Behind The Curtain: Entering Oz-sterity & Other Macro Challenges

August 19, 2011

Don't mindlessly follow the words of disconnected prognosticators down the well-trodden yellow brick road.


We are in a bull market in behavioral economics and we are in a bear market for regression-based economic forecasting (that relies on historical patterns repeating themselves).



In a memorable scene from the beloved 1939 film classic, The Wizard of Oz, Dorothy and her ragtag companions finally arrive before the great Wizard, after putting an end to the wicked witch. Their only wish is that he fulfills his promises. As the Wizard begins to address the yellow brick road gang, amidst much smoke, flames and other theatrics, a strange thing happens. The dog, Toto, tugs on a nearby curtain, revealing an ordinary person — nothing like the all-powerful wizard whose authority was projected before them — speaking into a microphone, while operating various cranks and levers.

Investors are witnessing a similar scene unfold in the wonderful world of financial markets. Western policymakers are no longer seen as having the same effectiveness as they once did. In fact, many other consensus assumptions are also now being called into serious question. Others have simply proved to be wrong. Firstly, the hope that the United States (and the wider Western world) would enter a self-sustaining recovery this year has turned out to be false. Most economic figures are now pointing to a sustained slowdown, with consumer confidence hitting lows not seen since the early 1980s. Secondly, the notion that the emerging markets — most notably China — can lift developed markets out of their economic malaise is being questioned. In reality, many emerging market countries are now also joining the developed world in showing signs of economic fatigue.

Finally, and most importantly, confidence in Europe’s policymakers has suffered a serious setback. In fact, combined with the political theatrics and brinksmanship surrounding the US debt ceiling debates, most Western policymakers are quickly losing credibility ... yanking levers and cranks with no discernible game plan. Even ECB president Trichet — long seen as the steward of monetary policy independence — has capitulated in recent weeks, buying Spanish and Italian bonds, ignoring a “no” vote from Germany’s Bundesbank in the process. According to a translation of recent comments in German, Trichet had this to say: “We observed that our decisions in the euro zone did not have the intended effect…that is why we decided to deviate from our monetary policy rules.”¹

It wasn’t always this way. In the past, central banker reputations approached near deity-like status, heralded as miracle workers (recall Alan Greenspan’s halo during the 1990s). When markets wobbled, central bankers mechanically lowered interest rate levers and stability was quickly restored. Of course, those long-running policies promoted runaway credit formation, aided and abetted asset bubble creation and, ultimately, contributed to the global financial crisis. But today, the trick bag seems empty ... or, at least, the wizards are losing their magic potency.


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