Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 12 December 2014

Bond market fairy tales part 2

In part 1 I contrasted the way I think about how different speeds of deficit reduction in the UK or US today will influence interest rates on government debt with how at least some people in those markets say they think about the same issue. That was a particular example of a more general phenomenon. The macroeconomics coming from economists attached to financial institutions often seems to be rather different to the macroeconomics of academic economists. When it comes to an issue involving financial markets, then it seems obvious who mediamacro should believe. Those close to the markets surely must know more about how those markets work than some unworldly academic. This post will suggest a more nuanced view.

As is often the case in macroeconomics, it all depends on the time horizon. Are we talking about what may happen over the next few days or weeks, or are we talking about what will happen over the next few years?

In terms of very short term prediction, financial market economists beat academic economists hands down. The only thing most academic economists can usefully tell you is that it is unlikely you will outsmart market opinion. If you really want to try then you need lots of short term information and a good nose for how that short term information is interconnected. Most academics (there are exceptions) just do not have time to do that work. I always remember the reply an academic member of the Bank of England’s Monetary Policy Committee gave to some MP who asked him about the implications of some latest data. I must have been doing some marking (grading) at the time that came out, was the reply.

Perhaps more surprisingly, those working in the markets are not as concerned about the longer term (what might happen in three or five years time) as you might expect. That is because money is made in predicting short term movements, and knowledge of where things are going over the next few years is a relatively weak guide to what might happen over the next few days. When I first started doing work on ‘equilibrium exchange rates’, I got a lot of queries from those in the markets, but the interest largely disappeared when I told them that ‘equilibrium’ meant where rates might be in about five years time.

This may surprise you because economists attached to financial market institutions often tell longer term stories, and sometimes they even produce detailed numerical forecasts of the type produced by central banks or governments. (See the list that the UK Treasury compiles for example.) But as I have often said, macroeconomic forecasts are only slightly better than guesswork. So it is only really worth putting any significant resources into producing a macro forecast if you are taking or seriously influencing decisions - like setting interest rates - where the costs of getting things wrong are extremely large. My suspicion is that financial sector macro forecasts are mainly there to give the impression of expertise to the institution’s clients.

I also suspect that economists working for financial institutions spend rather more time talking to their institution’s clients than to market traders. They earn their money by telling stories that interest and impress their clients. To do that it helps if they have the same worldview as their clients. Getting things right over the longer term seems less important, as Paul Krugman keeps complaining about in the context of those who have been predicting rapid inflation as a result of Quantitative Easing. 

It is also useful if they leave their clients with the impression that they have some unique insight into how the markets work. So instead of suggesting - as an academic would - that markets are governed by basic principles, it is better to suggest that the market is like some capricious god, and they are one of a few high priests who can detect its mood. Now in the short term the market really can behave in volatile, unexpected and sometimes mysterious ways, but over the longer term there are some basic rules that markets obey.

The incentive system for academics is very different. They are judged by their peers. If they present stories to the media that differ greatly from conventional wisdom about theory or the empirical evidence, they will be given a hard time by their colleagues. They need to have an idea about how markets work to do good macroeconomics. They want to be more like scientists than high priests. (This has an unfortunate by-product. Most academics would rather not lose precious research time talking to journalists, particularly if the quotes they give may fail to contain the caveats normally demanded in academic work. In contrast talking to the media is part of a city economist’s job description.)   

So who should journalists trust on the economy? If you want to know about the latest retail sales numbers or where the economy might be heading over the next few months, with a few exceptions financial economists are better bets than academic economists. If you have a more long term question, like how alternative speeds of deficit reduction will influence interest rates, then perhaps surprisingly you may tend to get a more reliable answer from academics. Like most things in economics, this is a tendency: there are some seasoned city economists who I would trust over many academics.

There is an important implication about political bias as well. Academic economists are no saints on this, but I do not think there is a clear average bias among academic macroeconomists towards the left or right. However partly because financial economists need to be good at telling stories that their clients find sympathetic, their worldview tends to be one where a smaller state is good for the economy, higher taxes on top incomes are a bad idea, markets are generally efficient and regulation is harmful.

If you think this is just self-serving conjecture, look at this evidence. The question of whether, in the UK, the 2013 recovery vindicated 2010 austerity was a no-brainer. Anyone who thinks about the logic for a moment will realise the answer is no, even if they think austerity was a good idea. To suggest otherwise would be to argue that it was a good idea to close half the economy down for a year, because growth in the following year would be fantastic. To answer yes to this question probably indicates political bias rather than lack of thought. When the Financial Times asked this question, only two out of twelve academics gave the answer yes. About half the city economists who were asked said yes. 


  1. " That is because money is made in predicting short term movements, and knowledge of where things are going over the next few years is a relatively weak guide to what might happen over the next few days" Spot on!

  2. I'm making one last go at the BBC to see if they can give some balance to their output on the (invisible) bond vigilantes.

    It takes about 3 months to get through their complaints procedure (really, it does), so starting now will if nothing else give something akin to an FOI request on their conduct during the election campaign.

    I would have thought that arguing that a supposed attack on government bonds by the City may well be expansionary not contractionary due to its being offset by a fall in the exchange rate is a little better than bruiting a work by George Orwell at 6 am on Radio Four as though qualifies as speaking truth to power.

    1. Hi there

      A few thoughts on the BBC complaints process.

      I'm still involved in the complaints process re Nick Robinson describing Alex Salmond as not answering a question that he did answer. The ECU have given their provisional response and it's a blatant white wash.

      Here are some of the things that have allowed them find (provisionally for now) in Robinson's favour when no reasonable person could.

      First, they address lots of similar complaints at once and say that, therefore,
      they cannot consider specific arguments. But they do consider detailed arguments from whichever part of the BBC is being complained about.

      Second, they put a lot of emphasis on journalistic license to interpret but ignore the flip side, ie that a certain level of competence and knowledge must be expected from senior journalistic staff.

      Third, they don't explain the basis for their provisional findings clearly making it more difficult to provide comment/counter arguments.

  3. The vast majority of what financial markets do has no socio-economic value whatsoever. 97% of what they do is pure casino style gambling and should be regulated by Gambling Commissions world wide. Commercial Banks should lend money and that's all. Central Banks should run the payment, clearing and settlement systems world wide. The latter is the only thing you need to keep alive in a crisis like 2008. That was the lever the Banksters used to force governments to bail them out.

    The FX market, places $5 trillion worth of bets every day. In four days, it will have traded the equivalent amount of foreign exchange, to finance a whole years worth of global trading in goods. The rest is pure casino betting; one currency against another. I don't ever want to be bailing out "bookmakers" (that's all they are) when they go bust.

    Likewise, I don't want to bail-out a Bank that allows its clients, to insure (place a bet) on other peoples houses burning down. Or, allows its clients to take out bets on some other people not being able to pay their mortgage, when the "teaser" interest rate trebles three years into the mortgage.

    1. «The vast majority of what financial markets do has no socio-economic value whatsoever.»

      Perhaps no socio-economic value to you and the bottomost 90% of workers, but it has a lot of value to the people who make good incomes from them. "The Economist" magazine famously said of the UK job market and the City of London financial markets:
      «Britain will one day wake up to discover that it has lost one of the world's most successful business clusters, and the best hope the next generation has of earning a decent living.»

      «97% of what they do is pure casino style gambling and should be regulated by Gambling Commissions world wide.»

      For people reading this, and who are not familiar with jargon: "derivative trading" is purely an euphemism for "gambling", they have exactly the same meaning.

      «Central Banks should run the payment, clearing and settlement systems world wide. The latter is the only thing you need to keep alive in a crisis like 2008.»

      That's why bankers earning huge bonuses on speculation acquired control of the boring banks running the retail credit and payment system, and why governments in Anglo-American culture countries privatized them whenever they could: to ensure that saving the system of retail credit,bills-of-trade, checks etc. gave them a good excuse to handout a lot of money to failed bankers.

      «That was the lever the Banksters used to force governments to bail them out.»

      "forced" seems a bit Excessive. Governments keen on "national champions" were only too happy to throw hundreds of billions of handouts to those promising the «best hope the next generation has of earning a decent living». :-)

    2. i think that some kind of bail-out of banks occur because of th experience in th US in 1929. If the US or the UK were like the government of Canada, there would be no need for bail-outs because the banks there are properly regulated.

  4. I agree, but would add: different perspectives ref. risk and corruption; there is not much in academia; Wall Street is little else.

    1. «risk and corruption; there is not much in academia»

      Really funny! In academia those who don't want "risk and corruption" can content themselves with small salaries. Those who are eager to be sponsored can become seriously rich as "mediamacro" sell-side "authorities"...

      A lot of this is documented by Charles Ferguson for "sell-side" Economists:
      «But to put it bluntly, the entire situation smells very, very bad. Enormous conflicts of interest among former government officials and/or economists, particularly those who specialize in regulation or antitrust policy, are now the rule rather than the exception. In addition, many of these economists violate their own university regulations by spending more time consulting than doing academic work, by not fully disclosing their consulting relationships, and by publishing research favorable to their clients without stating that they consult for the industries discussed in their publications.
      Now, given this situation, suppose you're a graduate student in economics or management, writing a Ph.D. thesis on telecommunications policy. Choice A: attack the clients and publications of all the senior professors supervising your work, and who are critical to your career. Choice B: make lots of money working for them, and then continue in their footsteps. Perhaps unsurprisingly, very few seem to opt for choice A. A number of prominent economists are privately very disturbed by this situation, but they are outnumbered and few dare to comment publicly about it. University administrators seem to be remarkably timid about reining in this problem.»

    2. This comment has been removed by the author.

  5. Okay, but academic economists don't help themselves by making a fetish of advanced mathematics, which the macromedia (or anyone else) cannot readily understand. That's without asking if it's really valid to use it.

    1. Do you read this blog at all? I have yet to see an equation.

      Here is some readily valid academic economics: the risk of sovereign default is non-existent when there is a central bank standing by as lender of last resort.

    2. Argentina were pegged to the dollar.

    3. «Here is some readily valid academic economics: the risk of sovereign default is non-existent when there is a central bank standing by as lender of last resort.»

      That is both incorrect and misleading:

      * incorrect because a sovereign can always choose to default;
      * misleading because a formal sovereign default is not what matters, what matters is the more relevant notion of cramdown/haircut, and that can take the form of the central bank inflating or devaluing the currency in which the loans are denominated.

      Both notions above appear in *many* «valid academic economics» textbooks...

    4. «making a fetish of advanced mathematics»

      I think that's because it lends "respectability", and there are many arguments against it. Which reminds me of what looks like a very proper :-) quote:
      «I found myself sitting next to a very likable young middle-aged academic tenured at an elite British university, whom henceforth I will refer to as Doctor X and whose field is closely associated with this blog.»
      «Every year I publish papers in the top journals and they’re pure shit.” Doctor X, who by now had had a glass or two, felt bad about this, not least because “students these days are so idealistic and eager to learn; they’re really wonderful.” Furthermore Doctor X could and would like “to write serious papers but what would be the point?”»
      «The amount of funding Doctor X’s department receives depends not on how many papers or their quality its members publish, but instead on in which journals they are published. The journals in Doctor X’s field in which publication results in substantial funding will not publish “serious papers” but instead only “pure shit” papers, meaning ones that merely elaborate old theories that nearly everyone knows are false. Moreover, even to publish a “serious paper” in addition to the “pure shit” ones could taint the department’s reputation, resulting in a reduction of its funding. In any case, no one at a top university would read a “serious paper” because they only read “top journals.”»

    5. gg:
      No peg, no default. Hardly the whole story though is it? How was life for them before the peg? In 1975, 23 pesos bought one dollar-by the early 1980s one would have needed 80-90,000 pesos for $1.

  6. The experience of Phillips and Drew in the 1990s makes your case well about business risk and economic or investment views. Tony Dye called the market correctly in the medium term but couldn't predict the timing. Very expensive to clients and the firm at an institutional and personal level.

  7. I don't think anyone who is going to their money (or someone else's) with their mouth is will trust a rational expectations model. I think this where the mistrust from many in the financial markets with respect to academics comes from. There is a widespread belief that they have taken models out of physics and just put economic "meanings" to them and in so doing make up rubbish. Many people have studied enough macro-economics to suspect this. There is also a belief there is too much abstraction and not enough attention to data and historical and real world knowledge. Many academics, for example, do not seem to really properly understand the monetary transmission mechanism, and regularly make very basic errors. People in finance envy academic economists - they have more time to really get across the information and freedom to really pursue it - as you say free of client prerogatives. But academic macro-economists come across as cynical people who wish they were physicists or pure mathematicians and are taking the next best option.

  8. The hoardings I've been working on haven't been near a wi-fi hot spot this week so I've just caught up with this blog.

    Looking at the comments to the last two posts. The absolute downside to the UK not trying to get the deficit down is a run on the pound as foreign investors lose faith with UK debt and or the economy and all seek to sell their UK assets at once. All the sects of you economics guys agree that a run on the pound is possible but differ on how likely that is depending on different models and theories. It must at least be possible if the Emir of Qatar awoke on Monday and decided to sell all his UK assets by Friday it would have some effect on the pound. Hopefully he doesn't read this blog.

    1992 was the last time there was a run on the pound and when the Palindrome moved on to his next trade things looked up quite quickly. Can anyone describe a worst case scenario of what might happen. Exchange controls ? Falling Pound ? Would the City of London die with exchange controls? Would the real problem be a Government that thought it had to have high interest rates to prop up the pound and sell UK debt? How could we pay for food imports if no one in the world wanted pounds ? Could the UK weather the storm or even prosper with the right policies? What would those policies be?

  9. Brilliant post. I note that even here, in a rather harsh post, you are a bit diplomatic. When I read

    "However partly because financial economists need to be good at telling stories that their clients find sympathetic, their worldview tends to be one where a smaller state is good for the economy, higher taxes on top incomes are a bad idea, markets are generally efficient and regulation is harmful.

    If you think this is just self-serving conjecture, "

    I immediately thought "yes of course."

    The conjecture that markets are efficient and regulation is bad serves the interest of employees of financial institutions, who get bigger bonuses if they are allowed to gamble heads they win tails the Treasury loses. And of course, a city employee who conjectures that high taxes on high incomes are bad policy is serving his or her self interest.

    Then I found out you were discussing the possibility that your analysis might be self serving conjecture.

    Oh that's completely different. I don't have much understanding of what serves your self, but you convincingly argue that your analysis sure isn't mere conjecture.

  10. I want to type something more substantive. I think that a City economist conventional wisdom is self reinforcing. Here I think there is a clear relationship between trading horizons and the costs and advantages of conforming. Of course I must quote Keynes "the market can stay irrational for longer than you can stay solvent." As also noted by Keynes, the key issue these days is more keeping the confidence of clients than remaining solvent.

    A city economist (or even a real authentic trader) who understands that most traders will missunderstand the implications of a datum gains from predicting the short term movement from the error. He or she does not gain from knowing that, in the long run, fundamentals will outweigh the error.

    A very simple example is an asset bubble which has a 10% chance of bursting per year. Shorting the asset gives a 90% chance of a loss when annual bonuses are decided. The strategy of shorting and keeping a stiff upper lip till the bubble bursts is useful to people whose main aim is be able to say they told us so years after they are fired for underperforming the market.

    Also, going against the conventional wisdom is necessarily risky. Highly respected analysts have, by definition, a lot to lose. Their self interest is served by the safe strategy of saying what everyone else is saying. This can be a Nash equilibrium even if no highly respected analyst believes what all highly respected analysts are saying.


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