Posts filed under “UnGuru”
“When will these guys ever learn that maybe, just maybe, these Fed policies aimed at targeting asset prices at levels above their intrinsic values is probably not in the best interests of the nation?”
-Dave Rosenberg, chief economist and strategist at Gluskin, Sheff
Not long ago, I was listening to former Federal Reserve Chairman Ben Bernanke discuss the central bank’s actions during and after the financial crisis. I came away very impressed with how thoughtful and intelligent the former head of Princeton’s economics department was. Combining a deep academic background in the Great Depression with outside-the-box thinking made him the perfect person to lead the Fed during this period.
There was one issue in particular that bothered me about his tenure, and it isn’t a minor one. It is the Federal Open Market Committee’s focus on the so-called wealth effect, and its corollary impact, the stock’s reaction to Fed policy.
Let’s begin with a quick definition: The wealth effect is an economic theory that posits rising asset prices leads to beneficial effects in consumer sentiment, retail spending, along with corporate capital expenditure and hiring. It is based on a belief in a virtuous cycle that begins with equity prices. As they rise, investors and senior corporate managers begin to feel more secure and comfortable in their financial circumstances. This improvement in psychology releases the “animal spirits,” along with a commensurate increase in spending. Pretty soon thereafter, the entire economy is moving on the right direction.
But Fed policy makers seem to have gotten this precisely backward. Their premise is based upon a flawed statistical error, one that confuses correlation with causation. Building an entire thesis upon a flaw is likely to lead to poor results.
Why is the wealth effect a flawed theory?
Start with that correlation error: What actually occurs during periods where stock prices are rising? As Benjamin Graham observed, over the long term, markets act like a weighing machine — valuing equities based on their cash flow and earnings. During periods of economic expansions, it is the rising fundamental economic activity that reflects the positive things wrongly attributed to the wealth effect. Companies can hire more and increase their capital spending. Competition for labor leads to rising wages. Employed, well-paid workers spend those wages on capital goods such as cars and houses, and discretionary items like entertainment and travel.
Oh, and along with all of these economic positives, the stock market is buoyed as well, by increasing profits and more buoyant psychology.
In other words, all of the same forces that drive a healthy economy, leading to happy consumers spending their plump paychecks, also drive equity markets higher. The Fed, though, seems to think that the stock-market tail is wagging the fundamental economic dog.
As we saw in the mid-2000s, it wasn’t the wealth effect driven by rising home prices that led to greater economic activity, but rather access to cheap and widely available credit.
The flaw in this thesis is even more obvious when we consider the distribution of equity ownership in the U.S. The vast majority of employees and consumers have only modest investments in equities. When we look at 401(k)s, IRAs and other investment accounts, we see these are primarily held by the well-off. Ownership of equities is heavily concentrated in the hands of the wealthiest Americans. Start with the top 1 percent: They own about 40 percent of stocks (by value) in the U.S. The next 19 percent owns about 50 percent. That leaves the remaining four-fifths of American families holding less than a 10 percent stake in the stock market.
With so few people actually invested in the results of the stock market, how can it have such a broad effect on consumer spending? It doesn’t, unless the Fed wants to make the case that it is driven primarily by the trickle-down effect. I doubt they would want to do so for obvious political reasons.
Which leads to a Fed policy that has become overly concerned with the markets reaction to well, everything. Fed policy, FOMC member speeches, even FOMC minutes are obsessively considered in light of how markets will react to them. This is a terrible and unique Fed error. It makes for bad policy and worse governance in a democracy.
Some might perceive the wealth effect and the focus on market reactions to be two distinct issues. In reality, they are so closely intertwined that they are effectively two sides of the same coin.
The Fed must put to rest this flawed approach, and along with it a wealth of poor policy decisions.
Preparing for Takeoff? Professional Forecasters and the June 2013 FOMC Meeting Richard Crump, Stefano Eusepi, and Emanuel Moench Following the June 18-19 Federal Open Market Committee (FOMC) meeting different measures of short-term interest rates increased notably. In the chart below, we plot two such measures: the two-year Treasury yield and the one-year overnight…Read More
The following assortment of quotes comes from Paul Farrell 2007-2008 bank credit meltdown — the top nine happy-talking gurus False predictions made before the 2008 subprime credit meltdown: ‘Mad Money’ Jim Cramer: “Bye-bye bear market, say hello to the bull.” Ken Fisher: “This year will end in the plus column … so keep buying.”…Read More
One of the funny things about running an asset management shop is that you get to see how other firms assemble portfolios. They range from good to bad to terrible. If they were all that good, we probably are not seeing much of them, for those clients are happy to stay where they are. Hence,…Read More
10 reasons why economics is an art, not a science Barry Ritholtz Washington Post, August 9, 2013 “Why did God invent economists?” “To make weathermen feel good about themselves.” That’s a quip from David Rosenberg, former chief economist at Merrill Lynch who is now working at Gluskin Sheff, the wealth management…Read More
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Whatever Happened to the Economic Policy Uncertainty Index? Mike Konczal Aug 6, 2013 Jim Tankersley has been doing the Lord’s work by following up on questionable arguments people have made about our current economic weakness being something other than a demand crisis. First, he asked Alberto Alesina about how all that expansionary austerity…Read More
Lately, I have been spending an inordinate amount of time with economists.
This past month, I have been at several dinners (party of 8) with them, spent time in the woods of Maine chatting them up, listened to their debates on economic policy, even spent time in a canoe fishing with them. Propriety — and Chatham House Rules — prevents me from naming any of the wonks, but it includes Chief Economists at major Wall Street firms, government entities, professors, with a few Nobel laureates thrown in for good measure.
This has led me to an interesting chain of thought about economists in general, and the failure of economics the discipline specifically. Note that I find economists to be intelligent, engaging and often charming. My references here are not to the people who call themselves economists, but rather to their work product that we call “economics.”
Long time readers know this is an an area of interest to me for many years (see the list after the jump). Way back in 2009, I gave 10 reasons Why Economists Missed the Crises. All 10 of the reasons given remain in force today, and may even be stronger.
In the intervening years, I have reached a few conclusions. This is worthy of much deeper study and analysis than the short shrift given here, but until then, I have a few ideas I wanted to jot down. If you have any intelligent thoughts on this subject, be sure to share them in comments.
Based on my time spent with Economists, here are a few anecdotal observations:
Issues of Economists & Economics
1. Economics is a discipline, not a Science. Physics can send a satellite to orbit Jupiter, Economics cannot tell you what happened yesterday. This is an enormous distinction, and has led to a) the “Physics Envy,” and b) an unnecessary emphasis on mathematical complexity.
2. Models are of limited utility. People forget that (as George Box has noted) models are imperfect depictions of reality. If you become overly reliant on them, you encounter a minefield of problems. Several analysts have told me that if the Fed cannot model something, than to them, it does not exist. Think about the absurdity of that viewpoint — and its impact on policy.
3. Contextualizing data often leads to error. This is more complex than it appears. What I mean by this is that everything that economists consider has to be forced into their intellectual framework; since everything is viewed through the imperfect lens of Economic Theory, the output is similarly imperfect — sometimes fatally.
4. Narrative drives most of economics. This is the corollary to the context issue. Everything seems to be part of a story, and how that story is told often leads to critical error. Think about phrases like “stall speed”, “second half rebound”, “muddle through”, “Minsky moment”, “austerity”, “escape velocity”, etc. All of these lead to rich tales often filled with emotional resonance.
5. Economists are loathe to admit ‘They Don’t Know.’ This trait is common to many professions, but I suspect the modeling issue may be partly to blame. Whenever I see forecast written out to 2 decimal places, I cannot help but wonder if there is a misunderstanding of the limitations of the data, and an illusion of precision. To paraphrase, “Only the people who understand both the data and its limitations will not get lost in the illusion of precision.”
6. A tendency to confuse correlation with causation. This is one of the oldest statistical foibles known to mankind, and yet economics remains rife with it at the highest levels. Look no further than the Fed’s obsession with the Wealth Effect for a classic correlation error; I shudder when I think about what other arenas they are fundamentally lost in.
7. The Peril of Predictions. I cannot figure out why economists seem to be so wed to making predictions, given how utterly miserable they are at it. Items 1 and 5 might be a factor.
8. Sturgeon’s Law: Lastly, there is a wide dispersion of talent in Economics, and following Sturgeon’s Law, many of the rank & file are simply mediocre.
One last note: This is not, as Paul Krugman has referenced, a debate as to which subgroup of economists are right or wrong; rather, its a set of observations of the species as a whole.
Perhaps this post is mis-titled; Instead of Blame the Economists it should read Blame Economics.