Complexity in financial markets -need and limitation of models

“We have indeed in many fields learnt enough to know that we cannot know all that we would have to know for a full explanation of the phenomenon”.
F. A. Hayek

Hayek's comment is a useful focus on our limitations to understand financial market. We fight the dark forces of time and ignorance that drive financial markets as we march through this crisis. We do not know how markets will behave in the extreme or what will be the react of policy-makers Keynes was the first to describe the problem of time and ignorance. Economic decisions are based on the future (time), bu the future cannot be known with precision, so we face ignorance.

Our models and stories are just a short-hand of what we think we know and not what may actually be occurring. However, models serve as a useful framework for determining what can be tested and knowable.

Does the Fed need a bazooka in its pocket?

We tongue-in-cheek believe that the Fed needs to take the approach from former Treasury Secretary Paulson’s quote at a July 15 Senate Banking Committee meeting that “if you have a bazooka in your pocket and people know it, you probably won’t have to use it.”

-Quote form Barclay's Bank research report on the need for the Fed to have the ability to buy more Treasuries

Do we need the Fed to have more power to add Treasuries to their balance sheet? I don't think so. The Barclay's argument is that if the Fed could be able to buy more Treasuries they will be better able to force Treasury rates down and allow for lower mortgages to help the housing market. Clearly, the cost of mortgages have increased and we are back to pre-Lehman levels. This will slow refi's which is a significant gain to borrowers. However, it is not clear that the Fed needs to place more assets on their balance sheet.

The only reason for allowing for a bigger bazooka would be to eliminate the uncertainty of whether the Fed will or will not ask for more. The overhang of policy uncertainty hurts the market, but adding more Treasury buying power also will not be helpful. Increasing Treasury purchasing power for the Fed would further fuel the flames of monetization arguments. Currently, the market needs to see some signs of monetary discipline.

Learning from Hayek on knowledge and the state

John Maynard Keynes of Bloomsbury: 

Four Short Talks 

17 February 2009 

The inaugural event of the Center for the History of Political Economy. Presented at the Nasher Museum of Art, Duke University in conjunction with Vision and Design:  A Year of Bloomsbury,a campus­wide interdisciplinary program surrounding an exhibition of Bloomsbury art at the Nasher Museum.

Keynes and Hayek by Bruce Caldwell

Hayek for his part often spoke about the limits of our knowledge and the hubris of reason: we just do not have enough knowledge to control something as complex as an economy. George Will recently quoted Hayek on this point: “The curious task of economists is to demonstrate to men how little they know about what they imagine they can design.” 

He was also wary about the effects of government intervention on the ability of ordinary people to make decisions. As he wrote in The Road to Serfdom, “The more the state plans, the more difficult planning becomes for the individual.” 

We are still faced with deep uncertainty on where the economy is headed through the actions of the government. This may still be our greatest risk.

New dollar order risk premium - Bretton Woods III

The old monetary order which defines the dollar as a reserve currency for international finance is being questioned. The world moving away from the dollar as a reserve currency is unlikely, but a new Bretton Woods is developing as a hodgepodge of regional and bilateral deals which reduce the importance of the dollar. A new monetary order will place less emphasis on dollar policy as countries try to manage currency relationships basd on their changing trade flows.

The rhetoric of an alternative reserve currency will heat up and the dollar will face a risk premium which questions its reserve status. This is rhetoric which we have not seen before. This will place a dollar risk premium in the market based on reserve status questioning. China questions the stability of the dollar. Greenbacks take a hit. China and Brazil discuss a currency deal. Greenback takes a hit. Russia discuss a new reserve currency. The story is the same. This does not mean the financial actions of the players change in the short-run. We will still see dollar reserve accumulation. What will change is the speed of this accumulation and attempts at diversification. It does mean that the market will react to the rhetoric and see dollar market down-turns albeit temporary. The cumulative effect is a a higher risk premium on dollars.

Bretton Woods II was the era of savings glut and dollar dependency whereby exporting countries were willing to finance the consumer spending of the US. The system worked as long the engine of global trade continued to grow. If the US consumer continues to pull back and the export engine is further damaged the financial order will change.

The upcoming BRIC meeting in Russia is a perfect example of the new monetary order discussions. The BRIC's represent 15% of world GDP and 43% of global reserves. Any discussion without he US or the IMF suggests that the central role of the dollar is in question. A new monetary order will not occur overnight but there is no question that the future for the dollar will be diminished.