December 13, 2016
"The peculiar essence of our financial system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.” —Walter Bagehot
Human beings crave certainty, and our clients are no different in this need. As investment counselors, we understand that no one can know the future and that making predictions about the future is usually a futile exercise. Importantly, we attempt to impart this verity unto our clients. Making definitive predictions can create an illusion of certainty which can lead to confusion and undermine long-term confidence and trust. As Warren Buffett said, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”
Advanced (successful) economies operate on the basis of trust and rely on the trustworthiness of the economic actors. Trust is a necessary and indispensable precondition for economic advancement. It has been suggested that if one were able to take a measure of the broadest level of trust in an economy (this is being attempted), it would explain the differences between a developed economy and one which is under-developed or not developing. Accordingly, the difference in the per capita income of the USA and Venezuela might be best explained by a certain measure of trust. Obviously, our modern, complex financial markets can only operate effectively when a certain level of trust is maintained; moreover, in our increasingly global and interconnected economy, trust in fair and free markets is necessary to keep the economic wheels moving forward. And there is the rub. What happens if or when there is erosion in the level of trust in a modern market economy?
Most interested observers will admit that there seems to be something wrong with the global economy. Investors have been operating within the shadow of the Great Financial Crisis for eight years now. All of the grand economic narratives include or are encompassed by the crisis. The grandest of the narratives describe the crucial role and great economic influence of the omnipotent Central Banks in the developed world and especially our own U.S. Federal Reserve Bank. In fact, for almost two decades now, the U.S. Federal Reserve Board has held sway over the markets and the global economy. They have been given space to operate without too much criticism and have been applauded for damage control and instilling confidence when it was most needed. A recent newspaper headline seemed to us to capture the zeitgeist and what we believe is also a serious problem: “It is all about the Fed!”
For the past eight years, the Fed and the other major Central Banks (the EU, the UK and Japan) have implemented experimental monetary policies that have distorted the financial markets to such an extent investors are wondering whether these entities are now causing more harm than good. More critically, investors (and voters) are questioning the “science” upon which these decisions and policies have been made. Between the activities of the Central Banks and the complex behaviors of the markets lies a theory. Investors are just now coming to question the ideological underpinnings of that theory.
What has all this science and data analytics brought us? For the past two decades, the Fed has been consistently wrong in most of its predictions. They missed the seemingly clear evidence of two economic bubbles (tech and housing). They have been overly optimistic about the outlook for economic growth. They have been aggressive and inaccurate about their predictions for the future level of interest rates. As a result, an enormous amount of wealth was lost in the financial crisis and the financial system was placed on a razor’s edge. These experimental policies seem to be amplifying the problems at this point and, as a consequence, the markets are hyper-sensitive and somewhat chaotic. To date, investors (and voters) have kept the faith, at least according to the skeptic’s definition: Faith is believing contrary to the evidence. Something is wrong with the global economy and this something might just be an erosion of trust.
"These experimental policies seem to be amplifying the problems at this point and, as a consequence, the markets are hyper-sensitive and somewhat chaotic."
As some evidence of the loss of faith, the lead article in a recent Financial Times op-ed by Martin Wolf was “Democratic Capitalism is in Peril.” According to Wolf, a Brit: “Consider the disappointing recent performance of global capitalism, not least the shock of the financial crisis and its devastating effect on trust in the elites in charge of our political and economic arrangements. Given all this, confidence in the enduring marriage between liberal democracy and global capitalism seems unwarranted.” There has clearly been an anti-establishment sentiment of late. Our recent Presidential election and the Brexit vote provide clear examples of this.
Wolf is not just questioning our elites and technocrats, he is questioning the legitimacy of political and economic orthodoxy; and he is not alone. Earlier this year, The End of Alchemy: Money, Banking, and the Future of the Global Economy, was released by Lord Mervyn King, the former governor of the Bank of England from 2003-2013. Lord King was in charge of the Bank of England before the financial crisis emerged and was instrumental in implementing the necessary correctives during and after the crisis. This book provides a critical analysis of the intellectual framework (the science) that supported those activities and guides the actions of the Central Banks around the world today.
The central focus of this book is the economic concept of “radical uncertainty,” which King says is a necessary precondition in a capitalist economy. To understand what economists mean by radical uncertainty, consider the distinction between risk and uncertainty. Radical uncertainty is the type of uncertainty that statistical analysis is not at all well-suited to deal with. Admitting radical uncertainty means that, fundamentally, there are things that we do not know or cannot predict because we simply cannot imagine them. Classical economists, on the other hand, say risk can be well-defined and measured against historical data. As a result, economists rely on probability studies to make predictions. King states that, nowadays, economists, financiers and regulators have taken the probabilistic approach too far and into areas where it does not work, generating a false confidence in its predictive capacity.
"...economists, financiers and regulators have taken the probabilistic approach too far and into areas where it does not work, generating a false confidence in its predictive capacity."
According to King, economists and policy-makers should recognize that we are not able to identify the probabilities of all future events and do not have economic equations that explain how people react to that uncertainty. He believes the crisis was, “a failure of a system, and the ideas that underpinned it, not of individual policymakers or bankers, incompetent and greedy though some of them undoubtedly were.” King also warns, “Without reform of the financial system, another crisis is certain, and the failure...to tackle the disequilibrium in the world economy makes it likely that it will come sooner rather than later…Only a fundamental rethink of how we, as a society, organize our system of money and banking will prevent a repetition of the crisis that we experienced in 2008.”
What is unique about Lord King’s book is that he radically dissects the reigning theoretical orthodoxy and demystifies modern monetary practice. Additionally, he offers sound advice for those who are willing to listen. His proposals start with bank reform and the creation of money. He calls for a simplification of bank regulatory schemes and offers ideas to reduce financial leverage and improve banks’ balance sheet liquidity, as well as reframing the role of Central Banks as lenders of last resort. Changing prevailing theory and practice, he warns, will be challenging. He worries that the experts appear locked into using the same mathematical models and have not learned from experience. Hopefully, it will not take another financial crisis for the current practitioners to undertake the rethink.
From our perspective, while there will surely be another crisis, in some form, down the road, we look forward to taking advantage of the investment opportunities that will come along with it. In the shorter-term, however, there are reasons for optimism. First, and foremost, there are indications that the world’s central bankers may be starting to adjust their thinking. Second, an opportunity for change is being presented in the form of the pending transition of power in Washington, D.C. The President Elect has been a harsh critic of the current Federal Reserve Board, accusing its chief, Janet Yellen, of a politicization of monetary policy by encouraging excessive speculation and asset bubbles that are only benefitting Wall Street.
"...while there will surely be another crisis, in some form, down the road, we look forward to taking advantage of the investment opportunities that will come along with it."
Over the next eighteen months, the President Elect can greatly impact the makeup of the Federal Reserve. He can fill a majority of the seven-member Federal Reserve Board with his own nominees and can immediately fill the two open seats on the Board. This Board holds the majority of the decision-making power over a larger group called the Federal Open Market Committee, which sets monetary policy in the United States and influences monetary policy globally. In addition, Fed Chairwoman Yellen’s term ends in February 2018 and Fed Vice Chairman Stanley Fisher’s term ends in June of 2018, allowing a change in leadership.
For some time, the Federal Reserve Board has been encouraging Washington to consider adding some form of fiscal stimulus to the current easy money policies. President Elect Trump appears amenable to this idea. It is likely, however, that Congressional Republicans will be calling for change. Republicans have already put forth proposals to constrain the power of the Fed and have been highly critical of the “misguided,” “inconsistent,” and “opaque” nature of current monetary policy.
"Policy-makers and practitioners around the world have been taking the first step, admitting fallibility and positing that the reigning economic orthodoxy may not have the solid theoretical footing once taken for granted."
As mentioned earlier, there are indications that the current group of global monetary policy-makers is adjusting its thinking, possibly incorporating some of Lord King’s advice. Policy-makers and practitioners around the world have been taking the first step, admitting fallibility and positing that the reigning economic orthodoxy may not have the solid theoretical footing once taken for granted. A sound science is self-correcting. The debate is not over! In our view, this admission is a positive turn which opens the chance of renewed confidence and trust in the enduring marriage between liberal democracy and global capitalism. Ultimately, how do we address this “radical uncertainty”? As Cormac McCarthy in “The Road” noted, “If trouble comes when you least expect it then maybe the thing to do is always expect it.”
Download Article: Radical Uncertainty
