The New Guru of the Central Planners

Another attempt to square the circle

by Pater Tenebrarum

The 'Most Influential Monetary Theorist' of Our Time

Talk is cheap – but not according to Michael Woodford, who is portrayed in this Bloomberg article. It appears that Mr. Woodford is the main author of the new central bank 'shamanism' we discussed in a previous article. In their constant quest to square the circle – this is to say to answer the unanswerable question: “how can we actually make the unworkable, namely central economic planning, work?”, central bankers and their advisors meet regularly to exchange ideas, e.g. at the annual Jackson Hole gathering.

They could of course exchange ideas until the end of the universe and central planning of the economy would still not work. There is no 'better plan' (this is not to say that there are no gradations of central bank policy possible). This is not something they are ever told or would even want to hear. Whenever their interventions blow up into our collective faces, their conclusion is that a 'better plan' needs to be cooked up in order to fix what the previous plan has wrought. It is only natural that they would think so. Admitting that the free market is superior to their schemes would be like foreswearing their life's work. Everything they have ever said or done would come into question. Moreover, admitting that the economy would function far more smoothly and efficiently without their interference would be an admission that their jobs are utterly superfluous.

Thus the constant attempt to square the circle. It is in fact grotesque, almost reminiscent of a Monty Python farce. There you have all these erudite, well-educated people in one spot, earnestly discussing which levers to pull next, and it is all for nothing. Worse, it is certain to cause even more damage!

The Bloomberg article on Mr. Woodford is very interesting, because it inadvertently illustrates some of the ways in which modern-day macro-economic theorizing has become utterly detached from reality. Leave it to Bloomberg's  editors though to once again provide us with an at first glance incomprehensible headline: “Woodford’s Theories Rooted in Japan Slump Embraced by Bernanke”. It takes a brief moment to realize that Bernanke isn't embracing the 'Japan slump', but Woodford's theories, which in turn are deemed to be rooted in the Japanese post bubble experience.

Mr. Woodford is described as the 'most influential monetary theorist of our time', which means 'the guy the central bankers listen to'. It does not mean that he necessarily knows anything worthwhile about monetary theory, because if he did, he would tell them that it would be best if their institutions were abolished. However, he is merely another central planner –  he quite possibly 'means well', but that is neither here nor there.

A Physicist Turned Economist

Let us look at an excerpt from Bloomberg's portrait: 

“His approach to monetary economics is the one that’s being followed, one way or another, at many of the world’s central banks,” says Richard Clarida, a colleague of Woodford’s at Columbia, a former U.S. assistant Treasury secretary for economic policy and an adviser to Pacific Investment Management Co. “Mike is the leading monetary theorist on the planet right now.”

Woodford, 57, has wrestled for more than two decades with the question of how central banks can promote growth once short-term rates have been cut to zero — including during a stint at Princeton University from 1995 to 2004. The Ivy League school in New Jersey was the place to be if you were an up-and-coming economist around the turn of the millennium.”

 (emphasis added)

It probably doesn't really matter whether it is the so-called 'MIT Cabal' (Woodford incidentally studied at the MIT as well) or the many prominent economists that hail from Princeton – one thing they have all in common is that they are central planners at heart. Just consider a few of the better known ones: the late Rudi Dornbusch, Ben Bernanke, Paul Krugman, to name just three. As a matter of fact, nowadays a macro-economist almost has to embrace statism and central planning if he wants to either get a tenured  position at a university or otherwise embark on a well-paid career in his chosen field. Let us briefly quote from an article we wrote for Asianomics a while back: 

“[...] the Fed creates employment for so many economists, both directly and indirectly, that criticism of the central bank has become a professional liability. The board of governors in Washington employs a staff of 220 economists, the 12 regional banks employed another 171 as of 2004 (the most recent number that could be ascertained). It doles out several hundred million dollars every year in research grants and for statistics gathering, so that at any given time, an estimated 500 economists are working on the Fed's behalf in addition to its staff. Some 1,600 economists across the US listed "domestic monetary and financial theory and institutions" as either their primary (968) or secondary field (717) as of 1992. Most influential editors of prominent academic journals are as a rule on the Fed's payroll and provide a 'gate-keeper' function as to what does and what doesn't get published. In short, the economics profession has been thoroughly bought off.” 

For more details on this see also: “Priceless: How the Federal Reserve Bought  Off the Economics Profession”.

However, in our opinion the real problem is an even more fundamental one. While anyone who is halfway awake will have noticed that mainstream criticism of the Fed never goes beyond certain limits – for instance, the very existence of an institution engaged in manipulating what is the most important price ratio in the economy is simply neverquestioned – the problem begins with the direction economics has taken as a science. Consider the following information about Mr. Woodford from the Bloomberg portrait: 

“Woodford didn’t set out to become an economist. He majored in physics at the University of Chicago and then earned a law degree at Yale University in 1980. Because so many of his Yale professors cited the importance of economic concepts, he decided to study the subject at the Massachusetts Institute of Technology.

“I got excited about economic problems and didn’t look back,” Woodford says. While still at MIT, he won a John D. and Catherine T. MacArthur Foundation fellowship, or genius prize.

Following MIT, Woodford taught at Columbia and then the University of Chicago. After economist Frederic Mishkin was named director of research at the Federal Reserve Bank of New York in 1994, he asked Woodford, newly arrived at Princeton, to be one of his advisers. This high-powered kitchen cabinet included Bernanke, Clarida and Christopher Sims, who later won the Nobel prize.

In 2003, Woodford published an equation-laden book titled “Interest and Prices: Foundations of a Theory of Monetary Policy” (Princeton University Press). It has come to be known as the bible of modern monetary economics, San Francisco Fed President John Williams says.” 

(emphasis added)

There can be no doubt that Mr. Woodford's is quite an intelligent and well-educated man. However, it is precisely the fact that he started out as a physicist that gives us pause. Most economists indeed believe that the science of economics should be akin to physics, i.e., employing an empirical, positivist method, the main object of which is supposed to be correct prediction. Milton Friedman prominently argued in favor of this methodology in his essay “The Methodology of Positive  Economics,” in Essays in Positive Economics (1953). Friedman was probably the most extreme positivist, even arguing that one should be prepared to admit false premises into economic theorizing as long as they delivered 'correct predictions' (he considered prediction more important than explanation).

What has come of this? As our readers will be aware, all the well educated economists working at the Fed are quite possibly worse at predicting the economy than the average housewife. Ben Bernanke, the widely hailed high priest of 'depression economics', couldn't predict his way out of a paper bag when it mattered most (note that we are not particularly condemning Bernanke's inability to make correct economic predictions, except to say that we think his view of economics is misguided, which makes it especially difficult for him to make correct forecasts. As the video we linked to makes clear, he was e.g. quite unaware that the Fed's interest rate policy had created a dangerous bubble in housing and mortgage credit instruments).

The new 'bible of modern monetary economics' by Mr. Woodford is characterized as an “equation-laden book”. Guess how many equations there are in Ludwig von Mises 'The Theory of Money and Credit', which to our mind is the only 'bible on monetary economics' anyone will ever need. That's right, zero. Now, we don't know Mr. Woodford's equation-laden text, so we cannot criticize it directly. We would guess though that given that he comes from a physics background, his equations may well impress many of his colleagues in the economics profession. As Murray Rothbard wrote in a monograph on methodology (“Praxeology as the Method of the Social Sciences”): 

“As one distinguished economist lamented, “Economics nowadays often seems like a third-rate sub-branch of mathematics,” and  one, he added, that the mathematician himself does not esteem very highly.” 

(emphasis added)

The use of mathematics in economics is partly a result of the focus on empiricism (which is all about collecting reams of statistics and trying to come to conclusions about them), and partly springs from the idea of 'modeling', in other words, the creation of mental aids the purpose of which is to help us understand economic concepts. To this end, 'equilibrium' can be a useful conceptual tool – the state toward which the economy constantly moves, but which it can never reach in reality as the data of the market constantly change. The mental constructs of a static or an evenly rotating economy in which nothing ever changes can be useful to isolate certain factors to better understand and explain them. In other words, it is worthwhile in economics to abstract from reality in order to be better able to explain specific economic laws and connections. However, it is quite erroneous to regard the equations describing a state of equilibrium as akin to reality, or even worse, to believe that the equilibrium state ought to be attained. As Mises noted, the evenly rotating economy resembles an anthill rather than actual human society. Lastly, there is nothing that mathematical equations can express about economic theory that cannot be formulated verbally – and usually better.

The problem of employing mathematics in economic theory is that it creates a sense of precision where no such precision exists in reality. Think about a very simple example like the curves commonly used to illustrate supply and demand and their intersection. The real demand and supply schedules in the economy are far more dynamic and unpredictable than these curves suggest. A simple test of this is to observe trading in financial markets, where both prices and trading volumes are readily and instantly available. It is obvious that there are no 'smooth supply/demand curves' discernible in these data, as sometimes sales increase at higher prices and decrease at lower prices, and no regularity of this phenomenon can be established. Thus these curves are at best mental tools, helping to convey a concept. 

The Method of Economics

If someone asserts that economic theory should be 'empirically testable', one immediately runs into the problem that this statement itself is purely conceptual. We would have to ask the empiricist how the statement: 'economic theory should be empirically testable' can be empirically tested. In other words, not even an avowed empiricist can operate without invoking a priori concepts.

If you look at the header of this blog, it states the first few sentences from the first chapter of 'Human Action' (incidentally, 'Acting Man' is the title of that chapter). This is the action axiom, which immediately makes clear why a social science like economics differs from a natural science like physics: it concerns human beings, that act with purpose and volition.

There is the famous anecdote of Newton, who while sitting under an apple tree, was (so it is said) hit on the head by a falling apple. This led him to think about the universal law of gravitation, since some force had to act on the apple to make it fall. Obviously though, Newton didn't need to pause to consider whether the apple wanted to fall, what goals it wanted to achieve by falling and which other opportunities it had to renounce in the pursuit of these goals. A physicist can move on to the empirical testing of his hypothesis in controlled and repeatable experiments (technological equipment permitting; some theories must wait a long time before they can be tested – think of the Higgs particle). It is of course definitely possible to express the motion of inanimate objects in precise mathematical equations. The same cannot be done with human action.

This does however not mean that there are no universally valid laws of economics, or the wider science of sociology, a term which Mises later replaced  with 'praxeology' in order to more clearly differentiate the logic of action from the anti-economic ideas propagated by many sociologists of his time.

The question is then, do a priori truths exist? Can the truth of a synthetic a priori proposition be established? If we accept that logic is universal, the answer must be yes. For instance, one cannot state that 'the action axiom is untrue' without immediately running into a logical contradiction, since the very act of making the statement is a purposeful action, employing categories of action such as choice and preference. The untruth of the action axiom cannot be established by logical argument. As Mises explains, a conceptual analysis of the nature of action can be achieved by means of logical deduction. Human beings give meaning to things, and from there, logical consequences follow. It is therefore possible to establish economic laws by means of deductive reasoning that are valid at all times and in all places. There is no need to empirically test such laws – their truth can be established without resorting to statistics. As an example, the law of marginal utility – that the first unit of a homogenous good will be put to the most highly valued use, the second unit to the second most highly valued use, and so forth -  does not require us to study historical events to prove that it is valid.

An important corollary to all this is that any economic laws that have been correctly deduced cannot be disproved by experience. Economic history, which is what empiricists look at, is the result of an interplay of a multitude of complex factors. In order to understand the events of economic history properly, one first requires a tenable theory, which one can apply to its interpretation. It is not possible to take the opposite route of constructing a theory from the events of economic history. Prediction, which Friedman regarded as the main goal of economic theorizing, is not entirely impossible, but it is subject to the constraints imposed by theory. We can e.g. categorically state that increasing the money supply will have certain effects ceteris paribus, but the precise timing and nature of these effects in the real world depends on a number of additional factors, some of which are not measurable at all. It should be obvious that no quantitative, but at best qualitative forecasts are possible.

Ironically, it is an empirical fact that followers of the Austrian school – including Mises himself, although he would probably have considered this information irrelevant – have generally been far more successful in predicting major economic events than other economists.

The main point we want to make with this excursion is that there exist very fundamental questions as to which method is appropriate to economics, and that furthermore, Friedman's demand that economics should be primarily able to produce correct and precise predictions based on empirical data simply makes no sense.

This is also why this idea has yet to produce any tangible results (it never will, except by coincidence). And yet, this is precisely the method employed by the central planners populating central banks. They say so themselves: in every FOMC statement we read that the committee's upcoming decisions 'will depend on incoming data', which is to say that the FOMC will make decisions about the future by considering the (highly imprecise) statistics describing the past. It is the functional equivalent of driving with one's gaze firmly fixed on the rear-view mirror. 

Woodford's Main Idea

Luckily for the economy, Mr. Woodford is apparently no big fan of 'quantitative easing'. In the US, the Fed's QE operations have so far increased the broad true money supply from $5.3 trillion in early 2008 to $9.5 trillion today. This has produced quite a party in the stock market and has no doubt also helped to increase 'economic activity', although not to the extent that the Fed had hoped for (much of the increased activity will later be unmasked as capital malinvestment – a process that we are likely approaching, as the interest rates not directly controlled by the Fed have begun to move noticeably higher).

Interestingly, although he reportedly uses a lot of mathematics in his paper on monetary theory, Mr. Woodford seems to prefer that the central banks employ psychological tricks in order to create an effect on economic activity once their administered interest rates have been cut to zero: 

“The academic presentation that made the biggest splash at Jackson Hole was Woodford’s. The professor questioned the efficacy of the central bank’s purchases of Treasury securities and suggested that any further buying of assets should be concentrated on mortgage-backed debt, to help the housing market. He also called for a revamp of the Fed’s communications strategy to solidify its commitment to returning the economy to full health.

At its next meeting, in September 2012, the Fed announced it would start to buy $40 billion of mortgage securities per month. In December, policy makers junked their statement that they would keep rates low until the middle of 2015 and instead pledged low rates until certain economic goals are met — the strategy Woodford had articulated. The Fed promised to hold rates at zero at least until unemployment falls to 6.5 percent, as long as inflation isn’t forecast to rise above 2.5 percent.

[…]

While saying that the Fed’s current guidance on interest rates is a “significant improvement,” Woodford sees problems with tying the policy to progress on reducing joblessness. As unemployment falls toward 6.5 percent, the Fed will be forced to explain what it will do, especially if, as Woodford suspects, it doesn’t want to raise rates at that time.

He says the Fed should adopt a broader goal: returning total economic output — nominal gross domestic product, in economist parlance — back to the trend it would have been on if the recession hadn’t occurred.

In Europe, Draghi said on July 4 that the ECB expects to keep its key interest rate where it is now, at 0.5 percent or lower, for “an extended period of time.” That was a step toward Woodford’s monetary formula.

And in the U.K., when Carney testified to Parliament in February, after being selected to become the next governor of the Bank of England, he invoked the academic. Defending the use of central bank interest-rate commitments, he referred his questioners to Woodford’s Jackson Hole paper in particular. In early August, Carney committed the central bank to keeping interest rates at a record low until unemployment reaches 7 percent.

Even Japan, the case study on the minds of the Princeton thinkers more than a decade ago, has taken some of Woodford’s advice. The strategy Bank of Japan Governor Haruhiko Kuroda began in April, as the government seeks to remedy what’s now a quarter century of sputtering growth, combines Bernanke’s recommended asset purchases with the type of communication Woodford favors, a pledge to push inflation to 2 percent.” 

(emphasis added)

The first thing to note here is that the 'economic goal' Woodford thinks  central banks should attempt to achieve isentirely quantitative in nature, namely: “…returning total economic output — nominal gross domestic product, in economist parlance — back to the trend it would have been on if the recession hadn’t occurred.”, a.k.a. 'NGDP targeting'. Note that no time has been wasted on thinking about the quality of said output. Just press on until you get the desired 'aggregate statistics'.

It is quite likely that such a goal can be achieved by a sufficiently motivated central bank. For instance, as we noted in our recent missive on 'Forced Saving', the unemployment rate of the Weimar Republic anno 1922 was below 1%. The economy was by all accounts going gangbusters in terms of a number of economic aggregates. Investment boomed, especially investment in higher order goods production. Ever more coal mines and steel factories were built, and ever larger stocks of coal and iron were accumulated. When the Reichsbank's cunning plan to inflate Germany to the Land of Cockaigne blew up a year later with unemployment soaring to nearly 30% as the currency ceased to function as a medium of exchange, monetary reform could no longer be avoided. At that point, a large portion of these investments turned out to have no value whatsoever. A lot of capital had been invested in things no-one needed or wanted. We are mentioning this example not because we expect modern-day central banks to act the same way, but because it was a temporally highly compressed event, showing the effects of inflationary policy very starkly and clearly. There are phases when a lot of good things seem to happen (who can be against full employment?), but these data do not really convey anything useful – they mask rather than illuminate the longer range effects of the policy.

However, can the goals formulated by Woodford be achieved by 'communication' alone? That seems highly unlikely. There can be no inflationary effects on the economy unless there actually is inflation. If the central bank ceases to inflate actively (if e.g. the Fed were to stop entirely with 'QE'), then inflation of the money supply will depend on the commercial banks. US banks certainly do have the wherewithal, since the Fed has blown up their free reserves, but at present, their inclination to issue additional credit is actually waning rather noticeably.

This is why we said above that 'luckily for the economy', Woodford seems not to think very highly of 'QE' (although he apparently seems to be in favor of some aspects of it, on this point the Bloomberg article is a bit muddled). The sooner the money supply inflation ceases, the less capital will be wasted and the sooner the  liquidation of malinvested capital will begin. Note here that this process cannot be avoided no matter what the central bank decides to do. The rule of thumb with regard to this is simply that the later it happens, the more painful it will turn out to be. 

Conclusion:

In spite of having erudite advisors at their beck and call, central banks cannot provide economic outcomes with their interventions that are superior to market-based ones.  Their focus on statistics and mathematical models is essentially useless. The free market cannot guarantee all around perfect outcomes either, as errors will always be made, but these errors will be corrected quickly and less capable entrepreneurs will tend to be weeded out over time. The goal of economic policy should not be to reach some 'aggregate number' by means of intervention, but to eschew central planning in favor of an unhampered market economy. Only then will there be a chance that the perpetual and ever larger manic-depressive boom-bust cycles plaguing the economy will cease.