Montreal, December 15, 2005 • No 161




Chris Leithner grew up in Canada. He is director of Leithner & Co. Pty. Ltd., a private investment company based in Brisbane, Australia.




by Chris Leithner

          During the last week of October, three chiefs of the U.S. Federal Reserve – one retired, one soon-to-retire and the other shortly to take the helm – generated prominent headlines. On the 27th, Paul Volcker, the Fed's Chairman from 1979 until 1987, submitted the Report on the Manipulation of the United Nations Oil-for-Food Programme to the UN's Secretary-General. Mr. Volcker's successor, Alan Greenspan (who retires at the end of January), once again received applause from the world's politicians, economists, financial media and market participants. And his successor, Benjamin Bernanke (whose appointment was announced on the 24th), collected their congratulations and best wishes.


          Many of the reflections about Dr. Greenspan's tenure were glowing, and some were rapturous. Lyle Gramley, a former Fed Governor (1980-85), concluded "he was exactly the right man for the job at the right time. It's hard to give him a grade of less than A-plus. He's been a phenomenal Chairman." President Bush enthused that Dr. Greenspan is "a legend." For Dr. Bernanke, too, there were cheers aplenty. President Bush stated "over the course of a career marked by great accomplishment, Ben has done path-breaking work in the field of monetary policy, taught advanced economics at some of our top universities, and served with distinction on the Fed's Board of Governors. He's earned a reputation for intellectual rigour and integrity. He commands deep respect in the global financial community. And he'll be an outstanding Chairman of the Federal Reserve." 
          During the last week of October, then, and whatever their views, financial journalists and market participants fixated upon two men. They mostly celebrated Greenspan's accomplishments and praised Bernanke's qualifications. And taking their cues from these men, most people expressed guarded optimism about America's present condition and future prosperity.

          Perhaps because he was otherwise engaged at the UN, or because nobody wanted to hear what he might say – or simply because they forgot he ever existed – during the week's frenzy of glad tidings nobody sought Paul Volcker's opinion about economic and financial matters (see, however, "Volcker Warns Inflation May Become Problem," AP, 1 November). Is this a coincidence? Maybe not: judging from his recent utterances and writings, Mr. Volcker is much more downcast than upbeat. Further, reactions to Dr. Bernanke's appointment included many laudatory things about central bankers but next to nothing disparaging about central banking. Present policy settings and Bernanke's promise to continue them were widely praised; but few wondered whether this policy – that is, anticipatory and aggressively inflationary monetary policy – actually does much more harm than good (see in particular "What Does Inflation Targeting Mean?" by Roger Garrison). The reaction to Greenspan's retirement and Bernanke's appointment, in short, was unbalanced. As a result, hardly anybody uttered any of three unmentionables:

1. Unlike Mr. Volcker, neither the present nor the incoming Fed chairman is in any position to offer a dispassionate view about contemporary financial and economic conditions.
2. Central bankers, however formidably intelligent and diligent they doubtless are, nonetheless profess to believe (and promise to do) things that common sense and everyday experience – and the laws of economics! – tell us are flatly impossible.
3. The Federal Reserve, like any central bank, is not just an historical oddity: it is a logical absurdity. Central banks are price-fixers that, uniquely among the many such institutions established during the first half of the 20th century, have retained and enhanced their prestige. But they swim again the tide of more recent history.

          These thoughts are completely taboo. Yet the investment returns of tomorrow reside where today's investors fear to tread. Accordingly, it is appropriate that investors ponder these thoughts, weigh their implications, draw their own conclusions and incorporate them into their plans.

Central Bankers' Fatal Conceit

          Consider an amazing conundrum (to use a word Dr. Greenspan has popularised). Central planning in its broadest sense has been utterly discredited, such that few sane people seriously believe that governments should own factories, roads, schools and hospitals, or fix the prices of train fares, surgical procedures and insurance premiums. Yet most people – particularly the influential people within governments, universities and major financial institutions – fervently support central planning by central banks. Consider another paradox: virtually everybody routinely alleges that central banks "set interest rates." But the simple fact is that they do not set rates; instead, they can only dictate a single rate (typically, the overnight cash rate at which commercial banks lend excess reserves to one another in order to remain within legal requirements set by the central bank).

          Now consider the claim that emerges from these paradoxes. Encouraged by their vast and vocal cheer squad, central bankers insist that they can maintain the economic room temperature at a figurative 18-26C – not too cool and not too warm – simply by manipulating this single rate! This "Goldilocks Standard" is the implicit claim to fame of Alan Greenspan – and, come 1 February, of Ben Bernanke. If things become a bit chilly, then a timely clockwise twist of the monetary policy dial will put things right; conversely, if it is too warm, or if warmer temperatures are expected, then a deft anticlockwise adjustment will do the trick. In either case, trust them: they know when, in which direction and how far to turn the knob. The assumptions, in other words, are that central bankers can accurately measure the current economic temperature; they can anticipate the direction and magnitude of any changes of temperature; and they possess tools that can reliably equilibrate desired and actual economic conditions within some desired band.

          A simple thought experiment, described by James Grant ("Future Shock at the Fed," The New York Times, 26 October), demonstrates the absurdity of this claim and its underlying assumptions. Let us imagine that a certain central banker's (call him X to maintain his anonymity and therefore his dignity) field of expertise is not just the price of overnight loans of reserves among major banks: it is also the price of petrol. Let's also say that X becomes Chairman of the Petrol Board. If X then offered a long-term – or even a short-term – forecast, would anybody act upon it? Would anybody even pay particular attention to it? Most importantly, would anybody have enough confidence in X's forecast to allow him to fix the price of petrol and then adjust it whenever he chose?

          Anybody who answers "yes" to these questions, if he is honest, would have to admit that he advocates price-fixing. And if he understands the implications of this position, he must be willing and able to justify his advocacy. In particular, he must explain how one man, X (assisted by one institution, the Petrol Board), can from one minute to the next know better than many buyers and sellers the market-clearing price of fuel. Further, he must not only divine present prices: because buyers and sellers routinely exchange contracts for future delivery, he must also accurately anticipate the future level and direction of prices. This proponent of price control would thereby be obliged to explain why this episode, directed by X and the Petrol Board, would end less comically or tragically than the countless others (beginning in Antiquity) that have preceded it. Expressed in these terms, and in Grant's words, "the world would laugh. Yet we seem to accept, and even desire, such ludicrous claims of foresight from a Fed chairman. It follows that anyone who is willing to take the job as Fed chief is, by that reason, unqualified to hold it."

"The Federal Reserve, like any central bank, is not just an historical oddity: it is a logical absurdity. Central banks are price-fixers that, uniquely among the many such institutions established during the first half of the 20th century, have retained and enhanced their prestige."

          What is a rate of interest if it is not a signal of the time-value people place upon money? Accordingly, on what possible basis can central bankers possess knowledge about these subjective valuations that is superior to that of borrowers and lenders? Interestingly, central bankers explicitly and repeatedly disclaim any particular or superior knowledge about the market-clearing price of petrol – or, indeed, of other producer or consumer goods. Conveniently, given the asset bubbles they have repeatedly inflated, they also disavow any ability to detect asset price bubbles in advance – or even after the fact! "Moreover," says Dr. Bernanke, "if a bubble does exist, there is no guarantee that an attempt to 'pop' it won't lead to violent and undesired adjustments in both markets and the economy." So targeting the price level of financial assets is a no-no because the central bank has no special aptitude for it, and because these targets may lead to various upsets. But targeting the price level of producer and consumer goods is core business: "the central bank should focus the use of its single macroeconomic instrument, the short-term interest rate, on price and output stability."

          Astonishingly, however, nobody (and certainly none among their cheer squad) laughs at this contention. And nobody, it seems, states the blindingly obvious: no matter how intelligent and diligent the central banker, and no matter how good his administrative support, no single person or Board of Governors, etc., can know better than the many actors in markets the present and future prices of assets, goods and services – including the appropriate price, tonight, tomorrow and every day thereafter, of overnight loans among major banks. To acknowledge this limitation and simultaneously to plead on central banks' behalf is thus implicitly to admit that they will routinely fix a rate of interest that does not tell the truth about time.

          Alas, virtually nobody draws this conclusion. As a result, most market participants allow central bankers to bamboozle them – indeed, the former seem to demand that the latter pull the wool over their eyes. These days, most people are readily susceptible to the fallacy that the employees of certain organisations possess vastly more or better information, or systematically clearer crystal balls, than everybody else. Central bankers also succumb to this fallacy. Because they tend to be straight-A students and Ivy League or Oxbridge graduates, these "insiders" are vulnerable not just to the applause of market participants but also to their own hubris. Behind closed doors, some of the best and the brightest believe that the world is theirs to command. And therein lies a great danger.

          Central bankers seem sincerely to think that they can comprehend the economic world and its complexities. In particular, they believe they can master it because their training tells them that they can model and measure it. This, given the subjective nature of economic calculation and the sometimes-arbitrary nature of statistical sampling and compilation, is (to put it mildly) a very ambitious belief. I do not dispute that Ivy League and Oxbridge graduates can (and often do) deploy outstanding brainpower in certain fields. I don't doubt that their brains are better than mine. Nor do I criticise them because they regularly fix what in retrospect is clearly a wrong rate. I censure them because – and despite all the logic and evidence to the contrary – they continuously presume to know what the "appropriate" (they usually call it the "neutral") rate is.

          Although they might cross central bankers' minds, the central precepts of Austrian School economics never ever pass their lips. They never concede that under specific but widely feasible circumstances, buyers and sellers in markets for goods and services act remarkably intelligently; and central bankers never admit that the transactions market participants undertake, as reflected by prices in unfettered markets, are almost invariably more sensible than those of the most intelligent individuals – including central bankers. Mark this point and mark it well: even if no market participants have formidable SAT scores, outstanding university credentials, etc. – indeed, no matter how "dumb" or "naοve" individual buyers and sellers might allegedly be – under a wide variety of conditions market participants as a whole will make better decisions than price-fixers and economic dictators.

Three Conclusions for Value Investors

1. Central Bankers Are Bureaucrats

          Look past their academic credentials, awards and adulation, and recognise that central bankers are simply glorified bureaucrats. A noble few bureaucrats are indeed formidably intelligent and admirably diligent; but the vast majority, submitting to institutional imperatives, decline to display these characteristics. Great or small, bureaucrats' major source of income is a government paycheque; and in that respect they are no different from struggling pensioners. To remember that central bankers are government workers is to realise that they have particular incentives and disincentives, that they routinely make mistakes – and, like all people, will devise extraordinarily clever strategies to draw attention to their "successes" and distract notice from their failures. Remind yourself regularly: what on earth can government workers, who routinely miscalculate and suffer no financial penalty when they do, know about the future course of producer prices, consumer prices and credit? Your answer should curb your enthusiasm for their soothing words and the low rates (and therefore high asset prices) they strive to deliver.

2. Bureaucrats' Reputations Will Fluctuate

          Today, Alan Greenspan is revered. The Fed is trading, figuratively, at a lofty multiple of its "earnings." It also commands a sharp premium to its book value and it pays no dividend. Market participants trust it so emphatically that it need not bother to pay a stream of tangible income: unrealised capital gains will do. But a quarter of a century ago a diametrically different situation prevailed. Paul Volcker, who had just commenced a long campaign to restrain the CPI, enjoyed no such lofty reputation. Nor did the institution he headed. In those days, the Fed "traded" at a single-digit multiple, below its metaphorical book value and at an allegorical double-digit dividend yield (which matched Treasury yields at the time). Many people doubted Mr. Volcker, others reviled him, and the Fed was widely regarded as either impotent or incompetent (and probably both).

          But many shall be restored that were once fallen. Interestingly, in recent years the stock of the Volcker Fed has risen. According to Abby Joseph Cohen (The Australian Financial Review, 26 October), "when history is written about the Fed, I think Paul Volcker will get much more credit than he gets now. He was facing a horrible situation with rampant inflation, and that's not taking anything away from Mr. Greenspan, but Mr. Volcker was a true hero." What does this resurrection imply for Dr. Greenspan's reputation? The omens are not positive: many shall fall that are now in honour. According to James Grant (The New York Times, 31 October), "home with his wife watching CNBC, the retired chairman may see strange and troubling occurrences: rising interest rates, a falling dollar, a bear market in residential real estate, a rising gold price. And though tempted to interpret these disturbances as the markets' expression of loss at his exit (he is, of course, only human), Greenspan on reflection may finally see the truth. He was, in fact, no oracle, after all."

3. Investors Reap What Bureaucrats Sow

          The principal risk that inheres in financial markets is not a crisis-induced loss of confidence. Instead, it is miscalculation borne of earlier overconfidence. The boldness and even recklessness among market participants that today's crop of central bankers has encouraged, and the artificiality of what these bureaucrats have created, is their unwholesome legacy to their successors. Part of this legacy is thus the possibility of speculative upset, of disgust with financial assets and a – long overdue – loss of faith in central bankers' stewardship of financial markets. Value investors should look forward to that day.

          As they buttress their fortifications, investors might hope that Dr. Bernanke and his colleagues really are as intelligent as advertised. In an interview with the Minneapolis Fed in 2004, Bernanke reflected "economics is a very difficult subject. I've compared it to trying to learn how to repair a car when the engine is running. The economy is always changing, our knowledge of it is very incomplete, and our ability to predict it is not impressive." These are surely among the wisest words he has ever spoken. If he adheres to them, then investors can rejoice because he will have to abandon any pretence of anticipatory and aggressively inflationary monetary policy.

          Alas, his next two sentences dispel any such illusion. They tell us all we need to know about the incoming Fed chairman – and about contemporary central bankers and their cheer squad more generally – and thus provide ample cause for concern: "Nevertheless, I think that having good data, good statistics – and the United States generally has better macroeconomic statistics than most countries – and having good economists to interpret those data and present the policy alternatives, has a substantially beneficial effect on policymaking in the United States, not only in monetary policy but in other areas as well. I think in the end good economic policy research makes a very big difference to the welfare of the average person." So be on your guard: they're from the central bank and, like social workers, are allegedly here to help us. In self-defence, let us pray that events – specifically, the long-delayed consequences of his predecessor's policies – control Bernanke. Let us also hope that these events render him more "Volcker" than "Greenspan."