The Federal Reserve is once again ignoring pervasive signs of financial instability that are widely visible.
Daniel Kahneman, Nobel Laureate and famous author of Thinking Fast and Slow turned 80 this March. The sale and popularity of his book exceeded his expectations. He puts it to chance, as he does to most things in our lives. He has enough raw material for his next book and that, I guess, is not due to chance. It has been there for quite some time. The transcripts of the Federal Reserve Open Market Committee (FOMC) meetings provide him rich fodder, either to use as examples of his theories or to use them as building blocks for another set of axioms of human behaviour. Apparently, Sherlock Holmes had said that it was a capital mistake to theorise before one had data.. However, it is a worse mistake to stick to one’s theories even after one has data. It is calamitous for the rest of us if the central bank that is responsible for the issuance of the world’s reserve currency is committing this folly.
Three professors from the Department of Sociology at the University of California at Berkeley published a paper in February this year in which they teased out the cognitive failures that were behind the Federal Reserve failing to see the financial crisis of 2008 (“Why the Federal Reserve failed to see the financial crisis of 2008: the role of “macroeconomics” as a sensemaking and cultural frame”). What follows are verbatim quotes from the paper.
“Their conversations focus on standard macro-level indicators like the inflation rate, the unemployment rate, and growth in GDP …They rarely see the connection between sectors…By contrast, Committee members rarely devote sustained attention to the “financial economy.”
…they grossly underestimated the extent to which the downturn in housing prices would affect the entire economy. It was not until the summer of 2007 that the Federal Reserve even began to notice the connections between the mortgage market and the functioning of financial markets,…. and even then, no one expected the problems generated by bad mortgages to cascade into a full-blown financial collapse.”
All of us, including this columnist, are wiser in hindsight. Therefore, the purpose of reciting the conclusions of this paper here is not to suggest that the members of the FOMC were stupid or lazy. They were not. If we had been in their positions, we would most likely have committed similar mistakes. That is the nature of our cognitive wiring. But, we are not utterly incapable of learning, either. One, we can also ask ourselves the extent to which we were lazy enough not to examine the facts that were always available. Two, we can learn from our errors so that, at least, we can avoid repeating the same mistakes even as we commit new ones.
First, let us look closely into the facts that were available. For the United States, we have post WWII data on job-creation in the non-farm private sector, on investment in non-residential equipment and software and on average hourly earnings from 1965 (See figure). Wages and investment data are in current dollars. Then, from the National Bureau of Economic Research, one can get their official dating of US business/economic cycles. Armed with this information, we can examine whether these fundamentals were responding to US monetary policy. If they were not responding, then it is fair to ask why the FOMC members did not proceed to examine the other areas their monetary policy was impacting.
It is evident from the chart that the United States expansion from the end of 2001 to the end of 2007 was the weakest in terms of all the three indicators that we present here: employment, wages and investment. As per the Berkeley paper, Greenspan, the then Chairman of the FOMC, explained the strength of housing based on immigration and land prices. Immigration had to show up in employment numbers if it had to impact housing. Mortgages cannot be financed without jobs and the incomes derived therefrom. Yet, the US was experiencing the weakest job creation in its post-WWII history despite the Federal funds rate having been brought down to 1.75 percent by end-2001, to 1.25 percent by end-2002 and then to 1 percent in 2003. Not only was their interest rate medicine not having an impact on the areas economic theory would posit but it was creating undesirable side effects. FOMC members were blind to both.
The primary purpose of learning history is to study their relevance for the present and the future. Looking at the same chart, there is more sobering evidence for the current FOMC since monetary policy in the United States and elsewhere in the West have taken an even more unprecedented turn since the global financial crisis of 2007-08. Post-crisis, the record of job creation in the United States remains patchy. More than five years since the official end of the last recession, the average annual growth in private sector employment (1.46 percent) is only marginally better than the growth rate of 0.9 percent in 2001-07. More importantly, growth in average hourly earnings is worse. At 2.07 percent, it is a full percentage point less than the wage growth in the expansion prior to the crisis.
This time too the medicine is not working, despite the dosage being much stronger than in the previous cycle, with quantitative easing supplementing zero percent interest rates. Hence, it is quite likely that the medicine is having unintended and possibly bigger side effects elsewhere. In the last cycle, the Federal Reserve took no cognisance of financial innovation, until it was late. When they did, they actually thought it was beneficial. This time too, they are ignoring pervasive signs of financial instability that are widely visible. If it was mortgage-backed securities and credit default swaps then, it could be junk and covenant-lite corporate bonds, high-frequency and algorithmic trading and internet companies with no revenues this time. The Federal Reserve appears to be happy that they had locked the barn doors through which the horses fled the last time.
Daniel Kahneman wrote in his book and recounted in an interview on his turning 80 that, for most human beings, facts were irrelevant. Who said mattered more than what was said. That is why people accept views of the people whom they respect without examining the intrinsic merits of those views.
This is the opposite of the Tamil saint-poet Thiruvalluvar said: he advised that we should figure and seek out the truth irrespective of who said what. It is unfortunate that academics and researchers at the apex of the global monetary system are not exempt from this rather common human fallacy. Well, can we blame them for not having read Thiruvalluvar?
At the Federal Reserve or in other similar gathering of experts with a homogenous background, the presence of dissenting voices and experts from other social sciences including behavioural sciences might help or it might not. There is a good chance that their views might be dismissed as novel and eccentric. In his interview published in October 2013 shortly before the release of his book, ‘The Map and the Territory’, Greenspan said that he realised that fear had at least three times the effect of euphoria in producing market gyrations and added that he would not have written anything like that before. Yet, evidence of human beings’ behaviour explained by loss aversion has been documented aplenty in the academic halls of universities in the United States. Mr Greenspan and the Federal Reserve could have accessed them. But, they chose not to.
Then, there is the risk of groupthink and wanting to belong. The Berkeley paper notes: “Not only was there no one in the room who took an extreme position, but speakers were constantly prefacing their remarks by downplaying the significance of even what they themselves considered to be the worst-case scenario…One could argue that these group dynamics guaranteed a tendency towards a “wait and see attitude” as well as a collective attempt to balance opinions.”
For the rest of the world, there are three lessons. First, if the FOMC members were neither stupid nor lazy, then we have to seriously consider the possibility of them being captured more than just cognitively. Second, if they are likely to stick to their tried, tested and failed methods, the rest of the world has to prepare itself for the spillover effects of the failures of their policies. Third, if we are cognisant of our inability to recognise and connect patterns, then we should be both humble about and wary of unleashing forces whose effects we are incapable of fathoming: smart phones to genetic modification to fracking to 3-D printing.
In a very thoughtful piece titled ‘The High-tech and High-touch economy’, Lord Adair Turner writes as follows:
“In short, ICT creates an economy that is both “hi-tech” and “hi-touch” – a world of robots and apps, but also of fashion, design, land, and face-to-face services. This economy is the result of our remarkable ability to solve the problem of production and automate away the need for continual labour.
But it is an economy that is likely to suffer two adverse side effects. First, it may be inherently unstable, because the more that wealth resides in real estate, the more the financial system will provide leverage to support real-estate speculation, which has been at the heart of all of the world’s worst financial crises. Major changes in financial and monetary policy, going far beyond those introduced in response to the 2008 crisis, are required to contain this danger.
Second, unless we deliberately design policies that encourage and sustain inclusive growth, a highly unequal society is virtually inevitable, with rising land values and wealth magnifying the effects of the unequal income distribution that ICT produces directly. Indeed, the modern economy may resemble that of the eighteenth century, when the land owned by the Duke of Westminster and the Earl of Cadogan was still just fields to the west of London, more than the middle-class societies in which most developed countries’ citizens’ grew up“.
What is the likely response of Western societies to such an outcome? Instead of examining the issue from its roots, they would turn more protectionist in trade and immigration and blame foreigners for the economic slowdown and inequality.
We will leave the last word to Kahneman: “The idea of self-defeating behaviour, of fate working through the actions of individuals to ultimately destroy themselves — that is a major theme. We put an inordinate weight on minor embarrassment relative to significant consequences. I would imagine that many people have died in house fires because they were looking for their trousers.”
 The reference to the pithy remark attributed to Sherlock Holmes, the famous character created by Arthur Conan Doyle, was made by Ben Bernanke, the former Chairman of the Federal Reserve Board, in his speech on ‘Economic Measurement’ delivered on 6 August 2012.