Arnold Kling  

Fed Attribution Error

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John Tamny writes,


Gold, the single best market indicator of a currency's true value, hit a high of $740 in the summer of 2006, and its 12 percent fall since then neatly foretold the troubles borrowers and lenders are experiencing today. With property no longer bolstered by a falling dollar, the pullback of lenders from the housing market became more certain.

Interestingly, there's a broad consensus today that the Fed's switch in bias towards rising interest rates in June of 2004 tells the tale of the present problems. History suggests otherwise. Rather than a market driven by low nominal rates of interest, the single best indicator of housing's health is the price of gold given its useful measure as the best proxy for the dollar.


I hate it when pundits claim that the Fed is behind everything that happens in financial markets. I call this the Fed attribution error. In Tamny's case, it is compounded by using the price of gold as an indicator, a practice that I view as the economic equivalent of astrology.

(Note: I may be in a bad mood. Like Tyler, I am dealing with the departure of a daughter for college.)

One of my beefs with Austrian economists is that they focus on the time premium as a determinant of interest rates while neglecting the risk premium. They, too, can become obsessed with issues of fiat money and gold.

In my analysis of credit markets, the risk premium plays a central role The risk premium moves for reasons that have nothing to do with the Fed.

Just as Douglass North sees the world as filled with challenges for establishing property rights and monitoring behavior (challenges that give rise to institutions such as corporations, contracts, standards, etc.), I see the world as filled with challenges for allocating financial risk. People with savings constantly have to be buying securities without knowing exactly the underlying risks.

We absolutely do not live in a Modigliani-Miller world of perfectly transparent financial intermediation. As an insurance company or a venture capitalist, my techniques for evaluating and managing risk are proprietary. The underlying risks that I take are never going to be perfectly transparent to my investors.

Given the inherent lack of transparency in financial intermediation, the market is constantly developing new institutions and practices for allocating risk. When innovations are successful, risk premiums go down. But, as in other sectors of the economy, not all innovations work.

What we are seeing in the housing market is not some astrological misalignment of the constellations of interest rates and gold prices. What we are seeing is some innovative risk-assessment and risk-transfer mechanisms that blew up.


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CATEGORIES: Monetary Policy



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The author at A Stitch in Haste in a related article titled Whose "Liquidity Crisis" Is It? writes:
    More demands that the Fed, among others, "just do something" --
    The past few weeks have exposed a giant crack in modern financial architectur...
    [Tracked on August 24, 2007 11:52 AM]
COMMENTS (7 to date)
spencer writes:

It is amazing how good an analyst you are when you forget your ideological blinkers.

ed writes:

What I don't understand is why it "blew up" suddenly like it did. People have been saying for months or years that flat housing prices and ARM resets were going to lead to higher default rates. What I can't understand is why insider investors would have been remotely surprised by this. Why do they seem, in hindsight, to have been so unprepared?

RobbL writes:

Hmm...when there is an unsuccessful goverment program that is to be expected. When a market "blows up" it is just an "innovative" idea that didn't pan out. No chance that there is a problem with markets in general?

To me, it is exactly the same thing that resulted in the Challenger explosion. Managers in organizations are expected to achieve results. They only get raises and promotions if they deliver. They have to ignore possible bad things that might happen...otherwise they would have no hope of "meeting their numbers".

Warning of the possible disaster would mean that they would have lost their jobs over the last years as their colleagues rolled up the profits. Now everyone get laid off together anyway as the market collapses.

Hopefully we can get some goverment regulation to save them from themselves the next time around.

Ray G writes:

Two cents from a former broker who never finished his econ degree. (That means perhaps what? My ideas or opinions are not quite formed completely?)

Anyway, I've always preferred any method of market analysis that looked deeper to the human action as opposed to only indicators. Those indicators, gold or whatever, can only be secondary to the human actions of avoiding or minimizing risk, maximizing personal gain, et cetera.

In other words, even if the price of gold were relevant here, it is here an effect, not a cause. A very similar situation in the future with a few different complimentary causes might produce a totally new effect, and those looking at gold prices would be completely in the dark.

Matias Forss writes:

I think the Austrians would accuse you of constant value of money error. What's the point of careful risk calculations in borrowing if the value of money changes? Money is the measure of all value, therefore its value cannot be measured. It's as simple as that. You have to rely on 'astrological' indicators like gold and housing prices.

Basically, I don't even see how you and Tamny are talking about the same thing. Maybe the innovative risk-assessment and risk-transfer mechanisms blew up because the falling dollar caused inflation in the housing market, maybe not. But when so many believed in these innovative mechanisms for so long, it's a bit rich to say that the Fed could not have had anything to do with it.

Alan Reynolds writes:

Perhaps John was just suggesting that gold and real estate -- two tangible "hedge" assets -- were both inflated by the Fed being too easy for too long.

If so, it doesn't follow that it would now be desirable for the Fed to "reflate" simply to make life easier for those who made leveraged bets on flipping condos (or gold coins) to some greater fool who failed to showed up after higher interest rates on cash made it more attractive at the margin to hold more cash.

John Tamny writes:

Let me first off say I'm flattered to be slapped around by Arnold Kling. I've enjoyed his articles on the economy in the past.

Still, I'm confused by his difficulty with this one.

The basic truth is that housing tends to do best when the dollar is weak, and as gold is the best proxy for the dollar's weakness, housing tends to do well when gold is rising. Not much to argue about there. Real estate boomed in Nixon's second term, was huge under Carter, and has been the main story under Bush. All oversaw a falling dollar.

The next question would be when is gold strongest? Despite conventional wisdom, the dollar tends to weaken the most and gold tends to be strongest when the Fed funds rate is rising. It's not just me who has been writing this for several years, as in H.C. Wainwright president David Ranson said much the same two weeks ago in a Wall Street Journal op-ed on housing.

So if you accept that housing tends to do well amidst dollar weakness, you then look to the issuer of the currency. Though politics frequently trumps Fed policy as I've written in the past, the Fed's devotion to the false notion that growth is inflationary (in fact, growth works against inflation by definition) makes its issuance of dollars less credible. Dollar demand is related to the credibility of the issuer to put it another way.

The dollar's fall in recent years (amidst rising rates - 425 basis points to be exact) is but one suggestion that the markets aren't as sanguine about Bernanke as his apologists are in the Republican party. And so, with the dollar having been on a downward slope over the last several years, real estate rallied as it always has, as did commodities. Nothing much to that.

Knowing all this, if we can't blame the Fed, who shall we blame?

John Tamny

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