How should one think about the credibility of institutions?

One especially interesting question today is how one should think about the credibility of institutions when it comes to understanding and prognosticating about the macro situation and outlook.

Today’s world emphasizes very highly the perceived requirement to justify one’s judgement of people and services based on criteria that one can persuade oneself and others are objective – people consider ‘track record’, standing amongst peers, and broader social influence as important factors in deciding whether to pay attention to a particular analyst.  The problem is that the world is complex, and at any one time many factors are at play, so that it is a matter of discernment to be able to assess who is really good compared to who is merely popular, or just got lucky once.  The sheer volume and intensity of information tends to blind us to the importance of history and context, which the astute self-marketeer will exploit, focusing only on their hits and playing down, if not denying their misses.

So acknowledging all of this, it is interesting to see how other market commentators respond to the latest offering of the BIS.  Under previous management, the Bank for International Settlements was one of the few institutions – official, or otherwise – to correctly diagnose the problems in the credit market that developed in the run up to the Feb 2007 – Dec 2008 period of unravelling.  Most of those who are today happy to take credit for their market call were right for the wrong reason (viz Roubini, who expected a typical emerging-market style crisis in the US triggered by a widening current account deficit and which would have led to a dollar collapse, rather than a very sharp dollar rally), with Marc Faber, Kurt Richebacher and Jim Walker being some notable exceptions.

William White has now retired from the BIS, and it is under new leadership.  Nonetheless, the proper attitude towards this body perhaps ought to be one of seriousness and to the extent that it does not accord with one’s views, a degree of self-questioning to consider whether – given their correct understanding in the past – they might perhaps have identified some phenomenon at work unknown to the analyst.

Instead, in response to their reasoned setting forth of the risks to the present very-easy monetary policy pursued by the developed world, we have a simple dismissal – apparently on the grounds that things are so difficult now that we cannot possibly afford not to act.  This appears to be a highly arrogant dismissal of many decades work on the limited practical usefulness of monetary policy to pursue active management of demand – amongst other things, long and variable lags mean that central banks tend to act late, and then do too much, in the bust going on to set the seeds of inflation during the next upswing.  In those circumstances, once a downturn has happened there is a very real danger from excessive activism.

There have been many panics and depressions since the Industrial Revolution, but there has only been one as bad as the Great Depression.  (There was another depression beginning 1873 that lasted for a couple of decades; it is usually known as the Long Depression, but was on occasion also called Great).  There were some peculiar circumstances involved that ought to make it the subject for a longer post at some stage.  But one has very thing grounds indeed for the popular habit of always worrying that we are on the verge of entering a new Great Depression (repeat of the 1930s).

A man who was honest, and rational, and concerned only with discovering truth would recognize the need to place the present episode into the greater context of business cycle history, and would refrain from trying to panic people into thinking that we are on the verge of a repeat of the 1930s until at the very least they have set forth the evidence for their case and seen it ignored.  Since I must assume that those of differing views are certainly honest and rational, I am utterly puzzled by their shrillness.

As statistical studies have consistently demonstrated the very poor record of most economists in navigating the business cycle, an honest man should be more humble about the strength with which his views are held and acknowledge the possibility that he may well be wrong, and consider the implications if so for the relative merits of his favoured policy.

Also, one ought perhaps if one wants to be taken seriously as a commentator give people some reason to take one seriously.  Anyone can explain all the reasons why what has happened in the past was inevitable, and why only fools would have failed to see this, but it is not so easy to sense what is about to happen before it unfolds.  And even if one is right, it may not be so easy to persuade people that one is correct.

I had a certain experience of this as I turned bullish German fixed income as the latest leg of the European crisis began to unfold, unknown to almost all mainstream commentators.  At the time, the headlines were full of stories about inflationary risks due to energy prices and QE2, and the ECB was in full-blown rate-hiking mode.  Yet it was quite possible to see beyond this, and realize that the wheels would not stay on in Europe, and that the ECB would soon be cutting rates.

More recently, I observed on 31st March 2012 (with crude prices close to their highs) that despite the panic at the time about the risks of an Israeli strike on Iran, and the possibility of an upward explosion in crude prices, we would likely see “crude and related energy prices to come down sharply, pushing down headline inflation” (and breakeven inflation rates too, especially for short dates).  This is exactly what has unfolded (below I show a chart of crude prices vs 1 year break-even inflation, with the top for both being c. March).

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The timing of these calls was not merely fortuitous – a great deal of work and thought went into identifying them.  I could go further back too, but I do not wish anyone to think that I might be marketing myself here.  And of course I have gotten some things wrong too – for example, I thought from Sep 2011 to Feb 2012 that we might have seen more or a selloff in fixed income than we actually did, whereas bond yields actually moved sideways to lower.  The point is that one doesn’t when investing need to get every move right, but make sure that one makes more than enough from the right calls to pay for a wrong call now and then.  Given that bullish EURIBOR bets in May 2011 paid out 10:1, one mildly bad call is not the end of the world.

So in conclusion, my broader point is that if one writes about markets and economics, and particularly if one harshly criticizes policymakers and other commentators, one ought to have some coherence and accountability to one’s views.  One ought to spell out the implications of one’s variant perceptions and views for the future path of real and nominal variables in both economics and markets (in pattern terms, at least), and then in some months time go back and look to see what happened.  If one is right, then there is at least a  pat on the back; and if wrong, then one can at least learn from the experience.  However, I am not sure if this is the mentality of most others.  It sometimes seems often more to be about ego gratification and self-aggrandisement than about learning and the pursuit of truth.

My opinion is that we will look back from a couple of years time and see that with the benefit of hindsight, monetary policy in the developed world certainly was too expansionary and that it would have been better had it been tighter.  I suppose the path of nominal and real bond yields will tell me if I am right: I suspect 30 year UST yields – both nominal and real – will move sharply higher from here.  (Micro-term, and from a trading-perspective, one needs to trade the zig-zag, but I do think we are in a good location for longer-term bearish bets – especially if one expresses in a way that is not exposed to the convexity).

— Some supplemental comments – originally posted to Historinhas blog – follow

  •  Cantillon Blog says:

    June 25, 2012 at 8:38

    So is your position that things would have been just fine if only the Fed had eased quickly enough in July-Sep 2008?

    What do you think about the clear evidence of sloppy lending during the 2002-2007 phase, such manic lending historically almost always associated with excessively easy monetary policy?

    What do you make of people who warned in early 2008 that a terrible deflationary episode was coming? These people being not in the habit of doing so idly, and having had great track records over many previous business cycles. If somebody predicts a building is going to burn down, and it does despite some others insisting it is perfectly safe, shouldn’t you pay attention to those who warned of it before it happened? You might pay some attention to those who – once the building ignited – warned that it was not being extinguished quickly enough, but it strikes me you would pay more attention to those who told you it would catch fire before it happened, particularly since these observers gave the warning because they saw conditions that have typically preceded Great fires throughout the ages.

    Therefore I am puzzled at your unwillingness to consider the role of easy money preceding the bust, although of course I realize this does not entirely fit with your narrative.

  •  Cantillon Blog says:

    June 25, 2012 at 8:49

    Messrs Steve and Nunes,

    I certainly have read Mr Steve’s comment.

    So far, all I see is name-calling, without much of an argument.

    The BIS is staffed by economists, so of course they have not succeeded especially in identifying inflection points in markets – that is not what economists do. I do not hold them up as a paragon of forecasting virtue for the near term, but merely point out that in the past they have been right about the only thing that mattered – ie the bigger picture – when almost everybody else was wrong.

    I personally do see my role as identifying inflection points, and therefore – as I wrote in brief form on my blog, and in longer form elsewhere – I did correctly identify the downturn in Europe starting in May 2011, as well as the turn in industrial commodities (actually I nailed the downturn commencing May – July 2011, the bounce from Dec – Feb, and the renewed leg down from Mar 31 2012). One can sometimes get things wrong of course, but the point is that in the general envelope of things the BIS have been more right than most other forecasters, and I think they continue to be so.

    So I think you owe them more than just namecalling – if you believe that they got the credit bubble diagnosis right for the wrong reason (which seems to be implicitly your view), then you ought to set out your case more thoroughly. Also, if you are setting out your stall as a superior prognosticator of macro trends (which I suppose you are, by criticizing them in such harsh terms) you ought to be transparent about it – set out your expectations for economic and market variables including what would prove you wrong. And then if reality doesn’t match up to your expectations, you can at least learn from it and inform your readers of what modifications you need to make to your ideas.

    This is what I understand to be the spirit of true science. Of course it may be more entertaining merely to throw rotten tomatoes, but I wonder if that will be a truly satisfying use of time.

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