Inexperience and central banks

“Given the uncertainties the Fed was tackling, Mr Powell [current chair of the US Federal Reserve] argued in favour of caution on rates policy and a ‘risk-management’ approach, praising Mr Greenspan’s 1990s approach of waiting for clear evidence of higher inflation before moving rates higher.”

(accessed online on September 27, 2019 at https://www.ft.com/content/e492d82e-a7a4-11e8-926a-7342fe5e173f)

If knowledge of unknowledge—knowing what the unknowns are—is next to impossible, is there a proxy for not-knowing that can be better known? I suggest inexperience is one proxy. This is illustrated by the example of Alan Greenspan as chair of the Federal Reserve. The implications are unsettling in ways not commonly supposed for the central banks of major nations, including but not limited to the current events referenced above.

–When chair of the Fed, Greenspan presented a paper, “Risk and Uncertainty in Monetary Policy,” to the American Economics Association, which published it in the Association’s Papers and Proceedings of May 2004. As Greenspan and his confrères recorded, the pre-eminent focus of the Fed was the maintenance of price stability in the face of turbulent events and considerable uncertainty:

“The Federal Reserve’s experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term, ‘uncertainty,’ is meant here to encompass both ‘Knightian uncertainty,’ in which the probability distribution of outcomes in unknown, and ‘risk,’ in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.”

One expects risk and uncertainty because the “economic world in which we function is best described as a structure whose parameters are continuously changing”. Greenspan took this uncertainty, coupled with the demand to ensure price stability in the face of it, to mean that the Fed could not rely on a fixed approach:

“Some critics have argued that [our] approach to policy is too undisciplined—judgmental, seemingly discretionary, and difficult to explain. The Federal Reserve, they conclude, should attempt to be more formal in its operations by tying its actions solely, or in the weaker paradigm, largely, to the prescriptions of a simple policy rule. . .But at crucial points, like those in our recent policy history (the stock market crash of 1987, the crises of 1997-1998, and the events that followed September 2001), simple rules will be inadequate as either descriptions or prescriptions for policy.”

Action, accordingly, must be developed with context, since no single or simple rule “could possibly describe the policy action to be taken in every contingency”. “The world economy has become too complex and interlinked,” he later amplified in his 2007 memoirs.

All the above makes sense—were it not for the blisteringly obvious fact that THE APPROACH DID NOT WORK when it came to events leading up to and during the 2008 financial crisis. The financial crisis’s $19 trillion in household wealth destruction hugely damaged Greenspan’s reputation and the approach he fostered as Fed chair.

And yet….

When you peel away the pre-crisis hagiography and post-crisis demonology around Greenspan and the Fed tenure, his policy management approach still looks eminently reasonable for accommodating risk and uncertainty: That is, as others have summarized, don’t get caught in intellectual rigidity, remain flexible, prepare for surprise, and avoid theory in favor of tested practice when managing risk.

So, again, what went wrong?

What’s wrong is that the approach failed, utterly, to demonstrate any kind of track record of experience in responding to, if not actually realizing beforehand, that they didn’t know what they thought they knew. Further, they may have known more than they thought, but we will never know that from the existing record.

Only well after the financial crisis did Greenspan admit publicly anything like having had to cope in the face of unknowns. In a 2013 interview he conceded, “when I was sitting there at the Fed, I would say, ‘Does anyone know what is going on?’ The answer was, ‘Only in part’ I would ask someone about synthetic derivatives, say, and I would get detailed analysis. But I couldn’t tell what was really happening”.

In actual practice, you don’t manage risk and uncertainty just because you lack the right information for direct control; you manage because there are limits on your ability to comprehend what information you have; and you manage that way through your demonstrated ability to appreciate or otherwise avoid those limitations (including cognitive biases) and their consequences.

All this, in turn, depends on your prior and active experience (including training) in coming to grips with what you know (but thought they didn’t) and what you do not know (but thought they did) in real time and over time. (Vide the blog entry, “Seeing unknowns”.) That specific track record, if it existed, was nowhere evident in the self-regard Fed risk managers held themselves as to the eminent reasonableness of their managing risk and uncertainty. Their certainty-about-uncertainty turned into another lethal version of 19th century positivism.

What this implies is that future histories of the 2008 financial crisis must extend the domain of inexperience considerably beyond that much-documented dearth of sophisticated mortgage buyers. (Anyone, for that matter, would be inexperienced when finding themselves in the midst of unstudied financial bubbles at that cognitive edge of knowledge and unknowledge.)

I am suggesting we will have to credit more of the 2008 financial crisis to inexperience than, as now, to the low, mean cunning of overpaid banksters aided and abetted by thralldom to Efficient Markets and Value at Risk.

In fact—and this is the sobering part—if inexperience was a very real and active culprit then, we should be doubly worried now. For the real concern today isn’t about writing future histories; it’s about what’s writing the futures now. It is exactly the lack of experience with quantitative easing, unprecedented bailouts, and sovereign debt negotiations along with their uncertain, if not unknowable consequences, that drives post-2008 responses by the central banks of the world’s major countries.

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