Trying to Make It a Legitimate 'Science', Economists Achieved the Opposite
It sets up the most interesting conundrum in decades. For a paradigm wholly dependent on rational expectations theory, for Economics to now so publicly chastise and try to degrade the most significant markets on the planet is perhaps a case study in unraveling. The contradiction is just too good to ignore.
And it is a very simple case of not being able to see the forest for the trees. Central banks around the world claim they are normalizing monetary policy for the first time in a decade because their respective economies have finally healed more than enough to warrant some normalness. Several of them, including the Fed and now the Bank of England, are raising rates to that end.
Yet, in doing so they are increasingly perplexed, visibly miffed even, at what little respect for their power is being displayed practically everywhere. Inflation is coming, they say. Growth is picking up, they say. With those can only be higher rates.
That’s true. If inflation was to actually accelerate along with economic growth and opportunity, bond rates especially at whatever long end would be rising. Each yield curve would steepen first in doing so, and then flatten as the process wound down into full recovery and an actual rather than imagined economic boom.
Yield curves are flattening, alright, only at the start of the process rather than at its end. It’s this that has central banks, and the media, nearly apoplectic. Central banker after central banker says things are working and getting better, and that because of this they will raise the short end of each curve. The bond market reply isn’t that central bankers are wrong about what they will do, it’s more so that markets don’t care one bit because they are wrong about why they will do it.
In short, bonds are calling the inflation/growth bluff. And why wouldn’t they? We’ve heard all this before, several times, and often in just as emphatic terms as now. Let’s not also forget 2004-06 and the last “conundrum” which pretty much amounted to the same exact dissonance. Alan Greenspan said growth was rising and the world normalizing from the dot-co bust while at the same time the US Treasury market said risks were rising not growth. Which view was proven correct?
The chief difference between that conundrum and this one, though, isn’t just numbers. A decade ago, long-term rates were considerably higher than they are now. In terms of risk/opportunity, that shows the bond market believes central bankers are today stretching their collected imagination by quite a lot. Even the mainstream has begun to notice, though this has been ongoing since November 2013.
From Bloomberg this week:
“The conundrum faced by Alan Greenspan is back -- and possibly worse. This time, the Federal Reserve is confronting a ‘far more dangerous’ backdrop in the bond market as it gears up to further raise interest rates.”
Again, the conundrum didn’t just rematerialize in the last week or month, but it did kick into overdrive recently. The terms of this flattening (the difference between long UST yields and short UST yields) are startling especially for those who believe in central bank gospel: since September 11, the 5s10s down 14 bps to just 29 bps in spread; 2s10s down 17 bps to 65 bps; the 5s30s down 31 bps to a mere 73 bps total.
These kinds of moves can’t go unnoticed even by Economists and policymakers. And it shouldn’t go unnoticed when the flattening really started to pick up – the Monday following the week where the 4-week T-bill went insane, which then completely messed up the repo market for weeks afterward. Repo fails for the week of September 6 were the highest since the bond market selloff of November 2016.
Rather than listening to the market, central bankers and economists are telling everyone else not to. This is extremely odd given that rational expectations demands respect for market prices. We know from history, however, especially the crisis history over the last ten years, that central banks don’t actually operate based on market reality but instead theoretical market “reality.”
The problem is science. What I mean by that is Economics can never really be one, at least not in the same way as physics or whatever other hard science. The scientific process is about observation, replication of results, and predictability. Any hypothesis must be observed, verified by results that anyone else can replicate, and lead to predictable outcomes.
For Economics, what truly counts as an observation? What actually happens inside any economy down to the smallest one is unobservable. We know that transactions and trading takes place, but there is no possible way to track and measure every single thing that occurs. Even if it was possible to track all of it, there is no clear method for aggregation and then useful analysis. Thus, any economic observer is always at the start forced into short cuts to try to make sense of Adam Smith’s invisible hand.
How can any discipline evaluate, scientifically, hypothesis on that basis? It was a great concern for a great many economists for a good long while, going all the way back to the 19th century and John Neville Keynes (John Maynard’s father). The technological revolution of the mid-20thcentury pointed them, however, in one possible direction. Milton Friedman collected several influential papers, several that he wrote, in his 1953 Essays in Positive Economics.
Positive Economics, Friedman wrote, was a system of rules and standards designed
“…to provide a system of generalizations that can be used to make correct predictions about the consequences of any change in circumstances. Its performance is to be judged by the precision, scope, and conformity with experience of the predictions it yields. In short, positive economics is, or can be, an ‘objective' science, in precisely the same sense as any of the physical sciences.”
I look at a flattening yield curve anchored at the long end at very low interest rates and I conclude that it’s a bad sign. If a steeper curve and higher nominal rates are what suggests coming inflation and growth/opportunity, how can its opposite be that, too?
An Economist steeped in the methodologies of Positive Economics, however, looks at a yield curve and doesn’t know what to think. The transformation of the entire discipline to what it has become started here with standardizing rules of evidence, so to speak. A yield curve isn’t a yield curve in Positive Economics until it can be transformed into useful observations for those purposes.
We are talking, of course, about statistics. That is the format which Positive Economics settled upon so as to replicate, or try to, laboratory conditions for the evaluation of secondary observations and indirect experiments. Financial market data must be regressed and then undertake many different statistical exercises so that the Economist can assure himself that the observation meets the scientific standards of the discipline.
Rather than turn it into a truly scientific process, however, the focus on mathematics has inverted the whole of it. The mathematics have become all that matters to an Economist, so that without it he can make no sense of anything that doesn’t fit. The main part of any scientific process is falsification, but in Economics there can be none. The models have become more real than reality.
The yield curve is a perfect example. To me, again, it’s telling the world there is everything still wrong in not just the economy but more so money (the interest rate fallacy that is actually being tested, successfully so far, by central banks “raising rates”). But in the regression analysis of Economics it doesn’t compute. All that math says that when a central bank is raising rates it’s because monetary policy works, therefore the bond market that doesn’t respond in that fashion must be wrong.
And that’s what central bankers have been declaring more and more over the last year. The latest was Bank of England Deputy Governor Ben Broadbent who charged to an audience at the London School of Economics “financial markets have underestimated the chance of further interest rate rise.” The reason he gave was Brexit, in that he believes the gilt market believes the BoE will have to tread lightly given the political and economic uncertainty surrounding the process.
Perhaps, though given this is a global phenomenon not limited in any way to Britain, British rates, and British central bankers who won’t abide by them, it’s far more likely in keeping with the rest of the global bond market and the current state of global interest rates. This is strong market evidence that they have it wrong, yet they refuse to concede that could ever be the case.
This paradigm instead falsifies the data refuting the central banker hypothesis rather than the hypothesis because in Positive Economics the math has to be unassailable otherwise it fails on its own terms. If the models are wrong, then the whole “science” of Economics must be, too. That’s falsification too far for what has devolved instead into an ideology playing a science on TV.
That’s where we have been for all of the last lost decade (and really longer). The econometric models developed out of the rules of Positive Economics have all said at one time or another exactly what Ben Broadbent is repeating. How many times has the bond market heard interest rates have nowhere to go but up only to find usually in a relatively short period of time that, no, interest rates can actually go lower because inflation never arrived, nor did growth, and because of those interest rates did instead trade even lower still.
Economics as a matter of Positive Economics as well as general scientific principles should be a flurry of activity right now all focused inward because of this one persistent disagreement. And yet, the academic resources dedicated to self-reflection and improvement, if there could be some, is trivial and at best intermittent.
One lonely effort was taken by San Francisco Fed researchers in a paper published in February 2015, right at the time Economists were making all of the same claims they are today. Inflation was only transitorily delayed, Janet Yellen would say all throughout that year, as well as the subsequent two years since, even as oil prices crashed all around her at that very moment. Economic growth coming out of 2014 was supposed to be unassailably robust, too, even though it was clearly and in many places sharply decelerating – just as the bond market had been warning about since late 2013.
“Research has identified numerous instances of persistent bias in the track records of professional forecasters. These findings apply not only to forecasts of growth, but also of inflation and unemployment (Coibion and Gorodnichencko 2012). Overall, the evidence raises doubts about the theory of “rational expectations.” This theory, which is the dominant paradigm in macroeconomics, assumes that peoples’ forecasts exhibit no systematic bias towards optimism or pessimism.”
The issue with Economics isn’t really bias toward optimist or pessimism, rather its bias toward itself. To complete any DSGE model, thus the standard evaluation technique for Positive Economics, the monetary variable must be first definable and then behave only in a predictable fashion. You can see why Economists in the seventies and eighties were quick to dismiss and write eurodollars completely out of their equations; such an open-ended monetary paradigm would riddle their models with unsolvable infinities and unworkable singularities.
To put instead the central bank at the center of money producing predictable correlations with other subsets of money was the only way to make the math workable. Thus, no matter what a central bank does it has to work. It’s nothing more than a core embedeed assumption of subjectivity never really tested by anything other than the models themselves. It amounted to circular logic; their statistics “tested” how markets and economies would surely react to untried monetary policies based on past conditions where untried monetary policies were never tried.
In that very important sense, this conundrum even more than the last isn’t truly about interest rates at all, nor even inflation. It’s a divergence, a hardened one, that isn’t just falsifying in market data the idea of inflation in 2018, it is falsifying Economics itself. If interest rates don’t rise all across yield curves all across the world at some point after so much (assumed) monetary input, there is no other explanation than Economics has it all wrong; Economics is all wrong.
From that realization, it’s not hard to imagine why central bankers would be so furiously annoyed about a recalcitrant bond market here, in England, Japan, Germany, etc. That doesn’t mean, however, we should sympathize with officials and their use of Positive Economics, only realize the level of their stubbornness is not born out of confidence but deep worry and despair their worldview may be falling apart before their very eyes.
And you can likewise appreciate why the bond market simply ignores central bankers; they are the boy who cried inflation (or recovery). Buying bonds or selling them doesn’t matter anymore, ZIRP or not ZIRP, central bank credibility is almost nonexistent where it really matters no matter what they do or claim they will do in the near future. The yield curve is preoccupied with other things that do matter, like the repo market in early September, and the related Hong Kong fireworks only intensifying since then.
The 2015 FRBSF paper summarized it better than anyone ever could, especially since its words are stamped by the imprimatur of the Federal Reserve System itself (though, as always, it disclaims that the opinions are the authors’ and not necessarily shared by branch management or the Board):
“Over the past seven years, many growth forecasts, including the SEP’s [Summary of Economic Projections] central tendency midpoint, have been too optimistic. In particular, the SEP midpoint forecast (1) did not anticipate the Great Recession that started in December 2007, (2) underestimated the severity of the downturn once it began, and (3) consistently overpredicted the speed of the recovery that started in June 2009.”
In other words, they got not one thing right; not one. That’s incredibly hard to do over seven years, now extended to ten facing already eleven. Again, the common theme through all of that is how it is merely assumed by the models monetary policy works, or in even more basic terms how monetary policy works. To be consistent with Positive Economics there is no other assumption they can make. That’s why the yield curve really matters here and everywhere else, as it is conclusive evidence that they really don’t know what they are doing.
In searching for a way to make Economics a legitimate science, Economists achieved the opposite. It has become a backward discipline, one of Aristotelian “logic” rather than in keeping with Enlightenment practices. This is no bond market conundrum, it is instead reduced to a global yield curve syllogism: monetary policy always works, so inflation will have to accelerate tomorrow, and therefore the bond market can’t ever be right today unless it prices only that scenario. Three thousand seven hundred fifty-three todays since August 9, 2007, and Positive Economics is still positive about tomorrow. It’s science, apparently.
