Time to Throw Out the Efficient Markets Theory

Over the last few months, I've not been surprised to read that recent events have thrown a bit of doubt on the Efficient Markets [EM] theory. As defined in an article this weekend in the Financial Times, EM is "the theory ... that market participants are governed by rational expectations and markets are self-correcting."


[Thanks to Greenwichroundup.blogspot.com for the image.]

If I understand this theory correctly, the correlation in practicality is that the most prudent long-term investment portfolio for the modest, ordinary investor, i.e. the one with the best risk-security ratio, would be something with a lot of Dow-type common stocks, because the collective markets take all factors into account quicker than any individual can do it.

The evidence behind this theory was provided, in part, by Jeremy Siegel of the Wharton School at the University of Pennsylvania in 1994, in a book entitled Stocks for the Long Run. Siegel analyzed data going back to 1802. According to another article this weekend in the Wall Street Journal, he based his statistics on data provided by two other economists, Walter Buckingham Smith and Arthur Harrison Cole.

However, the WSJ article points out two problems with Siegel's argument: (1) the stock samples chosen were "cherry-picked" and not "comprehensive," and (2) as of June of this year "U.S. stocks have underperformed long-term Treasury bonds for the past five, 10, 15, 20 and 25 years."

Oops.

Ever heard Benjamin Disraeli's phrase, "There are three kinds of lies: lies, damned lies, and statistics"?

I've always had a suspicion about the EM theory. It just seems too pat, too profitable to the Wall Street types, and not really adapted to the little guy: the forgotten men and women who just want to hold onto their hard-earned savings and gain a little real income from them.

I observe that Wall Street market players are not long-term thinkers who spend even a nanosecond worrying about the future of Western Civilization. They're the ultimate Instant-Gratification Kids, worried only about their next buck. "To hell with tomorrow," or such esoteric concepts as the "Forgotten Man."

Even more so today, as we slide into this second phase of our current recession, we realize that the Efficient Markets Theory--and even its supposed alternate, the "Treasury Bond Theory" (I'm inventing the name)--may both have failed us. This will be especially true if inflation hits us, as some predict (and I believe it will, when it comes time to put the Federal Reserve and Treasury credit genies back into the bottle).

The truth of the matter is that there is no stasis. No theory works all the time. As we slide up, over, and down the recessional curve, the corresponding statistical charts will prove first one theory and then the other, depending on where you start and where you stop the x axis.

So where does that leave us?

I would be very interested in some research comparing three model portfolios since approximately 1900 (more precisely, a year in which the market can be considered to have been healthy and balanced): an Efficient Markets portfolio, a Treasury bonds portfolio, and a Gold portfolio (one invested primarily in good gold stocks). To be fair, we would allow modification of common stock, bond, or gold stock picks, but only over the longer range to insure diversification, company soundness, and regular dividend issuance, and only according to some strict rule.

But such research is not easy to come by. Current advisers are not thinking in terms of the erosion of the dollar. Most of them take the dollar as the only game in town.

There was a fellow who tried his best to give us good information: Economist Edward C. Harwood. Up until his death in 1980, he took the position that inflation was the most pernicious waster of wealth we had to face, and that any safe investment must insure against excessive business cycle fluctuations and loss of purchasing power through manipulation of the currency by inflationary monetary policy. For the latter part of his life (1950s to 1980), his investment research pointed to recommendations based on a high percentage of gold holdings. (Or course, we have to keep in mind that the world was on a gold standard until 1971, and he was not alone in seeing the then-coming collapse of the dollar.)

Today, the current strength in the "price" of gold (in fact, it's really not the price of gold, but rather the weakened gold-exchange rate of the dollar) demonstrates once more that the world has not forgotten the role of gold as a monetary metal and does not have blind faith in the dollar, in spite of what the central bankers would like us to believe; and that inflation and possible dollar weakness is still very much on our minds.

You've probably noted over the last few months that China and Russia have made quite a show of recommending the return to gold as a store of value in place of the U.S. dollar. (See this Financial Times article, and my previous post about the Russian fellow Sterligov.)

These outbreaks, although embarrassing to the U.S., don't seem to worry anyone just yet. However, it would be a mistake to write off the sentiment behind them, which is probably shared by more Westerners than our politicians would like to believe. Note also that even our central bankers have slowed their gold sales in recent months. (Do you suppose they themselves are aware of its present and future potential "price"?)

There is a risk in holding gold. Roosevelt gave us the precedent: in the 1930s, he simply made it illegal for American citizens to hold any gold and forced them to accept the dollar. Nothing excludes that from happening again, especially with popular sentiment against "the rich" and "the speculators."

The dollar may have a few more years in it; but in the longer run, it may be just such market sentiments that will force our politicians and academic theoreticians to recognize the simplicity and efficacy of gold as a monetary metal, in some future international role.

I would love to believe that this must happen in my lifetime; and if it does, gold will find its true "price," well above what it is today, Efficient Market theory be damned (and along with it Modern portfolio theory).

I could be pipe dreaming. Meantime, my mantra still holds:

You can take gold out of the standard, but you can't take the standard out of gold.

Golden Hero From ... Russia?

I had to put aside my very pressing work on the biography of Edward C. Harwood to honor my subject's great respect for the gold standard and sound commercial banking, when I saw an ad on the front page of Section 2 of the Financial Times today. Unfortunately, I can't locate a link to the ad itself, but it says:

"THE FAST TRACK OUT OF THE CRISIS
The New Global Payment Unit
Troy Ounce Fine Gold 999.9
Paper money or real gold?
It's your call."

I immediately realized this was the handiwork of either a madman or a genius, or some combination of both, and so I set about finding out more about the fellow. Indeed, he is both.

He is a Russian billionaire named German Sterligov, and he has come up with a new, yet age-old idea: Using gold in international exchange transactions. He has ordered to be stamped under the label "ASCENT" (Anticrisis Settlement & Commodity Centre) 1.1 million Troy ounces of gold, acceptable at any ASCENT office worldwide in international trade deals done through his offices.

This fits in with the rest of his business, which is international barter exchange, a transaction style dear to the Russian heart according to some of the information I found on his US website.

On the European version, I found these two short videos featuring the madman-genius himself--a most intriguing character.

Interview with CNBC on June 23, 2009

Interview on Aljazzeera on May 4, 2009

I think I could grow to like the guy. He became rich in his twenties; he lost the Russian Presidential election to Putin in 2004; and now he raises goats.


[Thanks to Farmtoconsumer.org for the photo.]

I assume he has squirreled his riches away somewhere (and I bet I know where that is).

I agree with everything he says about gold, its historical use, and its potential to help rectify much that ails the world today. On the other hand, I fear for his life, because for this system to become a reality, many central bankers and the politicians who use them will find the competition unbearable.

I will watch this with great interest. Mr. Sterligov, please watch your back. You are playing a game with potentially some very powerful and nasty opponents. If you have any success at all, you will soon be challenged by all the armaments the current monetary authorities and legislators of the world can summon from their reading of the law, and from their judges and alphabet hit men. After all, centralized government's very survival depends upon the powers derived from fiat paper currency.

You could use some help from some small-government politician with the foresight to see the potential of your idea to get the forgotten men and women back to center stage, someone who has the guts and the personality to seize the moment and make a run for it. More power to you and this rare politician, Mr. Sterligov.

Get Your Gold Right Here!

In Germany, the art of the vending machine is at the forefront of its game. See this one in Wolfsburg, where you can choose your Volkswagen:


[Thanks to Jalobnik.com for the photo.]

Elsewhere, a fellow named Thomas Geissler has started a company that is installing 500 vending machines in various spots, and what do you suppose he sells?

Gold.

That's right, buyers have a choice among a 1 gram wafer for 30 euros, a 10 gram bar for 245 euros, or various gold coins.

There is a slight hitch: He has added a 30 percent mark-up to the cheapest products. Most dealers will ask only around 5 to 7 percent for bullion coins. And of course, prices are monitored and changed every few minutes.

See an article on this by Murray Wardrop at the UK Telegraph. And here's another at Reuters, and a third at Geissler's website.

Economist Edward C. Harwood introduced the notion of selling gold by the gram and potentially using it as an exchange medium back in the 1960s, and he even got his face on a one-ounce gold coin, in honor of his efforts. I don't know if he was the first; but his story is a fascinating one that I may be able to tell at some point relatively soon. I'm now working on his biography.

Meantime, I've often maintained that the gold standard can come back through various doors:

1. Official re-adoption by the politicians (but as my friend the former Columbia economics professor says, don't hold your breath);

2. Partial re-introduction, i.e. official acceptance of gold as legal tender so the public could use it as an alternative to the dollar in contracts and for repayment of debts public and private (I wouldn't hold my breath for this one either, because the politicians know how much this would limit the scope of their financial activities);

3. Demand by the public.

Now, this third avenue may just arrive in spite of a lot of skepticism. US gold coins are in short supply due to the huge demand in the US. Other countries are more aware even than we are of the importance of gold in the historical money markets. This experiment in Germany may tell us just how likely it is. If the public is willing to pay a 30 percent premium to own gold from a vending machine, then the urge to own something of value instead of fiat paper currency must be deeply ingrained indeed.

Mr. Geissler has surely thought this thing through, and has invested in some pretty heavy equipment (500 very solid machines, plus something to make the 1-ounce wafers) and security systems to see that his operation has a chance to succeed. I will be watching this one closely.

Remember my mantra:

You can take gold out of the standard, but you can't take the standard out of gold.

Skidelsky: The Economic Pendulum Has Swung Again

In his commentary in today's Financial Times about the economic policy of government stimulus of the economy, Robert Skidelsky, the noted British author and authority on John Maynard Keynes, declares:

"What is fascinating is that it is an almost exact rerun of the debate between Keynes and the British Treasury in 1929-1930."


[Thanks to Thefoucaultproject.co.uk for the image.]

I have already posted about this earlier. He is right, we are right back where we started. In the 1930s Keynes argued against then-current classical economic theory, holding that government spending would put people back to work. At the time, few economists dared to refute his pronouncements. (One notable exception: Edward C. Harwood.)

But the classical school of economics wasn't dead yet. Spearheaded by Milton Friedman, it girded up its loins and made a comeback, using new geeky esoteric mathematical formulas that were effective in shooing the Keynesians. Today, we see the latter group charging forth again to reclaim their territory.

This swinging back and forth says nothing good about economics as a science, and more particularly macroeconomics. There have been no decisive victories in this field since its inception. This is a scary thought when you think that economists are running the show right now.

This unscientific outcome is typical of a number of the social sciences. As Skidelsky points out:

"It is characteristic of the social sciences that their battles are interminable, temporary defeats being followed by the regrouping of the defeated forces for a renewed assault."

I agree, with a nuance. He seems to be saying that the social sciences are ... well, just different kinds of science. He implies that the natural sciences are like a man: logical, Darwinian, forward-looking; and that the social sciences are more like a woman: emotional, spiteful, revengeful.

I think an endeavor is either a science, or it is not. Skidelsky errs in his designation as science the quixotic behavior of certain persons he calls "economists." They may be generally recognized as economists, but they are not scientists.

The debate then becomes: Is the term "economic science" an oxymoron?

This is a very good question, and perhaps THE fundamental question. There are two possible answers.

1. Either it is an oxymoron and economists should re-designate the field of inquiry as an art form; or

2. Economics can be a science, in which case the methodology has gone awry, given the "interminable, temporary defeats being followed by the regrouping of the defeated forces for a renewed assault", i.e. no progress is being made, the pendulum is merely swinging back and forth. In this case, optimists would hold that the methodology can be fixed.

In the early 1950s, a group of scientists formed a group called the Behavioral Research Council to study this very phenomenon in the social sciences. To make a long story short, they premised their foundation upon the hypothesis that the social sciences did have the potential to be just that, i.e. real sciences in the true meaning of the word; but that much gobbledygook must be lifted off the real science that did exist, in order for the various fields of endeavor to make any real progress.

They published two books:

- Useful Procedures of Inquiry, by E.C. Harwood and Rollo Handy, based upon specific dialogue on methodology between two fellows named Dewey and Bentley; and

- A Current Appraisal of the Behavioral Sciences, edited by the above two gentlemen and authored by various social scientists whose work the group respected.

The first is still pertinent to our discussion, pointing out the very flaws in the methods of research in fields like economics, to which Skidelsky makes oblique reference. Apparently, nothing has improved--a scary thought when you think that our economic future depends upon the work of good-intentioned people like Bernanke and his ilk, who believe in policy research that is unscientific in the judgment of a good portion of their own fellow economists.

The second is out of date but still of interest, because it gives the status of each social science as of the last printing. An update of this text would be useful someday.

I'll conclude this post by stating that my observations of human nature, and specifically of those who would call themselves economic scientists and those who would call themselves political scientists, point toward the conclusion that we have a long, long way to go before they start thinking of us and of their science, and not of themselves. Meantime, look what we have allowed them to do to us all.

PS: Keynes had the potential to be a true economic scientist, but I believe he was too enamored of his own glib persona to limit his mutterings to the truly useful, in the scientific sense of the word. Lawrence H. White, on the other hand, is one of the modern economists who counters this new policy swing back to Keynesianism. Read his latest piece over at Cato to learn a scientific economist's analysis of the Great Depression of 2007 and why the Keynesian stimulus idea can't and won't work in the long run.

Angela Merkel, Lone Ranger

Among all of the Heads of State, Ms. Angela Merkel is the only one with the courage to denounce the policies of the world's most powerful central bankers, Ben Bernanke, Mervyn King, and Jean-Claude Trichet. Bertrand Benoit's piece in today's Financial Times describes the important ending of her otherwise uninteresting speech Wednesday.


[Thanks to Costumeco.com.au for the photo.]

She gave "a vitriolic attack on the world's three mightiest central banks"--something which she has never done in the past. People who know her well confirm that it was no slip of the tongue, that she is always careful to mean what she says and say what she means. She said that she is "sceptical" about the powers of the US Fed to control the flood of purchasing media and credit they continue to create, alongside their European counterparts.

According to those who surround her, she "does not blame the implosion of the subprime mortgage market for the economic crisis. She does not see securitisation as the culprit. Rather, she thinks the loosening of monetary policy under Alan Greenspan's Fed chairmanship fuelled the creation of asset price bubbles and encouraged excessive leverage within and beyond the financial sector." [You and my spell checker will have to excuse the apparent typos, but I'm quoting a British text.]

She reminds me of Mrs. Thatcher back when the English Prime Minister touted the economics of the Austrian, Professor Hayek, who if he were alive today would surely agree with both ladies about the origin of our problems.

This recession is being described as a quadruple whammy: The first round seemed to come from the imaginative excesses of the residential mortgage market and the Wall Street math geeks who played with them. The second is coming now from the equally imaginative over-expansion of the commercial development financing market and is undermining some major banks' already fragile balance sheets. The third will soon appear within the retail credit sector. And the fourth is the credit derivatives wild card.

The source of all four, however, according to Merkel, Hayek, and me, is the combined actions of the monetary and fiscal authorities, (1) whose decisions are not predictable, (2) who have too much power to distort our money supply, and (3) whose constant interventions can and will, everywhere and always, throw even the best-performing economies into havoc.

What makes this even worse is that omnipotent power attracts those who would profit from it. Just listen to the big market players--the seemingly indestructible huge banks and automobile companies--as they turn their sheepish bahs towards Washington. (Try out this website to hear what this sounds like.)

We are approaching an interesting crux of this recession. Economists and market players alike are split into two camps: those who think the principal danger (or speculative opportunity) is depression and deflation, and those who think it is inflation.

I'm in the inflation camp, alongside Ms. Merkel. I don't know whether the coming series of monetary bubbles will take one year or ten to appear and burst; but I feel very sure they are coming. When it comes time to pull the punch bowl away, this Fed will be no stronger than any other has been in the past (with perhaps the exception of Paul Volcker, but how short-lived his wisdom was). Our Fed governors' task will be complicated by their lack of real control of interest rates: Just when they will want to reign in credit, the rates will go up, putting them in a quandary.

As far as I know, and in the longer run, there has never been a nation in history that has survived the chronic debasement of its monetary unit. Ironically, this time it's Germany (or at least her Head of State) that seems to be the one ready to speak up. As Ms. Merkel puts it: "The most complicated phase will come when the crisis is over."

Quick Speculative Thoughts about Possible Future Trends

In reading the daily commentary of the American Institute for Economic Research for April 29, 2009, my speculative little crystal ball began to light up. AIER is the only serious business cycle analyst group that points out reality, and reality is that contraction is everywhere in the stats, in spite of the recent "good news" in the stock market. (Desperate exuberance, anyone?)

So let's think it over.

We all agree that the government and the Federal Reserve think they are doing their best to prevent a deflationary spiral, to un-freeze credit, and to save major industry players from precipitating us all into a deep depression. Money supply creation is high, and we can see that the Fed's balance sheet has never been in a more inflated state.

According to some signs, these policies seem on the surface to be taking effect. Sales of existing homes are turning around, and the stock market is maintaining its rally. Meanwhile, the money supply is expanding by an annual 8.1 percent, while at the same time the CPI is stable or falling.

If past experience is any indication, it would seem logical that we are headed for an arrest--and perhaps even a reversal--of price deflation; and if the money creation continues unabated, as would seem inevitable given current Fed policy and the expansionary will of the administration, inflation should be the outcome. Some are even talking about hyperinflation.

But I have a slightly different crystal-ball image (which could of course change tomorrow). Keeping in mind that this is just a game, and that no one's fortune telling is better than anyone else's, just for fun I thought I'd throw this out on a rainy Sunday afternoon.


[Thanks to Crystal-cure.com for the photo.]

Hyperinflation is not in my crystal image. This is not post-WWI Germany or Zimbabwe, in spite of the way things look. What is the reason? It's certainly not because there is no monetary excess going on; it's because, unlike the world of speculative finance, a good part of American industry is too savvy to get caught up in the exuberance.

In fact, American industry has been savvy for a long time, at least one century or more. In pre-1929, over-issued money supply did not all pour into consumers' hands, where it must be before it can create hyperinflation. In the decade leading up to 1929, prices were relatively stable, yet money supply grew. Where did it all go? It flowed into the stock market, for one, which experienced a huge run-up that subsequently burst and started a cyclical downturn.

Why didn't the country experience general price inflation? Economists speak of nominal inflation versus real inflation. Nominal inflation can remain low or non-existent, even as real inflation grows. Prices are stable, whereas they should be falling. This is what happened in the 1920s. And American industry knew this, while the Fed governors pretended not to (or were too inexperienced to realize it).

Later, during the long inflationary run of the second half of the 20th century, industrial market players and their public adjusted to chronic price increases. It's similar to what we do as we grow older (if not wiser): We get used to living with low-grade arthritis pain. This chronic inflating, however, culminated in another stock run-up and the acute crisis of the 1970s, which some say was deeper than that of the 1930s in real terms.

But we got over it and it didn't take too long to get back to our arthritic monetary ways during the 1990s, helped by urgencies in the savings bank industry and in the commercial banking industry's politically motivated foreign investments. This time, the inflationary run popped in 2000 and 2001, having inspired another stock market bubble. By now, we were so good at putting up with pain that we returned immediately to our bad habits, creating the real estate and credit-speculation bubbles that have dropped us to where we are today.

Instead of taking our medicine once and for all, we're off to the races again. Today's crystal ball tells me that we will get a renewed stock market mini-hyperbubble, along with a government stimulus maxi-bubble targeted to specific groups of rent-seekers (special interest groups like financiers, government workers and programs, construction conglomerates, unions, and the like). While this is going on, general prices will remain fairly stable, and banks and investment houses will go right back to their speculative games. Gold and commodities may go through a mini-hyperbubble as well.

But the business cycle really wants to contract. This time, the arthritic pain is too acute. Look at the stats at AIER. It's possible that real industrial GDP may not progress, even though government stimulus money may creep in, pushing up the digits for a while. But keep in mind that government stimulus must be paid back by future capital, depriving us in the coming years of investment in real industrial GDP. The figures will mislead us all. But American industry knows this.

So to conclude, we could get some short-lived hyperbubbles in the stock market and commodities, but they might deflate and run out of exuberance for a while. The maxi-stimulus fake bubble will run out of public support for sure. GDP will eventually dive again and will become chronic stagflation as the increasingly impotent government and Fed blow stimuli through the system like air bubbles in a fish tank. Most of the new air will dissipate through short-lived financial speculation. (Japan, anyone?)

Keep in mind that, having exposed my insights to you today, I'll probably rethink this whole crystal vision by my next blog. But if the deflationary business cycle fights back and ultimately wins this contest between it and our desperate government and Fed efforts, expect bubbly stagnation for a good while, until industry decides it's time to make a come-back. Then we'll probably get the inflation we've been fearing.

The Stress Test: Inspecting the Stable After the Horses Have Gone

[Thanks to Americaswildhorses.com for the photo.]

Even if it's too late, it's good to know that the US Treasury, other Government agencies, and the Federal Reserve are able to do what they were supposed to do all along, i.e. monitor the health of the US banking system. This Federal Reserve white paper amply demonstrates their know-how by detailing the accounting verification procedures they applied in their infamous "stress test" of 19 major US banks, the results of which they now hesitate to divulge to the public for fear of instigating another wave of panic.

This fear harks back to my growing list of examples of government running amuck through inappropriate intervention. Instead of intervening too late, they should have been minding the barn back when it might have turned up some loose beams and posts and kept the horses inside.

What makes this tragic situation worse is that since 2001 the BIS (Bank of International Settlements) has been discussing what to do about what central bank representatives had clearly identified as imbalances in international bank leveraging (e.g. assets vs. capital ratios) and as excessive fiat credit creation.

So where have our central bankers been? Why did it take so long?

Unfortunately, I have no answer to this question.

"[T]he Federal Reserve Board has regulatory and supervisory responsibilities over banks that are members of the System, bank holding companies, international banking facilities in the United States, Edge Act and agreement corporations, foreign activities of member banks, and the U.S. activities of foreign-owned banks. The Board also sets margin requirements, which limit the use of credit for purchasing or carrying securities." [Source. See also this and this.]

Looks like the Fed has spent the last nine years sleeping on the job. Maybe we should start a class action suit for negligence? (Just joking, I think.)

Government Intervention Run Amuck No. 20: Bank Intervention

My list of examples of the unintended consequences of government intervention in the marketplace gets longer and longer. This time, I'm going to point out the latest irony: Investment banking's profitable last quarter.


[Thanks to Thevoiceforschoolchoice.wordpress.com for the photo.]

This would be wonderful news if it were genuine, but looking a little deeper reveals the truth. First, in one of Barron's feature articles by Andrew Bary, we learn about a little-discussed fact: Goldman Sachs has only been able to issue low-cost debt due to the backing of the FDIC through a program called the TLGP, or Temporary Liquidity Guarantee Program.

I suppose this program is no secret, but somehow it had escaped me that Goldman, JP Morgan, Morgan Stanley, and others are relying heavily on it to survive, at the same time as they are declaring profits and claiming that they want to return the TARP money in a show of strength. In fact, it's all show and no strength when you look at the facts.

Here's another thing that raises my cockles. Goldman has stated first quarter earnings as $1.8 billion. As Alan Abelson points out in his weekly Up & Down Wall Street column, Goldman's profit statement all but ignores results for December because of a fluke fiscal-year switch. "Goldman lost some $780 million in December," says Abelson. This brings the four-month profit down to $1.02 billion, which is still respectible; but somewhere else in Barron's (I can't find it now) we learn that Goldman made most of that profit through a risky bet on bond futures.

Isn't risky betting what got us into this mess? And aren't firms like Goldman now gambling with our tax dollars? Aren't we rewarding and encouraging the very behavior that helped get us where we are today? And is there any guarantee that they will make good bets (with our money) in the future? Shouldn't these people be market-dead?

Abelson conjectures, furthermore, along with his source Zero Hedge, that some of Goldman's $1.8 billion profit may have come from payments by AIG, who "'gifted the major bank counterparties with trades which were egregiously profitable to the banks.' This would largely explain, according to Zero Hedge, why a number of major banks actually, as they claimed, were profitable in January and February. But the profits, it is quick to point out, are of the one-shot variety, and ultimately, they entailed a transfer of money from taxpayers to banks, with AIG acting as intermediary."

My free-market instincts have always told me to hold onto my resentment of big bonuses and the new divide between the rich and the "middle class," as illustrated in the supplementary section to this weekend's Wall Street Times, with glossy pictures of dozens of fabulous mansions for sale around the country. And echoing my own sentiment, Gregory J. Millman chides me in his Barron's piece this weekend, "let's not go ape about fairness." He's right--or he would be, in a free-market society.

But Mr. Millman, this market isn't free and hasn't been for decades. How can we talk about free market when the banking barons are divvying up our hard-earned tax money, thanks to the largesse of those who didn't earn it, our legislative representatives? How can we talk about fair competition when the playing field is rigged in favor of the big boys, and the small businessmen and women just have to suck it up when they learn from their subsidized bank that they can't have any of the handouts? How can we talk about a deflationary correction, elimination of the unhealthy business models, and a return to saner plain-vanilla banking, when our legislators continue to reward foolhardy risk-taking?

We're headed in the wrong direction. More limited government is the answer, not bail-outs of bankers who should be dead by any Darwinian-Schumpeter standard; not Treasury-instigated bank "stress tests" that will soon go bang in the night, raining multiple unintended consequences; not back-room cronyism in the name of "saving the system."

Taylor's (and Friedman's) Error

In a book review by Clive Crook in todays Financial Times, we read about the new work Getting Off Track by John Taylor, creator of the "Taylor Rule" for monetary policy. According to Taylor, if the Federal Reserve had followed his famous Rule instead of their own discretion over the last decade, we wouldn't be in the mess we're in today.

Taylor's Rule gives a mathematical formula for the calculation of monetary policy. As Crook describes it:

"The rule says central banks should set the short-term interest rate equal to one-and-a-half times the inflation rate; plus half of the gap between actual and trend gross domestic product; plus one. For example, if the inflation rate is 5 per cent and the output gap 3 per cent, the Taylor rule says make the interest rate 10 per cent: one-and-a-half times 5, plus a half of 3, plus 1."

His idea is similar to the formula of Milton Friedman, which at one point economists called the "k-percent rule." Friedman would have had the Fed increase the money supply annually by a fixed percentage. He is essentially Taylor's precursor.

Both economists advocated a fixed, formulaic determination of the expansion of money supply because they were wary of a discretionary monetary policy open to the whims of central bankers and the politicians who appoint them.

Where both these illustrious gentlemen err is in their naive belief that any political appointee(s) would be capable of limiting themselves to a non-discretionary monetary policy once they have the power not to.

In a July 2006 e-mail exchange with the Wall Street Journal's Tunku Varadarajan, Friedman wrote: "There are certainly occasions in which discretionary changes in policy guided by a wise and talented manager of monetary policy would do better than the fixed rate, but they would be rare." WSJ Archives.

Rare indeed. Didn't he realize that "rare" is in the eyes of the rate-setter?

Friedman's incongruous naivety is at odds with his skeptic personality. In his own book Capitalism and Freedom, he says:

"As matters now stand, while this rule [the k-percent rule] would drastically curtail the discretionary power of the monetary authorities, it would still leave an undesirable amount of discretion in the hands of Federal Reserve and Treasury authorities with respect to how to achieve the specified rate of growth in the money stock, debt management, banking supervision, and the like."

So why does he even bother with the k-percent rule in the first place?

Both Friedman and Taylor seem to be aware of the fallibility of agency intervention into the supply of money; and yet, inexplicably, both seem in the end to take for granted that the agency in question will be willing to renounce discretion when push comes to shove.

This is equivalent to sitting two-year-old Dick and Jane in a room with a big box of chocolates, telling them they can have only one each, then leaving the room. It just won't work.


[Thanks to www.lib.udel.edu, the Univ. of Delaware Library, and The New Fun with Dick and Jane, Chicago: Scott, Foresman and Co., 1956.]

And it's not Dick or Jane's fault. Dick and Jane are only two years old. Monetary policymakers are just humans. Humans are control freaks. They are tinkerers. It is a rare economist who, once appointed to the position of Federal Reserve Board Member, can look deep down inside existing economic science and declare the truth of what he finds, i.e. that no one knows how to control monetary policy, with or without a formula.

For one illustration of the mindset of our FRB Members, read this speech by Governor Mishkin. It's an eye-opener, revealing just what the more rational economists like Taylor and Friedman are up against. These Governors see themselves as monetary artists, not scientists.

For a second example of Federal Reserve mindset, take a look at this astonishingly self-serving article by Alan Greenspan in the Wall Street Journal last month. We perceive between the lines that there's a nasty feud going on between Taylor and Greenspan, and rightfully so. Taylor is Jane's older brother (he's six) and Greenspan is little Dicky.

Now children: I guess we'll just have to take that box of chocolates away, now won't we? (Gold standard and sound commercial banking, anyone?)

The PPIP Drip

Another version of my April 4th cartoon, suggested by a friend. Which one do you prefer? (Click on the image for a larger version.)