar" traders, not economists.

This is the reason that I still mark the anniversary of August 9 despite it being now nine years distance. It is an incredible amount of time to remain in so much ignorance, let alone in sight of all that has happened since. Here we are just after August 9, 2016, and the Fed is repeating the same mistakes as generated from within the same philosophical bubble all over again. Why isn't the FOMC concerned about inflation being so far below target despite four QE's, trillions of dollars in so-called money printing? "Professional forecasters" tell them that long-term inflation expectations remain anchored even though market-based inflation estimates strongly disagree and to 2009-type levels again. Models over markets, still.

How about money markets? Repo rates haven't been right since October 15, 2014, a date which policymakers have also written off as "nothing to see here." GC repo is supposed to trade over time at a negative spread to federal funds, representing the hierarchy of risk in secured lending vs. unsecured. Yet, the opposite condition has been in place where the repo rate is almost always above federal funds. Either balance sheet capacity (still) or the irrelevancy of federal funds is to blame, and neither of those suggests fruitful monetary conditions where the Federal Reserve is at the center.

LIBOR has been rising far out of proportion to either rate hikes or 2a7 money market fund reform (which has become the latest mainstream bogeyman to, like 2007, attach a benign but plausible-sounding explanation to what is becoming a very real problem again). That has left the TED spread, the difference between 3-month LIBOR and the 3-month T-bill, surging in what used to be a universally accepted indication of interbank funding risk; i.e., liquidity. Only for the most part it has been ignored because economists, primarily, have determined it either exclusively a product of regulatory reform (2a7) or, like 2007, another market "disequilibrium" that can't possibly mean what it so clearly does.

But it is eurodollar futures that truly draw and direct our attention again in just that manner, especially in the absolutely astounding move since last summer. The Fed says they are going to raise rates and even managed to do it once, at least in federal funds. Eurodollar futures instead only rise in price (meaning the indicated money yield falls). They suggest even more illiquidity and funding problems that only bring this all full circle; to emphasize just how little monetary policy has grown despite mistake after fatal mistake, opportunity after opportunity, to do so these past nine years. What the eurodollar futures curve has done since last August, a period of time during which a string of negative events that were also judged "impossible" actually happened, is nothing short of extraordinary. And the Fed disregards them all over again.

Economists today claim there is nothing wrong; credit and funding markets are positioned very much otherwise. The stock market is still in the camp of economists, but barely, which has only served to reassure them and once again complete the circuit of circular logic: stocks are up because economists forecast nothing bad, and economists forecast nothing bad in large part because stocks are up.

That impenetrable bubble of confirmation bias is all predicated on the same fundamental flaw; that monetary policy is still monetary policy. Bank reserves are still thought of as money and even "money printing" despite nine years of economic depression and near-constant market disruption and illiquidity that wholly prove otherwise. The Fed nevertheless thinks it is the center of global dollar markets when just one day, August 9, 2007, showed that an utterly false superstition. All the rest of the days since are just piling on because economists refuse to change.

It is that single day that explains why real GDP is $16.5 trillion instead of $21 trillion; why nominal disposable personal income is $14 trillion rather than $18 trillion; why global trade is figured by the OECD to be $22 trillion this year, $9 trillion less than it should have been if the prior growth trend had been maintained; and so on and so on in economic account after economic account all over the world. In other words, had the Great Recession actually been a recession we wouldn't be thinking about August 9 for the tenth time.

A recession is a temporary deviation from trend growth; a depression is a more-than-temporary reduction. Recessions are a normal course of the business cycle; depressions are monetary. No one need look any farther than US treasury yields to confirm it. The UST yield curve, as the eurodollar curve, is lower and smaller now than it was at any of the worst points in 2008 and 2009. Economists see that as a matter of "stimulus" and policy; eurodollar futures, in what has become a permanent departure, sorely disagree. The world of the last nine years and all its lost growth and opportunity was explained and even listed in those FOMC discussions that led right into it. On August 7, 2007, policymakers declared such a scenario highly unlikely, a trivial concern, but even though that confidence would last not even forty-eight hours it remains August 7 still to this day.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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