The 300 Club - A Call for Honest Fools

7/27/2019 The 300 Club - A Call for Honest Fools

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With public anger at the nance industry growing by the day, banker

greed and the bonus culture are widely blamed or all that is wrong intodays world. From public sector cuts to the neglect o manuacturing towidening disparity between haves and have-nots, disillusionment with thebanking industry remains a common and constant theme. Te nancialproblems o today are indeed complex, yet such anger is directed entirely atsymptoms rather than underlying causes. A sound analysis o the integrityo any construction must surely begin with that constructs oundations,and the oundations o our capital markets are our central banks. Tis paperquestions the knowledge base upon which central banks act to eectivelymanipulate capital markets in the name o the common good. It argues that

aulty reasoning and presumed knowledge lie at the very core o our capitalmarkets behaviour, and thereore at the very core o todays crises.

It seems counterintuitive, but trying harder doesnt always work. A amous experiment asked

groups o people or and against capital punishment to evaluate two separate studies, one or

capital punishment and the other against. Te group in avour o capital punishment ound

the study in avour to be more valid, while the group against capital punishment ound the

study against to be more valid, and that ater reading each report, each groups prior belies

were strengthened as was their hostility to the other. What I ound especially ascinating was

that when the study was rerun only this time the experimenters explicitly told the subjects to be

strictly unbiased in their judgement (i.e. try harder) the eect was to make the polarisationeven more pronounced!

It is this aspect to those studies I want to think about here, the incorrect application o aulty

models. In essence, that is all that study was really about. Subjects applied a aulty model

- a mental algorithm saying accept only supporting evidence - which resulted in a biased

assessment o the evidence. rying harder did not work because the problem was the aulty

model, not the lack o eort and applying that aulty model with more determination just

caused an even bigger error. Psychologists have a name or this. Tey call it the lost pilot eect

ater the lost pilot trying to reassure his passengers by saying, I have no idea where were going,

but we are making good time!

Flawed thinking got us into this mess, but rather than changing that awed thinking, our policy

makers are applying it with even more rigour. We have more debt or insolvent borrowers,

more nancial engineering, more complicated banking regulations, more blaming speculators

or everything, more monetary experimentation by central banks. Our policy makers have

absolutely no idea what theyre doing, but theyre giving it a go!

Flawed thinking got

us into this mess, butrather than changingthat awed thinking,our policy makers areapplying it with evenmore rigour.

A call or honest ools Dylan GriceGlobal Strategist or Socit [email protected]

Views expressed here are those o theauthor, who is solely responsible or anyerrors and omissions.


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2 | Te 300 Club |A call or honest ools | July 2012

Te latest rom the Fed provides a wonderul example. Undeterred by the latest calamitous

ailure o Consumer Price Index (CPI) targeting regimes (a brie history o which will be

presented below) it has announced an explicit 2% ination target. But why? Would an explicit

target have made any dierence to the last crisis? Will it prevent the next one? And where

did this 2% come rom? We dont know, but we suspect that past uninormed capital markettinkering has ailed to control the uncontrollable, and we are pretty sure these ones will too.

In act, i such tinkering has in the past been the primary cause o crises, then why wont

this latest attempt - the 2% ination target - be the cause o the next one? Tere are

certainly precedents. argeting stable prices isnt a new idea. Te rst experiment was

actually conducted in the US in the 1920s, and apparently it was successul. Indeed, so

stable were consumer prices then that the authorities assumed there was no inationary

threat. Moreover, so enamoured were they with this brilliant new idea that stable consumer

prices were both a necessary and sufcient condition or economic stability, that the NY Fed

adopted it as a policy objective. On January 11th 1925, then-Governor Benjamin Strong

wrote to a riend:

Tat it was my belie, and I thought it was shared by all others in the Federal Reserve System,

that our whole policy in the uture, as in the past, would be directed towards the stability o prices

so ar as it was possible or us to inuence prices.

During the 1927 Stabilization hearings beore the Committee on Banking and Currency

regarding a Bill to amend the Federal Reserve Act to provide or the stabilization o the

price level or commodities in general, the governor was asked i the Fed could stabilize

prices more than it had done in the past. Strong replied:

I personally think that the administration o the Federal Reserve System since the reaction o

1921 has been just as nearly directed as reasonable human wisdom could direct it toward thatvery object

Like a driver ocused on the speedometer rather than the speed, oblivious to the risk that

the speedometer might be aulty, they kept their oot on the gas until they crashed. So

ocused were they on the stability o the CPI (rst chart below), and so condent and

convinced that it was the be all and end all o ination, they completely missed what was

happening in the credit markets (second chart below).

US CPI YoY% in the 1920s

No problem here!

...oops!

1923 1924 1925 1926 1927 1928 1929 1930 1931

0%

-6%

-8%

-4%

-2%

2%

4%

6%

Source: Bloomberg

... past uninormedcapital market tinkeringhas ailed to control the

uncontrollable

Like a driver ocused onthe speedometer ratherthan the speed, obliviousto the risk that thespeedometer might be

aulty, they kept their ooton the gas untilthey crashed.


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More recently we have experienced the same thing with the tech bubble o the late 1990s

and the real estate bubble, which we are still recovering rom (see charts below). On each

occasion, the monetary authorities were blinded to the runaway ination in the markets or

equities (rst chart below) and real estate (second chart below) by stable CPI ination.

I see no infation

NASDAQ comp (rhs)

CPI %YoY

25

20

15

10

5

0

5,000

4,500

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

1994 1995 1996 1997 1998 1999 2000 2001 2002

0

Source: Bloomberg

I stillsee no infation!

Case-Shiller house prices

CPI %YoY (rhs)

200

180

160

140

120

100

22.5%

17.5%

12.5%

7.5%

2.5%

-2.5%

1995 1997 1999 2001 2003 2005 2007 2009 2011

Source: Bloomberg, Robert Shiller

Ination targeting, it seems, has a history o ostering asset bubbles because the notion that

a stable CPI equates to a robust economy contains numerous alse premises.

Te rst allacy is that ination is measurable. Einstein once had the words not everything

which can be measured counts, and not everything which counts can be measured on thedesk in his ofce at Princeton. While the world might be simpler i it wasnt so, I believe

ination happens to be one o the things which counts but cant be measured. Te act is

that once money is created you dont know where it ends up. Maybe it will end up in the

consumer goods market, maybe it wont. Or maybe it will be multiplied via the nancial

Ination targeting, itseems, has a history o

ostering asset bubbles

because the notion thata stable CPI equates to arobust economy containsnumerous alse premises.


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Te 300 Club |A call or honest ools | July 2012 | 5

system into new credit which will inate asset prices instead. Even then, we dont know

which assets.

However, suppose we did know where money would end up, how would you weight them

together into one index? Should stock prices be included in the CPI? I so, what should the

weight be? And i youre going to add stocks, why not add corporate bonds too? And what

should their weight be? And i youre going to add bonds, why not add house prices? Etc.

etc. Isnt it obvious that the rich concept o ination is unobservable? So who said that

proxying it with a narrow sub-category - consumer prices - was a good idea?

Te second erroneous belie is that consumer prices themselves should be as stable as

possible. But is that correct? Isnt the natural tendency o our species to do more with less,

to lower the cost o a given good or service, to increase productivity? In other words, isnt

deation a part o the human condition? Je Bezos, the CEO o Amazon, amously said

there were two types o company in the world, those that work to charge more and those

that like to charge less. His company, he said, would belong to the second group.

Shouldnt someone warn him o this olly in the pursuit o deation? O the untold

havoc hes set to unleash by trying to undercut Apples iPad? And how about those guys

at Walmart? Surely they deserve a stern ticking-o, oblivious, it seems, to the downright

irresponsibility o their Everyday Low Prices strategy? Maybe all the clever economists and

Ivy League Nobel Prize winners should make going to Arkansas to explain to the Waltons

that theyre playing with re a matter o urgency?

Or maybe the clever economists arent so clever. Maybe they have it all wrong. Maybe

deation is most painul when there is an excess o debt, and so maybe they shouldnt be

encouraging excessive debt accumulation - and the nancial excesses and imbalances we

today see are associated with it - in the rst place, by distorting the interest rate market inthe pursuit o aims they dont ully understand the consequences o.

Tis brings us to a third alse premise, that there is some optimal rate o consumer price

ination. Judging by the targets o most central banks which have them, that rate is around

2%. But why is it 2%? Why not 3%, or 4%, or 6.78384%? Whats so magical about 2%?

Where did that number come rom?

One o my avourite people o the 20th century is Richard Feynman, the Nobel

Prize winning physicist who, among other things, pioneered the study o quantum

electrodynamics. In a antastic documentary about him or BBCs Horizon show called

Te Pleasure o Finding Tings Out, he said something I ound moving and proound.

He was talking about the experts he saw on V and how, although he didnt have any

expertise in the area they claimed to have expertise in, he elt quite sure that they didnt

know what they were talking about. He said this:

Tere are myths and pseudo science all over the place. I might be quite wrong, maybe they do

know all this ... but I dont think Im wrong, you see I have the advantage o having ound out how

difcult it is to really know something. How careul you have to be about checking the experiments,

how easy it is to make mistakes and ool yoursel. I know what it means to know something. And

thereore, I see how they get their inormation and I cant believe that they know it. Tey havent

done the work necessary, they havent done the checks necessary, they havent taken the care necessary.

I have a great suspicion that they dont know and that theyre intimidating people.

So i I apply Feynmans test and ask mysel how hard most economists worked or their

knowledge, I cant help thinking they have not worked hard or it at all. I dont think they

have worked hard to know what ination is, or whether it can or should be targeted. I think

they have just assumed it, and anyone can do that. As Feynman warned, theyve allen into

But why is it 2%?Why not 3%, or 4%, or6.78384%? Whats somagical about 2%?Where did that numbercome rom?

I I apply Feynmans testand ask mysel how hardmost economists worked

or their knowledge, Icant help thinking theyhave not worked hard

or it at all. I dont thinkthey have worked hard toknow what ination is, orwhether it can or shouldbe targeted. I think theyhave just assumed it, andanyone can do that.


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the trap o ooling themselves. Tey have assumed that ination can be proxied by the CPI

because it is easier to do that, they have assumed that 2% is somehow the right rate or it,

and they have assumed theyre capable o setting interest rates at the appropriate level.

But what i those assumptions are wrong? What i, or example, the natural rate o

consumer price ination was 0% and so by trying to keep it at the unnaturally high rate o

2% theyve had to articially goose up the rest o the economy by setting interest rates at

an inappropriately low level? And what i, like orce-eeding steroids to a horse because you

assume it should be running aster, in doing so you kill it, distorting the credit system so

grotesquely as to crash the rest o the economy?

Tey have assumed that wouldnt be a problem, and they assumed that i there was one they

would be able to x it (Ben Bernanke supposedly promised Milton Friedman that there

would never be another great depression because the lessons had been learned rom the

1930s). However, assuming you know how the animal behaves is not the correct way to

go about attaining knowledge about how the animal actually behaves. By not attaining the

knowledge about how the animal behaves, the animal keeps mauling them.

Nevertheless, they keep doing it. Now a 2% CPI ination target is going to make all the

dierence, and I nd it a very strange thing. I just do not understand why theyre so sure

they know all this stu despite all the evidence to the contrary. I eel like R.P. McMurphy in

One Flew Over the Cuckoos Nest: Tats right Mr. Martini, there is an Easter Bunny.

Te oundational premises on which our capital markets are regulated are demonstrably

alse. Te premise that central banks can manage the economy efciently by distorting

markets on the basis o orecast behaviour has been proven incorrect (price setting has a

track record o ailure, as does precise orecasting the ofcial euphemism or impossible

appears to be difcult). Is the economy even something which needs to be managed?We are dealing with a complex system. Complex systems sel-organise. Why does the bank

need to have a target or anything? Why does it have to exist? Tese are questions that need

to be asked.

When power has been given to people who dont seem to know what they dont know,

unintended consequences are the rule, not the exception.

Mr. Feynman said something else which I like. He said:

Ordinary ools are all right; you can talk to them, and try to help them out. But pompous ools -

guys who are ools and are covering it all over and impressing people as to how wonderul they are

with all this hocus pocus - that I cannot stand! An ordinary ool isnt a aker; an honest ool is allright. But a dishonest ool is terrible!

I think hes right. A dishonest ool is terrible. Why do we let them run the credit system?

However, assuming youknow how the animalbehaves is not the correct

way to go about attainingknowledge about how theanimal actually behaves.By not attaining theknowledge about howthe animal behaves, theanimal keeps maulingthem.


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Te 300 ClubTe 300 Club is a group o leading investment proessionals rom across

the globe who have joined together to respond to an urgent need to raise

uncomortable and undamental questions about the very oundations o

the investment industry and investing. Te mission o the 300 Club is to

raise awareness about the potential impact o current market thinking and

behaviours, and to call or immediate action.

Current economic and investment trends will change the investing landscape

over the next two decades and we are at a crisis point which presents huge risks

to investors, according to the 300 Club. Moreover, the 300 Club believes that

current nancial and investment theory and practice run the risk o ailing

investors at their time o greatest need.

Contact us

For urther inormation about the 300 Club contact our Media eam:

Asmita Kapadia

+44 (0) 20 7680 2120

[email protected]

Jean Dumas

+44 (0) 20 7680 2152

[email protected]

Te views and opinions contained herein are individual views held by those o the 300 Club.Te inormation herein is believed to be reliable but the 300 Club does not warrant its completenessor accuracy. No responsibility can be accepted or errors o act or opinion. Tis material is not

intended to provide and should not be relied on or accounting, legal or tax advice, or investmentrecommendations. Tis document is published solely or inormational purposes and is not to beconstrued as a solicitation or an oer to buy or sell any securities or related nancial instruments.Although the 300 Club believes that its expectations and the inormation in this document werebased upon reasonable assumptions at the time when they were made, it can give no assurance thatthose expectations will be achieved or that the actual results will be as set out in this document.Te 300 Club undertakes no obligation to publicly update or revise any orward-lookinginormation or statements.

The 300 Club - A Call for Honest Fools

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