Enlightened Economics

Economics for an Enlightened Age

Posts Tagged ‘Economic’

• Financial and Economic Modelling – A Waste of Time?

Posted by Ron Robins on May 30, 2011

By Ron Robins. First published April 21, 2011, in his weekly economics and finance column at alrroya.com

“…both risk models and econometric models… are still too simple to capture the full array of governing variables that drive global economic reality,” wrote Alan Greenspan, former chairman of the US Federal Reserve in the Financial Times on March 16, 2008. And if anyone should know about the quality and predictive validity of such models, it would be Mr. Greenspan. Time and again it has been shown that reliance on the predictions from such models is foolhardy.

It was the reliance on, and failure of their predictions, that caused enormous global financial and economic carnage in 2008 and 2009. Yet today dependence on these models seems greater than ever. I suggest our overt focus and use of them is often a wasted effort.

A truth that many modellers and their followers seem to have difficulty accepting is that the past—which most modellers use to prognosticate the future—has frequently been shown to be a poor basis upon which to determine future outcomes. Modellers can continue to refine their models in great detail, and then some unusual event occurs with a one in a million chance of happening—such as the US sub-prime mortgage fiasco—and their models fail. Sadly, the variables which may encompass a one in a million event are numerous. Among them are sudden changes of investor attitudes, weather patterns, geological events, and political and social upheavals.

If we look around today from the sudden movements in sovereign bond markets to the extraordinary weather recently in Australia, to the horrific Japanese earthquake, tsunami and nuclear reactor troubles, to the political upheavals in North Africa and the Middle East—all are kinds of exogenous events that can trash the predictions of the most exacting risk or econometric model.

Furthermore, a ‘perfect’ econometric model would only be possible, metaphorically speaking, if the modeller had ‘the mind of the creator.’ Only then perhaps, could all be known and predicted. Sadly—and I do not mean any disrespect to the modellers—I do not believe that many (if any) of them have that level of intelligence and consciousness at this time. So those constituencies that trust in these models are doomed to suffer continuing disappointments.

Another problem with these models is how to model for human behaviour, as it is both rational and irrational at different and unpredictable times. Therefore, before such modelling can ever hope to fully succeed, it must completely understand human consciousness: who we are, and how and why we act. And the modellers are a long, long way from such an understanding. Incidentally, there is a branch of economics, ‘behavioural economics,’ that is moving in that direction. I wish them good luck with that!

Economists today, unlike those of earlier eras, seem to believe that the only way they can be perceived as legitimate is to be scientifically oriented. Hence their passion for increasingly complex models and their statistician-like orientation.

The type of economic modelling that incorporates mathematics and statistical relationships to economic data, is termed econometrics. Google econometrics and you will probably find over 5,000,000 links. They are largely links to innumerable academics, research institutions, studies, papers and journals. With so much effort put into this field, any independent observer could conclude that econometrics must be a highly successful and seemingly scientific endeavour. It reminds me of the enormous quest for artificial intelligence (AI) to recreate the abilities of the human mind in computers. At least AI is somewhat plausible as it advances the field of computing and robotics which have many, many practical applications that we all know about.

But unlike AI research, economic and econometric models—with their significant variances and failures—have much less to offer society at this time. Mark Thoma, Professor of Economics at the University of Oregon offers these pertinent remarks in his blog, Economist’s View, on February 8. “Much of the uncertainty in economics derives from our inability to do laboratory experiments, and that includes uncertainty about which model best describes the macroeconomy. When the present crisis is finally over, those who advocated fiscal policy, those who advocated monetary policy, and those who advocated no policy at all will all say ‘I told you so’ based upon their reading of the evidence… the answers you get are only as good as the model used to get them, and considerable uncertainty remains over which macroeconomic model is best.”

In the 19th century’s Europe and North America, there were no econometric models (not in the way we know of them today), yet those continents experienced unprecedented economic growth. And the concept of gross domestic product (GDP)—which is usually a top concern in econometric modelling—was not created and used until World War II.

We know that econometric models are unreliable in providing information on how economies behave as well as their projections of future economic activity. Similarly, modelling for financial risk has been shown to be more than problematic and history shows reliance on risk models brings eventual failure and grief.

Therefore, given the facts, we need to be much, much less anxious about trying to create perfect risk and econometric models—and not rely on these models, generally. After all, it was mostly intuition and drive, not decisions based on risk and econometric models that led our greatest inventors, financiers, entrepreneurs and leaders to great success, thereby creating our modern economies.

Copyright alrroya.com

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Posted in Economic Measurement, Economics, Finance & Investing, Statistics | Tagged: , , , , , , , , , , | Leave a Comment »

• Banks’ Cheap Money is Economic ‘Poison’

Posted by Ron Robins on March 13, 2011

By Ron Robins. First published March 10, 2011, in his weekly economics and finance column at alrroya.com

Developed world bankers continue to proclaim that enforced low interest rates—cheap money—will lead their countries back to economic prosperity. But didn’t the same policies a few years ago help bring us to the precipice of financial and economic collapse? Do they still not understand that cheap easy money led to many large US and European banks becoming gambling institutions, eventually failing and bailed out at taxpayers’ expense?

And above all, that cheap easy money enticed people, companies and governments, to become horribly indebted, with many individuals and companies failing. Soon, even developed country governments may go bankrupt. As proof that cheap easy money is again causing extraordinary economic problems, just look at where some of it is now going—to the commodities’ markets. There, it helps inflate food prices, thus causing starvation and food riots around the world.

Do the bankers not read history and know that artificially induced cheap easy money can be economic poison?

Of course one simple reason that many bankers advocate cheap easy money is that it makes them a lot of money. When they can—as they did for many years and still seem able to do—‘leverage-up’ their assets in relation to their equity, they can make multiples of profits compared to before. And since, often courtesy of their benevolent central bank, they can frequently borrow at nearly free rates and ‘invest’ those proceeds in bonds/securities/commodities that often offer high potential returns, it is possible for them to make ever bigger profits.

For most large US and European banks, their assets frequently exceeded their equity by 20 to 60 times before the financial crises. That is, keeping it simple, they were somehow able to leverage every $1 of equity, usually by borrowing funds, to create $20 to $60 of assets! The risk in such high leverage is that a small loss in asset values of say, just five per cent, could wipe out their equity and cause insolvency and bankruptcy.

Unfortunately, very high leverage ratios continue in many developed countries’ banking and financial institutions. (Perhaps this is the real unspoken reason for cheap money: to inflate asset markets to keep the banks semi-solvent! Though, that topic is for another post.)

Therefore, the real story is the culture of leverage and risk that numerous developed world banks now embody as a result of easily available cheap money. This is in contrast to that during much of banking history when money was regularly relatively expensive (with higher rates of interest) than today and often difficult to obtain.

The easily available cheap money encourages enormous ‘moral hazard’ among bankers and all players in the financial system. Moral hazard denotes a lack of morality and a carefree greed mentality that produces excessive speculation. It is this attitude that promotes the creation of maximum leverage and the taking of big risks—and not caring too much about any potential losses as they are covered by others. Bankers under the influence of moral hazard are like addicted gamblers who cannot stop gambling. But the gambling is not at the card table. It takes place in their boardrooms and trading desks.

And fortunately for the bankers they can enjoy their moral hazard largely at the expense of taxpayers. As we know, much of the potential and accumulated massive losses in the US and European financial and banking systems have been transferred to governments and central banks. The US and European governments and central banks make light of these burdens saying that as their economies recover these losses will be greatly reduced. However, the ‘central bank of central banks,’ the Bank for International Settlements (BIS), has issued new global bank regulations (Basel III) that—if implemented—might reign in some of the excesses associated with moral hazard.

Of course not all banks speculate or gamble to the same extent. In Islamic banking, spiritual and ethical considerations greatly restrain speculation. Also, for instance, Canadian banks adhere to more conservative principles and are better regulated and so have not suffered the same fate as that of many of their US and European rivals.

For now though, cheap easy money is seen by bankers as our economic salvation. And it inflates global markets, including those related to food and energy. As their prices rise, the unforeseen repercussions of the bankers cheap easy money ‘poison’ assists in creating starvation, food riots, and political upheaval around the globe.

Furthermore, the continuing high leverage, moral hazard, and gambling tendencies within the banking and financial system assures that some of today’s ‘good’ investments will sour and suffer large losses. Will the taxpayers again assume those losses? If not, then what? Until the cheap easy money poison is banished it continues creating conditions for even bigger economic and social catastrophes in the years ahead.

Copyright alrroya.com

Posted in Banking, Economics, Monetary Policy | Tagged: , , , , , , , , , , , , , , , , , , | Leave a Comment »

 
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