Enlightened Economics

Economics for an Enlightened Age

Posts Tagged ‘financial’

• 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 »

• A Global Central Bank and Currency?

Posted by Ron Robins on February 16, 2011

By Ron Robins. First published January 27, 2011, in his weekly economics and finance column at alrroya.com

There are many paths forward for the global monetary system, but the hitherto unthinkable is becoming debatable: a global central bank and currency. However, despite the recent financial distress and potential for further financial calamity, the creation of such a new institution or currency is far off. But would a global central bank with possibly its own currency help bring monetary solace, universal prosperity and humankind together? Or would such a bank and currency result in yet another calamitous monetary failure?

The 2008-2009 financial debacle showed just how unprepared the global financial system was to deal with a loss of faith in, and imploding of, the global banking system. To stave off a global financial meltdown, the central banks of the US, the EU, Japan and many others around the world advanced vast sums in loans and guarantees to banks and financial entities. And the US Federal Reserve (the Fed) in particular loaned out hundreds of billions of dollars to foreign-owned banks, in effect acting as a bank of last resort to the global banking system.

As big as the Fed is, it and other central banks, for many reasons, may not be able to address the demands of a future global financial maelstrom with possibly even larger calls for loans of last resort. For the Fed, this is due to 1) the declining relative importance of the US economy and the dollar in relation to the global economy, and 2) potential political interference in its activities.

The mounting problems and lessening importance of the US economy and its dollar globally are obviously why a new international currency regime is being considered. International Monetary Fund (IMF) data (published in The Economist magazine) shows that while the US now makes up about 24 per cent of global gross domestic product (GDP), its dollar accounts for 84 per cent of foreign exchange transactions. Furthermore, over 60 per cent of international central bank reserves and about 60 per cent of global bank deposits are denominated in US dollars.

The continuing use of the US dollar internationally is largely dependent on the performance of the US economy and its domestic fiscal and monetary policies. Domestically, the US government is growing massive unsustainable debts while the Fed is hugely expanding the creation of new money and the buying of US government bonds (its quantitative easing programs). These actions are likely to further devalue the US dollar globally. Thus, holders of US dollars and assets will increasingly be less interested in retaining them.

Rising to compete with the US dollar has principally been the euro. However, with its member countries’ debt problems, the attention is turning primarily to China’s yuan. It is probably no accident that on January 12 China made a significant step forward in yuan foreign exchange convertibility by allowing it to trade in the US. China has also recently made deals with Russia, Brazil and other countries to settle trade accounts in yuan.

Such gains in the international acceptance of the yuan make it likely to be included in the revised and re-invigorated Special Drawing Rights (SDR) issued by the IMF. The SDR is presently a type of currency used in a limited way among central banks and the IMF. However, its role could eventually be expanded and in the decades ahead might even form the basis of a global currency.

The SDR comprises a basket of currencies that include the US dollar, yen, euro and pound sterling. Besides including the yuan, a revised form of SDR might include additional currencies and even gold or other commodities as well. As gold has an inherent market value, proponents for its inclusion suggest it could help bring further stability to the SDR. Changes to the SDR are favoured by many countries such as Russia and France.

Hence, the IMF may well begin to act in the coming years as a quasi global central bank. However, Barry Eichengreen of the University of California in the US cautions—quoting the Economist magazine of November 4, 2010—that, “no global government… means no global central bank, which means no global currency. Full stop.” Economists like Mr Eichengreen have the weight of evidence on their side regarding the need for a global government before a true global central bank and currency could come about. One only needs to look at the European Central Bank’s problems to see how the lack of an overarching, integrated and authoritative governance structure greatly impeded its ability to deal with the recent crises.

Advocating against the concept of a global central bank and currency are some free market proponents such as Ron Paul, a US Republican and now chairman of the powerful US Congress’s Monetary Policy Sub-committee. He and many others believe currencies should be freely chosen and have intrinsic value, backed by commodities, most likely that of gold. They say without gold backing, any currency and central bank issuing such currency, is deemed to eventual failure due to the historical fact that governments inevitably print excessive amounts of money. This ‘printing’ thereby debases the currency’s value and essentially commits fraud against the holders of the affected currency.

It is possible that the world may proceed towards a global central bank and currency over time. In the near future, the IMF will probably revise, re-invigorate and expand its SDR program to assist in the transition from reserve dependence on the US dollar. But the dangers with the SDR are that it is still largely linked to the viability and variability of national economies and their domestic policies and currencies. Advocates of a completely free market approach such as that proposed by US Congressman Ron Paul might also hold sway. The idea of a global central bank and currency is still just an idea. But it is an idea arising out of the calamity of our present day reality. It deserves hot debate.

Copyright alrroya.com

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

 
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