Irrational Exuberance!? On Whose Side!?

Yesterday I read the excerpts from a conversation Alan Greenspan had with Justin Fox that the later published in the HBR blog ( The most remarkable thing is that, with hindsight, Greenspan questions the ability of the FED to stop a bubble once it is set in motion and also of forecasting when it will burst (even when they had 250 first-rate PhDs in Economics to perform the trick). One might be tempted to ask what does the FED do if it cannot perform these tasks, even more so when, Greenspan wonders, bubbles are very likely to appear as a result of the FED being so good at doing their job.

From what I understood, Greenspan’s storyline goes like this: 1) the FED does a wonderful job at forecasting (everything but stock exchange crashes obviously); 2) this allows them to stabilize the real side of the economy; 3) yet, the financial side grows confident, greed conquers fear and bubbles form; 4) nonetheless, empirical tests show that fear is stronger than greed, thus when fear takes over, crashes happen; 5) fortunately, these crashes affect mainly the financial side of the economy; 6) because changes in the market price of wealth have little to no impact in the growth of the economy, as is shown in the GDP figures that remain fairly stable even in the midst of financial crisis; 7) if investors were rational all the time, these crashes would not happen at all, because the market prices always recover (tell that to the Japanese).

It is hard to know where to start, so let us go from the beginning. The FED has two mandates: to stabilize price levels (at roughly 2% because empirical studies say that is where the economy maximizes its output) and to promote economic growth. How can they tell they are doing a good job? The first mandate is measured by the CPI and the second by the GDP. Now I wonder. Could it be that the fact that monetary policy is aiming at specific levels for these aggregates is simultaneously creating huge distortions in certain features of the economy that are left out of the data (such as asset prices and investment and financing decisions – current vs non-current assets, long vs current liabilities and leverage)? Could it be that the wonderful job they do at forecasting (t.i. achieving) specific goals in terms of CPI and GDP actually stabilizes all things those numbers mirror at the expense of everything else? Could it be then that the monetary policy that allows for those stable outcomes, in fact sets in motion a process that, quite rationally, attracts both investors and consumers into taking more and longer-termed debt? What I mean is, isn’t meddling with the price system causing people to see future demand where it does not exist and future prospects of wealth where it cannot be sustained?

Assuming the boom and bust cycle has little impact in the real side of the economy as is shown by the GDP is ignoring the quality of those GDP numbers. State tax revenues went down by over 10% in most countries and the only reason the GDP did not experience a contraction of similar magnitude is because central banks found a way of funding governments with the difference while bailing out the financial sector. From an accounting point of view it might seem the same if government is spending money in very unproductive things (while massively increasing their future liabilities) rather than letting individuals pursue their own ends, but it isn’t. It might look the same if low interest rates allow businesses to remain open even if they have inadequate capital structures and low productivity (more so if we consider they have to fund the state’s increased future liabilities at some point), within a rigid price structure that prevents productive factors (namely workers) from being put to profitable use, but it isn’t. We are not talking about downside effects in the financial side of the economy. If high and persistent unemployment is not a consequence to the real economy I don’t know what can be.

But all this happens because people (other than Greenspan I presume) are mostly irrational. If I build a model that says that people’s motivations are either greed or fear and measure these motivations by the thickness of tails in the stock market I will also empirically conclude that fear is stronger than greed. But if I measure greed and fear by the amount of time the market goes up or down I may very well reach the opposite conclusion. After all, if fear and greed are the only motivations then it is perfectly reasonable to assume that when the market is rising, even if moderately, the majority of investors are being greedy. That is the problem with models, if you torture data long enough it will confess to anything (and if you have 250 first-rate PhDs working on it wonderful things can be achieved). Could it be that the disproportion of the tails is a manifestation that the act of destruction is faster than the act of creation? Trust is a hard thing to build, and harder still are institutions. When they are in place they are, fortunately, hard things to break. They endure a lot of abuse. But when they disappear things crumble fast. I believe it was Reagan who said freedom is never more than a generation away from extinction. I belive it is the same for every human endeavour where other people’s cooperation is necessary, sometimes even less time is required.

When Israel was on the GDP Land…

Yesterday I said I was not impressed with the fact that QE helped in sustaining GDP. Today I hope I can help you understand why. Here it goes: GDP is just a number. Somewhere back in the 1930’s somebody though it was a good idea to measure the wealth produced by a nation by measuring the aggregate production, expenditure or income. Nothing wrong with that of course, assuming every individual is working to satisfy their own needs (and before you mention, these needs can be altruistic). A slave working in a plantation is adding to the GDP but we can arguably say he is better off. But even voluntary work has its setbacks. Maybe the work is voluntary but somebody ended up paying the bill unwantedly.

We can gaze at the pyramids in wonder yes, but most of us are glad we did not have to build them. As far as we know the workers were paid, but somebody had to pay them and if that was achieved by taxation it means a multitude of individuals were hindered in their pursuit of their own happiness just so the pharaoh could have a safe journey to the after-life. In reality I cannot weight this august end against a multitude of others (although I have a strong opinion about it), but then again nobody can. To assume the fact GDP held off was good for the economy is assuming the “wealth” it measures is actually wealth.

Maybe, the Egyptians were proud of their pyramids and happy to finance the effort. The empire lasted for thousands of years (with a lot of turmoil in between) and even if the emblematic gigantic pyramids were the product of a short span of time (perhaps an indication things had gone too far?) a lot of smaller pyramids were built. So probably pyramid building was akin to a national pastime and not the best of examples. I don’t want to give the impression that, since I value the pyramid function as valueless, I believe the pyramids themselves were valueless for the ones who built them.

Tintoretto, Solomon and the Queen of Sheba (1545), Gallerie dell'Accademia, Venice.

Tintoretto, Solomon and the Queen of Sheba (1545), Gallerie dell’Accademia, Venice.

I’ll use one of my favorite examples instead: that of wise king Solomon. Never before nor again did the Kingdom of Israel reach such a territorial extent. Furthermore, it seems Solomon was a ladies man, and quite successful too. According to the Bible he had some 700 wives and 300 concubines making a fine consumption pushing those GDP figures rather extraordinarily. King Solomon is also universally known (and praised) for restoring the Temple yet, undoubtedly he feared what the idleness of excess capacity in the construction sector would do to his economy. He set to build a network of palaces to provide shelter for a) his enviable harem, b) the consequently numerous offspring and c) the necessarily large amount of eunuchs that reassured him of the legitimacy of the majority of that same offspring. It could be said that wise king Solomon built a cluster of activities that prevented aggregate demand from depressing the economy. He also engaged in multiple military operations to extend and defend his and his predecessors’ territorial gains. What else could the man do to fight depression and unemployment?

Some might call it a coincidence, but when old king Solomon died, the Northern Tribes refused to acknowledge his son Rehoboam as their ruler. This is a bit odd. His father was the wise King Solomon and his grandfather the heroic King David, why would they hold a grudge against him? They didn’t, they just feared he would continue to tax them heavily like his old man had been doing for so long. So they refused him and both Kingdoms, Israel and Judah, went separate ways.

I don’t mean to imply Solomon was not wise. He most likely was, as he managed to live in luxury for his entire life. But the country could not support such a lavish lifestyle even if GDP never looked better. Austerity necessarily followed and his poor son had so settle for just 18 wives and 60 concubines. I almost pity the poor old fellow.