The Maanga

The last Jackson Hole symposium produced some interesting papers. Foremost was the Mishkin paper that set out how the Bernanke Fed would act in the face of the financial crisis, and the Taylor paper that blamed the crisis on Greenspan keeping interest rates too low (As Soros suggests in his book, this was to get W re-elected, a suggestion conspicuous by its absence in Greenspan’s own book.)  

Mishkin’s position was the same as Greenspan’s. If it is not possible for the market players to recognize a bubble, it would be impossible for any central bank, including the Fed. So, Fed policy cannot be changed to prick asset price bubbles which may develop over a long period. However, since asset price busts can happen very swiftly and create problems in the real economy (cause a recession), the Fed must cut interest rates swiftly and provide sufficient liquidity to forestall any problems in the real economy.  

Taylor’s paper simply said that the Fed deviated from its usual interest rate setting rule in 2002-2004, keeping interest rates too low, even while the economy was improving. This is what led to the housing bubble in the first place.  

Both Taylor and Mishkin could not possibly be right. If Taylor was right, then Mishkin and Bernanke were trying to solve a problem (housing bubble) caused by low interest rates by ahem, lowering interest rates swiftly. One year later, it is evident to everyone that things haven’t quite panned out as Mishkin may have expected.  

In the current Jackson Hole meet, Willem Buiter presented the case against the central banks’ handling of the crisis, particularly that of the Fed. The paper is far too long, but quite amusing, as is Alan Blinder’s reply to it.  Focusing on the three central banks, The Fed, the ECB and the BoE, he says that while the Fed did well to contain the current crisis, it has definitely failed in preventing future crises (the same point that John Taylor made last year), and handed the wooden spoon for handling the current crisis to the BoE.  

Dave Altig ponders over the symposium in a very good summary. According to Dave, the best paper at the Symposium was presented by Anil Kashyap and Raghuram Rajan along with Jerome Stein, who proposed an insurance policy that would infuse the banking system with capital when it needs it the most (like now). Somehow, it seems a bit like closing the barn door after the horse has bolted. To his credit, apparently Rajan proposed the same thing three years ago, and was told off by “women have no brains” Larry Summers.  

I wonder why the experience of another developed country, with a recent housing boom bigger than the US, but one that benefited from prudent central banking was not considered. I guess it was, in a small footnote on page 24 in the Rajan paper.

In his new book, Soros dwells on flaws in philosophy and economics that have led not just to the current financial crisis, but all financial crises.  

In philosophy, Soros starts by looking at the Enlightenment fallacy. Aristotle distinguished between a cognitive function for understanding reality and a manipulative function for affecting reality. By the time of Enlightenment (Descartes -I think, therefore I am), reality and thinking became separated, at least for philosophers. Reality was taken as given, and one could think their way to a perfect knowledge of reality. This wasn’t much of a problem then, as people weren’t really capable of affecting the natural world, and weren’t too close to a good understanding of it.  

Facts corresponded to reality and statements to thinking. When the separation of thinking and reality reached its peak in logical positivism, only those statements that corresponded to facts (verifiable statements) were true and meaningful and others were discarded as meaningless. Russell helped the positivists along by trying to solve the paradox of the liar by abolishing self-referential statements. This helped preserve the pristine separation between facts and statements, and between reality and thinking for a while.  But Wittgenstein came along and pointed out the absurdity of such a world, where self-referential statements were abolished and the thinker himself was absent, and where all statements were tautologies. He abandoned the quest for an ideal logical language, and started studying the workings of ordinary language in his new book, Philosophical Investigations.   

Now, to Soros’s thoughts on economics. Capitalists belong to a religion that believes that the invisible hand will always lead markets to equilibrium, forgetting that fairly strict conditions of perfect competition or at least perfect knowledge are necessary. Much of modern financial theory is devoted to separating reality and thinking. Reality is composed of prices that fluctuate randomly, markets are efficient and someone who analyzes these prices on a Bloomberg can have a perfect knowledge of markets. Most Nobel prizes in economics have been handed out for perpetuating this separation.  

What Soros says is that there is a two way connection, that he terms reflexivity,  and thinking affects reality. Now, this might seen commonplace, as buying or selling does affect prices, but Soros suggests that this happens in a deeper way, that thinking affects the fundamentals in the markets, not just the prices. As it affects the fundamentals, the analysts are fooled for longer. For example, the willingness to lend against, say mortgages, affects the value of the collateral itself as it did in 2005-2007, as the unwillingness to lend (currently) affects the value of the collateral, only adversely.  

The situation in finance now is similar to the situation in logic in the first half of the twentieth century, and needs a Wittgensteinian or Sorosian revolution.  But then, wasn’t it Einstein who said the observer was important?