Sunday, January 20, 2013

Fed chose not to understand fundamental driver behind financial crisis

Why has the Fed chosen not to understand that opacity and with it the freezing of major areas of the capital markets is the fundamental driver behind our current financial crisis?

In an earlier post (see here), your humble blogger looked at the transcripts from the Fed's 2007 meetings and conference calls and noted that Fed officials knew about the problem with opacity in large areas of the financial system.  Yet, they effectively ignored it by assuming it away.

For example, in response to the freezing of the subprime mortgage securities market at the beginning of the financial crisis, the Fed chose to provide liquidity to the capital markets until such time as the market figured out how to value and price these opaque securities.

Of course, without transparency, the market will never be able to figure out how to value and price the opaque subprime mortgage-backed securities.

The Washington Post's Neil Irwin (see here) suggested that the reason the problem of opacity was and still is ignored is that very bright people can have access to data that the rest of the market participants would love to have, but still not understand how to interpret this data to make it useful information for purposes of setting policy and addressing the financial crisis.

I have written numerous posts that would support Mr. Irwin's observation.  These posts cover group think (many of the leading central bankers were at MIT at the same time), failure to understand that transparency is the necessary condition for the proper operation of the invisible hand, and regulatory capture by the banking industry directly and indirectly through politicians.

However, I don't think these posts provide a satisfactory answer to why the Fed continues to choose not to understand the role of opacity in the current financial crisis.

Princeton's Paul Krugman (see here) provides more insight into the Fed's actions as he saw the 2007 transcripts providing personal vindication for the economic policies that he has been suggesting.

He too completely skips the importance of opacity.  He seems to think that because he said that the fiscal stimulus program was too small to restore the economy to health that this indicates his analysis of the problem is correct.

In reality, as shown by Japan over the last 2+ decades, the burden on the real economy from servicing all the excess debt in the financial system can offset a tremendous amount of fiscal stimulus.

Professor Krugman prediction was directionally correct, but this was not because of his insight into the driver of the economic crisis, but rather because the impact of this driver was in the same direction he predicted.

The reason I said that Professor Krugman provides more insight into why the Fed chose not to understand that opacity was the fundamental driver of the current financial crisis is that his self-serving analysis reminded me of my conversations with various Fed officials ranging from governors to economists.

Regular readers know a) I worked at the Fed in the early 1980s and b) that I was very vocal about the impending financial crisis and how to moderate its impact.

Naturally, I reached out to the Fed and these officials.

Each of my conversations fit perfectly into the Professor Krugman view of the world.  Each of these officials effectively told me that opacity could be ignored because their economic model of how the economy worked explained what the right policy response was.

I recall one governor hearing my description of opacity (I used my example comparing structured finance securities to a Brown Paper Bag) and the response was the Fed could predict the US economy using data that was available on a quarterly basis and therefore a Brown Paper Bag was not opaque.

This mind set continues to this day.  It is clear that the Fed officials will cling to the belief in the infallibility of their economic models.  After all, they have modified their models to include a banking sector (something that prior to the crisis the models assumed was irrelevant).

What we have learned in the 2007 transcripts and since is that the Fed's economic models could not predict the US economy as they didn't predict the financial crisis and they have not predicted the success or failure of the various fiscal and monetary policies implemented since the beginning of the financial crisis.

Despite this track record of failure, the Fed continues to chose not to understand the role of opacity as the fundamental driver behind our current financial crisis.

As shown by Professor Krugman, his comments reflect the simple reality that economists prefer working with their models and the assumptions behind these models and ignoring inconvenient real world facts.

Real world facts tend to make the models messy.  Although, in this case, the real world fact of opacity actually makes the model much simpler.  After all, their economic models are built on the assumption that the invisible hand is operating properly.

The existence of opacity gives them an excuse to say why their models haven't worked and that the models cannot be expected to work until transparency is brought to all the opaque corners of the financial system.

From a quest post on Zero Hedge by Gary Evans of Global Macro Monitor:

In his lecture at the Latsis Symposium 2012 “Economics on the Move” in Zurich,  Nobel Laureate Joe Stiglitz nails the fundamental problem and crisis of modern macroeconomics, which failed to predict the financial crisis. 
If you say…what is good science is prediction… and you can’t predict the most important event in 75 years, what good are you?  
In particular, it might be very nice you can talk about the likelihood of an one tenth increase in GDP growth rate…and you miss a major economic downturn….or worse, they said the things can’t happen… 
Here are the money quotes: 
We all know the shock in this crisis…was a credit bubble and we have had those credit bubbles since the beginning of capitalism…So it was remarkable the intellectual bubble led people to believe there were no such thing as credit bubbles when there was 200 years of history of that…..How could people be so stupid? …The theory was with well functioning financial markets, spreading risk, diversifying risk, risk is contained.  They came to believe the models and that’s always dangerous.
Actually, it is not that they came to believe the models so much as they did not know that the models are based on the idea of transparency.

The models assume that all market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

The models and the economic system failed because large parts of the financial system are opaque.  This includes both structured finance securities and bank balance sheets.

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