Taylored Tales of the Monetary Bards

The title of this blog may appear a bit rude, and it is not intended to be denigrating of this particular paper from the Kansas City Fed linked below, but rather the organizational mindset that uses it to adjust anything more complex than the timing on a 1967 small-block Chevy with a straight face and a clear conscience.

Although a bit wonkish, "Was Monetary Policy Optimal During Past Deflation Scares?" does an exceptionally good job of explaining the Taylor Rule, how it has been derived and is utilized by Central Banks in evaluating and formulating monetary policy, ie., short term interest rate targets. The author gets high marks for clarity of language and a willingness to allude to some of the shortcomings of the method which is remarkable for most Fed research papers.

Financial engineering reminds one of saying we used to have in Bell Labs , when some individual or group was trying to formulate a practical response to a complex problem based on dodgy theories and elaborate field data: "Measure it with a micrometer, mark it with a grease pencil, and cut it with a hatchet."

One suspects that in this case, reducing the complexities of the economy to the output gap, real inflation gap, and the equilibrium nominal interest rate is like trying to arrive at the average depth of the ocean by using a micrometer to take a few ocean depth readings in a hurricane.

Yes each component has additional inputs, that vary widely and are difficult to measure, but to paraphrase, it does not matter if you calculation works, as long as it looks good, and darling doesn't this economy look marvelous.

It would be interesting to see the fun that Benoit Mandelbrot would have dissecting the Taylor Rule equation, derived from an 'optimal period' in US monetary policy. His book The The Misbehaviour of Markets is a must read for anyone who needs to be convinced that much of modern financial engineering and risk models are exercises in mathematical oversimplification and misdirection.

For those that are not so inclined to read this paper, let us just say that the data going in to the equation is subject to wide disagreement, adjustment, and interpretation, and the data coming out has enough spread from lack of modeling robustness to support just about anything, any outcome. Given the 'thinness' of the equation, which as the author refreshingly and freely admits, can choose from widely varying measures of 'core inflation,' while taking no account of asset prices and government industrial policy among other things.

I am sure the Board of Governors would respond that this Taylor Rule is merely one input into the collective decision-making of a group of wise men, who at the end of the day are combining their various perspectives into a judgement as to the optimal course of action, which includes their vast experience and readings of not only tools such as this, but anecdotal data from their various regions.

Too bad that our last Fed Chairman was a dissembling, blithering idiot, a standing joke in his private practice, who could not find the optimal monetary policy with both hands. But he was a masterful politician and bureacrat, surrounded by fellow sycophants, and did know how to serve the banking interests and make himself look credible, at least to outsiders. And in retrospect, this paper asserts that in fact the Committee under Chairman Greenspan did make a mistake in easing too aggressively for too long a period in the early 2000's. (well, duh).

And too bad the Fed has a significant amount of influence and power, so that even academic economists are too cowed by fear and greed to have said much while Sir Alan and His Merry Pranksters blew serial bubbles in support of the new banking economy. Because if Her Majesty the Queen wishes to be truly illuminated, that is why most economists failed to see the Crash coming: you get what you pay for.

Like Elliot Waves, this Federal Reserve process and these tools 'look good' when applied to historic examples, but one wonders who could possible use it to predict anything and take action on that with any level of success. Has the US Fed really had any unqualified successes based on their own initiatives, other than when Volcker took the economy in hand and, applying a sufficient amount of will, personal resolve, and common sense, tamed the pernicious inflation of the 1970's? They appear to have created more problems than they have solved.

So what is the answer? To do nothing and let the markets play themselves out? That is folly as well, because for better or worse markets are highly subject to manipulation from a number of sources, and the distortions caused therein are potentially devastating, when one considers the willingness for example of the Asian states to manipulate their currencies in support of a mercantilist policy of importing jobs as a means of solving domestic social problems. Or the propensity of the Anglo-American establishment to perpetuate gross fraud as a means of ravaging foreign peoples that too trustingly adopted the globalist model of deregulated banking and modern derivative financing.

The answer of course is that only a significant systemic change can take us out of this cycle. It will have to be one that recognizes that globalism is not an a priori good in a world where nations and peoples wish to settle on their own way of life, and solution set to particular problems in ways that suit them.

We are probably nearing the end of a long cycle of economic deregulation and monetary mysticism, in which old barriers and protections and particularities were struck down, often with little or no serious thought to the policy implications and long term social practices. The zenith of this trend is the consideration of the IMF or some such body as the global Central Bank, with a council of global governors setting everything from trade rules to de facto living standards. One way to make the models work and end conflict among the nations is to make everyone a slave.

When the financial and social engineers fail, their natural response is to make excuses and seek more power. If the CPI is proving to be an impediment to our calculations, let's change how we measure it. If the measurement of inflation is now adjusted, but gold keeps signaling inflation, let's manage the price of gold. And if people keep making independent choices that are not consistent with the predictions of our model, let us manage their perception, influence their judgement, override their own experience and the advice of their parents, and persuade them to take on more debt than they can possibly ever repay, and still remain free.

Hopefully this trend will fall apart before the globalists can do any more damage in the real world, but if it does not and we do get a Council of Global Governors, remember that their oracle is likely to be in dodgy, over simplistic equations such as this, which will be used to throw some clothing around what is most likely to be an exercise in influence peddling, elitism, and raw, naked power of the few over the many.

"Those in possession of absolute power can not only prophesy and make their prophecies come true, but they can also lie and make their lies come true."
Eric Hoffer

Was Monetary Policy Optimal During Past Deflation Scares?

Icelandic Police Raid KPMG and Price Waterhouse in Banking Frauds

There is serious fraud and criminal activity permeating the global banking industry. So far, few governments have taken serious action to expose the fraud and begin serious investigations, much less criminal indictments.

So far we have seen the occasional outsiders being thrown off the back of the sleigh for the wolves, but the serious insiders contine on, and in the case of the US, it's business as usual with bonuses back to record levels, and banks chasing trading profits using public monies.

Will some party, some group, rise up in the US to break the grip of the monied interests on government? It appears that it will not be coming from the Obama Administration, which is seriously compromised by conflicts of interest, and the Republicans which are the seed bed of corporate malfeasance and corruption.

The banks must be restrained, and the financial system reformed, and balance restored to the economy, before there can be any sustained recovery.

UK Telegraph
KPMG and PwC Reykjavik offices are raided by Icelandic police
By Rowena Mason
9:30PM BST 01 Oct 2009

Police have raided the offices of KPMG and PricewaterhouseCoopers (PwC) in Reykjavik, seizing documents and computer data as part of an investigation into alleged criminal activity at three collapsed Icelandic banks.

The targets of the raids were the firms' banking clients Kaupthing, Glitnir and Landsbanki, but the move is nevertheless likely to cause embarrassment for the two companies, both among the "big four" accountancy names in the world.

The Reykjavik branches of KPMG and PwC are owned by its partners, common with most accountancy practices, but are also part of the multinational network of firms.

The office of Olafur Thor Hauksson, the Icelandic investigator charged with examining the collapse of the three banks a year ago, confirmed that 22 policemen and six foreign accountants took part in the searches yesterday.

"The purpose of the searches was to look for and secure evidence related to the investigation of several charges which have been investigated by the office," a statement said.

Among the matters being investigated are "violation of laws on accounting and annual reports, violation of laws on financial institutions and securities transactions and violations of laws on public limited companies". PwC Iceland could not be reached for comment.

Sigurdur Jonsson, the chief executive of KPMG Iceland, told The Daily Telegraph that the raids related to some of his clients and that none of his staff had been questioned. He refused to comment further on the investigation.

Mr Jonsson has already become embroiled in controversy after it emerged that KPMG Iceland had been responsible for investigating events leading up to the collapse of Glitnir, despite the fact that his son was chief executive of the bank's largest shareholder. KPMG later resigned from the case.

The UK Serious Fraud Office (SFO) agreed last month to send a team of investigators to Iceland to help "get to the bottom" of whether there were any criminal intentions in the country's collapsed banks, which had extensive links with London.

The Icelandic banks, which had large customer bases in the UK, failed last October, leaving 300,000 British savers unable to access their money and institutions nursing billions in losses. Following the crisis, the Treasury had to pay out £7.5bn to compensate UK savers, although £2.3bn of this will be repaid by Iceland over the next 15 years.

Allegations of fraud, embezzlement and market manipulation have been under investigation in Iceland since February. The SFO has separately been gathering intelligence on the Icelandic banking sector and its UK operations both involving investors and borrowers, which intensified after the leak of Kaupthing's loan book on to the internet last month.

Practical Decision-Making: A Priori versus Empirical Reasoning

"In times of change learners inherit the earth; while the learned find themselves beautifully equipped to deal with a world that no longer exists." Eric Hoffer

A Priori:

from Latin, literally "from the former." Reasoning that starts from accepted first principles or facts requiring no proof or foundation, being a self-evident assumption to the true believer

Empirical:

a. Relying on or derived from observation or experiment: empirical results that supported the hypothesis. b. Verifiable or provable by means of observation or experiment: empirical laws. 2. Guided by practical experience and not theory,

A Priori reasoning is often associated with religion and other belief systems, because it is 'top down' reasoning from a given, accepted fact that is judged to be self-evident and sufficient in itself. So for example, if one believes in an all-powerful and loving God, one can start making logical deductions from that first principle.

Empirical reasoning is often associated with the 'scientific method.' This is reasoning from the "bottom up" based on data, evidence and replicable experimentation and demonstrable relationships. Empirical reasoning can only take one so far, and generally follows the pattern of hypothesis - proof - re-examination - new hypothesis based on new data or insights.

In Economics, it never ceases to amaze how quickly people gravitate towards a priori reasoning once they have become wedded to a belief in an idea, a trading system, a school of thought, or a cult of personality.

If I believe, for example, that deflation is inevitable, no matter what else, then I will selectively choose data to support this view, even if unconsciously, and evaluate all information in the light of deflation as a given outcome, accept that which supports my belief, and rejecting or diminishing in significance the contrary data.

One can make the same case, for example, for those that believe that hyperinflation is an inevitable outcome in the near term. Or those who believe in the infalliblity of a particular trading system such as Elliot Waves, or some favorite indicator.

In less lofty terms, it is what we call a prejudice, although that term has become too specifically associated with racism in the modern world. It is literally a prejudging of situations, and fitting them all into a common pattern no matter what.

Sometimes the lengths to which true believers will go to hold on to their opinions becomes almost funny, if it is not so often accompanied by ad hominem attacks and rather nasty, immature behaviour when the true believer becomes cornered by reality. Or the tragedy of genuine loss when believers are led into folly and the consequences of their errors.

How funny is it, for example, to see a noted pundit keep drawing lines in the sand for the maximum price appreciation of a commodity like gold, and having to change them every year, ignoring past failures and pretending as though they have not been wrong, not daring to acknowledge their failure and attempting to explain it, to at least integrate it into their system in some credible manner.

There is always an alternate count, always the oddly possible but highly improbable excuse or rationale for their own mistaken belief, to avoid admitting that they or their system are imperfect, that they do not know the future with any certainty.

One can believe in something that might eventually become true, but for the wrong reasons. The 'belief' part is accepting the truth before any rational evidence would lead one to accept it logically. It really depends on the odds, and whether they get 'lucky.' People are therefore fooled by chance.

This by the way is the problem I have had with some of the adherents to the Monetarist and Austrian schools of economics, among others gathered in schools. They believe something, and are inclined at times to twist the data to support their predispositions and claims, and reduce objections or alternate views to caricatures that are not correct on close examination by the unbiased mind.

A scientific approach is to assess what is, rather than what we would like things to be, and to draw conclusions carefully from it, calculating probabilities when the evidence does not support a single outcome, and a willingness to accept new data and act on it when it appears, even if it appears contrary to a current working hypothesis.

This does not mean it is wrong to carefully examine evidence that seems to be 'on the tails' of our existing body of knowledge, to see if an adaptation of the hypothesis is all that is required.

Why is this important to us here in this forum?

Because belief is in the realm of the spiritual and the philosophical. Even a statement like "it is self-evident that all men are created equal" is clearly an appeal to a philosophical stance.

Finance, business, trading are not worthy of belief excepting for the ethical implications of behaviour that is contingent on all realms of human endeavor, depending on what one believes.

So, in trading, one should try to avoid becoming a 'true believer' in one idea or person or system. They are all likely to be flawed, and will very often blind the believer to the reality of the situation, so that they can lose impressive amounts of money fruitlessly following a belief that has no validity in their particular case.

In other words, no one knows the future for certain. There are always probabilities involved in every situation, every outcome. Some are more easily discerned than others, but they tend to be in the long and short term trends.

People naturally tend to carve the 'hits' or successful predictions based on their system or belief in marble, and write the 'misses' in sand. They tend to fool themselves as a portion of the belief in what they think must be true. It is a natural, but potentially deadly, behaviour.

In religion, faith alone can lead one to do outlandish things as in the South Seas cargo cults. So there is the thought in the western tradition that one relies on faith and reason together. But of course reason can only take one so far, and then one is faced with what Kierkegaard called 'the leap of faith.'

One might be willing to 'lose money' for the sake of righteousness by refusing to engage in unethical behaviour in their business activity. But foolish is the person who loses money because they have put their faith in human error, in party politics, in groupthink, and profane beliefs.

On an almost daily basis I see otherwise intelligent people making this mistake, and Wall Street takes advantage of it, to the max. I have made this mistake in the past. Overcoming it is one of the great steps towards becoming a successful trading and maintaining a balanced life of the material and the spirit. We render unto Caesar that which is Caesar's, but what is God's is God's.

When the leap of faith is applied to the deployment of a trading account it is too often results in a leap off a cliff. When faith is misplaced in an ideology such as natually efficient, self-regulating markets, or state planned command economies, it can take whole nations into the abyss.