When it comes to macro-economic forecasting, LSE failure breeds LSE success

“During a briefing on 5 November 2008 – conducted with big wall-chart graphs – about the ongoing ‘financial crunch’, the Queen dropped a (bombshell) question on the assembled throng of academics. ‘If these things were so large, how come everyone missed them?’ The venue (the LSE) was certainly a highly pertinent place for the Queen to ask the question about macroeconomic forecasting, as in the previous year (2007-8) the LSE had been the largest single institutional recipient of UK taxpayer finance for economic/econometric research funnelled via the Economic and Social Research Committee (ESRC a quango, 100% taxpayer-financed). Moreover, it is now openly admitted by a leading (and Nobel laureate) economist at the LSE, Professor Christopher Pissarides, that he and others at the LSE (and elsewhere) had failed to foresee the nature, timing and severity of the crunch.

what has the ESRC actually done?…at an (announced) cost to taxpayers of 5 million pounds sterling, it has set up a new Centre for Macroeconomics, based on LSE and chaired by Christopher Pissarides, but also encompassing (we are told) University College, London, Cambridge University, the Bank of England, the NIESR, and ‘other leading global institutions’ (read a charmed circle of selected insiders’. John Burton, http:// http://www.iea.org.uk/blog/more-macro-quackery

LSE has learned well how to make big money out of its major intellectual failures. Would this happen if the monies had to be raised from private sources? What do you think, dear readers.

Ben Bernanke socialism roils U.S. financial markets

U.S. financial markets have been increasingly skittish in advance of the Federal Open Market Committee meeting scheduled for Wednesday June 19. Will the Fed or will it not begin to taper its $85 billion monthly purchase of Treasury and federal-agency bonds? When eight males and four females meet to determine whether an extended exercise in socialism will end or will continue, millions of individuals fidget with their wealth portfolios. Traders around the world, who in better free market times considered a wide range of variables, now focus on a single one, Federal Reserve policy.

In bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other in order to maximize yield. But in the new world of Bernanke-rigging, they often head in the same direction. That is not good for investors or for capitalism.

Bondholders surely expect bond prices to fall and yields to rise if the Federal Reserve removes its socialist prop. However, they also worry whether the 15,000 Dow may be a Bernanke bubble that will also deflate as the Fed taper begins. Let us follow the money to see how this may occur.

The Fed makes its Treasury bond purchases from the primary ‘dealer’ banks. The proceeds boost the banks’ deposits at the Fed far in excess of legally required reserves. To encourage the banks to hold this base money sao that it will not entrer the credit markets and destroy the value of the dollar, the Fed pays the banks a quarter of a percentage point interest on their deposits.

But it is far from easy to contain $2 trillion in inflationary cash. Many analysts believe that excess deposits are a direct factor in the run-up in stocks since March 2009. Banks have constant dealings in the shadow market with non-bank entities, like money-market, hedge funds and other big money pools. It is a short stretch to imagine these institutions accessing excess bank reserves as collateral to raise money for stock market speculation. Margin debt at the New York Stock Exchange reached a record high of $384 billion in April 2013 – and that means that the stock market is receiving heavy support from borrowed money.

If the Committee of Twelve decides to pull the plug tomorrow, watch out for significant declines both in bond prices and in the Dow and the S & P 500. The enormous quandary now confronting the Fed is a direct consequence of the constructive rationalism of Ben Bernanke and his colleagues at the Fed. Like all socialists, as Friedich von Hayek observed half a century ago, their fatal conceit now threatens the green shoots of a fragile economic recovery.

Hat Tip: George Melloan, ‘How the Fed Turned the Market Skittish’, The Wall Street Journal, June 18, 2013

High-rolling Bernanke empties Fed pockets in the last chance saloon

The economy is in the tank, the national debt is out of control, the banks are largely insolvent, the housing market is under-water, and Washington is a dysfunctional political jungle.

So hey guys,  let us live things up in the Eccles Building’s Kit-Kat club!   Let us pour a few cool ones down for B.O. on November 6, and enjoy Ben Bernanke’s generosity as an effusive, big-spending Master of Ceremonies.  And always remember that life is a cabaret, old friends,  life is a cabaret!*

Just keep a half eye open for those shadows in the corner of the club. They just may be National Socialists waiting in the wings for inflation to take its toll. And believe me, my friends, life will then be no cabaret, save for those with a penchant for surviving under dictatorship.

Revelers in the Kit-Kat club had been clamoring all night long for the Master of Ceremonies to refill the punch bowl.  Ever anxious to please, Bernanke responded to the cries, as he had  done twice before. This time, however, he forgot the fruit juice. The punch bowl is over-flowing with 80 per cent alcohol  and the spigots will remain wide open until no one is left standing. Now this is a real cabaret!

Quantitative easing 3 is here to stay. The Fed will buy $40 billion of agency-backed mortgage securities a month indefinitely, funding its outlays through the printing press.  It will keep rates at rock-bottom levels through the middle of 2015 and it will retain such an accommodative policy for a considerable time period after the economy strengthens.

As clearly as Bernanke can make it, without using the dreaded words, the Fed is now dedicated to inflating the US economy out of stagnation.  As surely as history has demonstrated, Bernanke is leading the U.S. economy into stagflation.  Given usual monetary lags, Bernanke will be safely exiled on some offshore island by the time that this calamity hits the large majority of Americans insufficiently skilled to avoid its catastrophic consequences.

As always, the prescient will survive. Yesterday gold jumped 2.2 percent to trade at $1,750 an ounce.

* Musical Cabaret 1972

Hat Tip: The Lex Column, ‘QE3’, Financial Times,  September 14, 2012

High time to bury the Keynesian multiplier

“the time has been, that, that when the brains were out, the man would die, and there an end;  but now they rise again, with twenty mortal murders on their crowns, and push us from our stools”  The Tragedy of Macbeth, Act III, Scene iv

In 1936, John Maynard Keynes offered policy makers what appeared to be a wonderful free lunch that would just keep on giving. He suggested that during periods of recession increases in government spending exert an augmented impact on the national economy. Not only is the national income increased by the initial expenditure, but a follow-on increase in consumption expenditures will multiply that impact. Keynesian optimists pressed the case for high multipliers – as high as 2 in many instances.  In such circumstances, an increase in government expenditure by x dollars would impact the economy by 2x dollars. According to Keynes it did not matter whether the stimulus was transient or permanent. The multiplier would always apply.

Politicians are rare indeed who will turn aside the temptation to belly-up to a free buffet.  So an extended era of persistent budget deficits began.

The first problem with this line of argument is that government spending must (eventually) be financed. It may be financed immediately by taxes, in which case the balanced budget multiplier at best is equal to 1. Or it must be financed by delayed taxes – inflation or the repayment of the debt –  in which case any initial positive multiplier will be penalized by a later negative multiplier.

The second problem is that government spending in a recession almost always redirects resources from more productive to less productive activities. It takes income from households that contribute to the national product to those who do not. It takes income from profitable companies to those who have failed the market test. So, in the balanced budget case, the size of the government expenditure multiplier predictably is below 1.  Increasing government expenditure in a recession will lower the rate of growth of national income (where growth remains positive).

Western nations learned this harsh lesson and abandoned hydraulic –  or old-fashioned –  Keynesian economics during the 1970s. Britain’s Prime Minister,  James Callaghan expressed  open contempt for Keynesian economics during the late 1970s, as his government confronted electoral  defeat in the midst of rising rates of price inflation coupled with increasing unemployment rates and economic stagnation.

Macro-economists responded to this empirical defeat by modeling the macro-economy on the basis of rational expectations, initially along New Classical lines and later on New Keynesian lines. The New Classical School effectively removed fiscal multipliers in their entirety. The  New Keynesian School struggled to keep them in play, albeit with a greatly reduced impact

Following the 2008 financial crisis, however, a number of influential New Keynesians abandoned their new insights and crawled right back into the rotting old-Keynesian infrastructure. In the United States, these economists persuaded the dying Bush and the emergent Obama administrations to indulge in a pure Keynesian stimulus junket. Economists across the globe followed suit.

Well the evidence is now in, decisively, that the Keynesian multiplier works in reverse, systematically slowing economic recovery, the more so the higher the levels of government injection into the economy.

Arthur Laffer (The Wall Street Journal , August 6, 2012) draws on IMF statistics to re-bury the Keynesian fiscal multiplier.  Here are some of his results relating (B) the change in real GDP growth from 2006-07 to 2008-09 to (A) the change in government spending as a %  of  GDP from 2007-09  :

United States              A = +7.3%   B = -8.4%

United Kingdom       A=+6.9%      B =-11.5%

Japan                            A= +6.7%     B= -10.5%

Australia                     A= +3.3%     B= -3.5%

Poland                         A= +2.3%     B= -6.3%

Laffer’s statistics  cover many more countries. Always, the positive stimulus is met with a negative impact on growth rate. For the most part, the larger the percentage stimulus, the larger the negative impact on the growth rate.

Whatever our political leanings, these are facts that cannot easily be ignored.

 

 

 

 

United States:

Here they go again: and here comes stagflation!

This leaves a second option: the Fed could couple more quantitative easing with a formal announcement of a higher inflation target. Some Fed leaders are open to this. Charles Evans, the Chicago Fed president, has floated the idea of a 3 per cent target, effective until unemployment falls below 7 per cent.  A higher inflation target would lead markets to understand the Fed is committed to quantitative easing of game-changing magnitude, inducing the behavioral shifts needed to make the policy succeed.  Financiers would embrace risk assets rather than safe ones with real returns that would be clearly negative.  Companies expecting more growth , would step up investments.  Consumers, seeing the real value of their debts eroding, would probably spend more.” Sebastian Mallaby, ‘Show some real audacity at the Fed’, Financial Times, July 25, 2012

Mallaby is not alone in this crazy desire to return to the stagflation of the 1970s.  Tyler Cowen and Scott Sumner among many other so-called free market thinkers take the same line.  They have short memories. Once politicians began to exploit the fictitional Phillips Curve, trading off  higher inflation against lower unemployment, the statistiical trade off disappeared. Phillips himself was not at all surprised. He was my tutor at the LSE and advised me of the foolishness of trying to exploit such a purely statistical relationship. Of course,  A.W. Phillips was absolutely correct.

Nations witnessed rising rates of unemployment coupled to rising rates of price inflation and associated with economic stagnation. Politicians abandoned Keynesianism in droves, aware that its continued application would drive them out of the political market-place. Until September 2008, the vast majority of economists were stamping on Keynes’s grave.

The real motive behind inflationist rhetoric is to steal wealth from creditors and transfer it to debtors. Not only is such a policy one version of socialism – that is why true free market economists would never advocate it – but it is also full of moral hazard.

Always a borrower and never a lender be!  A wonderful prescription for economic success!

The limits of the rational expectations approach

Last week I praised the Swedish academy for turning its back on hydraulic Keynesians and awarding the 2011 Nobel Prize in Economic Science to two rational expectations scholars – Thomas Sargent and Christopher Sims. Today I devote a column to the insights of John Kay, who confirms my own view, expressed in earlier columns, that the rational expectations approach must not be pushed too far, as its practitioners are only too prone to do.

“In their world, the validity of a theory is demonstrated if, after the event, and often with torturing of the data and ad hoc adjustments that are usually called ‘imperfections’, it can be reconciled with already known facts – ‘calibrated’. Since almost everything can be ‘explained’  in this way, the theory is indeed universal; no other approach is necessary, or even admissible” John Kay, ‘The random shock that clinched a brave Nobel prize’, Financial Times, October 19, 2011R

 Rational expectations scholars are far from shy in pressing the universality of their approach:

“Asked  ‘do you think that differences among people’s models are important aspects of macroeconomic policy debates’, Prof Sargent replied: ‘The fact is you simply cannot talk about their differences within the typical rational expectations model.  There is a communism of models.  All agents within the model, the econometricians, and God share the same model.” John Kay, ibid.

When mere academics talk this way, one knows instinctively that they have lost a lot of contact with reality. I realized that many years ago at a meeting of the American Economic Association when Robert Hall accused me of challenging ‘the revealed truth of the profession’  because I had the nerve to mention the Austrian economics critique of the  rational expectations approach.

Now John Kay makes exactly the same point about Thomas Sargent:

“Rational expectations consequently fail for the same reason communism failed – the arrogance and ignorance of the monopolist.  In their critique of rational expectations, Roman Frydman and Michael Goldberg employ Hayek’s critique of planning; the market economy, unlike communism, can mediate different perceptions of the world, bringing together knowledge whose totality is not held by anyone.  God did not vouchsafe his model to us, mortals see the present imperfectly and the future dimly, and use many different models.” John Kay, ibid.

Perhaps the only characteristic that  hydraulic Keynesians and the rational expectations economists share in common is a belief in the communism of belief in their respective models. In both instances, that is why they should be treated with extreme caution by doubters whose intelligence and insight they are so wont to despise and summarily to reject.

Models that purport to explain everything, but that fail to predict anything correctly,  are not exactly the Gold Standard for an economics profession that does not fare well in predicting the future of the macroeconomy. In truth, such modelers have helped enormously to put the ‘con’ into economics.

Swedish academy regains its senses

Since September 2008, a significant number of economists have abandoned scientific scholarship to embrace the technically flawed doctrine of hydraulic Keynesianism. They include Lawrence Summers, Joe Stiglitz, Paul Krugman, Christina Romer and Bradford De Long, all of whom were exposed to adaptive and rational expectations theories,  all of whom embraced  to some degree, the New Keynesian version of those theories before returning to the economic Stone Age.

Once President Obama entered into office, in January 2009, all these scholars threw away their accumulated learning to join in the progressive bandwagon that would be  fired on the long- broken anvil of John Maynard Keynes.  For a while, it seemed as though the Swedish academy had also jettisoned hard-learned knowledge and was bent on rebuilding the Keynesian vision.

Well, new evidence has now piled up demonstrating that Maynard Keynes and his disciples have no clothes. With all the political oxygen rushing out of a beleaguered White House,  Obama’s Keynesian cronies have deserted his ship and are looking for richer pickings well outside the domain of the Democratic Party.

Thankfully, the Swedish academy has shaken itself loose from the Keynesian corset by awarding the Nobel Prize in Economic Science jointly to Thomas Sargent and Christopher Sims, both of whom have made significant contributions to rational expectations.

According to rational expectations theories, individuals do not respond passively to changes in economic policy or economic conditions.  They anticipate future conditions and adjust their own behavior in their best interests.  This implies that it is hard for politicians to manipulate individuals into behavior that does not make economic sense.  President Obama has learned this lesson the hard way during the first three years of what looks increasingly likely to be a single term in office.

Chistopher Sims yesterday demonstrated that he takes his own models seriously:

“Asked yesterday what he would do with his half of the $1.5 million prize money, Mr. Sims said: ‘First thing I’m going to do is keep it in cash for a while and think.” Editorial,  ‘The Return of Rational Expectations’, The Wall Street Journal, October 11, 2011

President Obama must really wish that he had appointed Christopher Sims, instead of Larry Summers, to be his chief economic adviser in January 2009. As must a large majority of educated American voters!  If only all those trillions of wasted dollars were still in the money market!

 

Bob Lucas leads Chicago economics into a Keynesian free fall

“If you think Bernanke did a great job tossing out a trillion dollars, why is it a bad idea for the executive to toss out a trillion dollars?  It’s not an inappropriate thing in a recession to push money out there and trying to keep spending from falling too much, and we did that.” Robert E. Lucas, The Wall Street Journal, September 24, 2011

One would expect such fallacious remarks to emanate from  East Coast Nobel Prize winning economists  such as Paul Krugman and Joseph Stiglitz.  When the words pour out over the forked tongue of a Chicago, Freshwater economist like Bob Lucas, one knows that the disease has metastasized and is now spreading out of all control. 

We’re all Keynesians now’ crowed Richard Nixon in 1968, just at the moment when the profession was waking up to the Keynesian fallacy. Well, it turns out that Tricky Dick was focused on the long term, rather than the short, and that he had Nobel Prize winner Robert Lucas firmly in his sights.

There may be some residual hope for Chicago Economics. Lucas has now turned 74 and has moved into retirement, at least from undergraduate teaching. So the minds of the young will not be exposed to the economic mis-perceptions  that Helman W. Watkins Jr. met when he interviewed the Nobelist for his WSJ column. Unfortunately, there is yet another Benedict Arnold – in the form of Richard A. Posner  – still wandering the hallowed corridors of that once great program.  And it must be remembered that Barack Obama was allowed ten totally unproductive years in the Chicago Law School, learning from Judge and Senior Lecturer  Richard Posner, while awaiting his opportunity for a Liberal-Democrat bid for the  White House.

In any event, and for whatever reason, it turns out that Bob Lucas was an early advocate  for Obamanomics:

“I ask about a report that he voted for Barack Obama in 2008, supposedly only the second time he had voted for a Democrat for president.  ‘Yeah, I did.  My parents are dead for a long time, but my sister says, “You have to vote for Obama,for what it would have meant for Mom and Dad.’  I felt that too.  It’s a huge thing. This history of racism has been the worst blot on this country.  All of a sudden this charming, intelligent guy just blows it away. It was great.’ ” Holman W. Jenkins, Jr., ‘Chicago Economics on Trial’, The Wall Street Journal, September 24, 2011

Well, it was a momentous shift to the left for the United States. And President Obama really did help to blow the United States economy downwards  on its free fall into Second World status.  Just as Bob Lucas (and Richard Posner)  have done their level best respectively to blow Chicago Economics and Chicago Law downwards  from Freshwater to Saltwater status in one generation. 

 Let us hope and pray that Bob Lucas’s loss of focus is a monetary mis-perception that triggers just a real, Pareto-optimal economic cycle and not a permanent  prisoners’ dilemma  downshift in real economic performance.

If not, then there is a great deal of ruin in this particular Nobel Prize in Economics. And let us keep our fingers firmly crossed lest another Nobel Prize might be under consideration for the second Benedict Arnold on the Chicago faculty!  Or even, once Barack Obama is ejected from the White House, for the newly-returned Third Man.  After all it is the Swedish Academy that awards the Nobel Prize in Economics.

Let’s not twist again

“Come on let’s twist again like we did last summer

Yea, let’s twist again like we did last year

Do you remember when things were really hummin’

Yea, let’s twist again, twistin’ time is here

Yeah round  ‘n up ‘n down we go again

Yea, let’s twist again, twistin’ time is here.

Chubby Checker Lyrics, 1961”

 Chubby Checker’s  twistin’ time is here again!  On September 21, 2011, The Federal Reserve Open Market Committee  announced its decision to revert to a 1961 policy twist designed to reboot the United States economy.  The stock market saw the policy for what is was worth: the Dow Jones Industrial Average dropped 283.82 points on the news flash.

 Ben Bernanke has done it again! When Bad Ben is about to make a policy statement, sell the U.S. stockmarket short and you will make a packet. That is what happens when progressive socialists occupy positions of authority in a market economy.

To be fair, the problem does not lie entirely with Bernanke and the other six stagflationers on the Federal Reserve Open Market Committee who voted with him, though it surely does not lie with the three dissenters who stood up for price stability and sound money.  The problem lies also with the dual  mandate Congress gave the Fed – to pursue maximum employment and stable prices over the long term. 

 This dual mandate is not required of central banks in the rest of the world, where the pursuit of stable prices is the only mandate imposed.   The current state of economic knowledge does not support the dual mandate, since the goals of maximum employment and price stability often appear to be in conflict. Monetary policy should be restricted to promoting sound money and price stability. Laissez-faire capitalism,  operating under sound money and the rule of law, will do the rest. 

The F-twist, in its 2011 manifestation, involves the Federal Reserve selling off immediately $400 billion of  its  Treasury notes due to mature within three years or less while simultaneously purchasing $400 billion of  Treasury bonds  at the long end of the market – with six to 30 year maturities.  The intent of the F-twist is is to put further downward pressure on longer-term interest rates and to help to make broader financial conditions more accommodative. With long-term interest rates already at historic lows, this policy is unlikely to promote an investment boom across the United States.

The F-twist goes further than this.  The Fed will also invest the principal payments that it receives on its asset holdings into mortgage-backed securities, rather than into U.S. Treasuries.  The objective here is to reduce yet further mortgage rates, thus supporting the housing market.  With mortgage rates already at historic lows, this policy is unlikely to reverse the downward trend in house prices or materially to reduce the foreclosure overhang that is the key symptom of house-market disequilibrium in the United States.

The F-twist clearly worsens the balance sheet of the Federal Reserve. With its balance sheet distorted  by excessive long maturity holdings, should sound money require significant increases in long-term rates of interest, the Fed’s assets could be halved or more as bond prices collapse.  With its balance sheet distorted by holding high risk securitized mortgages, if foreclosures get back on track, significant portions of the Fed’s assets may turn out to be worthless.  Both possibilities render the Fed a hostage to fortune.

If the Fed were restricted to a single mandate of  ensuring sound money, it would more likely acknowledge the evident truth of September 2011. The United States economy is experiencing a capital strike that will continue until President Obama is removed from office, be it in 2012 or in 2016.  Few firms will invest in market development or will hire new employees while uncertainty about the future of the federal debt and question-marks over the direction of progressive socialism hang over the market-place.

Only the political market-place can clear those uncertainties and determine whether the United States will continue on its current trajectory into Second World status, or whether it will recover its exceptionalism and, once again, show other nations a clean pair of economic heels.

Unfortunately no agency of government can twist its way around that epochal  choice. It can only take the economy round ‘n round and up ‘n down again!

Nobel prize Winner, Robert Lucas as idiot savant

Robert Lucas won the Nobel Prize in Economic Sciences for his contributions to the theory of rational expectations. The timing of his award itself signified the limitations of his theory. For Robert Lucas had been divorced by his first wife some 9.5 years before the Prize was awarded. His divorce settlement required him to transfer half of the prize to his ex-wife should he receive the Award less than 10 years after the divorce became final. So Lucas had to pay up half a million dollars  for his monumental error of judgment!

Robert Lucas still stands by his theory, even in the wake of the financial crisis.  Asked why academic economists have so little to contribute to predicting the course of events, the sage responded by explaining that the crisis was not predicted because economic theory predicts that such events cannot be predicted. Wow!  That response is surely  worth a high Chicago University tenured salary!

John Kay dissects this line of thinking in a splendid Financial Times column on September 7, 2011.  He admits that there can be no objective basis for a prediction of the kind: ‘Lehman Brothers will go into liquidation on September 15, 2008’ because if there were, people would act on that expectation and Lehman would go into liquidation straight away.  The economic world, far more than the physical world, is influenced by our beliefs about it.

As Kay explains, such reflexivity leads to the efficient market hypothesis (EMH) which claims that all available knowledge is already incorporated in the price of securities.  The hypothesis is substantially correct.  But if it is a mistake to ignore the efficient capital market hypothesis, it is an enormous mistake to take it too seriously.  Market prices incorporate a great deal of information; but not necessarily accurately or completely.  There are usually wide and persistent differences in beliefs, and widely different perceptions of an uncertain future.

Surely, there can be no method that systematically identifies departures from EMH because, if there were, people would act on that knowledge, and the observations would cease to be anomalies or exceptions:

“But to conclude that there is no general model of exceptions and anomalies in the EMH is not the same as saying that such anomalies and exceptions do not exist.  The behaviour of great industrialists such as Henry Ford and Steve Jobs, or great investors such as Warren Buffet and George Soros, cannot be predicted by general rules.  If such prediction were possible, their actions would have been anticipated and these individuals would not have been innovative or become rich.  And similar unpredictability applies to the actions of great fools, such as those who believed that securitization conjured immense wealth out of thin air.  Like ingenuity, stupidity endures but constantly finds new ways to express itself.” John Kay, ‘Ingenuity and stupidity endure, but they defy all prediction’, Financial Times, September 7, 2011

John Kay concludes that profit opportunities are not easy to come by, but the search for such opportunities drives markets.  Nothing could be stranger – or more deeply irrelevant – than a model of the market economy whose axioms exclude its central dynamic.

I conclude that only a bunch of economists located in a non-market economy such as Sweden would ever recognize such a  theory as justifying a Nobel Prize in Economic Sciences. It is rather like a bunch of socialists in Norway awarding a Nobel Peace Prize to Yasser Arafat!