Notes From Underground: My Response To Larry Summers

First, the RBA finally cut the lending rate by 25 basis points to 2.75%. By the close of the market, the Aussie dollar remained weak as some were surprised by the move. As I promised my readers of NOTES it is the 2/10 yield curve where the indicator of further currency and bank action will be found. The 2/10 steepened a slight three points, but the action ahead will be the key. Failure to take out recent steepener highs will be an indicator that the RBA has more work to do if it wishes to give a boost to the Australian economy.

Even with today’s cut, the yield on the two-year note is below the overnight lending rate. The new contagion for the global financial system is a battle to ease pressure on what have been very strong currencies. THIS IS POLITICS OVER FINANCEMBAs have never been to the barricades. This BLOG uses the tools of political economy to analyze the markets for to do otherwise is to accept that 2+2=4 … always. It seems that RBA Governor Stevens is answering the call of PM Gillard, who has decried the overly strong Aussie dollar. The RBA cutting rates four months ahead of the Australian national elections … ah, a mere coincidence.

***Sitting in the Commander Hotel in Cambridge, Mass (sounds like a Joanie Mitchell song), I feel obligated to respond to Larry Summer’s op-ed piece in Monday’s Financial Times. Professor Summer’s enters the Reinhart/Rogoff discussion with a piece, “The Buck Does Not Stop With Reinhart and Rogoff.” Summers maintains that “… the errors such as the ones they made are distressingly common.” Summers rightfully maintains that no policy should be made on the output of a single study.

Then the professor tries to bring reason to what has been an emotional debate with the following insight: “Even then,there should be a reluctance to accept conclusions from ‘models’ without an intuitive understanding of what is driving them. It is right and understandable that scholars want their findings to inform the policy debate. But they have an obligation to discourage and, on occasion, contradict those who would oversimplify and exaggerate their conclusions.”

I think that the good professor is spot on, but it raises a question about why the FED and Chairman Bernanke are allowed to have the results of their models accepted as policy. The use of global economy as a laboratory for economic theory should also be called into question and held to the same standards that Professor Summers recommends for all theoretical models. Remember that the Fed proclaimed the subprime crisis contained in 2007. Did the Fed’s brain trust rely on the same models now in promoting massive QE programs as they did previously?

Yes, equity markets are rallying and bond yields are remaining low but that is only part of the policy equation. Market manipulation makes all theoretical valuations suspect. Is there a way to test QE in a  way that limits the physics principle of the “observer effect,” in which the scientists mere observing has an impact on the data outcome? Or as Woody Allen would say: “But objectivity is subjective.” If Professor Summers is searching for high standards for the use of economic research in policy, let ‘s be consistent and demand the same from the FED in its use of theoretical models.

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12 Responses to “Notes From Underground: My Response To Larry Summers”

  1. Steven Says:

    I always look forward to your musings it really is top notch analysis and points. Keep up the great work and I have referred many traders to your blog. All the best

  2. Ronald Ferrill Says:

    Well, since most economists in government positions or tenured at Ivy League schools were “Raised on Robbery” (Joni), there’s no surprise that the Fed can’t be bothered with disclosing the sagacity of its models. All I can say is “Help Me”. We folk need to do something, or maybe nothing is best route, to protect and grow our meager savings. We were raised on golden rules and other, usually, Biblical precepts.

  3. Carl HT Says:

    Yra – I think Nassim Taleb has sufficiently covered the limits of statistical models and the Ludic fallacy. Summers sounds like he is taking heed of NNT’s cautions. As traders we embrace uncertainty, because it’s okay to be wrong. The legislature, and the central bankers by the same token, need to sell the certainty.

    Ronald – great point, the time proven methods, which were common sense has been replaced by a pseudo-science in economics/econometrics!

    Yra did you know Wayne Swan’s budget forecast was for an 11.8% increase YoY 2012-2013. Federal gov tax revenue has never increased at that pace, not even when inflation was high in the 70’s/80’s. I wonder about the models he was following!

  4. Kevin Says:

    Bernanke’s incistance that the high unemployment rate is due to cyclical rather than structural factors is case in point. We know that the millions of manufacturing jobs lost to Asia are not coming back to the US (some to Mexico perhaps).

    How much of the “output gap” is illusionary and given that how will the Fed respond to increasing unit labour costs despite “high unemployment”?

  5. GreenAB Says:

    great post – thanks Yra,

    with all the RR bashing over the last weeks all the pundits seem to have forgotten that it was the FEDs failed policies based on flawed models that brought us two spectacular bubbles near to a total collapse.

    i wonder if any “model” works today?
    how do they get their signals when they manipulate much of the input like treasury and equity prices?

    these guys are flying blind as their only guidelines left – unemployment and inflation rate – are lagging indicators.

  6. asherz Says:

    Reinhart and Rogoff have great validity IMO based on much backtesting. However ZIRP has compromised their conclusions for the short term. We know that normal rates are inevitable. And those that have taken the Bernanke model, like Summers or Krugman, will be shown to be snake oil salesmen.

  7. yra harris Says:

    These are all thoughtful and appreciated replies.Kevin the question about “output gaps” is important because at the end of the day that is always the Fed’s fallback rationale—we only hear it at certain times.Ron your humor is a great add to your incites and I can really say ‘don’t pave your mind and make it a parking lot’

  8. arthur Says:

    The Economist: “for all that many economists deny there is a currency war going on, note that New Zealand’s central bank felt obliged to admit today it had intervened to slow the pace of the dollar’s rise.”

  9. yra harris Says:

    arthur–that is what we have maintained long ago.It does not take the sovereign to outright purchase the debt as it will limit the supply available to private investors and force them to rebalance their portfolio’s elsewhere—for all those who maintained that Japanese investors have been repatriating money I ask and ask again—and how is it the Yen has dropped 6% during the period in question

  10. Chicken Says:

    I’m actually comprehending this, how scary is that! 😉

  11. Chicken Says:

    Seriously though, Summers knows exactly how Bernanke’s policy is achieving the goals. In short, it’s called rewarding the gamblers at the expense of the savers.

    Concerning gold, Central banks always sell their gold at the bottom and buy it back at the top, it’s this ability to distort reality which justifies the entire existence of gold in the banking system.

  12. yra harris Says:

    Chicken—this is what it is all about and now use it to benefit your investments.

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