Seeking To Explain Why Economists Were So Wrong

Earlier in the decade, no one on the Fed dared to question The Maestro, Alan Greenspan. Well it turns out that Greenspan got a lot of things wrong. Now, as we search the wreckage and try to piece together why economists were so wrong, it is time to re-examine long held beliefs like efficient market hypothesis. James Picerno discusses this in the following post from The Capital Spectator.

The market's taking a beating lately, and we're not talking here about investment returns. Rather, the theory that market prices offer valuable information is on the defensive…again.

The latest assault came over the weekend in Paul Krugman's New York Times Magazine article "How Did Economists Get It So Wrong?" Among the various indictments in the story is the charge that the efficient market hypothesis (EMH) is a principal cause of the economic ills that afflict the U.S.

Attacking EMH has become a popular sport recently, which is to say more popular than usual. Some of these attacks are exaggerated, others are misleading and some are just plain wrong, especially when it comes to interpreting (and often dismissing) EMH as it relates to investing. We've written about such issues regularly over the years and tackle the subject in more detail in our upcoming Dynamic Asset Allocation: Modern Portfolio Theory Updated For The Smart Investor, which will be published in February by Bloomberg Press. Meantime, let's focus on one point in Krugman's story regarding the management of the economy.

Krugman writes that "the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place."

Among the alleged smoking guns presented are the decisions by former Fed Chairman Alan Greenspan, who ran the central bank until 2006 and embraced a market-oriented approach to monetary policy. But equating the Fed's monetary policy under Greenspan, and currently under Ben Bernanke, with EMH is problematic.

The idea that the Fed's monetary policy and EMH are one and the same is a stretch. Yes, the price of credit is partly set by the market, i.e., supply and demand, although most of the market's influence resides at the medium and long-term points on the yield curve. Meanwhile, the Fed's influence is dominant at the short end of the curve, and the tool of choice is the Fed funds rate. But just because the Fed chooses to set Fed funds at a particular rate doesn't necessarily mean that rate also reflects supply and demand.

The Fed, in other words, manipulates the price of money at times. That may or may not be productive at times, depending on other factors. Even so, one can argue that a central bank is a necessary evil for reasons that start with the idea that the economy needs a lender of last resort. But the question before the house is: Was the Fed remiss in managing the economy in the years leading up to 2008? We can never answer definitively because we don't know how the economy would have fared if the Fed had done something different. Nonetheless, we can look back and consider what happened and review the context for the decisions by the central bank.

On that note we'll present one bit of evidence. In the chart below, we graph the real (inflation-adjusted) Fed funds rate on monthly basis for the past 20 years. Note that the real Fed funds rate has been negative three times since 1989. At such times the question is whether a negative rate is warranted?

Today, one could argue "yes," given the weak state of the economy at the moment. But what about 2001-2005? Allowing Fed funds to remain at negative real rates for nearly four years looks like a crucial error in monetary policy. Such extraordinarily low real rates almost certainly contributed to the excesses that came back to bite the economy in 2008, including an excessive degree of speculation in the housing market.

This is a critical issue for several reasons. One is that economists of the monetarist persuasion argue that monetary policy casts a long shadow over the health of the economy. Accordingly, if the Fed makes poor decisions in managing monetary policy, the economy will suffer sooner or later. In fact, there's a strong case for arguing that the Great Depression was largely a byproduct of poor monetary decisions. The central bank was also responsible for much of the economic troubles in the 1970s. And it looks like the Fed made a poor decision in keeping interest rates too low for too long during 2001-2004. Initially, in the wake of the market correction of 2000-2002, low interest rates were warranted. The problem was one of keeping the price of money too low through 2005.

If flawed monetary policy is a critical reason for recent macro events, it's not clear that this is a direct indictment of the efficient market hypothesis or the idea that market prices generally contain valuable information for investing as well as managing economies.

So, what's the solution? Krugman suggests that we should discard EMH. But there's another answer and arguably a superior one: improve the Fed's monetary policy.

Alas, there's no silver bullet here, although there are some changes that could help. That starts with dispensing with the standard that Greenspan established, which favored the idea of letting one man have an undue influence over interest rates. In short, the maestro approach to monetary policy has some problems.

There are a number of alternatives, and most of the good ones involve letting the market provide more input into the setting of Fed funds. Yes, that's right: we need more of the market's influence in the design and management of monetary policy, not less. Less is what got us into this mess, despite what some EMH critics argue. It's tempting to equate Greenspan's decisions with what an EMH-inspired approach would do, but that's misleading. It's unconvincing to argue that because Greenspan dismissed the idea of financial bubbles that also means that his decisions were defacto EMH-inspired choices. Greenspan was making activist choices that weren't necessarily based on market signals. As it turned out, some of his choices were wrong. The lesson is that individuals make mistakes, and so we should be wary about letting one Fed chairman amass too much influence over the setting of interest rates, regardless of what he thinks or says.

A better approach for setting Fed funds is incorporating more price information from commodities, housing, the stock market, to name a few key variables. There's also a case for setting a stated inflation target that the Fed is routinely targeting and that everyone can judge. There's some of this going on now, but there's still too much mystery surrounding the Fed's operations and how it reaches decisions about monetary policy. In turn, that fosters the possibility of making decisions that stray too far from what the market implies interest rates should be.

Monetary policy is too important to be left solely to a handful of people. Individuals aren't gods, even if they work for a central bank. Meantime, let's also recognize that the further marginalization of market forces isn't an answer either. Prices running skyward during 2002-2007 in a wide range of assets, from homes to commodities (including gold) to stocks and bonds, were telling us something. Unfortunately, it's not obvious that the Fed was listening.
This post has been republished from James Picerno's blog, The Capital Spectator.

Bailout Nation: A Scathing Critique Of Greenspan's Fed

For a book that explores how we got into the current financial mess, check out Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy. Author Barry Ritholtz casts former Fed Chiarman Alan Greenspan as one of the villains for his flawed leadership and misguided policy. Tim Iacono from The Mess That Greenspan Made reviews the book:

For some time now, I've known that Barry Ritholtz's new book Bailout Nation was definitely not going to be kind to former Federal Reserve Chairman Alan Greenspan, but, had I known that it would offer the most damning critique of his term at the central bank, I certainly wouldn't have let the book sit on my desk for the last few weeks before finally picking it up the other day and polishing it off in record time.

With the subtitle How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, it was natural to think the focus might be more on greed than easy money, but that's really not the case.

Greed is a constant on Wall Street and, for that matter, in most of the rest of the world, but financial systems don't implode unless generously lubricated with easy money, bailouts, and moral hazard - key elements of the Greenspan legacy.

Ironically, Fed economists and assorted hangers-on are meeting in Jackson Hole this week to deliberate on what's changed in the world of finance and monetary policy over the last year.

It was four years ago at that same gathering (i.e., before the housing and credit bubbles met their respective pins) that some were still lauding the former Fed chief as "the greatest central banker of all time" in something of a "going-away" party.

I wonder if his name will come up at this session...

Anyway, the book is not only fun-filled, thanks to the inimitable writing style of Mr. Ritholtz, but it's chock full of interesting little bits of information and perspective that, even to me, cast new light on what will surely be looked back upon as a disastrous period for central banking.

For example, it is common knowledge that Alan Greenspan was much more interested in asset prices than were his predecessors - they didn't coin the term "the Greenspan put" for nothing - but this passage gives the concept a bit more color.

History teaches us that the development of Bailout Nation, Wall Street edition, was not done in secret meetings. Rather, it occurred in the very public functions of the Federal Reserve, and the subsequent results of its policy actions.

The Greenspan Fed created an endemic culture of excessive risk taking. The U.S. central bank created moral hazard not by targeting inflation or the business cycle, but instead by focusing on asset prices. From the squishy focus on psychology, it was a short hop to asset prices. After all, when price go down, it negatively impacts sentiment, right? This was the Fed's fatal flaw under Greenspan's leadership.
...
The Fed's previous rate cuts had only implied a concern over asset prices; now, the chief explicitly affirmed the fact. The Fed was not concerned just about inflation and employment; asset prices were an "integral part" of its calculus, too.

This was revolutionary. Fed chiefs didn't usually care so much about stock prices; they were more concerned with the bond market. After all, it was the fixed-income traders - known as bond ghouls for their morbid affection for bad economic news - who set interest rates. Worries about deficits, inflation, and trade balances all found a receptive audience among the bond traders.

Once Wall Street figured out Greenspan was concerned about equity prices, it wasn't too long before it learned how to play the Fed like the devil's fiddle. When rate cuts did not materialize, the Street would have itself a hissy fit. It is always ill advised to anthropomorphize markets, but observing the market kick and scream when cuts weren't forthcoming was akin to watching a two-year-old throw a tantrum. It may be illegal to manipulate the markets, but no trader will ever got thrown in jail for manipulating Greenspan.

Unfortunately, the current Fed chairman seems to share this same trait.

Well worth reading...

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Greenspan Says Stock Market Recovery Could Lift Economy

Alan Greenspan, writing in the Financial Times, argues that a continued recovery by the stock market could lift up the economy. A healthy stock market helps supply banks with capital for lending, increases household spending, and spurs new capital investment, he argues. See below for more on Greenspan's thinking.

Maybe there was a Greenspan put after all?:

Inflation - the real threat to sustained recovery, by Alan Greenspan, Commentary, Financial Times: The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.

Is this the beginning of a prolonged economic recovery or a false dawn? There are credible arguments on both sides of the issue. ...[T]he crisis will end when ...[there is] a stabilisation of home prices or a further rise in newly created equity value available to US financial intermediaries...

Global stock markets have rallied so far and so fast this year that it is difficult to imagine they can proceed further at anywhere near their recent pace. But what if, after a correction, they proceeded inexorably higher? That would bolster global balance sheets with large amounts of new equity value and supply banks with the new capital that would allow them to step up lending. Higher share prices would also lead to increased household wealth and spending, and the rising market value of existing corporate assets (proxied by stock prices) relative to their replacement cost would spur new capital investment. Leverage would be materially reduced. A prolonged recovery in global equity prices would thus assist in the lifting of the deflationary forces that still hover over the global economy.

I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets. ...

Stock prices, to be sure, are affected by the usual economic gyrations. But ... a significant driver of stock prices is the innate human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it. ...

He also gives his view of the future inflation threat. I'll just note that I quite agree with Greenspan's assertion that he accords "a much larger economic role to equity prices than is the conventional wisdom."

This was reposted from Mark Thoma's blog, Economist's View.

Is Alan Greenspan The Main Villain Behind The US Housing Bubble?

Peter D. Schiff argues that Alan Greenspan will go down in history as the main villain in creating the financial house of cards that resulted in the historic crash. Greenspan, who was rarely challenged during his reign as Fed Chairman, may have inadvertently created conditions that resulted in the economic crash of 2008. For more on this, read the following article from Schiff as published on Money Morning.

Back during the U.S. invasion of Iraq, when the U.S. government issued its now-famous deck of playing cards featuring pictures of the 52 arch villains of the Iraqi police state, Saddam Hussein’s face adorned the Ace of Spades. If the Barack Obama administration wanted to engage in a similar public relations campaign - this time with a focus on the U.S. real estate crisis - that top card should be reserved for former Federal Reserve Chairman Alan Greenspan.

In a speech before the National Association of Realtors last Tuesday, Sir Alan “the-bubble-blower” Greenspan claimed that his low-interest-rate policies in the early and middle years of this decade had no effect on mortgage rates or real estate prices. As a result, he claims no responsibility for the subprime mortgage crisis. But even current Treasury Secretary Timothy F. Geithner - who shared interest-rate-policy responsibility as governor of the New York Fed during the Greenspan regime - recently admitted that overly accommodative policy helped inflate the bubble. So what does Greenspan know that everyone else doesn’t?

Greenspan’s primary defense is that mortgage rates were a function of long-term interest rates that were simply not responding to the movement in short-term rates, which he did control. While it is true that the flow of capital from foreign creditors with excess dollars did keep long rates low despite rising short rates, this “conundrum” was not the leading factor in the housing bubble. Although rates on 30-year-fixed-rate mortgages are based on long-term bonds, by 2005 such loans had become an endangered species. The housing bubble was all about adjustable-rate mortgages (ARMs) with teaser rates of one to seven years - which are primarily based on the benchmark Fed Funds.

The rock-bottom teaser rates, permitted by the 1.0% Fed Funds rate, were the primary reason that many homebuyers were able to qualify for mortgages they couldn’t otherwise afford - which, in turn, enabled them to bid U.S. home prices up to “bubble” levels. By pushing down the cost of short-term money, the U.S. central bank enabled homebuyers to make big bets on rising real estate prices. Without the Fed’s help, few borrowers would have “qualified” for these risky mortgages and real estate prices never would have been bid up so high.

Greenspan expresses exasperation now, as he did then, that his careful nudging of interest rates higher by quarter-point increments did not translate into corresponding increases in long-term rates. Unfortunately, according to Greenspan, the markets would not cooperate with his wise guidance, and to his dismay, mortgage rates fell despite his best efforts.

As they say in Texas, that dog just won’t hunt. If the “measured pace” of his quarter-point rate hikes were too slow to produce the desired effect, why didn’t Greenspan jack up the pressure? With interest rates far below the official inflation rate for so many years during the bubble, he certainly had plenty of room to maneuver. The claim that he was unhappy with the ultimate results of his rate hikes - despite his having done nothing to adjust that policy - is ridiculous.

In addition to his colossal errors on interest-rate policy, there were many other ways Greenspan blew air into the real estate bubble. One example was what the market called the “Greenspan put.” By creating the perception in word and deed (that has since proven accurate) that the Fed would backstop any major market or economic declines, lenders became more comfortable making risky loans.

In an often-quoted 2004 speech, Greenspan went so far as to actively encourage the use of adjustable-rate mortgages and praised home-equity extractions for their role in contributing to economic growth. In fact, rather than criticizing homeowners for treating their houses like ATM machines, he often praised the innovative ways in which such homeowners were “managing” their personal balance sheets.

In short, Greenspan was as much a proponent of leverage for homeowners on Main Street as he was for bankers on Wall Street.

The bottom line is that Greenspan fathered the housing bubble and now he refuses to acknowledge kinship with his wayward child. His denial of responsibility is an act of stunning bravado, and is a testament to his ability to turn even the simplest of situations into an impenetrable tangle of theories and statistics.

“The Maestro” easily trumps the private sector jokers who now hold top dishonors in our pack of economic villains. The fact that Greenspan still has any credibility shows just how little understanding the general public - including Wall Street and the media - actually has about this crisis.

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.