As the $1.9 trillion Biden stimulus package is emerging, its immediate impact and likely knock-on effects are being vigorously debated. Well-regarded thinkers are warning of a resurgence of long-dormant consumer-price inflation or, more problematically, stagflation. Others are inclined differently. They make the case for its polar opposite, deflation, and all that might augur. Some argue that financial stimulus will drive wealth and income disparity higher as a speculative mania in the asset markets has overwhelmed investment spending as the bedrock of economic growth. Another faction similarly concerned with wealth inequality sees those same payments as a remedy to disparity. And that’s just the tip of the iceberg of economic discourse.
If there is one institution that presumes the intellectual horsepower to claim informed insight, it’s the bankers’ bank, the U.S. central bank, or simply the Fed. Yet, as examined at length in our 2020 Annual Report, the track record of this ostensibly august institution’s economic predictions has been abysmal. Despite the confidence it has thus far telegraphed with its perpetually accommodative monetary policy, the zero bound has profoundly unleveled the playing field, to say nothing of effectively handcuffing the Fed’s optionality going forward. A toxic combination threatens equity and debt markets levitating without constraint as the interest-rate component of the discount rate is zero. A fledgling and tenuous economic recovery has become addicted to Keynesian demand stimulus, and the Fed fears that should it begin to withdraw the punchbowl anytime soon, markets will, true to historical form, protest severely. This leaves the reactionary central bank virtually rudderless as the storm clouds gather.
A Subliminal Common Thread Woven Throughout the Economy and Capital Markets
In August 2005 economist Raghuram G. Rajan was invited to deliver an important paper at the Jackson Hole Economic Policy Symposium. Alan Greenspan, in his last year as Fed chairman, was being honored for his long tenure as America’s central banker, the capstone of a self-described career as a risk manager of monetary policy through micromanagement of interest rates.
Indian-born Rajan, a rising star on the economic stage at 42, would later that year be named chief economist for the IMF, the youngest person and first non-Westerner to hold the job. Following a series of sycophantic presentations about Greenspan, Rajan shocked the audience in offering a starkly contrasted conclusion. He was almost universally lambasted. Larry Summers, then president of Harvard University, pronounced that he found the paper’s “basic, slightly Luddite premise” to be “largely misguided.”
The title was “Has Financial Development Made the World Riskier?” Contrary to Greenspan’s assessment, Rajan’s answer was an unequivocal yes. He argued that technological innovation, deregulation, and institutional transformations had eroded the traditional banking virtues of stewardship and prudence. Investment banking, in particular, on Greenspan’s watch had been profoundly transformed for the worse. Rajan, on the eve of the Financial Crisis, observed that salaries, bonuses, and other perks grew to millions of dollars a year for many investment bankers, a hot-button topic both on and off Wall Street.
According to a study covering the years 2003 to 2007, the CEOs of Wall Street’s biggest banks earned an average of $30 million annually, more than double the $12 million in compensation for non-bank Fortune 50 CEOs.
Once remunerated by a fixed salary, financial managers in deregulated banks vied with each other and institutions like mutual funds to attract investors’ cash.
Because their pay was increasingly tied to short-term returns, managers tried to maximize their compensation by betting on complex derivatives with potentially huge payoffs. Though a price decline of the securities could be disastrous, the probability of such an event—the “tail risk”—was low.
Since financial managers’ pay is set relative to their peers, everyone follows the same path. A herd instinct takes over. But if something went wrong, the results could be ruinous. The more crowded the trade, the greater the chance an unexpected turn in prices would cascade from institution to institution and potentially throughout the entire system.[1]
Rajan pointed to credit default swaps—a type of insurance—as examples of financial innovations that posed enormous danger. Some of the financial institutions making bets using CDSs (credit-default swaps) also held some of the same underlying securities on their books. If these failed, the risk would be magnified, putting the banking system itself in peril.
“The interbank market could freeze up, and one could well have a full-blown financial crisis,” Rajan concluded. Banks would no longer trust each other. The result could be a catastrophic meltdown.
Given the setting, Rajan’s paper was notably bereft of esoteric economic postulating and theorizing. It was enriched by a far more pedestrian persuasion—and thus perhaps made comprehensible and even utilitarian—incentive-induced human behavior. Could such an obvious dynamic be a common thread woven through all of economics and capital markets?
Incentives: Out of Sight, Out of Mind
Five years later Steven Levitt put flesh on those bones in Freakonomics: A Rogue Economist Explores the Hidden Side of Everything, selling 7 million copies by 2014. Levitt makes the case that economics is, at root, the study of incentives. Incentives drive and affect people’s actions: “… As history clearly shows, most people, whether because of nature or nurture, generally put their own interests ahead of others’. This doesn’t make them bad people; it just makes them human.”
Observing Greenspan, Ben Bernanke, Janet Yellen and Jerome Powell through Levitt’s lens, the behavior of these well-coifed Fed chairs takes on a more primal hue.[2] Despite being the calm before the storm, the “Great Moderation” bestowed such unadulterated adulation upon Greenspan that the Fed chair took on the aura of a superstar. The Financial Crisis and the Fed’s response, a decade of doubling down despite anemic economic results, bolstered the central bank’s image. The near exclusive focus on the financial markets, however, largely obscured the impotence of its policy.
The investment-banker barons against whom Rajan railed were the superstars of the early 2000s. Enriched first by underwriting dot.com IPOs and then creating the shadow banking system built on the backs of flimsy mortgages, it was presumed that these kingpins were economic seers, incapable of such drastic miscalculations as manifested in the chaotic collapse of Lehman Brothers, simultaneous with the bailout of AIG. Misplaced confidence by investors, apparently suspending the once-burned, twice-shy rule, has accorded to the central bank a similar blind allegiance.
As in the 2007-2009 crisis, for which the banks did not bear the brunt of economic suffering, there is no mechanism today that assigns the consequences of miscalculation at the Fed to the bank or its chair. Those at risk are still those without the means to redress the wrongs. Nor is there a way for recompense. As Nassim Taleb would say, those with authority all too often have “no skin in the game.”
Moreover, warranted or not, the office of the chair of the Federal Reserve Board confers on its holder the formal reins of power, as well as the other p-words enumerated in footnote 2. It’s heady stuff. The pressure to maintain the façade is its own perverse incentive. Yellen’s own forecasting record has been poor.[3] Succumbing to the deadly combination of hubris and myopia, she held fast to a policy course that will eventually crash upon the shoals of the most basic of economic truths: There’s no such thing as a free lunch. As with their predecessors and likely successors, these former captains have conspicuously found themselves in some unassailable state (usually as highly paid consultants) whenever the eventual consequences of their decisions ultimately see the light of day.
In place of manufactured confidence, Yellen could have been forthright and forthcoming about the potential adverse consequences of financial repression. She might have expressed epistemological humility about the Fed’s capacity to accurately forecast under conditions of perpetual uncertainty. Though the Fed’s statutory mandate does not include capital-market price stability, its actions have led to the hyperinflation of asset markets. Historically loath to prick that bubble for fear of it bursting, the Fed’s reticence, dating back decades, could well leave Jay Powell without a “chair” when the music stops—and a wide swath of investors without a figurative farthing to their name. Since the ruse of omnipotence is often emasculated by impotence, wouldn’t one think that the safer middle ground would be reducing exposure to either of these two extremes?
Enabling a Ponzi Scheme
The pandemic already has exacerbated an established and self-destructive trend toward wanton speculation, a fitting future chapter for the classic, Extraordinary Popular Delusions and the Madness of Crowds. To highlight a single provocateur, the comportment of Tesla’s Elon Musk bears a striking resemblance to the mercurial Scottish financier John Law and his brainchild, the 18th-century Mississippi bubble.
The charismatic Musk is emblematic of the flamboyant lineup of excesses that can be expected to eventually come back to haunt both capitalism and the capitalist, from the titans to the teeming throngs of the heretofore tremulous and timid. By some accounts, Musk, currently the richest man in the world, is the personification of an ongoing Ponzi scheme run amok. The dizzying ascents of Bitcoin, other crypto currencies, and individual stocks popular through social media websites like the Reddit community WallStreetBets, have been accelerated by tweets from Musk. His own incentives toward perpetuating this behavior are evident and manifest.
So what would Rajan say today about such across-the-board malpractice? As in previous episodes, behavior at the Fed and within security markets tend to mirror each other. Extend and pretend. When markets have imploded in the past, the Fed has helicoptered to the rescue and, not coincidentally, sought to safeguard its own reputation despite the scars—and common threads—from prior miscalculations.
To this conflagration, the Congress will soon add the fuel of another huge dose of Keynesian fiscal stimulus. No one, it appears, is concerned about the limited capabilities of humans, particularly at the seat of power, to see beyond the madness in the moment.
This proclivity Rajan aptly identified in 2005. It is no less true today.
[1] Booth, Danielle DiMartino. Fed Up. Penguin Publishing Group, 94.
[2] Incentives motivate people to do something. Though incentives are outwardly financial in business, for those who govern in the political sphere they also include the unspoken and often unspeakable: power, prestige, privilege, patronage, pride, pomp, pageantry, pyramid of scarcity, etc., and that list is limited to words starting with the letter p.
[3] Ibid, Booth.