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Wednesday, March 19, 2008



by which i mean the aftermath of the most radical episode of central banking since and perhaps including the great depression.

charlie rose last night interviewed saint paul volcker, former fed chairman and quite probably the most universally respected american central banker of the 20th century. the journal has excerpts, and video will soon be available. volcker of course hasn't sought to be a saint, but his de facto canonization is particularly evident these days.

some points:

Rose: Somebody said to me that we entered a period in which they were worshiping mathematical models … And mathematical models had no business sense.

Volcker: The market was being run by mathematicians that didn’t know financial markets. And you keep hearing, you know, god, that event should only happen once every hundred years, according to my model. But those every hundred years events are coming along every two or three years, which should raise some questions.

i would argue that this is an important manifestation of the long-run trend toward scientism. financial markets are far from the only place where humans subscribing to the empirical tradition of david hume have lost sight of the limitations of modeling drawn on simplistic linearities. what fits for climate change also fits here:

it seems to me that the irreducible complexity of the system will always defy meaningful analysis, despite what adherents of scientism and the cult of techne might like to believe. our models -- such as they are, being hopelessly reductive -- are constructed essentially by backtesting some broad ideas and adjusting parameters to fit the data we have collected on the recent past -- itself a sample size too small to be significant -- and in any case without anything that an appropriately honest scientist would call a well-understood mechanism.

under such circumstances, any prediction our integrated assessment models of the global environment eject on a hundred-year scale then is little better than a coin flip -- for the same reasons that mathematical models backtested to fit the stock market invariably lose money. the reality is itself unpredictable -- the actual open system is both complex and chaotic. observation of past behavior yields no mechanism by which long-term future performance can be even hinted at.

so why should these predictions be treated seriously?

indeed they shouldn't be, at least not too seriously. in adopting scientific method, one must be sensitive to the philosophical limitations of the method -- and the boundary lays at the edge of complexity, whereafter what seem to be broadly identical inputs to a system yield widely different outcomes.

this is an irreversible verdict against quantitative trading, in my opinion, and indeed on the very sort of historical and mechanistic contextualizing that i use to inform my own trading. it also does much to explain the general ineffectiveness of economics and psychology in making useful predictions. at best, one might hope to ascertain probabilities with a significant factor of error, often larger than the magnitude of the prediction itself.

Rose: Has [the economy] bottomed out, or have we seen the worst?

Volcker: Look. The basic economy is not irretrievably damaged in any way, shape, or form. We had to go through an adjustment, which is tough. It’s happening much quicker. You’d rather have it happen gradually. But I’m optimistic that, okay, we’ve got to get the consumption down, we got to get spending in line with our capacity to produce. I think that’s going on. And that process is going to take a while. If we can stabilize the financial market, we ought to come out of this. Then we’ve got a lot of work to do about what we do with the regulatory system, the supervisory system, what the role of the Federal Reserve is, what the role of the Treasury and the government is, because this is a different financial market.

we may rally here -- fashioning a rope ladder higher from the very noose of historical expectation -- but there will be more fallout from the mean reversion of indebtedness and consumer spending. volcker seems to believe that the reversion will be a long process, and i tend to agree.

Volcker: We’ve seen the Federal Reserve take more extreme measures in some respects than any that have been taken in the past to deal with a financial crisis, which raises some real questions about not only for the Federal Reserve and its authorities, but for the structure of the financial system… The Federal Reserve is designed to lend to banks. And the banks were considered to be at the center of the financial system, and lend liquidity, provide cash in return for good assets, when a bank got in trouble. Now they found in this case, where some of the investment houses were in trouble, and prototypically Bear Stearns … it’s lightly regulated by the SEC or some other, but not for the same reasons. They haven’t got the concern over the stability of those things….We’re going to lend to them and protect them, shouldn’t they be regulated?

Rose: Is it a wise precedent?

Volcker: Whether it’s wise or not depended upon how severe this crisis was and their judgment about the threat of demise of Bear Stearns. That’s a judgment they had to make and an understandable judgment. There is no question about it.

Rose: Could we have risked the failure of Bear Stearns?

Volcker: Well who knows? It would take a lot of courage.

The Federal Reserve … has not, in the past, been conceived as a place where you put in bad assets, possibly bad assets. Lending institutions take risks. I’m not suggesting the assets are terrible, but they have collateral. But that is a new departure. And at some point, the government ought to — in my view, the government ought to be taking responsibility for that kind of action, not the Federal Reserve, which is an independent agency designed to provide an ample supply of liquidity to the economy but not too much, protect against inflation, not to protect particular sectors of the economy from bad loans.

Rose: So the Federal Reserve should not be doing that, in your judgment. It’s not because it shouldn’t be done, it’s the role of the federal government.

Volcker: Absolutely. In this situation, they stepped in and nobody else was there to do it…They stepped into a vacuum, and I think quite appropriately, it’s a judgment they had to make. But is this what you want for the longstanding regulatory support system? My answer is no.

volcker is pointing up the need for fiscal remediation, a view that is coming to be widely held in financial circles. the federal reserve is not designed to forgive bad debts, but some government construction could be -- along the lines of the resolution trust corporation (or RTC). an mentioned at across the curve today, one of the drivers of a continuing large curve flattening move is...

... a Wall Street Journal back pages story that the administration would be willing to hold talks with Congressional Democrats about a coordinated Federal response to the crisis. The translation is that they will soon spend taxpayer money to fix the mess.

moreover, a move by GSE regulator OFHEO to release fannie mae and freddie mac from capital constraints put in place when the books of the GSEs turned up sour a few years back. this is another step toward making the GSEs part of the reliquifaction of the mortgage-backed securities market -- but also more heavily levered and volatile than ever. in time, one suspects, these institutions which back 60% of the american mortgage market will be openly nationalized, becoming part of volcker's preferred legislative resolution to the housing bust.

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