Wednesday, August 30, 2017

The premise determines the conclusion

One of the features of my recent research that I find fascinating and frustrating is the reality that, when it comes down to it, just making a few subtle shifts in our priors can completely flip our conclusions.

This is the problem I have with behavioral explanations for recent phenomena.  Behavioral explanations are basically explanations that presume inefficiency of some sort - mispricing that an omniscient or reasonably rational collection of traders would avoid.  But, how do you falsify that?  So, there is a certain amount of presumption involved in those explanations.  But, once you accept that presumption, then explanations fall into place.  Mortgage debt is bound to scale with real estate values, so if there is a presumption that mortgage credit can lead to inefficient or unsustainable prices, then it can always appear to be causal.

So, then, every sign of rising prices is taken as a signal of unsustainable demand, whether it is or not.  I think this reached an extreme in 2006 and 2007, when, amid a sharp downturn in housing starts, mortgage growth, homeownership rates, and residential investment, the consensus view was that the economy was characterized by excess.  And, the heavy demand for AAA securities, of all things, was taken to be evidence for risk taking.  That's because, by that point, these presumptions had taken so many people so far down the road toward that conclusion, in a way that wasn't really justified by the evidence, that it was difficult to square evidence of extreme risk aversion with the consensus that had already developed.

So much analysis of the business cycle falls into this category.

Here is a recent Financial Times article by John Auther that is an example of this.  He claims that rising equity prices are being propped up by easy money.

From the article:

"The central bank has bought bonds to try to push down their yields and so push up the valuations that people will put on stocks - and they have been phenomenally successful."

I would question whether Fed bond buying pushes yields down over this time frame and scale and I would also question the effect that long term yields have on equity prices.

Here is the main chart he references:

My question is, What's the counterfactual?  Let's say that we had gotten ourselves into a case where interest rates had fallen to zero because monetary policy had been too tight, so that the QEs were a move toward a more optimal policy.  The economy needed cash, and to a certain extent, the QEs led to some money creation.  If that's the case, then what would this chart look like?  Wouldn't it look just the same?

So we have competing priors. Auther's prior, which seems to be commonly held, is that the values of homes or long term bonds or stocks can be regularly pushed far from any normalized value by central bank activities even while consumer prices move along at roughly 1-2% inflation rates.  My prior is that at this scale, prices of all of those assets are much more influenced by real economic factors.  The stock market moved higher because our collective economic future had improved.

Is that na├»ve? Maybe.  But, let's say either of us is wrong.  In that case, which premise is more of an offense?  Can I suggest that if you will only be satisfied with contraction and deprivation, that you might require a higher standard of confirmation?  If core inflation hasn't even touched 3% for more than two decades, can we shelve the endless complaints of Fed largesse?

1 comment:

  1. If core inflation hasn't even touched 3% for more than two decades, can we shelve the endless complaints of Fed largesse?--KE

    Oh, I could even say that since 1982---that is 35 years ago---we have been hearing the Fed is too loose, with an ulterior motive as a statist-inflationary institution. The government wants to pay back debt with cheaper dollars.

    In that time, inflation has fallen from double digits to under 2%, and is one recession away from becoming deflation.

    The private-sector bond market, through long-term interest rates, forecasts low inflation foo as about as far as the eye can see.

    But the Fed is too loose! The Fed is too loose! The Fed is too loose.

    That the "Fed is loose" is some sort of affinity- or virtue-signalling, or aging political statement.