• C++ Programming for Financial Engineering
    Highly recommended by thousands of MFE students. Covers essential C++ topics with applications to financial engineering. Learn more Join!
    Python for Finance with Intro to Data Science
    Gain practical understanding of Python to read, understand, and write professional Python code for your first day on the job. Learn more Join!
    An Intuition-Based Options Primer for FE
    Ideal for entry level positions interviews and graduate studies, specializing in options trading arbitrage and options valuation models. Learn more Join!

You Can't Model Animal Spirits

Our Uncertain Economy

By EDMUND S. PHELPS
March 14, 2008; Page A19

In recent times, most economists have pretended that the economy is essentially predictable and understandable. Economic decision- and policy-making in the private and public sectors, the thinking goes, can be reduced to a science. Today we are seeing consequences of this conceit in the financial industries and central banking. "Financial engineering" and "rule-based" monetary policy, by considering uncertain knowledge to be certain knowledge, are taking us in a hazardous direction.

Predictability was not always the economic fashion. In the 1920s, Frank Knight at the University of Chicago viewed the capitalist economy as shot through with "unmeasurable" risks, which he called "uncertainty." John Maynard Keynes wrote of the consequences of Knightian uncertainty for rational action.

Friedrich Hayek began a movement to bring key points of uncertainty theory into the macroeconomics of employment -- a modernist movement later resumed when Milton Friedman and I started the "micro foundations of macro" in the 1960s.

In the 1970s, though, a new school of neo-neoclassical economists proposed that the market economy, though noisy, was basically predictable. All the risks in the economy, it was claimed, are driven by purely random shocks -- like coin throws -- subject to known probabilities, and not by innovations whose uncertain effects cannot be predicted.

This model took hold in American economics and soon practitioners sought to apply it. Quantitative finance theory became a tool relied on by most banks and hedge funds. Policy rules based on this model were adopted at the Federal Reserve and other central banks.
The neo-neoclassicals claimed big benefits from these changes. They boasted that their statistical approach to risk made the financial sector much more effective in matching lenders with borrowers, with vast savings in labor and increases in profits. They asserted a decline in "volatility" in the U.S. economy and credited it to the monetary policy rules at the Fed.

Current experience is putting these claims to the test.

Subprime lending and the securitization of debt was an innovation that, it was believed, offered the prospect of increasing homeownership. But "risk management" was out of its depth here: It had no past data from which to estimate needed valuations on the novel assets, it did not allow for possible macroeconomic dynamics, and it took inadequate account of the system effects of unknown numbers of entrants into the new business all at nearly the same.

The claim for rule-based monetary policy is weak on its face. In deciding on the short-term interest rate it controls (the Fed funds rate) the Federal Reserve thinks about the "natural" interest rate -- the rate needed if inflation is neither to rise nor fall. Then the Fed asks whether the expected inflation rate is above or below the target. The Fed also asks whether the unemployment rate is above or below the medium-run "natural" unemployment level -- the level to which sooner or later the actual rate will return.

But the medium-run natural unemployment rate and the natural interest rate are anything but certain. About the natural unemployment rate, Friedman and I used to say at every chance that it is not like the speed of light; it is always shifting, temporarily or permanently, with new developments. We know many of its determinants by now -- but not with any precision and, for sure, not all of them. It is uncertain. More than one view about it is tenable.

The Fed's view seems to be that the medium-term natural unemployment rate is stable. Thus the rise of actual unemployment in the past year is wholly or largely temporary -- a result of passing forces such as the surge in the price of energy, the time home prices are taking to get to down to their new equilibrium path, and the financial market tangle yet to be unwound.

Accordingly, the Fed has cut the Fed funds rate with each increase of unemployment. This "cushions" the fall of employment, as Fed governor Donald Kohn put it, until the contractionary forces pass and unemployment retracts to its former level.

What if inflation -- and thus inflation expectations -- move up? Tighter money can deal with it in the future from a position of strength -- i.e., when employment is high again.

Yet there are good reasons why the medium-term natural unemployment rate may be a lot higher now than before. The permanent decrease in house prices will permanently decrease the jobs in residential investment activity. Share prices, which give some indication of how firms would value additions to their stock of business assets, have fallen markedly in the past year -- more so if we remove the rising value of overseas operations from share prices. That portends fewer jobs in domestic capital goods industries. Absent a great deal of luck, these job losses will not be offset by job gains in export industries.

Keynes, in my reading, had a radical thought here: that the natural rate of unemployment cannot be fully determined by economists. Entrepreneurs' willingness to innovate or just to invest -- and thus create new jobs -- is driven by their "animal spirits" as they decide whether to leap into the void. Central bankers, he implied, can try to guess which way entrepreneurs are going to jump, but some wide swings in employment are inevitable.

The Fed's view seems to be that the natural interest rate has decreased with the business downturn. But this too is uncertain.

We should consider Hayek's argument that the upheavals in a boom may change the natural rate of interest. If the boom left it elevated, failure by the central bank to raise its interest rate correspondingly would cause inflation to begin rising. Something like that may be happening now.

I would add another possibility. Consider the sharp decline over the past year in Americans' stock market wealth. This means, at unchanged interest rates, a decrease in their income from wealth.

For households to be willing in such straitened circumstances to save as much as before -- cutting their consumption by the whole amount of the drop in their income from wealth -- they would have to be compensated with a higher interest rate. At unchanged interest rates, people will not want to leave consumption in the present so pinched. So natural interest rates are driven up.

There may be other mechanisms at work. Uncertainty reigns. But if the above scenario comes to pass, the Fed cannot keep interest rates as low as now for very long. We may see in the near future higher interest rates and higher unemployment than have prevailed in the recent past.

Mr. Phelps, winner of the 2006 Nobel Prize in economics, directs the Center on Capitalism and Society at Columbia University.
 
That was George Box, I think...

I think it's one of the most important things we'll learn.

Models are the coolest things going. I enjoy building them. They are tools, subject to the discretion of the one who uses them. A person can't be expcted to build a house without some type of hammer, but a hammer can't be expected to build a house by itself.

I am inclined, when considering this article, to make a distinction between using models for analysis and for prediction. The leap from the former to the latter is almost cosmological. Or maybe quantum: seemingly infinitesimal but with gargantuan ramifications.

Modelling the behavior of a financial construct under a range of conditions is one thing; predicting and planning an economy is in a different realm.

What I'm hinting at, really, gets down to this: It almost seems as though Mr. Bernanke, who is clearly brilliant and capable, demonstrates a lack of understanding of the social side of markets which, no how matter sophisticated our numerical our treatment of them becomes, will never go away. Markets are social things, made up of people, and people are not so easily modeled: "You can't model animal spirits."

Furthermore, his proposal that banks reduce the principal owed by their debtors, while well intentioned, seems to be rooted in a complete absence of understanding of the creative power of people (expressed in the markets) to solve problems. It also gives a glimpse of his perception of the scope of the problem: he must think it's huge.

This too suggests that his appreciation for the power of his "pulpit" could use a little burnishing.
 
to round out the comments about Mr. Bernanke...

Bernanke to Get on Top of Credit Squeeze, Says Israel's Fischer

By Simon Kennedy and Elliott Gotkine

data



March 18 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke has the skills to guide the U.S. economy through a credit squeeze, now in its eighth month, said Bank of Israel Governor Stanley Fischer.

``You can inject liquidity in the economy and it happens that Ben Bernanke is an expert on this issue,'' Fischer, 64, who advised the Fed chief on his doctoral thesis at the Massachusetts Institute of Technology in the 1970s, said in an interview in his Jerusalem office yesterday. ``That the Fed will get on top of this, I don't doubt.''

A student of the Great Depression, Bernanke is rewriting the Fed's play-book as he seeks to prevent a financial market meltdown and recession. Economists say the central bank will cut its key interest rate by at least 75 basis points today. Two days ago, the Fed lowered its rate on direct loans to banks and became lender of last resort to the biggest dealers in U.S. government bonds.

The latest round of action accompanied the emergency purchase of Bear Stearns Cos. by JPMorgan Chase & Co. after a run on Wall Street's fifth largest securities firm. The Fed will provide up to $30 billion to JPMorgan to help fund the purchase.

Fischer rejected the view that the Fed was orchestrating a bailout that would encourage investors to take greater risk in the future. He pointed out that shareholders of Bear Stearns will get stock in JPMorgan equivalent to about $2 a share, compared with $30 at the close on March 14.

No Bailout
It's important ``you maintain the capacity of the financial system to operate,'' Fischer said in a Bloomberg Television interview. ``Whoever was the owner of Bear Stearns was not bailed out.''

The Fed has lowered its benchmark overnight rate five times and the discount rate seven times since the middle of August, when the collapse of U.S. subprime mortgages started to infect markets around the world. Since then, the S&P 500 stocks index has dropped 11 percent and the dollar has fallen 14 percent against the euro.

Fischer gained insight into rescuing economies as the International Monetary Fund's number two official during the Asian financial crisis and Russian debt default of the 1990s. In that period, the IMF made a quarter of a trillion dollars in emergency loans to countries including Argentina and Korea.

Still, the implication of the U.S. slump ``for the global economy far exceeds the things I've seen previously,'' he said. ``I haven't seen anything on this scale for the global economy at least since I've been active.''

Growth vs Inflation
Complicating Bernanke's task is that even as growth slows, inflation is accelerating as rapid expansion in China and other emerging markets pushes up consumer prices through higher food and energy costs.

While Fischer acknowledged the ``Fed is clearly more concerned about growth than inflation,'' he ruled out a repeat of the early 1980s when the U.S. central bank confronted double- digit inflation and unemployment. That is unlikely to happen because Bernanke's Fed would raise interest rates ``long before'' inflation got out of hand, he said.

``The world is full of surprises, but I don't think that is a likely scenario,'' he said. ``Ben Bernanke is an outstanding economist.''

Fischer is rare among the current crop of central bankers in that he has experience of academia, policy making and banking. As well as working at the IMF and teaching at MIT, he served as chief economist at the World Bank and, prior to moving to Israel in 2005, was employed by Citigroup Inc. as a vice chairman.

He declined to forecast when the credit squeeze will pass, only that it would. ``I've lived through crises, they have a rhythm,'' he said. The U.S. economy is ``not going to collapse, it will come back.''
 
Fischer is rare among the current crop of central bankers in that he has experience of academia, policy making and banking. As well as working at the IMF and teaching at MIT, he served as chief economist at the World Bank and, prior to moving to Israel in 2005, was employed by Citigroup Inc. as a vice chairman.

I know about this bloke. I used to see him on television when he was an IMF official. He's one of the most senior errand boys available to the US policy elite. He does what he's told, says what he's told to say (including the statement cited).
 
Top