Monday, July 29, 2013

The Ben Bernank ordering breakfast doesn't make him hungry, or . . .

Getting cause and effect backwards.

Often I hear investment pundits describe an effect as a cause giving them reason to be bullish or bearish on particular sectors, etc. The typical mistake runs like this: "We expect equity flows (investments into stocks) to increase driving stock prices higher." Think for half a second how one might determine the value of a stock . . . Stock is ownership in a company. That company derives value for owners by creating profits. Those profits eventually must become a series of cash flows back to the owners. If we could make a good estimate of the timing of those cash flows and apply a reasonable discount rate, we could approximate the present value of the cash flows (what they are worth in one, lump-sum price today) and hence the present value of the company.

Nowhere in that analysis is room for the thinking that if more people like the cash flows, they are worth more. True if more people like the series of cash flows, the discount rate goes down and the present value goes up. But here again we are getting it backwards. Why do people like the series of cash flows at a given price more all of a sudden? Because the discount rate used to calculate the present value now seems wrong. Therefore, the price seems low making it more attractive driving the desirability up until the price seems right again.

The girl is more attractive after the Extreme Makeover not because people are now more attracted to her. People are more attracted to her because of the makeover.

So how does this relate to The Ben Bernank and The Fed? I think many people including some economists often get it wrong in describing the cause and effect related to the economy and Fed activity. Consider this Arnold Kling post which points back to this Scott Sumner post which points back to this David Glasner post all of which got me thinking about this issue once again. And here is a money quote from another Arnold Kling post that illustrates my thinking:
Probability that monetary policy “merely reacts to what would have occurred anyway” = .75
I think I would put that probability at least that high. To explain why, I'd like to introduce a metaphor that I believe aptly illustrates the right way to think about the Fed's role in the economy as it "sets" monetary policy ("sets" is too powerful a word here; "escorts" might be better):

Think of The Federal Reserve as the regulator of a man-made lake where The Fed controls the dam and where it controls a floating dock that many boats use as a prime spot for anchoring. The lake is the money supply and the dock is both the Federal Funds Rate (the interest rate at which reserves held at The Fed are traded between banks) and the Discount Rate (the rate at which The Fed will lend money to banks to cover short-term needs). The Fed can control the outflow from the lake to help determine the water level (money supply), but this is a clumsy process. If The Fed doesn't have a good handle on what nature (the market) will bring in terms of rainfall and drought (i.e., if indicators are poor), then too much or too little water may be in the lake. Likewise, if The Fed sets the federal funds rate or the discount rate inappropriately low (high), the dock will be under water (way out of the water). In either event, boats can't use the otherwise popular dock which makes lake activity difficult.

Some want The Fed to look out on the lake with omniscient vision seeing well-planned development. In truth The Fed is simply trying to accommodate the level of water nature otherwise wants for the lake while trying to satisfy those who desire to use the lake as a resource--adding or reducing water to smooth the ups and downs. If only The Fed could ask nature what was in store for lake water levels (an NGPD futures market), it could do so much better getting the water level "correct".