This week we are going to examine in some detail Alan Greenspan's speech given today in Jackson Hole, Wyoming. I was working on an entirely different letter when this speech hit my inbox. I think it is so important that I am going to start over in the middle of a letter, which I cannot remember ever doing.
For better or worse, Alan Greenspan is one of the most important men in the world. His views matter and are taken quite seriously by the market. This is one of Greenspan's more significant speeches (it may come to be seen as his most important) and a departure from his usual opaque (or in Texan: clear as mud) style.
I think, come Monday, this speech will be seen by different parties in completely different ways. On the one had, I think this speech is destined to be hailed as the best example of how the Fed really works and as the rationale for the current Fed structure and role. Others will see it as yet another attempt to make excuses (remember "I was not responsible for the bubble" from the last Jackson Hole speech?) and as the best reason to abolish the Fed and its meddling in the work of the Free Market.
Both views are too simplistic by half. It does far more than either of those assessments. This speech puts the nail in the coffin of econometrics and its promise of exactitude in economics. What Greenspan is asserting is that the Fed models are simply not powerful or robust enough to be able to predict anything with a real degree of certainty, no matter how much economists would assure us they do. He opens up a brave new world of uncertainty, and for that candid admission, I say, Bravo!
I have often been a critic of Greenspan, especially for his lack of clarity. Today, I must applaud him for being clear and candid. I must also applaud him for his candor. While I will quibble with him over some points, overall this is a speech I found refreshing in its acknowledgement of a reality that most observers, including myself, believe to have been the case: that fallible humans run the Fed using their best judgment.
This is not a speech I ever expected to read. Let's go into it in detail. Before I make comments on the speech, let me give you some of the more interesting quotes and my interpretation of what he is saying. (For the rest of this letter, quotes marked in italics will be directly from Greenspan's speech. Bold emphasis is mine. You can see the full speech at http://www.federalreserve.gov/boarddocs/speeches/2003/20030829/default.htm.)
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Monetary Policy under Uncertainty
For those who want to believe there is a man behind the curtains who can pull the levers and make the economy move as he wants, this will be a most unsettling speech. The speech is entitled "Monetary Policy under Uncertainty" and starts with the sentence:
"Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape."
It then goes on to tell us just how uncertain monetary policy is:
"Despite the extensive efforts to capture and quantify these key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and in all likelihood will always remain so. Every model, no matter how detailed or how well designed conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis. Consequently, even with large advances in computational capabilities and greater comprehension of economic linkages, our knowledge base is barely able to keep pace with the ever-increasing complexity of our global economy. "
He emphatically points out that models only give us at best a reference point for policy. They cannot be prescriptive with any real degree of certainty. Nor does he offer any hope that such models can be developed in the future. Economic models are far from perfect and "in all likelihood will always remain so."
"Given this state of flux, it is apparent that a prominent shortcoming of our structural models is that, for ease in parameter estimation, not only are economic responses presumed fixed through time, but they are generally assumed to be linear. An assumption of linearity may be adequate for estimating average relationships, but few expect that an economy will respond linearly to every aberration."
While he says "our models" I think he is in fact referencing models in general. By linearity he means straight line assumptions or connections. It is as if we see that Trend A and Trend D seem to move in lock-step and draw a conclusion about the connection. But hidden, and not in the model, are Trends B and C which are the real connection between A and D. He is not saying that the Fed knows what B and C are and the rest of the world doesn't.
"Look, guys," he tells us (my paraphrasing), "stop looking at three different trends, running them out ad infinitum and then drawing a conclusion about the wisdom or stupidity of our decisions. The factors affecting your trends are so complex that any number of significant events could change the relationships between your trends and the desired policy."
Further, he points out that the traditional measures of money stock are becoming increasingly meaningless. The obsession with M-2 or M-3 makes for good newsletter copy, but what do such broad aggregates mean in a world where new forms of money (SWAPs, derivatives, mortgages bonds, etc) appear every day? The implication that the old linear relationships between money supply (as measured by some arbitrary and outdated statistic like M-2) and inflation may no longer be valid.
"Recent history has also reinforced the perception that the relationships underlying the economy's structure change over time in ways that are difficult to anticipate. This has been most apparent in the changing role of our standard measure of the money stock.....in the past two decades, what constitutes money has been obscured by the introduction of technologies that have facilitated the proliferation of financial products and have altered the empirical relationship between economic activity and what we define as money, and in doing so has inhibited the keying of monetary policy to the control of the measured money stock."
Not only are past relationships not always linear, but past relationships may change over time. This is the old principle of "past performance is not indicative of future results." Just because things worked in the past does not mean they will in the future, as the world is changing rapidly. A simple example of this is all the analysts who told investors to buy stocks in January 2001 when the Fed started cutting interest rates because the "models" showed that stocks always went up after the Fed started cutting rates. Now, we know that such a linear relationship is not always true.
Real World Central Banking
"What then are the implications of this largely irreducible uncertainty for the conduct of monetary policy? A well-known proposition is that, under a very restrictive set of assumptions, uncertainty has no bearing on the actions that policymakers might choose, and so they should proceed as if they know the precise structure of the economy. These assumptions--linearity in the structure of the economy, perfect knowledge of the interest-sensitivity of aggregate spending and other so-called slope parameters, and a very specific attitude of policymakers toward risk--are never met in the real world. "
Paraphrase: "How," he asks, "can we base monetary policy on assumptions that we know do not necessarily work in the real world? Clearly we cannot. Therefore, we must find another basis for actions than total reliance on some model. There is no simple answer."
"These considerations have inclined Federal Reserve policymakers toward policies that limit the risk of deflation even though the baseline forecasts from most conventional models would not project such an event."
OK, one comment here, as this is interesting to me. I have been writing about deflation for close to five years. I wrote in 1999 or so that Greenspan was also worried about deflation, even though he did not talk about it, as the Fed actions suggested that concern. Few models used by economists at that time suggested inflation, although empirical analysis of the problem was screaming deflation, at least to me. In this speech Greenspan is clearly telling us they are worried about deflation, even if the models do not show it.
Then he gives us the rationale for this policy in the next few paragraphs, which are among the most important of the whole speech.
"In implementing a risk-management approach to policy, we must confront the fact that only a limited number of risks can be quantified with any confidence. And even these risks are generally quantifiable only if we accept the assumption that the future will replicate the past. Other risks are essentially unquantifiable..... because we may not fully appreciate even the full range of possibilities, let alone each possibility's likelihood. As a result, risk management often involves significant judgment on the part of policymakers, as we evaluate the risks of different events and the probability that our actions will alter those risks.
"For such judgment, we policymakers, rather than relying solely on the specific linkages expressed in our formal models, have tended to draw from broader, though less mathematically precise, hypotheses of how the world works. For example, inference of how market participants might respond to a monetary policy initiative may need to reference past behavior during a period only roughly comparable to the current situation."
Econometric models, no matter how elaborate and thoughtful, are not enough to establish policy. Welcome to the world of behavioral economics.
When analyzing the risk of investment portfolios, an analyst will use something called a Monte Carlo Simulation to develop all the possible combinations of funds and their histories to try and understand what the probability of certain outcomes might be. Then the analyst begins to work to mitigate or hedge against the more negative potential outcomes.
Greenspan is saying that in essence the Fed does the same, but not just with computers as do analysts, but through the filters of their judgment. The world is far to complex to be understood totally in some linear, static computer model. There are too many variables, and as soon as one starts changing, the inter-relationships in and of themselves begin to change, thus making the model less useful.
Thus, without human judgment, the Fed could not only simply not do its job but would do far worse relying upon rules or econometric models.
Rules by their nature are simple, and when significant and shifting uncertainties exist in the economic environment, they cannot substitute for risk-management paradigms, which are far better suited to policymaking.
In this and other paragraphs following, he answers critics that want the Fed to set precise rules for their policies. Such rules, he avers, are not only simplistic, they can lead to major policy errors. Any such rules are subject to interpretation and thus only serve to compound a policy problem by seemingly imposing hard interpretations when such actions might create the opposite of the desired result. Judgment, at least when it comes to central banking, is better than rules.
For instance, France and Germany are ignoring the European Union rule which says they cannot have a deficit of more than 3% of their GDP. They both believe they need to stimulate their economies and that an austere budget would throw their respective countries into deepening recessions or worse. The other nations are demanding they adhere to the rules, as to not do so adversely affects them. Who is right? The view depends upon who is experiencing the recession.
The Greenspan Uncertainty Principle
I think the thing I enjoyed the most was the refreshing acknowledgment of a reality we should all know exists: there is no Fed chairman pulling levers behind the curtain, ala the Wizard of Oz, that can control the economy. They cannot manage all the risks. All they can do is manage some risks, so it comes down to a decision as to which risks to try and mitigate or work against.
Repeating the first sentence of the speech: "Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape."
I think it is no small thing to recognize that Greenspan is taking on a goodly portion of his economic peers. The econometric model King has no clothes, nor is it likely that it will ever be able to weave any. It is an illusion they foster among themselves.
Greenspan says, "Trust Me"
Now let me give you a few more of my first thoughts on the speech before getting reaction from others. Let me start with a story from Dennis Gartman. He was once playing with a four man group for a state golf team championship. They were in the hunt, and on the 17th hole, one of the team members (interestingly his last name was Duffer), missed a 7 foot putt by a half an inch. Hearing the groans of his teammates, he turned around and said quietly, "Gentleman, that is the best I could do at the time."
First, Greenspan is saying that human beings run the Fed, and they have to make judgments. The best way to do that is to try and avoid the big risks. In essence, the Fed is like a giant economic insurance company, trying to avoid the big risks which could wreck the economy (like deflation, in their view) and thus willing to take smaller risks (like inflation, again in their view).
He tells his critics who look at static models that they are being too simplistic, and with some justification in most cases, I might add. That is not to say I would agree with a certain policy, but in this Greenspan is right: you cannot focus on just a few trends and extrapolate to a correct policy.
Second, Greenspan is saying, "Trust Me." Not explicitly, but implicitly it is all over this document. As he answers critic about specific actions (like 1998 monetary easing), he confidently asserts, "Gentleman, that is the best I could do at the time."
Third, he acknowledges what everyone knew: the world is vastly complex and cannot be understood in any one way. Further, every action will have unintended consequences, and the best you can strive for is not trying to "fix" the economy, but assessing risk and trying to avoid the worst case scenarios based on that risk assessment.
Fourth, I hope this means we can do away with all the silly economic models that are bandied about showing how the Fed actually thinks and upon which supposedly "they base their decisions." The models may be interesting, even useful and instructive, but they clearly have not been, nor will be, the final basis for any decisions.
Fifth, as we look at future Fed policy actions, we now need to start looking at future risks rather than current statistics. As an example, when the Fed tells us that they are more concerned about unwelcome disinflation, that means they are not going to raise rates until we get unwelcome inflation, no matter what some historical models state about the economic recovery and the Fed raising rates.
Finally, this is hopefully going to start a new debate about the role of the Fed in general. The World's Greatest Central Banker has now said there is a group of men who meet eight times a year and use their best judgment to determine what is the best policy for an economy and a country, if not the world. Not some rules, not some agreed upon model, but judgment. We now have established that Central Banking is an art form, and not a science.
Do we want to be subject to unelected officials making such rules for us? Even more frightening, do we want elected politicians (Think California, Texas and Washington, DC) getting even close to a Federal Reserve seat? Is this the best system we can devise?
Is it possible that market economics will work no matter what the Fed does? That imbalances will get resolved sooner or later? Or does putting off today's immediate problem allow for a more relaxed and benign realignment over time?
Does the free market need help? Does meddling with the economy and the money supply create greater imbalances than simply letting the business cycle do its work? Are we stuck with increasing imbalances which must sooner or later be rectified?
Will Washington politicians and Fed governors ever sit by as the economy goes into recession, letting the market work to bring back growth or will the people demand a Fed and the government come to the rescue? Is it even remotely possible in the current political climate to think about, except as theory, a world without a Fed?
I rather think not, and thus we are stuck with a Fed that can affect our lives as few other institutions can. We have a few men, sitting in a room eight times a year, with extraordinary power. They use their best judgment. What more, we are told, can they do?
On Sylvan Trails
I have been told that my letters needs to become more intellectual. Not because I am too simplistic (though I may be), but because my letter uses lots of words that spam detection software thinks of as bad (like mortgage rates, energy, exclamation points, increase and other "suggestive terms"), I should use words like "sylvan" which are not known for being in spam to demonstrate to various software programs that my letter is indeed information. Thus, the erudition of my letter will increase, I mean rise, I mean expand or something like that. I will leave it to the reader to meditate on the significance that words used in sexually oriented spam and economic musings are often the same.
For those of you who use such software, it would also be helpful if you informed your computer that you want to receive my letter, rather than complaining that we have dropped you from the list. If you have trouble getting this letter, it is highly likely either your spam software or your ISP. We faithfully send it out every Friday evening.
And while we are on computers, let me urge every one of you to update your virus software daily. The new viruses, such as SOBIG.F, are quite a problem to many of us. At its height last week, we were getting thousands of emails an hour. It makes it appear that someone is sending an email, which contains a virus, when in fact, that computer is virus free. What happens is that an infected computer sends email which looks like it is from people on the infected computers list to people who are on the list. There is no way to trace whose computer is actually infected.
So, if you got an email from me other than my regular weekly letter, the answer is that it wasn't really from me. It was from one of your friends who also gets my letter and has its address in his internet mailbox.
The only way to solve such problems is to for everyone to be VERY vigilant. Every day or time you are on the internet you must update your virus protection software and run more scan-checks every week. No exceptions. Your computer can do such things in the background
SOBIG.F was in one sense benign. It did not destroy anything. The next virus may not be so friendly. It could wipe out your files. So back-ups are important, but even more so is prevention.
Labor Day is a time for family and friends, and I hope you will be able to spend some time with yours. I am off to see mine.
Your Atkins dieting, hoping to get under 190 this month analyst,