Monday, 21 March 2016

Helicopter money: great minds think alike. And they don't change

Would the FED and the ECB allow financial markets, and especially equity markets, to suffer a massive fall? Or would they, if deemed necessary to avoid such an outcome, extend QE and start to buy equities at some point? Could they resort to helicopter money and e.g. deposit, on a non-refundable basis, ten thousand euros / US dollars on each Eurozone / US citizen's bank account (possibly conditional to the money being used to pay down debt)?

Normally, to gain a deep understanding of reality - how the economic system works and things are likely to play out - you have to quantify it. Occasionally, however, you can gain the required understanding by analysing the top decision-makers' intellectual framework, background and the incentives guiding them. Let's do the latter to answer the questions above.

Who were/are the main top decision-makers in the post-2008 financial crisis world? Where do they come from? What's their intellectual background? The main decision-makers were/are: Ben Bernanke, Mario Draghi, Mervyn King, Olivier Blanchard, Larry Summers. The "PR department & fan club" cheering publicly their actions was/is led by Paul Krugman, Joe Stiglitz, Jeffrey Sachs.

All of them did their PhD studies in the same city and University in the 1970s. With the exception of Joe Stiglitz and Mervyn King. Stiglitz is a bit older than the others and finished his PhD at the end of the 1960s. In the same city and University. So, not an exception after all. Mervyn King studied in Cambridge, UK. And came later to the city and University for a 2-year tenure as visiting professor. During his time there he shared an office with the then assistant professor.....Ben Bernanke - so, not an exception after all either. Mario Draghi, by the way, was the first Italian to obtain a PhD from the University in question.

The University's economics faculty had 4 intellectual giants: Samuelson & Solow, who shared one office, and Dornbusch & Stanley Fischer, who shared another office. Samuelson is Larry Summers uncle. 

The University is the MIT (note: Larry Summers, who did is BA at MIT, and Jeffrey Sachs were PhD students at Harvard. But the MIT had an open door policy allowing Harvard PhD student to attend lectures. Summers and Sachs did just that. And Dornbusch's lectures with many of the students-turned-policy-makers-and-or-international-VIPs are legendary)

Cutting a long story short, if you know what the 1970s MIT's view of the world - and how to deal with financial crisis - is, you will understand the boys-turned-central bankers approach to the financial crisis to date and what they are likely to do in the future. This begs the question: what was 1970s MIT's analytical approach to problem solving and resulting view of the world? Answer: MIT's analytical style was based on developing simple and concrete mathematical models directed at answering important and relevant questions. I fully identify with this style - you don't analyse and try to find solutions for a complex reality by building models that are even more complex than the reality you are trying to analyse. You keep the models simple by identifying what are the key variables impacting the dynamics of the problem at stake and modelling accordingly (even because if you have a model with 20 variables most of them will be correlated and therefore redundant). 

However, once you get into this simple-model-analytical-framework mindset you risk being captured by it and think that for every economic problem there is a simple and straightforward solution at hand to solve it. As policy maker you will then tend to become too interventionist in areas you shouldn't and don't let the system correct its excesses. This is what happened in the post-2008 financial crisis world. Instead of focusing on the right side of the balance sheets and incentivising painful debt restructuring measures, balance sheet repair and debt-to-equity swaps in an over-leveraged economic system (starting with the banking sector), policy makers focused on the left side of the balance sheets and in reflating asset prices. Misallocation of resources is the result and we all will have to bear the consequences of it at some point down the road.

Are policy makers likely to change their crisis resolution approach, start to focus on the balance sheets' right side and on supply side / structural reforms (which arguably include public investment in human capital and infrastructure)? Very unlikely. People don't change - especially when it comes to their over many decades developed intellectual framework. The top decision-makers would have to be replaced for a radical change in economic and central bank policy to take place.

One could now argues that a major replacement already took place: Ben Bernanke is not the FED's Chairmain anymore. But that's irrelevant. Janet Yellen is intellectually very close to Ben Bernanke. And the current number 2 at the Fed, appointed de facto by Yellen, is....Stanley Fischer. Yellen, by the way, is married to George Akerlof - Nobel Prize winner and PhD from.....the MIT.

Do I need to say more?

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