Why the Fed Can’t Get It Right
The World Health Organization declared the coronavirus a pandemic today. The virus has now spread to over 100 countries and infected well over 100,000 people.
After Monday’s 2,000-point collapse of the Dow and yesterday’s 1,100-point gain, stocks broke down again today. The Dow puked another 1,465 points on further fears.
What we’re seeing now is the very definition of volatility. The market’s in a highly unstable state right now.
These violent swings show the inadequacy of the standard models that the Fed and other mainstream analysts use.
The Fed assumes so many things about markets that are simply false, like that markets are always efficient, for example. They’re not.
Under volatile conditions like these they gap up and down — they don’t move in rational, predictable increments like the “efficient-market hypothesis” supposes.
The problem is that the Fed’s models are empirically false. Studies have proven how faulty their models are.
The Fed has the worst forecasting record in the world. It’s basically been wrong every year since 2009.
Equilibrium models like the Fed uses basically say the world runs like a clock and occasionally it gets knocked out of equilibrium. And all you have to do is tweak policy or manipulate some variable to push it back into equilibrium.
It’s like resetting a clock. That’s a shorthand way of describing what an equilibrium model is. They treat markets like they’re some kind of machine. It’s a 19th-century, mechanistic approach.
But traditional approaches that rely on static models bear little relationship to reality. Twenty-first-century markets aren’t machines and they don’t work in this clockwork fashion.
On the other hand, complexity theory explains financial panics much better than the Fed’s old-fashioned models. Complexity theory accounts for market shocks that seem to come out of nowhere, like the one we’re seeing now.
It also lends you greater insight into where markets are going next, unlike traditional models.
And I promise you, because I know firsthand, the Fed doesn’t use complexity theory. I’ve discussed it with them and they know nothing about it.
But it’s not just the Fed. I’ve talked to monetary economists. I’ve talked to staff people. They just stare at me blankly. They can’t even process what I’m saying.
Complexity theory has had great success explaining phenomena in fields such as climatology, seismology and many other dynamic systems.
And I’ve taken the insights of complexity theory and applied them to financial markets, which are perfect models of complex systems.
I’m happy to say I’m one of a few pioneers who have applied the insights of complexity theory to financial markets.
That’s how I analyze risk in financial markets, and it’s very powerful. Applying complexity theory to markets sets my analysis apart from the mainstream. The evidence for its effectiveness is very, very strong.
What led me to start studying complexity theory? And what exactly is it?
Back in 1997, I was a lawyer for Long Term Capital Management (LTCM). We had two Nobel Prize winners on our staff. We had a team of Ph.D.s from MIT, Harvard, Yale, Stanford, etc. We had some of the best brains in finance working for us, in other words.
I trusted all those Ph.D.s and Nobel Prize winners because they had made us a lot of money. I had no reason to doubt them.
Then the Asian financial crisis came along. By the time the crisis was over, I lost 92% of my own money.
I was only their lawyer, so I wasn’t making these deals. And I didn’t understand the deeper complexities of the financial system at the time. I’ve since learned the truth.
The truth is that their models had nothing to do with the real world. If their models were right, the crisis never would have happened.
I began studying the dynamics of capital markets on my own. I took some university courses, but I did most of the research on my own.
I studied physics, network theory, complexity theory, applied mathematics, behavioral psychology and so on. I took all that learning and applied it to the markets, which the Fed does not do.
So I’ve studied complexity theory intensively for over two decades now. And I’m more convinced than ever of its effectiveness in understanding markets.
for The Daily Reckoning