E-piphany

As I noted when I began to write this blog…and as I have noted repeatedly over the years!…one of the reasons I write the blog is because the comments and feedback make me analyze my own positions.

A friend who read the early blog posts wrote to me privately and objected, quite reasonably, to my negative spin on the entire behavior of the government (Fed and Treasury) through the recent crisis. In thinking through my response to him, I hit on what I think is a pretty decent analogy and, since there wasn’t a lot of news today worth talking about (unless you want to reflect on the fact that Bernanke’s remark about how the economy faces “significant headwinds” is curiously – and I think not accidentally – evocative of Greenspan’s phrase to describe the challenges the economy faced in late 1991, which became the title of Chapter 7 in Maestro, My Ass!: “fifty mile-per-hour headwinds”) I thought I’d relate the analogy.

I think that one’s analysis of what the Fed should do in the crisis circumstance depends on (or anyway should depend on) whether you believe fundamentally that the financial system is stability-seeking or instability-seeking. Is the Fed supposed to dampen swings and control a system that is fundamentally out of control without its oversight, or is it supposed to avoid unnecessary interaction because the system is fundamentally self-stabilizing?

Both sides of that argument have some history to them. The Federal Reserve, of course, was founded because Congress thought the cycle of financial boom and bust was fundamentally destructive and needed taming. While this is arguably a paternalistic view of the role of government (we’re not safe unless the government is in charge), there are clearly some roles that governments need to play…or there wouldn’t be any need for government at all. We accept that having a cop on the beat is necessary, to preserve, protect, and defend. To provide for the common defense, promote the general welfare and secure the blessings of liberty (and so on).

But there are also many areas in which we think the government has little reason to be involved. Frighteningly, the number of these seems to be shrinking, but it is still generally conceded that the government doesn’t do well at running competitive industries – I think they don’t do well at running monopolies either, but some people would debate that point I suppose. (Interesting side note: does government involvement in the auto industry make sense because the American auto industry isn’t particularly competitive, in either sense of the word? Discuss.)

I think that financial systems, left to themselves, tend to be stability-seeking. That doesn’t mean that they are always stable, because they are always being perturbed by outside forces. I am saying they are stability-seeking. There is lots of evidence to support this: many asset return series display mean reversion tendencies. Volatility itself is mean-reverting. I would argue that many of Kahneman and Tversky’s observations about the behavioral tendencies of individuals provide something of a mechanism for such self-stabilizing behavior. And, if you want to get metaphysical, we can note that the entire universe tends towards greater stability, aka higher entropy, at least if you buy the Second Law of Thermodynamics. The physical system is always “seeking” the local state with the lowest energy, which is why atoms are stable. Why should non-physical systems be different? Was the Architect just playing with us?

But I digress.

So the question is – and here comes the analogy – should Bernanke push the swing? Should the Fed, generally speaking, be pushing the swing?

Assuming that we agree that stability is a nice thing, then certainly if the swing happens to actually be at rest the Fed ought to keep its hands off. But what about when Johnny has kicked the swing up and it is out of control? Should the Fed push against a swing that is out of control, to bring it under control, or better yet should it push against the swing to keep it from getting out of control in the first place?

Here we have two problems: theory and practice. Other than that, I would say yes.

The theory problem is that, as I discuss more fully in my book (two plugs in one blog!), if the authorities intervene to keep the system stable in the short run, that action is inherently destabilizing in the long run because the guy in the swing grows to expect that external controls will keep him safe.

The practice problem is more poignant. The idea that the Fed should push against the swing is hardly new. Fed Chairman William McChesney Martin referred to the Fed’s “leaning against the wind” in 1951, and the Fed has often tried to tilt against prevailing speculative opinion. Unfortunately, in 96 years of history the Fed has yet to engineer a ‘soft landing,’ and herein lies the problem in practice. Any given action by the FOMC might dampen the swing’s amplitude, or might increase it! In truly catastrophic crises, it is at least plain which direction the Fed ought to be pushing (more liquidity!), and then the main problem is the theory one. But even in such times, once the swing’s amplitude has decreased somewhat then the Fed ought to step back lest they start to do more harm than good.

So should Bernanke have left well enough alone? I assert that if he had, or at least stayed within the Fed’s mandate, then the crisis might have spun further out of control – but it would have stopped eventually, and we would be healthier now, and 5 years from now, for it. However, I will grant that doing nothing was not a politically viable option. But he surely could have done less, even if Hank Paulson was yelling at him to do more.

The Fed’s role in my view is to make sure the components of the swing are in good working order, and then if Johnny wants to take his life in his own hands, it’s his choice. The Fed is not Daddy.