Thursday, February 5, 2015

Monetary Orbit: Do We Have A Kepler?

David Beckworth has consistently argued that the US is a monetary superpower. He writes, "The Fed has this power because it manages the world's main reserve currency and many emerging markets are formally or informally pegged to the dollar. As a result, its monetary policy gets exported to much of the emerging world. The ECB and Bank of Japan are also influenced by the Fed's decisions because they are careful not to let their currencies become too expensive relative to these dollar-pegged currencies and the dollar itself. U.S. monetary policy, consequently, gets exported to the Eurozone and Japan as well."

This is hardly a recent phenomenon. I've been reading Barry Eichengreen's "Exorbitant Privilege", and it describes (among other things) the international conditions that led to the creation of a European single currency. The Nixon administration is probably most famous in popular consciousness for Watergate and foreign policy actions in Vietnam and China, but its inflationary policies were the the architect of serious change in international monetary arrangements. The threat of dollar devaluation led to capital flows to Germany, upsetting the European balance of competitiveness. "The report of the Werner Committee, issued in October 1970, saw irrevocably locking exchange rates as essential for preservation of the Common Market and as insulating Europe from destabilizing monetary impulses from the United States." The breaking of the dollar's peg to gold proved even more momentous. As Eichengreen notes, "Not for the first time, erratic U.S. policies pushed Europe into monetary cooperation." 

The dollar's power worked in Europe's favour (well, in the short-term, at least) after 1992. "Just as a weak dollar had contributed to Europe's earlier financial difficulties, a strong dollar now relieved them", setting the stage for miffed European partners to make nice and resume the path to monetary union. Eichengreen observes, "There is no little irony in the fact that a strong dollar helped make possible the transition to the euro, given that a weak dollar had regularly provided impetus for Europe to move in this direction." 

Even so, US monetary policy cannot act in isolation. Bernard Connolly's "Rotten Heart of Europe" posits that the Wall Street crash of 1987 was sparked by the Bundesbank raising its official rates in October 1987 for the first time since 1981. Connolly writes "The impact on the other side of the Atlantic was immediate. James Baker denounced [Bundesbank President] Schlesinger for, in his view, jeopardizing the world recovery. Schlesinger replied that German price stability could not be put at risk. US financial markets feared that American interest rates might rise, or at least be prevented from falling. The stock market had been booming while long-term interest rates had been rising, a vulnerable combination. Now, the open conflict between Baker and Schlesinger and the prospect of a long period of high long rates shattered the fragile, misplaced confidence on which the stock-market boom had reposed."

These episodes perfectly capture the nature of the economy as a multi-agent system. This doesn't really simplify matters - see, for example, the difficulty of formulating the current ECB-Greece standoff in game theory terms. In fact, the economy is probably even more complicated than that, better represented as a complex adaptive system, since economic actors are responding to and shaping central bank actions in unpredictable ways. It's a theme I cover a lot, but this view of the economy seems to present a problem for those who deny the importance of a macro framework for their investment processes. Macro changes spread through the economy, without respecting the supposed imperviousness of security selection and fundamental investing. 

But there's an opposite problem, which I cover here a lot as well. Our ability to perceive and foresee change is flawed. But more importantly, the effects of some of these changes are essentially unknowable - that, after all, is one of the challenges of observing a complex adaptive system. In assessing monetary orbit, we may be hard pressed to find a Kepler, much less an Einstein. So what should we do then? One strategy proposed above is to ignore macro change. I don't think that works. Driving without a map seems a silly proposition. But so does building a system that purports to capture the complexity of the real world. 

This sets up a paradox: 

(1) Investors (and policy makers) have to accept they operate in a complex adaptive system, where they will be buffeted by the occasional, unexpected gust of wind. They need to create a framework that incorporates data without fetishizing the veneer of precision. File this along with other paradoxes such as:

(2) Asset markets are occasionally inefficient, allowing nimble investors to scoop up bargains (or harvest risk premia). But investors rely equally on efficient markets: if they were always inefficient, the savvy investor could never (a) determine fair value or (b) recognize a profit by selling at fair value.

(3) Tied to (2), from a behavioural standpoint, this demands that the investor be arrogant enough to believe she has identified a mispricing but humble enough to realize she could be wrong.

This might be enough to make you tear your hair out in frustration, but I plan to cover in a future post some strategies for dealing with these issues, inspired by a surprising array of sources. 

No comments:

Post a Comment