“I can say therefore with confidence – and without any complacency – that we will secure the return of inflation to 2% without undue delay, because we are currently deploying tools that we believe will achieve this, and because we can, in any case, deploy our tools further if that proves necessary.”
- Former Goldman Sachs employee and ECB President Mario Draghi, 4 December 2015.
“You have what degree of confidence in your ability to control this [inflation] ?”
“100%.”
- Ben Bernanke being interviewed on ’60 Minutes’, 5 December 2010.
“Do not arouse the wrath of the great and powerful Oz ! ..Pay no attention to that man behind the curtain.”
- The Wizard of Oz.
In economics, the fancy-sounding ‘general equilibrium theory’ holds that in a complex economy, a set of prices exists that will result in an overall (general) equilibrium. This theory was brought to you in large part by the economist and idiot Léon Walras, whose principles only exist in the first place because he stole them from the world of physics.
But ‘general equilibrium theory’ is not the only economic theory addressing order, or the lack of it, in markets. George Soros advocates an alternative which he terms ‘reflexivity’:
“..financial markets can create inaccurate expectations and then change reality to accord with them. This is the opposite of the process described in textbooks and built into economic models, which always assume that financial expectations adapt to reality, not the other way round.”
Walras spent his last years lonely, bitter and afflicted by dementia. George Soros is a billionaire. Draw your own conclusions as to which of these theories is more likely to be correct.
“Inaccurate expectations” also sounds like a pretty accurate way of describing what investors brought along with them to digest Mario Draghi’s every word at the Economic Club of New York last week. The markets didn’t like what they heard: both the Dax and the CAC fell by over 3.5% on the day; the euro rose by over 3%; euro zone bond yields surged by over 20 bp.
As Mr Draghi’s deputy, Vítor Constâncio, told CNBC the following day, this happened because investors are stupid whereas central bankers are highly intelligent:
“The markets got it wrong in forming their expectations. They did indeed have higher expectations than were there and that’s why they reacted like they reacted but that was not our intention.”
Mr Draghi on Friday also went on a damage limitation exercise, announcing that the ECB had “the power to act, the determination to act and the commitment to act.”
He is certainly acting.
He added,
“There cannot be any limit to how far we are willing to deploy our instruments, within our mandate, and to achieve our mandate.”
It is not clear whether he was standing behind a curtain while he said this.
An attitude of ‘father knows best’ is not unique, in place or time, to the unaccountable bureaucrats of the ECB. It was vividly displayed after the Panic of 1907 by the US Senator Robert Latham Owen, one of the primary founders of the Federal Reserve, who had an almost Walrasian career of failures in banking:
“It is the duty of the United States to protect the commercial life of its citizens against this senseless, unreasoning, destructive fear that seizes the depositor when he has been sufficiently hypnotized by the metropolitan press with its indiscreet suggestions.”
Former Fed chairman Ben Bernanke once confessed that he, too, like Mario Draghi and Vítor Constâncio, was sometimes too intelligent for the markets:
“That was actually very hard for me to get adjusted to that situation where your words have such effect. I came from the academic background and I was used to making hypothetical examples and … I learned I can’t do that because the markets do not understand hypotheticals.”
It is always tragic when we rubes toiling in the markets stop banging rocks together for a second to listen to the awe-inspiring intellects at the central banks, only to misunderstand them.
Perhaps the real problem is one of overconfidence. Not our overconfidence. Theirs.
How much confidence did Ben Bernanke declare in 2010 in the Fed’s ability to control inflation ? Without hesitation: 100%.
Mario Draghi claims “with confidence – and without any complacency – that we will secure the return of inflation to 2% without undue delay”. If he’s so confident, why hasn’t inflation in the euro zone returned to that (somewhat arbitrary) 2% level ? Why, for that matter, is a central banker determinedly fuelling price inflation in the first place ?
But of course we lack the intellectual equipment even to raise these questions.
Russo and Schoemaker (1989) devised a simple self-test for overconfidence. They posed 10 questions and asked respondents to put down answers with a 90% confidence range between low and high (i.e. if they were incorrect, the true answer would lie outside that range just 10% of the time).
You can conduct this test yourself. So please state:
90% confidence range
----------------------------
Low High
1. Martin Luther King’s age at death
2. Length of the Nile River
3. Number of countries that are members of OPEC
4. Number of books in the Old Testament
5. Diameter of the moon in miles
6. Weight of an empty Boeing 747 in pounds
7. Year in which Mozart was born
8. Gestation period, in days, of an African elephant
9. Air distance from London to Tokyo
10. Deepest known point in the ocean, in feet
(The answers¹ appear at the end of this commentary.)
Plous (1991) went on to test confidence in two separate groups of experts – weathermen and doctors. Each group was given information relevant to their own discipline: weathermen were provided with weather patterns and asked to predict the weather; doctors were given case notes and asked to diagnose the patient.
The weather forecasters did remarkably well. Doctors, on the other hand, performed disastrously. While they were 90% sure they were correct, they were actually right less than 15% of the time.
“Why,” asks James Montier, in his book ‘Behavioural investing’,
“is there such a difference in the performance of these two groups ? It largely appears to relate to the illusion of knowledge (defined as a situation where we think we know more than everyone else). Weathermen get rapid undeniable evidence on their abilities as forecasters; after all, you only have to look out of the window to see if they managed to get it right or not. Doctors, in contrast, often lack feedback so find it harder to know when they have been right or wrong.
“It might be tempting to think of [the investment] industry as akin to weathermen; if we make decisions or forecasts we should be able to see in the fairly near term if they were correct or not. However, recent evidence suggests that most investors are more akin to doctors than weathermen, at least in terms of the scale of their overconfidence.”
And if investors are guilty of overconfidence, how to describe central bankers ?
It’s time to face facts. QE simply hasn’t worked. We’ve had seven years and $14 trillion and nothing to show for it. It has distorted the prices of all sorts of financial assets, fuelled growing social inequality, and enriched many within the financial sector. The one thing it was meant to forestall, deflation, is increasingly visible throughout the system.
Confidence in central bankers is now hanging by a thread. Mario Draghi (and his fellow Goldman Sachs alum Mark Carney, for that matter) might want to adopt a little humility before that thread snaps completely.
¹39 years; 4187 miles; 13 countries; 39 books; 2160 miles; 390,000 pounds; 1756; 645 days; 5959 miles; 36,198 feet.
Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio.
