Economists Are Blind to How Little They Know
Humans are hard-wired for what may seem the strangest behavior because quite honestly we live in a complex world that has only become more so as perhaps the small dark cloud in the giant silver lining of inarguable progress. Rationalization is simply a part of who we are in basic biology and evolution, found even in other primates. In 2007, for example,Yale researchers reported evidence for cognitive dissonance in monkeys as well as 4-year old humans.
The monkeys, at least, were given candy, M&M's to be specific. With the only variation the unimportant factor of color, they were perhaps the perfect choice as a control mechanism (to say nothing about the great likelihood that monkeys would find them as irresistible as many humans). Essentially, the experiment showed that animals who had previously shown no particular devotion to a particular color M&M among a set of three would suddenly switch once being given a choice between two to actually eat one. If the monkey chose red, then suddenly blue was no longer a "preferred" color.
It seemed as if there was a primate primitive instinct to rationalize individual choice, where being given the chance it was perfectly natural to self-reinforce the internal idea that whatever choice we make is the right one - even if it is inconsistent with prior behavior.
A year later, however, Yale economist M. Keith Chen added some statistical doubt to the study. Demonstrating quite well the idea of complexity, Chen interjected on the grounds of a 1960's game show. Though it may sound ridiculous, keeping with the theme, there is a relatively well-known mathematical conundrum known as the Monty Hall Problem. I won't get into it here as you can find a good description and even the math behind it relatively easy. What Chen introduced was that complexities beyond the grasp of the Yale psychology researchers may not have been factored, and thus the monkeys may not have been rationalizing what they had done but actualizing hidden preferences that the study didn't or even couldn't factor.
In 2010, all the parties reconvened through John Tierney's column at the New York Times. The psychologists reran their tests with monkeys and M&M's now with the Monty Hall Problem in mind, with Chen then critiquing the new results. About the only solid conclusion to be gained was the further proof that economists are but statisticians rather than as their name implies (a well-deserved cheap shot).
Cognitive dissonance or rationalization is still well-established as a matter of everyday experience. In more scientific terms, as much as can be taken from a social science, the ideas took shape in the 1950's first in a groundbreaking experiment written up in the 1956 book When Prophecy Fails. Social psychologists Leon Festinger, Henry Reicken, and Stanley Schacter infiltrated a doomsday cult in Chicago whose leader claimed knowledge of the end to the world via a terrible flood. With a preannounced date in hand, Festinger et al knew that this was a unique opportunity to study dissonance when inevitably, as the book's title makes clear, very dear beliefs are invalidated.
The cataclysm was scheduled for December 21, 1954, at seven hours after midnight. Right at midnight, this faithful group was supposed to be visited by some being from outer space who would then shepherd them into a craft to avoid the doomed fate of all the rest of humanity. As the book describes, the cult followers went to great lengths that night so as to prepare for their rescue, including determined removal of all metal objects from their persons.
At 12:05am, with no spacecraft in sight, one of the group noticed that a clock in another room shows only 11:55pm, a possible imperfection which they all agreed led them to the conclusion that the clock in front of them must be wrong. They sat largely in silence broken occasionally by weeping or sobbing until 4:45am when the cult leader is given a message via "automatic writing" that by light of their own demonstrated faith the "God of the world" has chosen instead not apocalypse but to spare all. The assembly eagerly accepts this new "information."
But this condition is not just in isolation of individual people (or monkeys), it is far more often than not socialized just as in a cult. As Festinger wrote, "If more and more people can be persuaded that the system of belief is correct, then clearly it must after all be correct." This phenomenon borders on the behavior of markets, a similarly more widely distributed information system which presupposes that someone somewhere has the "right" answers and that certain someone is leading, eventually, all price action through the rational conduct of social analysis if over time. In the cult setting, it's a dubious proposition simply because the base of knowledge supporting the group is intentionally far too narrow; in a market, it is near infinite in its possible proportions.
From this view, the allure of manipulating market prices is for a central banker overwhelming. If he, now she, can through the non-economic act of purchasing whatever asset control the price of it and perhaps others related to it, there is the chance that this action would be accepted as Festinger describes of cultish behavior. If bond yields are low because a central bank buys those bonds, what does that price actually mean? In truth, it means only that the central bank bought those bonds, but the utter complexity of markets as well as bonds cannot establish that factor alone; therefore, in the drowning noise of finance economists average it all out such that this "market" will have no choice but to accept the price as the price.
But even to central bankers this isn't straightforward, either. It is itself a rationalization that stands on dubious ground. As Ben Bernanke wrote in last year introducing himself as a blogger for Brookings, the key to lower interest rates as an "acceptable" outcome is where they decline because of reduced "term premiums." Economists believe in Fisherian deconstruction or hierarchy of interest rates. In UST's, there are, supposedly, three components: the expected path of real short-term interest rates; inflation expectations; and, term premiums. That last is essentially the reward of prospective higher returns a bond investor demands to hold a longer maturity instrument, and therefore a component of risk perceptions.
For Bernanke, longer-term interest rates that decline based on "term premiums" are the fruits of successful monetary policy. But like the end of the world and the irrational belief in space alien salvation, you cannot falsify the existence of "term premiums" because they aren't anywhere observed. What math has been devoted to extracting them from actual market prices (yields) is at best incomplete and contentious.
That leaves just the other two components as possible observable variables. And for Ben Bernanke, it just doesn't look good for QE. As I wrote a few weeks ago:
"It really is that simple even if we can't accurately measure any of these pieces individually. Unlike his ‘neutral' interest rate that leads to his favorable math of ‘term premiums', we have very, very solid evidence that the current trajectory of low nominal rates if they could ever be so decomposed would be moving lower on the bottom two sections rather than the top. Eurodollar futures, as noted yesterday, continue to reflect a truly unnerving future path of short rates, not one that leads in Yellen's direction. At the very same time and in very corroborative fashion, TIPS trading has broken down inflation expectations into 2009-style lows."
What is inarguable is that interest rates have fallen, and more so outside of QE than with it, contradicting already "stimulus." Even if we were to accept Irving Fisher's deconstruction, there is only evidence that rates have declined, precipitously, because the future expected path of real short-term rates have sunk in addition to inflation expectations that are like 2009 rather than "full employment." The market behavior of those two components greatly raises the probability that "term premiums" rather than falling due to the great work of the Federal Reserve in healing the financial and economic wounds of past panic may have been rising instead as long rates overall fell, meaning that the vast and deep bond market sees greater risk on the horizon and has been preparing for it. In this view, all three components would have agreed on where this was all going, and going still.
Interestingly, it was Paul Krugman who wrote about this scenario back on Christmas Eve 2012, using When Prophecy Fails as the backdrop of rationalizing for his Republican, largely, Cassandras. Krugman quite rightly pointed out that on his favorite topic of austerity (the government, according to his view, always needs to spend more, and when more isn't enough it is because it wasn't enough; circular logic goes hand in hand with rationalizing in "economics") that critics were wrong about the national debt. There would be no skyrocketing interest rate calamity because:
"Regular readers know that I and other economists argued from the beginning that these dire warnings of fiscal catastrophe were all wrong, that budget deficits won't cause soaring interest rates as long as the economy is depressed."
Again, this is exactly right. It should be pointed out that agreeing about rates is not the same as agreeing that debt doesn't matter; only that in a world of tradeoffs, depression comes first (another pioneering empirical demonstration brought to us by Japan). And that has led "us" into the opposite rationalizing prophecy not of doom but dawn. As rates have sunk, curves collapsed, and economies generally smaller and slower with them, the siren song of "recovery" remains as deafening as ever; only now the monkeys are saying how much they always liked the green M&M's all along.
This comes in various forms primarily attached to the unemployment rate, but also equally if not more so QE itself. In an article published in Bloomberg earlier this week, we are told that even though so many market indications are flashing warnings we just shouldn't believe them:
"That's because the once-dependable indicators traders relied on for decades to send out warnings are no longer up to the task. The so-called yield curve isn't the recession predictor it once was. Swap spreads are so distorted they can't be trusted. Even the vaunted VIX -- sometimes referred to as the ‘fear gauge,' is leading its followers astray, strategists say."
Though the TED spread has been recently as high as 2009, or LIBOR-OIS widest since 2012, comparisons both to some pretty dark financial conditions, those no longer matter...because. As one quoted analyst put it, "There aren't a whole lot of reasons to believe there are funding strains in these big financial institutions."
It would be easy to respond with Deutsche Bank, too easy really, but it's not as if DB is an outlier. At worst, the big German bank has been the leading edge of an industry-wide downward lurch. What's even more ridiculous is that you can establish this with just a few minutes work by plotting the price of Deutsche's stock or those of European banking as a whole or even US banks (of the wholesale variety) as a group against the 10-year swap spread now persistently negative. They all move almost perfectly together, with their unmistakable inflection last summer just before CNY broke and "global turmoil" rather predictably followed. To the prophecies of Janet Yellen's recovery, none of this consistency can be valid because it is inconsistent with the GREAT assumption. The Bloomberg article tells us:
"As central banks around the world pump billions of dollars into the global economy every month and policy makers pass regulations to safeguard against a relapse of the 2008 financial crisis, the market's best and brightest say some warning signals are flashing at precisely the wrong time."
Every major civilization in history has some variation of a great flood myth, Noah and his ark being the most widely known by its inclusion in the Bible. In the mainstream economics bible written by statistician economists, QE was its flood myth. Nothing bad especially of global illiquidity can possibly happen because the Fed flooded the world with dollars in the four money printing operations of scientifically determined quantitative easing. The world so deluged with dollars just doesn't act that way because, as the kids would say, reasons.
From inflation, which would be the first to respond if "central banks around the world pump billions of dollars into the global economy", to interest rates to even stocks, which have gone nowhere for over two years, timed, not coincidentally, to the contradictory appearance of the "rising dollar.", "something" has changed. I have to write it in quotes because to write it out is emotionally unnerving to the narrow constraints of what is equally narrowed discourse. All the evidence points to "dollar" illiquidity and even great shortage, but that just cannot be because reasons.
It changes none of this emotion that central banks have already admitted implicitly that it was all a lie. If QE had been such a success establishing how all these warnings are misconstruing what are really good times, then why are central banks everywhere quietly but very seriously evaluating only other options? The answer is, for once, refreshingly simple: faith in central banks among market participants is at a low, while faith in central banks in the media and mainstream remains largely (but not totally) undaunted. Central bankers in their vanity care much about the latter, but for their survival are finally forced to deal with the former.
The media through economists has chosen to believe but not verify that QE is money printing, and no amount of market contradiction, sinking economic fortune, global "dollar" illiquidity, Donald Trump, Brexit, unexpected Japan "dollar" attention, or China will ever convince them otherwise. None other than Janet Yellen spoke last Friday where her topic was all the things that economists didn't know - and it was a lot, all vitally important concepts. Of one very telling passage in her speech I wrote:
"The Chairman of the Federal Reserve claims that it is now necessary to study whether or not people and firms act differently. I am not in any way surprised that I just wrote that sentence, but I suspect the vast majority of people in the world would be stunned by it. Alan Greenspan's reign was truly the dumbing-down of economics because during it these economists really believed simple, common sense ideas were immaterial. As Yellen recalls in her speech, they just assumed that they could model but one kind of ‘average household' as sufficiently representative of all the rest."
Though the world is blindingly complex, economists were until just recently convinced they could sidestep it all through Positive Economics in the form of econometrics. As Milton Friedman said of it, they could get away with knowing very little so long as that little explained a lot. By accident of circumstances unique in time, Alan Greenspan thought he had done just that with his "all-powerful" federal funds rate tinkering. The Fed believed fully that it didn't need to know why minor adjustments here and there to a minor market of only one small part of the money system appeared to work, just so long as for them it did. It is a highly flawed concept even where it might even have been right once, "The fatal conceit with all of this is that it applies only to a static world; even if you could actually explain a lot knowing so very little as economists clearly do, that still doesn't mean you can always explain a lot by knowing very little."
What all these have in common is more than just interest rates or TED spreads, even global depression; it is the entire idea of technocracy itself. Since before Plato, people have dreamed of a utopia where enlightened, dispassionate philosophers would govern and guide messy, often awful human existence toward and into "optimum" outcomes. It took until "economics" in the latter half of the 20th century for such hubris to take literal hold; there is an entire branch of the "science" dedicated through statistics just so to determining both "optimal outcomes" as well as the duty to "nudge" people toward them using the power of government if need be.
Economics is where technocracy was tried in widescale fashion first, and where it was thought at one time perhaps perfected. The Greenspan Fed, before the dot-com bust it needs to be pointed out, was believed by far too many the Socratic Ideal brought at long last to our world. So enthralling was the arrogance that it has been rationalized down by reality to what looks more like a cult than anything. Don't believe market warnings, continue to believe The Fed Chair even though she finally confessed that economists can't afford to keep assuming how little they know is enough. I am absolutely positive the next great psychological case will be written of the consistently imaginative dissonance leftover from When Policies Fail. It has already been started.