It is difficult to argue that the digital revolution hasn’t improved most people’s standard of living. The tremendous breakthroughs in computing and communications technologies have forever altered our daily interactions. Never has the world been so interconnected with our ability to store and retrieve information seemingly ever-increasing. Despite our growing obsession with bits and bytes, the drive to a digital world hasn’t wholly displaced the analog world. A digital reproduction of the Mona Lisa will never truly capture the zeitgeist of Leonardo da Vinci or the brilliance of each brushstroke. Nor will a digitized version of Freebird ever replicate the extemporaneous riffs of Rossington and Collins played live.
The digital age has led to an obsession with precision in the measurement of everything, be it the weather forecast or our car’s tire pressure. The finite definitiveness of digital technology gives rise to the fallacy of overprecision or false precision, however. Armed with our reams of data and computed outputs, we force undue precision on imprecise situations warranting greater nuance. In the end, the digital world is an approximation. It may not be as precise as we give it credit for.
We see this fallacy of overprecision play out in markets too often. Slavish reliance on economic models has time and again proved erroneous. We regularly underestimate the madness of crowd psychology. We can predict how consumers will respond to higher wages, lower interest rates and job security relatively. An individual will behave subject to their utility curve and subject to their unique circumstances. However, it does not have to fit a logical model. Often their actions are influenced by emotional factors that don’t “fit” the model. This ambiguity is frustrating to policymakers seeking a simple solution to a complex problem. An alternative has been to rely on the level of stock prices as a gauge of economic health.
The Trump administration and Federal Reserve are fearful of recession given high debt levels. Both of these actors view rising stock markets as a digital barometer of the success of fiscal and monetary policies. The fact that there is a significant divergence in the impact of economic well-being between Wall Street and Main Street does not deter them. Despite slowing economic growth combined with declining revenue and earnings projections, stocks are trending higher. Factors such as corporate tax cuts, stock buy-backs and M&A activity can distort the results. Confidence may be the only thing that transfers directly from the board room to the shop floor.
Stock prices are digital, a logical deduction from supply and demand. Governments can and will manipulate stock markets easier than they can alter economic conditions. The transmission mechanism for fiscal and monetary policy is less precise. Policymakers want the biggest bang for their buck and want to believe in the greater good. Yet, so few citizens have real exposure to stock markets.
In the 1920s, excess debt fueled consumption leading to an economic depression. Individuals felt it was in their best interest to curtail consumption and save as the economy contracted, and policymakers tightened credit conditions. Stocks fell. During the more recent global financial crisis, policymakers responded with extraordinary accommodation fearing the mistakes of the 1930s. Individuals saw the easier credit conditions and negative interest rates of the oughts as a signal to speculate. Stocks rose.
The 1930s were characterized by the liquidation of the debtor. This past decade will be known for the financial repression of the saver. Interest rates fell in the 1930s because of the lack of demand for credit. In the current period, interest rates are lower, resulting from the unconventional demand of central banks and their willingness to expand balance sheets. The exit from the 1930s was looser policies to promote growth. The exit from today’s policies will have to be tighter policies. That assumes that an indebted global economy can withstand higher interest rates. Earlier attempts this cycle to pull out of accommodation have proven difficult.
Being well-versed in the economic history of the Great Depression, former Fed Chairman Ben Bernanke was alert to avoid the same mistakes as his predecessors. Instead, he set us on a different path dependency. He intended that his successors would have the ability to withdraw the unconventional accommodation when economic conditions improved. That has proved very difficult. Attempts in late 2018 to tighten policy proved premature.
Currently, we are back to lowering interest rates and expanding balance sheets with the zero bound closer at hand. Markets have responded favorably without the simultaneous pick-up in economic growth. Inflation remains subdued, and deflation remains the threat despite our difficulty in measuring it. Our gauging of the economy appears to rest more on a feeling (aka sentiment) than on the certitude from our data spreadsheets or model outputs. Perhaps Mona Lisa’s smile is a smirk at the notion that we think we know more than we do.
To download the PDF version, click here: 2019-11 Mona Lisa
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