Wednesday, February 16, 2011

And Then What? The Question the FED Can't Answer

An investment manager writes about the one question the Federal Reserve can't answer: "and then what?"

Analyzing Analysis

One of our favorite authors is the ecologist/economist Garrett Hardin, author of works such as Living Within Limits and Filters Against Folly, as well as the famous essay on the “Tragedy of the Commons.” In Filters Against Folly, Hardin outlines his approach to rational thinking through three major filters: literacy, numeracy, and “ecolacy.”

Literacy is easy to define: What do the words mean? Language, as Hardin points out, can be used to inhibit or enhance clear thinking. (Think about how politicians use certain words and phrases to frame issues.)

Numeracy is straight-forward as well: What are the quantities involved? As Hardin saw it, the failure to invoke quantities is a major weak-point in critical analysis. Any competent analyst (not just in business, but in all human endeavor) must be in tune with quantities, numbers, and scale.
As for his “ecolate” filter, Hardin focuses on the first law of ecology: You can never merely do one thing. Even the most numerate and literate analyses usually forget to ask the crucial question: “And then what?” It’s a messy question; asking it leads you to a lot of dead ends. But that doesn’t mean it should be ignored. The second order of effects can often dwarf the first.

Hardin’s filters are useful in analyzing complex systems like the global economy. An economy is like an ecosystem: complex, interconnected, adaptive to change, and consequently, highly unpredictable. As an example, let’s take the problem of Federal Reserve “Quantitative Easing” and put it through our filters.

Literacy: What do the words mean?

What does “quantitative easing” actually mean? In essence, it’s the creation of money by the Federal Reserve in order to purchase debt obligations. The effect is to inject dollars into the banking system (which may or may not be subsequently lent out) and “monetize” the outstanding debt – mostly mortgage bonds and US Treasury bonds. By being a huge source of “demand” for bonds, the Fed is trying to use this tool to keep long-term interest rates lower, stimulating economic activity and raising asset prices. We believe the jargon “quantitative easing” seeks to inhibit thought, rather than promote it.

Numeracy: What are the quantities involved?

The Fed has spent over a trillion dollars and has hundreds of billions more planned. The Fed is expanding its balance sheet by multiples, not small fractions. (Before the first round of QE, its balance sheet was in the $1 trillion range.)

But while the quantities themselves are known, some questions remain: What are the appropriate quantities to take into account? What should we compare the amount of QE against to judge its size? We’ve heard arguments that it’s way too large (potentially causing hyperinflation) or, alternatively, that it’s just a drop in the bucket, a useless distraction. Which you agree with depends on the quantities you consider relevant and the historical examples you choose to cite.

Ecolacy: And then what?

Here’s the major question that neither we nor the Fed can answer (although, at least we admit we can’t answer it): What are the domino effects of the government buying bonds in scale and attempting to dampen interest rates? From the vantage point of Mr. Bernanke, the effects have been mixed so far: asset prices have increased across the board and animal spirits have been raised, but long-term interest rates have actually increased. Would they have been even higher otherwise? How does increased speculation in financial assets support long-term growth? What if it’s actually a net negative? How much QE is too much?

Getting back to our numerate analysis, there are few truly objective measures of the success or failure of Fed action. We get the feeling that there is a statistic to support any position, and even with hindsight, it will be difficult to pinpoint what the effects of QE were. All we know is that artificially distorting the monetary system is a dangerous game; although we can make models and informed guesses, we don’t know the long term effects. When you combine the actions of the Fed with the actions of foreign countries in response, the complexity becomes mind-boggling. You can never merely do one thing.


The foregoing is not an attempt to show our prowess in macroeconomic analysis. In fact, it’s the opposite: we hope to show the near impossibility of the task. Clear thinking only allows us to understand the severe limits to how much we can know. In light of this, our approach is basic: We try to be prepared for a wide range of outcomes.

In our opinion, more reliable conclusions can be made in determining microeconomic outcomes (competition between individual businesses), so those are the ones we focus on. Instead of dealing in large-scale trends and trying to “get exposure” to them, we build the portfolio one by one, evaluating each opportunity on its merits.