Brad Setser

Brad Setser: Follow the Money

Print Print Email Email Share Share Cite Cite
Style: MLA APA Chicago Close

loading...

Turning on a Paradigm

by Mark Dow
August 3, 2009

This post is by Mark Dow

Very few things rouse the rabble as much as an ideological debate. And over the past year it has been looking like we are having the beginnings of a nasty one in economics and finance. The current economic and financial crisis has shaken a few trees and made many go back and question first principles. Often, the answer is that the prevailing received economic and financial wisdom has fallen woefully short.

That said, those who are looking for a debate here may be disappointed. A narrow ideological debate is not the can I wanted to open up. Instead, I thought it would be useful to review from an historical perspective how we got here, and then address why this should matter.

For me, making the transition from economist to trader raised a lot of issues about efficient markets and animal spirits. It underscored the shortcomings of formal training and our incomplete understanding of the human element in finance and economics. As a result, the issue of paradigm shift has been simmering on my backburner for quite some time now.

One of the most important lessons I have learned as a trader is not just that emotions play an outsized role in market dynamics—that much became clear quite quickly—but that the emotions regularly swing, as if they were a pendulum, from one local extreme to the opposite. In other words, around any given trend there are oscillations above and below, moments of high bullishness and high bearishness. Time and time again we transition from moments when any positive statement is met with skepticism to moments when no one dares say anything negative. In short, we slowly change directions, see that the new direction starts to work and jump on, take the new direction too far so that it stops working, and then we start the whole process all over again.

These pendular swings in the market can take anywhere from a couple of weeks to numerous months, and they are marked by a distinct, three part psychological process: denial, migration, capitulation. In the first phase, participants deny that a change in market character is truly afoot. Markets rally on bad news (or sell off on good news) and traders look for others to blame for their trading losses (suggestion: when in doubt blame government; no one will ever disagree.) Then, little by little, traders begin to recognize ‘what is working’, start to question their previous beliefs, and then begin migrating from their old camp to the new. In the last phase, capitulation (or give-up phase), the final holdouts switch camps and jump on the new bandwagon—often in climatic fashion. This then completes the pendular swing.

This manifestation of human nature is not confined to intermediate term swings in the market. It also applies to ideological fashions in economics. At the time of the Great Depression the prevailing ideology was the Austrian Business Cycle School, a variant of the classical school of economics. (This school of thought was responsible for the useful term “creative destruction”). As the Depression took hold, the policy response was to allow the system to purge itself of its excesses. In retrospect, the mainstream view is that this policy response—or lack thereof—severely exacerbated the length and depth of the downturn.

Economists of every stripe have their own pet reasons as to what caused the Great Depression and what got us out of it. Leaving this debate aside, it is not controversial to say that Keynesian polices were perceived to have helped lift the US out of the Depression.

As a result of the belief that Keynesian policies ‘worked’, its adherents grew in number. The 50s and 60s were characterized by less faith in markets and more faith in government’s ability to solve problems. One might call this the ‘migration’ phase. By the time the 70s rolled around things had been taken even further, and we began to see wage/price rigidities and activist monetary and exchange rate policy take a serious toll. You could say people took a good thing too far.

The onset of the Reagan era marked the end of this pendular swing. Policies that placed greater faith in markets and considerably less in government, coupled with a more independent central bank, were perceived to have saved the economy from Keynesian excesses. As the economy grew over the course of the 80s, this new ideology—monetarist, supply-side, efficient market hypothesis—saw many new adherents jump on the bandwagon. By the late 90s/early 2000s, this prevailing ideology was scarcely seriously challenged. Markets were believed to be largely infallible and self-regulating, and no one doubted that everything government touched was going to be ruined. Fast forward to 2008: markets did fail, and the pillars of the existing ideological edifice started to crack. You could say people took a good thing too far.

Thus, the pendulum has started to swing again. Why does this matter? In short, we are going to be facing a lot of policy issues in the coming years, and many in markets, policy circles, and in the population at large are having a hard time getting off the paradigm. A lot of the baby boomers who learned their economics reading the Wall Street Journal editorial page in their formative years are still stuck in 1982. The high degree of residual ideology in the system is impeding, in my view, the fundamental rethink that the US needs at this juncture to get ahead and stay ahead of the rapidly moving global curve. In other words, with so many people still looking in the rearview mirror it increases the chances of car wrecks.

In my experience there is little room for ideology in economics. No set of rules or principles can fit all of reality for all points in time. The world to too complex and moves too quickly for this. The ‘perfect’ mix of markets and government is not a static concept. It is dynamic, and highly contextual. Again this post is not ideological. It is more a cautionary tale about human nature and the way we follow trends. We are trendy by nature. We stick with our old ideas for too long after the facts on the ground change. We then begrudgingly migrate to what appears to work, and, inevitably, take things too far. No amount of regulation can fix this; it can only mitigate the consequences from it. Let’s just hope that the amplitude of the next pendular swing is less extreme—but I suspect we are years, if not decades, away from worrying about it.

27 Comments

  • Posted by Brian Hayes

    A far reaching and very concise wrap leaving very little out but the names. And maybe a wee bit about capture.

  • Posted by Lupita

    “As the economy grew over the course of the 80s, this new ideology—monetarist, supply-side, efficient market hypothesis—”

    I think we will know the pendulum has swung when Americans call this ideology by the name it is given worldwide: neoliberalism.

    “By the late 90s/early 2000s, this prevailing ideology was scarcely seriously challenged.”

    This is when so many countries experienced financial crashes and numerous 3rd world economists and governments started to openly challenge neoliberal ideology. Countries amassed foreign reserves, nationalized resources and, particularly in South America, elected anti-neoliberal governments which in turn helped cause…

    “Fast forward to 2008: markets did fail, and the pillars of the existing ideological edifice started to crack.”

    No, the pillars have actually collapsed.

  • Posted by Michael

    Lupita, you speak the harsh truth.

    What I actually find the most fascinating historical/current/future issue is also about ideologies and paradigms.

    The 1978-2008 cycle saw academics and financial/political industry economists join the bandwagon that “The question of planned economies vs. free market economies as growth producers has finally been settled, with the absolute victory of the free market.” The preferred examples were extremes like the Soviet Union (planned) vs. Ireland (free).

    All the subtle facts about stages of development were left out, as was the fact that no significant country has been fully “free” market for the last 100 years. Victory was simply declared and, as Lupita notes, all evidence of economic collapse in countries that went Friedmanian (e.g, Argentina, Russia, Poland, and several Asian Tigers) were conveniently ignored or explained away as “unique” and irrelevant to the unstoppable historical principle.

    This set of ideological blinders is the only explanation (other than outright dishonesty) for the numerous statements from all the academic and financial/political economists (with Greenspan and Bernanke leading the pack) that “This [2008] economic crisis was completely unpredictable.”

    The equating of government economic planning and/or any government ownership of resources or industry with socialism and the equating of socialism with Communism made the ruthless promotion of neoliberal economic principles a holy war against atheistic totalitarianism and relegated any serious examination of the specific costs and benefits of central planning vs. privatization as quaint as the Geneva Conventions. Is anyone even still aware that the Soviet Union grew at double digit rates throughout the ten year period of the Depression when all the world’s market economies crashed and burned?

    Now, we are faced with a real-time unfolding complex series of events that will yield very relevant information on this issue, as China (the only one left) holds on to central planning in key economic sectors while most of the world merely bails out its large private companies.

    It’s a great opportunity to actually learn about what is and is not stabilizing and/or growth-promoting in which sectors under these conditions (worldwide credit, consumption, and trade contraction), but to learn we will have to discard the ideological blinders and see what the data actually tells us.

  • Posted by FG

    Lupita: I think we will know the pendulum has swung when Americans call this ideology by the name it is given worldwide: neoliberalism.

    However there is little chance that anyone would call it that name in the US as the great priests of ideology mean the exact opposite when they use the word “liberal”.

  • Posted by VennData

    The “great priests” are fighting the “Cash for Clunkers” with all their might. If they let this one get away… a data point will exist in the voter’s minds.

  • Posted by Rien Huizer

    Michael:

    “The equating of government economic planning and/or any government ownership of resources or industry with socialism and the equating of socialism with Communism made the ruthless promotion of neoliberal economic principles a holy war against atheistic totalitarianism and relegated any serious examination of the specific costs and benefits of central planning vs. privatization as quaint as the Geneva Conventions. Is anyone even still aware that the Soviet Union grew at double digit rates throughout the ten year period of the Depression when all the world’s market economies crashed and burned?”

    You are absolutely right. Planning can be efficient. Well ordered democracies too. It depends on the circumstances. Even anarchy (at least it can beat a very weak democracy). Look here:

    “Anarchy and Development: An Application of the Theory of Second Best

    Peter T. Leeson and Claudia R. Williamson”: Law and Development Review 2009 Vol2 Art 4

    Somalia’s anarchic economy beats Sierra Leone’s predatory state..

  • Posted by df

    indeed, nothing new here.

  • Posted by RebelEconomist

    Mark,

    I doubt your hypothesis about market cycles. If some kind of sentiment cycle existed, then it should be possible to forecast market direction using an autoregressive model (indeed these are sometimes described as suitable models for a pendulum disturbed by a peashooter).

    I am not sure that we have had a deep paradigm shift yet either. In my opinion, the fundamental cause of the financial crisis was a growth of cultural moral hazard produced by over-protective monetary policy. Regulation, derivatives, bankers’ bonuses etc are subsidiary issues that policymakers (ie central bankers as well as politicians) find much easier to deal with than disappointing the unrealistic expectations (eg regarding mortgage rates, pension fund returns and commodity prices) of millions of people. Since the response to the crisis has been quantitative easing, it seems to me that the unsustainability of this process has yet to be accepted. Before the financial crisis unfolded, I commented on this blog (when it was on rge) that the US was on the road to Argentina. I think it still is.

  • Posted by Mark Dow

    df – Tell that to the Wall Street Journal editorial page!

  • Posted by Mark Dow

    RebelEconomist – The swings are real and consistent enough. I live them. But they are not consistent enough in terms of amplitude and time to be formally modeled. Many technical analysts use overbought/oversold oscillators and stochastic metrics to try and capture these swings. These can help, but are still imperfect. Just because a phenomenon can’t be captured in a statistically robust way doesn’t mean it doesn’t exist.

  • Posted by Cedric Regula

    My read on the status of any paradigm shift is similar to rebel’s. I think many have come to an intellectual conclusion that the starry eyed, Adam Smith has been right for 250 years mindset needs some serious rework. But we still need to see some real implementation of political and economic policy changes.

    In reality, we are still doing more of the same, the short list being even looser monetary policy, record stimulative fiscal policy, Laffer taxes, coddling the banks, and waiting for the American Super Consumer to come back to life after a brief encounter with Kryptonite.

    The reasons are acknowledged to be that it’s a bad time to change the approach, and there is no choice. Which to me is like saying the pendulum should have broken already, and we are just in “finger crossing mode” hoping it can swing back in the other direction.

    So what we have are some green shoots of paradigm change, but like the markets, the underlying realities have yet to develop.

    But as far as the stock market goes, my read on what market professionals have to deal with is short to intermediate term noise, because you have to participate, it’s your job. That is not really seeing the market really sync up with an underlying paradigm change.

    I’ll believe the US stock market has synced up with fundamentals when somehow we reconcile the fact that we can have multi-year averaged PEs of 20 going thru the worst recession since the 30s, and anyone with half a brain knows it’s more than a simple business cycle recesion, but PEs in many other eras could be more like 10 in an expanding economy with lesser structural problems.

  • Posted by Judy Yeo

    Mark

    I have no doubt the swings are real if you’ve been in an old fashioned brokerage it’s really a zoo except the ones on display are human, kinda proves the evolution theory, one would think.

    Looking at the way commodities, currencies and equities have gone recently, there is no way there isn’t a free for all, in fact it feels more like a game of dare, the one who goes over the cliff being the one who held on for too long.

    So how long so you think before the next stroke of the w is painted? And do you really believe anyone can run ahead of the curve? Frankly the markets look (big picture wise) bipolar , but a noted economist (at least according to the FT) dismissed that last year -what fo you think?

  • Posted by jonathan

    When RWR was President, it was freedom versus totalitarianism, us versus them, and we won, with the Berlin Wall falling, the Soviet Union falling, etc.

    By the time GWBush became President, the ideology had progressed, as they tend to do, and freedom was increasingly defined as = absolutely free markets with minimal or no regulation because freedom means that markets self-regulate. They must self-regulate because that’s freedom and freedom is inherently good. The enemy became government regulation because that prevented the full flowering of the market’s potential. (We can see that bluntly enacted in the cries from the not-so-fringe sections of the current GOP comparing the Democrats to Nazis and other totalitarians.)

    Ideology runs amok like a parasitic vine in your garden. It needs to be pruned, to be controlled, to be cut back and not allowed to take over.

    (And yes, that was a “Being There” reference.)

  • Posted by Ali Al-Salim

    Perhaps this is a good time as ever to take a closer look at other more “dynamic” schools of thought, such as George Soro’s Theory of Reflexivity, or in more model-based realsm, the Adaptive Market Hypothesis proposed by Andrew Lo.

    EMH is a relatively crude, idealistic framework that has obviously failed.

  • Posted by C. Michael Reilly

    re; Mark Dow post
    “One of the most important lessons I have learned as a trader is not just that emotions play an outsized role in market dynamics—that much became clear quite quickly—but that the emotions regularly swing.” I think the challenge here is to separate ‘fundamentally-driven’ swings from trend-driven emotionally based swings … along these lines I recall Warren Buffet describing the ” Three ‘I’s ” with respect to industry innovation and over-investment as innovators-imitators-idiots enter markets.

    Thought-provoking post Mark ! Thank you.

    re; Lupita post;

    I have no idea how these three frameworks/perspectives ( “monetarist, supply-side, efficient market hypothesis” ) constitute an ideology whether it is new or not …
    and in turn how they relate to ‘neoliberalism’ ?

    Question-provoking post Lupita ! Thank you.

    re; Cedric Regula

    “I’ll believe the US stock market has synced up with fundamentals when somehow we reconcile the fact that we can have multi-year averaged PEs of 20 going thru the worst recession since the 30s, and anyone with half a brain knows it’s more than a simple business cycle recesion, but PEs in many other eras could be more like 10 in an expanding economy with lesser structural problems. “

    Talk about a pendulum swing in risk perceptions !
    Thought-provoking post Cedric ! Thank you.

  • Posted by Mark G.

    Mark Dow,

    You posted in the comments to bsetser words to the effect “I had just left treasury and their excellent money management is continuing”

    What were you referring to?

  • Posted by RebelEconomist

    I reckon that if a pattern is sufficiently regular for you to observe it, Mark, it can be modelled and forecasted. If by “I live them” you mean that you bet correctly and make money out of them, good for you, but in my experience as a fund manager, everyone who I encountered who claimed, even thought themselves, that they were making money out of market timing were actually making money out of selling liquidity or accepting tail risk. This, in my opinion, is why we have had a growing series of financial crises going back at least as far as 1998. Faced with a realisation of these risks, and consequent widespread distress, the authorities mitigated them each time, so that, albeit with some sleepless nights, the risk-accepting approach succeeded and grew. Actually, the risks have not been real; it’s been more like a bungee jump, with the central bank as the cord! The notion that the crisis is a product of free market ideology is incorrect.

  • Posted by Cedric Regula

    Paradigms are in the eye of the beholder. A lot depends on how we describe them, and that has a lot to do with recognizing if and when something changed.

    Try this description of tha late great paradigm on for size.

    Manhatten is a city-state where the Masters of the Universe reside.

    Washington, DC is a city-state where the Administrators of the Universe reside.

    The Administrators believe they have a symbiotic relationship with the Masters. The Masters believe the Administrators are their servants, but are usually to schrewd to say so.

    The Late Great Paradigm was driven largly by credit expansion, leverage, PE multiple expansion and finally a real estate bubble. The long term economic trends where falling interest rates, some tax rate reduction from a high rate, and the economic magic of productivity gains, but much of that may have come from outsourcing.

    The end of the paradigm is frequently described as the popping of a credit bubble.

    But perhaps that description is too crude. Maybe we should talk in terms of “credit froth”, which would be a whole bunch of little bubbles. These can pop and loss be transfered from private to public sector. The popped ones can also be left on bank balance sheets and ignored, and maybe or maybe not the bank eventually pops and is absorbed by the FDIC. The Fed and Treasury makes new money to give to the financial system so they can supply more credit to the popees.

    The Chinese continue to fund it and also continue to peg so as not to screw up our productivity.

    The city-states could keep this going for quite some time, which would completely screw up our ability to time the end of the old paradigm, and beginning of the new one!

  • Posted by Mark Dow

    RebelEconomist – By saying “I live by them”, I don’t mean I always get things right, or even that I always try to “play” them. Different parts of my book are invested with different time horizons in mind.

    But as a guy who has done a fair amount of statistics and econometrics over his career, as can assure you that there are many processes that are too complex to model in a way that is both parsimonious and robust enough to use for forecasting–particularly across the many asset classes and geographies that are in my mandate.

    Also, I am pretty sure that playing the pendular swings and selling liquidity and tail risk are not at all the same thing. For example, you can try to play the former by doing things as simple as buying and selling S&P futures or the Euro. I don’t think trading either of these assets would be confused as selling tail risk and liquidity.

    Lastly, my arguement is that ANY ideology taken to an exteme is likely to end in crisis. We saw that in the 70s and are seeing it again with a diametrically opposed ideology today. And this tendency, alas, is in the nature of the beast that is us.

  • Posted by RebelEconomist

    Mark, you mistook my point. I meant that, assuming that the fund manager is able to mix strategies to some extent, they may emphasise, say, their skill at market timing, whereas over a series of positions, the juice is actually coming from, say, a credit switch. For example, a manager adjusts the duration of a fixed income portfolio by choosing a shorter or longer bond, but they always switch into a less liquid or less creditworthy bond. In my day, this was known as “corporate tilt”. The P/L on the duration bet is comparatively large, but effectively random if they have no market timing skill, while the return to the liquidity or credit component is generally positive until…..poom! Without rigorous return attribution you may not spot this pattern before the crisis.

  • Posted by Mark Dow

    RebelEconomist – I see your point. I know guys do do that. And I know that this always happens in the run up to a crisis. But where I differ is with the statement:

    “everyone who I encountered who claimed, even thought themselves, that they were making money out of market timing were actually making money out of selling liquidity or accepting tail risk”

    I think there are indeed a lot of guys who fall into this camp–especially in the fixed income/credit space, but it is by no means universal.

  • Posted by RebelEconomist

    That’s just my experience, Mark. I can believe that there are, for example, some guys with highly specialised knowledge who can make genuine alpha for a while at least until others copy them – eg bankruptcy arbitrageurs might have done well recently. But they are a minority and economic policy would not be modified to rescue them and their clients.

  • Posted by Twofish

    RebelEconomist: I reckon that if a pattern is sufficiently regular for you to observe it, Mark, it can be modelled and forecasted.

    No.

    Once large numbers of people start making money off the pattern, the pattern will change.

    You can divide economic patterns into two groups, positive feedback ones, and negative feedback ones. Negative feedback patterns disappear if people act on them. (The supposed advantage of investing in small caps basically disappeared once people pointed it out.)

    There are also positive feedback patterns that expand when people act on them. People see stock prices rise, they buy more stock, prices price more. Eventually it blows up and the feedback works in reverse.

  • Posted by Twofish

    RebelEconomist: I doubt your hypothesis about market cycles. If some kind of sentiment cycle existed, then it should be possible to forecast market direction using an autoregressive model.

    It is, the trouble is that in boom times, the model gives the wrong numbers. You are making 2% whereas everyone else is making 20% and laughing at you. What most people do at the point is to give into temptation with the hope that they can get out before the market crash. That doesn’t work.

    Also the market dynamics works against you. If you are a money manager making 2% while everyone else is making 20%, then no one is going to give you any money to manage.

  • Posted by Twofish

    I don’t think that it is so make a pendulum swinging. The reason that Keynesian economics fell out of favor in the 1970′s is that Keynesian economics really has no answer to stagflation. If you have high inflation/low growth then Keynes just doesn’t tell you what you should do whereas Milton Friedman did.

    The reason that Keynesian economics is back in fashion is that the Chicago school and monetarism offers basically no answers for current problems.

  • Posted by Keith Eubanks

    Mark,

    What you discribe as the three phases of recognition (denial, migration, capitulation) are a discription of what I call the perception delay; that is perception of reality is delayed from that reality — always and in all phases of the pendulum swing. We really do drive by looking in the rearview mirror.

    My background is in the field of system dynamics — a modelingly technique developed at MIT that applies concepts from feedback control engineering to studying social systems such as markets or the general economy. My observation is that what we generally term as the “economy” (the collection of national or world economic activity) is far, far too complex for any individual to understand or forecast simply by thinking about it. Hence, we have all of these idealogical conflicts.

    Mental models are not sufficient to sort out these issues and I doubt there are currently any mathematical models sufficient to either. Hence, we are left arguing about it.

    However, I do think that the debate could be enlightened by putting our theories (mental models) to the test in very explicit mathematical models — at least to explore the plausible and perhaps discount some of the implausible.

  • Posted by Merril The Welder

    To say that there is absolutely no place in economics for ideology in economics is a very bold statement. On a global stage, it’s a different playing field because cultural differences affect economic decisions and what appears logical to one culture appears absurd to another. That’s impossible to root out, except on paper and in theory.

Pingbacks