Fama

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Game Stop Fun

Game Stop, I trust you know what I am talking about.  For those who don’t, all you need to know is that it is a bricks and mortar seller of video games and associated paraphernalia.  It had a huge, almost ubiquitous, presence in the malls of America.  Then everything moved online. Streaming became the norm.  Game Stop slid on its way to probable oblivion.  It lost $1.6 billion over the few quarters leading into early 2020; fired a boatload of people and managers; its stock plummeted downwards; and the future looked very bleak.  At $18 per share there seemed to be sufficient downside for Wall Street short sellers to pile in and make a bundle.  So, right on cue, a couple did.  The smart money, which Wall Street likes to think it has a lot of, was betting on Game Stop’s inevitable demise.  It was the closest thing to a dead certainty since … well since Wall Street was high on all those “can’t miss” mortgage backed securities back in the day.

Was this a Eugene Fama moment?  Or was this a Robert Schiller moment?  (I still can’t get over them both winning the ersatz Nobel prize in the same year!)

Then something funny happened.

Game Stop’s demise and the shorting of its stock came to the attention of an obscure backwater of the internet where people gather to watch Wall Street activity and make their own bets on stocks.

Yes, I know.  “Make their own bets” is not technical language for what Wall Street does, perhaps I should stick with the formalities and point out that the short sellers were backing the fundamentals.  That’s the word they all use to describe the bits and pieces of information that they pick up and glue together to paint a picture of the future.

In any case those fundamentals were grim.

But the denizens of the internet don’t see stock prices through that Fama-esque lens.  They see it through a more exuberant lens.  They like to play games and take bets.  At least they’re honest about it and don’t slather themselves with the hubris of a typical Wall Street banker.

So what happened when fundamentals clashed with exuberance?

The stock price shot up.

From the starting point of $18 per share it rose at a dizzying pace, hitting a high of $380.  It was true mania.  A wonderful thing to watch and confirming everything skeptics like myself think about the stock market.  The short sellers were caught in a vicious squeeze and eventually they caved in.  They cashed out and took very large losses.  One was even motivated to launch a verbal attack on the internet gamers saying it was unfair and vindictive.  Poor thing.  I hope his hedge fund survives.

Quite what happens to the gamers now they’ve driven the Wall Streeters to the sideline is anyone’s guess.  I imagine they’ll be taking their losses too as those fundamentals assert themselves.  Who knows?

It does make me chuckle though.

I always thought that the entire Fama fantasy about the efficiency of market prices was an absurdity.  Wild gyrations in price are supposed to signify information being assimilated into the market, every single price is supposed to be a correct reflection of this steady drip of information.  Prices are never wrong.  Ever.  There can be, in the land of Fama, no bubbles. I remember discussing the topic with a former Federal Reserve bank chairman.  No, I was told, there are no bubbles.  The market knows how to price.  I was young, how could I argue?

Back to the drawing board.  Efficient market theorists now have to take into account the oddities of investors who see the stock market as something of a game — unlike the professionals who, we must all remember, “invest” they do not “bet”.  No not at all.   No doubt somewhere in Chicago they already have their response lined up.  Perhaps they can add another circle or two to their Ptolemeic geometry.

Meanwhile those of us who live in the real world and accept the vagaries of uncertainty and limited knowledge, don’t have to adapt a thing.  We know the answer:

It’s a complex world.  Stuff happens.

Like Game Stop’s stock price.

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The Fama Quasi-Nobel: Posthumous Award for EMH?

They’re kidding, right?

Nope. They mean it.

What’s really weird is that he splits the award with Robert Shiller and some guy called Hansen who is an econometrician and thus unintelligible and largely irrelevant to sensible discussion of the economy.

Back to Fama and Shiller: there are a few ways to deal with this.

Take One:

Fama was the guy who created the Efficient Markets Hypothesis (EMH). Looked at strictly this theory tells us that there is nothing an investor can do to outfox the market. This is because all the information that is out there is incorporated in prices. Thus all those ads telling us about past performance and about clever investment strategies are simple hoaxes. The market is what it is, and neither you nor I can outwit it unless by dumb luck.

This interpretation of EMH means it is a still solid, relevant and good piece of work. The problem is that it is built on much of the same quicksand as its companion theories that posit rational behavior. And because it can be reduced to that dictum that “the market is what it is” it has little value to anyone other than obscure finance theorists. It says that incoming news will produce a different result tomorrow, so today’s market price has no implication or meaning for tomorrow’s price.

In a nutshell EMH is another example of the hermetically sealed reality-resistant thinking that dominates modern economics: the only quirks or rotten stuff sit outside the pristine and pure wondrous working of the marketplace. Which is why theorists like Fama are so ideologically hell bent against anything that appears to intrude into their precious markets. Especially governments.

Take Two:

But Shiller has devoted much of his professional career to pointing out that people are a bit less – perhaps a lot less – than rational. At least in the meaning Fama has for rational.

In particular Shiller achieved notoriety for his study of real estate prices and noting the rise of the bubble that so famously burst a few years back.

Bubbles would suggest that markets are somewhat less than rational and are inclined to significant overshooting, undershooting, and other total misinterpretations of information. This is hardly efficient. Indeed a quick look at Shiller’s work seems to imply that he has debunked EMH pretty well. Don’t forget that according to EMH a house priced $100 one day and $1,000,000 the next is entirely within the realm of rational experience. The difference simply reflects different information. Duh.

So the quasi-Nobel prize committee is backing both sides of a very important argument. One that has huge implications for, inter alia, bank regulation. Do we regulate banks because they are likely to get swept away by Shiller-like exuberance? Or do we leave well alone because they are embedded in the smooth rational workings of the financial market place a la Fama?

Take Three:

This is what I call the “Krugman cop-out”.

His argument is that, even though Shiller seems to have undone Fama, and even though the work of the two seems to be in contradiction, the award to Fama is still worthy. After all someone had to dig the hole Shiller’s work subsequently filled up. Krugman is taking the old academic high road and trying to focus on all that now discarded effort. Perhaps he’s mindful that his work could also be debunked one day, and so he has closed ranks.

Take Four:

My view is that the quasi-Nobel committee was on the brink of giving Fama the prize back in the mid 2000’s, but was stopped dead in its tracks by the crisis, the bursting of the bubble, and the disarray this meant for the Fama camp. The committee had to wait for the dust to settle and for Fama’s defenders to rally around. They also had to allow the public of anyone interested in the prize to lose sight of EMH amongst all the post-crisis confusion and exposure of economics generally. Then they had to get someone else to steal the headlines – Shiller is a terrific choice – so that few outsiders would notice.

In many ways the award is akin to posthumous recognition. It is a reward for hard work done in the service of a now debunked theory.

EMH still has its supporters or course. They are that hardy band of rationalists who still dominate much of the economics landscape and who strenuously fight to keep reality at bay. Most of them appear to live in Chicago, which rather calls into question their rationality. Doesn’t it?

Well I think so.

 

Addendum:

For those of you confused by my references to the “quasi-Nobel”, I should make myself clear. I refuse to recognize the economics prize as a Nobel prize. It isn’t. It is a prize funded, not the Nobel Foundation, but by the Swedish Central Bank who sub-contracts the entire bureaucratic side of the award to the Nobel committee. It is thus a “faux” or “quasi” Nobel prize.

Besides, does anyone really think economics deserves a Nobel prize? I mean really?

 

 

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Was It Interest Rates?

One of the enduring myths about the banking implosion is that the real estates bubble was facilitated in part, or in main, by the incredibly lax monetary policy started by Alan Greenspan and then continued by Ben Bernanke. This story goes like this: interest rates were keep much too low for much too long during the years after the 2001 recession, partly in response to the recession and partly in response to the bursting of the hi-tech bubble. These low rates flooded the markets with liquidity and encouraged steadily increasing risk taking. The end result being the burgeoning of the sub-prime mortgage business which, in the eyes of the analysts pressing this line of reasoning, became the cause of the crisis.

One piece of evidence often used in arguing this case is the so-called Taylor rule I have mentioned here before. The Taylor rule is a ‘rule of thumb’ calculation that correlates the goals of the Fed – managing inflation and unemployment – with an appropriate interest rate. For those of you who have read more about these things the Taylor rule recalls the relationships we all used to see in the ‘Phillips curve’ of yore. The Taylor rule suggested a level of rates a good 3% higher than those actually implemented by the Fed for long stretches from 2001 onwards. This gap between what the rule suggested and what rates actually were is the ‘smoking gun’ that purportedly damns the Fed.

My issue with this is that it ignores so much else.

While I agree that the Fed kept rates too low for a long time and thus missed an opportunity to throttle the bubble before it collapsed on us, I am no longer sure we can simply point at the Fed and ignore everything else.

The banks, for instance, were surely complicit. There is nothing in the Fed keeping interest rates too low that forces a bank to throw caution to the wind and abandon sensible loan underwriting policies. Lax standards at the banks are a much more likely cause of the bubble than rates.

Then why didn’t the profit motive, that old ‘market magic’, prevent the banks from being stupid? After all Alan Greenspan’s extraordinary naivety was based upon a faith that the market would identify and compensate for any foolish or overly risky activities. Instead the entire market went over the cliff, lemming like, at the same time. Far from acting as a balancing and purging force the market accelerated and hyped up the failure. This was an epic example of a ‘market failure’ – something that free market exponents have always told us cannot happen.

And this is why we see the blame shifted to the Fed.

The free market advocates deny that markets could be so insane as to allow an asset bubble to occur. Indeed Eugene Fama of the University of Chicago, and the inventor of the Efficient Markets Hypothesis we find at the center of the failed risk management models the banks used, still denies that a bubble even existed. So such people have to look for an alternative cause and, being ideologically so predisposed, they point to the government.

They actually point to two government errors:

First is the low rate environment of the Fed. Second is the social tinkering in real estate and the obsessive desire of American governments to encourage home ownership. This second cause found, according to the likes of Fama, its manifestation in the over funding of Fannie Mae and Freddie Mac, and in the continuation of the tax break given to home owners who use debt to buy a home. To Fama, if the government had not tried to skew the market towards home ownership there would have been no crisis.

I agree. Well in part. Clearly the government’s continuous support of home owners at the expense of renters does produce an over investment in housing. This inflates home prices because it encourages people who might otherwise rent to buy a home – the government is subsidizing ownership and not renting. So the number of people buying homes is artificially inflated and prices are forced up by this ‘excess’ demand. Abolishing the tax credit for mortgage interest would not just help close the budget deficit – it is one of our most expensive welfare programs – but it would lower home prices.

But what about market efficiency?

Should markets not adjust for this?

The rational expectations hypothesis of Fama’s colleague Robert Lucas tells us that consumers are rational enough to realize, and adjust to, distortions they see the government introducing. This is why Lucas argues against any government intervention and is such an ardent opponent of Keynsian style stimulus. [Lucas won the Nobel prize for this work]

So what happened?

The free market crowd cannot have it both ways. They cannot argue, as Lucas and Fama do, that it was all the government’s fault, and then turn around and argue that stimulus won’t work because the market won’t be fooled by it. I have to ask: why was the market fooled at all? By those low rates for instance?

The problem is much less complicated if, like me, you are more skeptical about markets than Fama and Lucas are. I prefer Minsky’s interpretation of Keyne’s basic theory: markets can and often do wander away from a balance or equilibrium position. They are often inefficient and absorb information poorly. They are prone to excess and crisis. Bubbles are a frequent and natural result of this inefficiency.

Minsky’s ‘Financial Instability Hypothesis’ stands far more justified by recent events than Fama’s Efficient Markets Hypothesis. This is a resounding defeat for the Chicago school of thought, the legacy of Milton Friedman, in economics, and brings to an end a very divisive chapter in the history of economic theory. Keynes has been rehabilitated from the temporary victory won by Friedman and his ‘monetarist’ colleagues and the subsequent ‘New Classical’ theory developed mainly at Chicago.

The irony of this was summed up well by Greg Mankiw, a Harvard professor and sometime advisor to George Bush, who wrote in 2006 that most of economic theory developed since 1970 has proven to be useless at best and damaging to public policy at worst. Mankiw is a Keynsian of sorts and so probably delights in the travails of the Chicago school.

For the rest of us: we see the conflict over economic theory form the outside. It manifests itself in this discussion over the role of the Fed. If you are a New Classicist and believe in market magic then the Fed must be at fault since the market is always correct. If you are a Keynsian you can be more ecumenical and so can spread the blame around.

It wasn’t just the Fed. The private sector went insane as well. The market failed.

Which is why we need to set up new rules and boundaries to stop a repeat. This is the basis for the re-regulation argument. Since markets can and do go wrong, it is socially less expensive, and very wise, to limit the extent of the market by hemming in the players with institutional rules. We call those rules ‘regulation’. The people who are regulated see it all as unnecessary government tinkering and red tape. Taxpayers should see it as insurance to limit the cost of the next bail out.

And, yes, we will need another bail out. Markets go wrong. That means banks will need help. Regulations are designed to reduce the cost of that next bail out.

So it wasn’t just interest rates.

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Comments To Tim Geithner

Mr. Secretary:

Thank you for giving me this opportunity to present my comments and suggestions regarding the potential reform of the US banking and financial system.

Let me preface my comments by thanking you, your predecessor, and the Chairman of the Federal Reserve Board for the decisive and apparently successful efforts you made to remedy the crisis of this time last year, and its ramifications as they affected the economy this year. The fact that the credit markets have, with little exception, settled down, if not all the way to normal, then close to it, is testimony to that success.

But it is not enough.

My fear is that without action that some, including yourself, may consider to be radical, we are simply laying the groundwork for a new bubble – one that will have far more severe effects than the last.

I believe this to be true for the following reasons:

  1. The financial system is inherently unstable. I do not believe, as you and others do, that market forces are an adequate safety mechanism that provides us with assurance that imbalances in banking will be automatically corrected. On the contrary I think that there is sufficient evidence now to make the opposite claim: banking is immanently unstable and will, without externally imposed safeguards tend towards periodic bouts of crisis. I believe, in other words that Minsky’s ‘Financial Instability Hypothesis’ has more explanatory power than Fama’s ‘Efficient Market Hypothesis’. This leads me to believe that frequent asset price bubbles, and waves of losses based upon a subsequent correction to them, are an endemic feature of capitalist banking systems.
  2. Self-regulation is a total failure. Nowhere is this more obvious than in what used to be called the investment banking system. The explosion in marginally productive, and ultimately socially damaging, derivatives products demonstrates that the motivation to earn short term profit will always overwhelm any attempt made from within banking to impose self-regulated limits. We cannot rely at all on the goodwill of bankers to forego profit for the sake of social goals. This skepticism is amply justified: the asset leverage ratios that the banks felt capable of sustaining – and the mistakenly regulators tolerated – were primary causes of the need for taxpayer assistance. Not only was there no voluntary restraint, there were open efforts to exploit that lack of restraint for personal gain. In effect bankers robbed shareholders of capital by applying egregious economic rents to unsustainable cash flows. This has to be stopped. That, in the months since the crisis abated, such rent seeking has again sprung to the fore completes my view: bankers must be controlled as they are incapable of self-control.
  3. The regulatory system itself, as currently constituted and enacted, failed completely. I have just mentioned regulatory complicity in the build up of excessive leverage. I am unaware of attempts to penalize the banks for this level of transparent risk taking. Evidently regulators were either asleep at the wheel or so captured by the thought processes of the banks that the amassing of systemic risk passed by unnoticed until it caused the implosion last year. Without a decoupling of the regulators from the regulated we cannot expect the public interest to be well served. And, as I stated above, since the financial system is inevitably headed, by its very nature, back into excessive risk taking, it appears to me that it is essential that such a decoupling not just take place, but is enforced and policed diligently. So the regulatory system needs thorough, not incremental, overhaul.
  4. I admit here to a problem that may be difficult for you to overcome with ease: the large banks are global in nature which enables them to engage in regulatory arbitrage by moving their assets to jurisdictions with more benign regulatory regimes. You must not tolerate this. Global banks have established vastly complex and difficult to understand governance structures both to avoid regulatory limitations and to avoid paying taxes. This has compounded the systemic risk within the banking system by masking cash flows and legal responsibilities: the lack of transparency in bank governance is astounding. That this activity is openly an attempt to avoid taxation and to inhibit regulatory control at the sovereign level is, frankly, a brazen affront to the public whose money provides the safety net to the very banks who avoid their civic responsibilities. Nothing could be more insulting than a bank’s attempts to avoid contributing to the pool of taxpayers money needed to save that self-same bank form bankruptcy. We clearly lack what Justice Brandeis called the disinfectant of transparency. Global activities need global oversight and should never allow a shirking of responsibility. Nonetheless I realize this particular issue needs international cooperation for its resolution.
  5. Global organizations are also large. Size matters in banking. This feature of our system is now worse than it was before the crisis because of the loss of large market participants and the subsequent consolidation of business within the survivors. The largest banks now control excessively large market shares in all the major lines of banking activity. If we faced a problem of having banks ‘too large to fail’ last year, we now have an even more severe problem. Banks who operate safe in the knowledge that we cannot afford to allow them to fail, no matter how stupidly or incompetently they are managed are dangerous. They hold us to ransom. That we have allowed this to occur is a failure of public policy at the highest level and must be undone, and addressed urgently.
  6. Which brings me to my next point: the specter of moral hazard haunts the system as never before. Banks are continually subsidized by the presence of the taxpayer provided safety net, yet they are never charged for that subsidy. They get away scot free. This can only enhance their willingness to undertake socially problematic and excessively risky behavior. Many of the issues I have already mentioned are the result of the existence of moral hazard: leverage that pumps asset levels beyond reasonable limits is very likely not going to occur in a system where the shareholders have no ‘put’ to the taxpayers. If shareholders genuinely were the last resort source of capital to a bank it would treat them with more respect and protect itself from failure with more diligence.
  7. This leads naturally to the scale of finance. I am not the first to express alarm at the disproportionate amount of our overall economic wealth attributed to the financial system: the system has grown massively in scale and scope since its deregulation. Much of this growth is attributable to the explosion in off balance sheet and trading book activities that seem to provide little or no enduring social benefit. If the purpose of finance is to allocate capital within the economy as efficiently and as cheaply as possible, then the system we have today fails. It has just imposed an epic cost on society for which we received no particular benefit. Most of the vaunted innovation so revered by the banker’s apologists appears to have been to the sole benefit of the bankers themselves, and not to the wider economy. The inter-bank trading of incomprehensibly complex products may generate fat fees for bankers, but I am not sure it solves any social problems. And certainly is not worth the risk of a repeat melt down such as last year’s. The efficient allocation of capital can take place comfortably within a less bloated system.
  8. Finally, and following on from this, I believe the current system is too self-referential. It lacks differentiable and independent internal checks and balances. It is replete with conflicts of interest. This extends beyond the intellectual group-think that seems to have settled upon the entire industry – especially its obsession with ‘market forces’ – but is more specific: banks hold positions on both sides of a deal; they trade in CDS instruments that give them profits when the underlying security fails, even though the CDS is supposed to be an insurance against such an event; they write their own credit ratings; and have oligopolistic market power to prevent free access by non-market participants to many of the allocative features of the system. All of this must be undone if we wish to establish control over our financial markets.

This, then is my list of the more obvious problems that reform needs to remedy. Given the comprehensive nature of these kinds of issues and problems I cannot see that incremental reform can possibly be expected to secure the future. On the contrary I see tepid reform as contributing to an unsettled future precisely because it creates an aura of reform having been undertaken without establishing concrete change. In such a scenario the only winners would be the very banks whose behavior we are trying to adapt to socially responsible norms.

So what to do?

  • First establish capital ratio regulations that provide a deeper pool of protection against failure.
  • Capital as it counts towards these new and higher requirements should also be higher quality: the tendency to allow all sorts of quasi-equity structures as components of capital should be eliminated. Pure equity should constitute the lion’s share if nor the entirety of a bank’s capital as it relates to regulatory ratios.
  • Then enforce those regulations rigorously.
  • Next: establish punitive capital requirements to penalize excessive size. The larger and more systemically important the bank the more capital it should hold against its assets. The capital required should scale up rapidly against the marginal accumulation of assets such that it no longer becomes profitable to build a balance sheet beyond a certain size. That size can be determined as a function either of all bank assets, or as a function of the aggregate economy. The point being to limit bank growth.
  • Bank innovation and activity should be inhibited, or at least directed towards the true purpose of banking – capital allocation – through the adoption of regulatory oversight of product development. This can be accomplished by the creation of an approval process so that products are deemed socially useful and not harmful. The proposed agency to protect consumer interests needs to be augmented with oversight of wholesale product innovation as well. This will slow bank growth. A form of ‘Tobin tax’ could be imposed on transactions to raise their cost and hinder the unlimited trading of unnecessary products. I am not entirely convinced of the efficacy of such a tax, but in the absence of a good alternative I believe we should consider its merits more closely.
  • Banks should be limited in the scope of their activities. This could take the form of the re-introduction of Glass-Steagall style regulation. Or it could impose even more severe limits by imposing a separation of buy and sell side activities. The essential notion here being to break the oligopolistic pricing power now enjoyed by the banks. Competition is sadly lacking from the system and we should take every opportunity to introduce it by encouraging the emergence of smaller, more agile, and hungry banks.
  • Both extra competition and higher capital requirements will go a long way towards eliminating the broken bonus and pay habits of the industry, but I think we will need to address the subject of bonuses explicitly, if for no other reason than politics. The objective should be to lengthen the time period that a bonus recipient has to wait until being paid, and to change the form of the bonus from cash to some form of risk instrument such as stock. Bonuses should be risk adjusted, not risk free if we want to re-link the risk/reward structure of banker’s pay: bankers should be paid for adding to wealth not destroying it.
  • In order to address moral hazard head on banks should be forced to provide a living will that allows for their speedy and risk free winding up in the event of potential bankruptcy. In particular all the components of a bank’s governance structure must be made explicit and comprehensible – this will raise the tax cost to banks by eliminating their tax arbitrage opportunities, and will thus reduce shareholder returns – but transparency is vital for an orderly post bankruptcy deconstruction of a bank’s book of business. So transparency must be imposed. By increasing the ease with which a large bank can be wound up we reduce our fear of the consequences of such a bankruptcy. We thus reduce the hold that banks have on our ability to rid ourselves of them in the event of their potential collapse.
  • The use of off balance sheet activities should be curtailed or eliminated altogether. If a bank enters into a position that entails financial risk it should do so on the books where a capital charge can be imposed. Capital requirements aren’t worth much if they do not cover all the risk a bank takes.
  • The regulatory regime needs to be reformed. I have little confidence in the ability of the Federal Reserve Board to manage or oversee systemic risk. It is too involved in monetary policy and aggregate economic management to be a credible overseer of this aspect of the system. And its recent performance in the run up to the latest crisis leaves much to be desired. Its traditional role as an independent central bank is better preserved – as I believe it should – by putting the onus for operational risk management and the application of systemic regulatory activity elsewhere. Perhaps in a new agency built from a blend of some of the existing agencies. Having said this I believe that the exact locus of regulatory oversight is less important than making corrections to the financial system itself. Remedying the anti-social aspects of bank activity will go a long way to resolving the regulatory failure, simply because there will be less ‘bad behavior’ to worry about.

These steps form the backbone of a more radical reform than the set currently proposed. The objective should be to limit, severely, the ability of the inherent instability of finance from destabilizing and threatening the viability of the economy as a whole. And it should be to refocus banks on their proper role as mediators of capital. Profits should be shrunk and rent-seeking opportunities limited by the imposition of strongly enforced and mush higher capital requirements. Moral hazard should be addressed both by compelling ‘living will’ winding up plans and by making access to the public purse expensive – very high capital requirements can accomplish this latter task. Conflicts of interest and other opportunities to game the system must also be eliminated.

The resultant banking system should be smaller, more competitive, and more efficient. It will also be safer and less likely to create a crisis of the size and danger of that we experienced last year.

Thank you once again for this opportunity to present my views.

I look forward to answering your questions.

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The Federal Reserve Board

The central role of the Fed has put it top of many people’s agenda’s as either a heroic bastion against the disasters wrought by the big private banks, or as the epicenter of all that is evil in the tangled world of oligopolistic big money.

The truth is somewhere in the middle.

I don’t want to re-hash my views on the Fed too much, but allow me to call attention to an awful article in the Huffington Post by way of demonstrating how difficult it must be to be a central banker – no one likes you.

The central argument of the HuffPo piece is that the Fed, by virtue of its patronage and power has effectively captured and molded the economics profession in its own ‘big money’ image. This is supposed, I think, to be a commentary to elaborate on Paul Krugman’s excellent New York Times article over the weekend. Krugman asks rhetorically: what happened to economics? And this very thin piece by the HuffPo is supposed – presumably – to further the discussion.

Except it fails miserably.

The truth is exactly the other way around. Which is what any sensible reading of Krugman would have led you to conclude.

Still I imagine it is always more easy to roll out yet more populist anti-establishment drivel than it is to think through and come up with a constructive comment.

The fact as I see it is this: economics as a serious academic body of thought has wandered way off track. Most of the major work of the past few decades, including much of that for which Nobel prizes have been awarded, is lamentably irrelevant to the furtherance of our understanding of real world economies. That we have known this for some time, and that a debate has been simmering within the profession for decades was largely and understandably unknown to the public at large.

Who knew? Well economists knew. Or at least some of them.

The point is that we have known for years that the models used to shape economic policy are so abstracted from reality that their usefulness has been eroded practically to zero. Unfortunately they are also what is taught in all the major universities. It is simply not possible to build a solid reputation within economics unless you subscribe to the central dogma. And it is this dogma that the HuffPo article argues flows from the Fed. It does not. It flows from academia into the Fed. The causation is reversed from that described in HuffPo.

That this is so makes for a much different article. In fact it makes for the kind of article Krugman wrote.

The key public policy issues we face in finance and economics are not driven by an attempt by the Fed to dictate economic thinking; but by the fact that our central economic theories are screwed up.

None of this exonerates the Fed. As a center for applying economics it should have been more open to non-traditional ideas. It, like Wall Street, was captured by ‘free market’ theories. This was most evident in Greenspan’s era, but it carried over under Bernanke’s rule too. It took the crisis to highlight to the economics elite that they were off track – they would still be adhering to a deregulatory free market viewpoint were it not for the recession. In many ways they still subscribe to the old theories. Why? Because, as Krugman tells us, there are no fully formed alternatives. We are learning on the fly.

The good news is that the Fed staff is sufficiently intelligent that they were able to kluge together a response to the crisis that has worked so far. We are not done yet – we need a good exit strategy – but the signs so far give me confidence that the Fed can perform that task as well.

Now, I don’t want to go too far in defending the Fed. I think they have been deplorable in the commitment of their regulatory duties. They are so steeped in central banking that the details of regulation sometimes [always?] take a secondary place on the agenda. People like Bernanke understand, roughly, how an economy works at the high level of macroeconomic policy, but they are far less certain about the organization and governance issues that affect the day-to-day execution of banking. This is the only plausible explanation I can give for the mess the banks were allowed to make of the derivatives market. There seems to be little or no public purpose served by much of the fancy finance that goes on in the Wall Street trading rooms: big profits are made, big bonuses are generated, but at enormous risk and in, ultimately, anti-social ways. So why was it permitted?

If we assume, as I think it is safe to do, that the objective of the banking system is to allocate capital across the economy in efficient ways such that growth is encouraged and supported, then the primary purpose of regulation is to ensure that task occurs as flawlessly and at as low a social cost as possible. Financial innovation is meant to help this allocation of capital become even more efficient. And by efficient I think we mean less expensive and at lower risk. If these are the two primary markers of success, then modern finance, economics, and thus the regulatory framework has failed as about as abysmally as it could. We have just plunged the entire world into a near depression, tens of millions of people worldwide have lost their jobs, and we have burdened ourselves with trillions of dollars of debt precisely because Wall Street and its regulators fouled up. Someone should be accountable for that. I think the Fed is right at the heart of the problem.

It is one thing to be applauded for taking the steps needed to right the ship, it is another to avoid owning up to the fact that it was you who nearly sank it to start with.

So as we look forward to financial reform – which is now bubbling to the surface again as a top agenda item – I, for one, would feel a lot safer and better about the future were the Fed to be restricted to banking and left out of a revamped regulatory structure.

The entire banking industry is operating, still, a failed business model. That will change as the clean up proceeds and regulators enforce higher and better quality capital standards. We need a regulatory system untainted by rotten theory and distanced from the banks. Right now the Fed is neither of these things.

Which brings me back to that awful HuffPo article: it argues the Fed has too much clout in economics. My take is that the Fed caved too easily to the fanciful dreamlike theories peddled by the likes of Lucas, Fama, and Prescott. Had it been a bastion of practical banking, the way I envisage it should be, it could have pushed back against those utopian models and injected a sense of reality. In other words it would have been good for the Fed to dictate economic thinking as long as it wasn’t what was being taught out there in Chicago!

If we are to break the stranglehold of mythical free market economics a good place to start would be the Fed. Will we see that? I doubt it. As Krugman indicates, economic theory is now in crisis. We have exposed the ‘flat earthers’ as clinging to a foolish argument, but have yet to discover a good alternative. Meanwhile the Fed needs to act. So what does it use? Whatever ad hoc stuff it can lay its hands on. That doesn’t give me much confidence, but it would have provided a much better story than the nonsense HuffPo posted this morning.

My solution? Get the Fed to focus on central banking and monetary policy. Recent experience tells me it has a lot to learn and an equally large task ahead to steer us clear of any new bubbles that may be forming on the back of our massively re-liquified economy. Leave bashing the banks – and I mean bashing in the harshest sense – to someone better equipped.

And ignore HuffPo.