The Market Mind Hypothesis, page 29
What is relevant in answering our torturing question is that ultimately prices are not just information carriers but also the conductors of qualitative market states. Just as musical instruments not only carry frequencies and the like, but also conduct the sounds into music, particularly when played together. It is through prices that the market mood is meaningfully expressed and experienced by those who “play and listen”. Crucially, prices convey—symbolically and ineffably—how we deal with hazards and threats that are immeasurable (Knightian or true uncertainty), not only rationally but also emotionally.
And here we have arrived at the Marathon Man as a metaphor for the debt dynamics that we observed over recent years. Policymakers are using very crude tools to extract information from the markets on a question that is no longer clear. Moreover, the cognitive attempts to make sense of, and possibly answer, the question are accompanied by the sensation of drilling for that information. Whereas Laurence Olivier’s Dr Szell drills without an anaesthetic, arguably central bankers have been providing too much of the stuff.
One of its side-effects has been a relentless search for yield in safe assets, also to compensate for the ‘negative’ safety of sovereign bonds. Showing nothing has been learned, the financial industry has put some new lipstick on one of its infamous pigs. Recently ETF (exchange traded fund) and other structures have been created that will hold CLOs (Collateral Loan Obligations). These are similar to the notorious CDOs (Collateral Debt Obligations) that contributed to the GFC. Still, one change is that CLOs often consist of tranches of floating-rate loans rather than fixed-rate mortgages, exposing investors to a different kind of risk. Supposedly things are different this time around because the CIO of one firm confidently stated that the highest-rated tier of CLOs held by its ETF offered “a safe space”.
And then there is gold, or rather fake gold, in another case that beggars belief or rather a false belief. The Chinese media group Caixin reported in June 2020 that 83 tons of gold bars used as loan collateral by Nasdaq-listed Wuhan Kingold Jewelry, Inc. turned out to be nothing but gilded copper bars. Roughly a dozen Chinese financial institutions had issued more than RMB 20billion (US$ 2.8billion) in loans backed against it over the previous five years. Amazingly, asked by Caixin if the pledged gold was indeed fake Kingold chairman Jia Zhihong replied: “How could it be fake if insurance companies agreed to cover it?” What should add to anybody’s disbelief is that the amount of fake gold (weight-wise) was equivalent to 22% of China’s annual output and nearly 5% of its 2019 gold reserve. Fraud is typical during bubbles, particularly when cheap money is being thrown around and moral hazard is rife. What is arguably the safest physical asset is not immune to this. This case especially brings in stark contrast the mental world of belief and the physical world of reality.
To conclude, years of bailouts, guarantees, subsidies, off-balance sheet transactions, and other distortive therapies have been joined by Zero/Negative Interest Rate Policies (respectively ZIRP, and NIRP), QE, forward guidance, currency interventions and trading bans. Without much consideration for the unintended consequences this is bad economics:
A main factor that spawns new economic fallacies everyday … is the persistent tendency of men to see only the immediate effects of a given policy, or its effects only on a special group, and to neglect to inquire what the long-run effects of that policy will be not only on that special group but on all groups. It is the fallacy of overlooking secondary consequences. In this lies the whole difference between good economics and bad. (Hazlitt, 1946, p. 4)
The most damaging consequence of such price interference is that it violates the psychophysical laws, in particular the law on discovery. Under free and open conditions, the latter allows true exploration with prices bridging the mental domain of our collective psyche with the physical domain of the real economy, while accepting uncertainty. Comedian Stephen Fry’s comment on limiting free speech arguably applies to limiting free prices as well, making it very appropriate to capture what I mean by violating psychophysical laws: “To be forced to feel other than we do [e.g. via the wealth effect] is manifestly an impossibility, therefore what is really being asked is a pretence” (Woolcock, 2020). Healing the mind of the market looks a long way off when you don’t recognise it.
In the next subchapter I will explore the principle of blind spots further.
4.3
An Invisible Gorilla as (Another) Elephant in the Room
Consciousness is the elephant in the room, the blind spot of mechanical economics. However, there is more to what is overlooked. We live in a world of big and growing data, where investors are ‘forward guided’ to focus on particular areas like unemployment, corporate earnings and regulations. But are we at risk of missing something else, exactly because we have confidence that we have it all covered with our advanced analytical tools?
Suppose you watch a video of a basketball game and suddenly somebody dressed as a gorilla would appear, dancing around the court. Would you notice it? Roughly half of the subjects in a famous experiment, called The Invisible Gorilla, did not. There were mitigating circumstances though. Specifically, before watching the video subjects were instructed to concentrate on carefully counting the number of passes between members of one particular team. This and similar experiments confirmed a psychological condition called inattentional blindness: the failure to see an event because all your mental resources are heavily allocated to paying attention to a particular activity. In mind-as-market terms, you made a concentrated bet. In some situations that can turn into an expensive exercise.
In broad terms, the relevance of this phenomenon was already highlighted by the earlier example of her Majesty the Queen pointing out economists had not “seen it coming”. Moreover it impresses the risk of ‘overpaying’ attention to single events, the mental equivalent to having ‘all your eggs in one basket’.
Shortly I will list a number of overlooked gorillas that either are already dancing on the economy’s lawn (where some see green shoots) or may trespass later, possibly disrupting the party inside (inside the financial markets, that is). First, at least as interesting is the realistic assumption that subjects in the experiment actually did perceive the gorilla, but at a subliminal level. This leads to the broader issue of the role of the unconscious, a.k.a. System 1 (or S1):
If until recently academic psychologists have been reluctant to accept the power of the unconscious, so have others in the social sciences. Economists, for example, built their textbooks theories on the assumption that people make decisions in their own best interests, by [deliberately] weighing the relevant factors. If the unconscious is as powerful as modern psychologists and neuroscientists believe it to be, economists are going to have to rethink that assumption. (Mlodinow, 2012, p. 22)
Let’s think of the unconscious as an invisible gorilla in investment research. At the same time, it is treated as yet another elephant in the room. Following Mlodinow’s point, it is important to break this taboo.
We need to complement our investment analysis to get a balanced view on our big data. Exclusive reliance on analysis and ratio involves risks, including an inflated ego which, in turn, is the source for overconfidence (e.g. ‘Of course there is no error in my spreadsheet!’). Instead, we should aim to be more modest by respecting the unconscious and how it has served humans across all time, not just our time.
If you agree that you may have overlooked something and that there is a possibility that somebody or something ‘uninvited’ can spoil the game, you better take your exclusive focus off the ball. Relax a bit more, look around the audience and take in the atmosphere. To get a sense of what this would entail, the BBC Horizon documentary Out of Control (2012) discusses the influence of the unconscious on our behaviour and decision making. Towards the end of the documentary, one of the neuroscientists discusses the generation of, what he calls, “a-ha signals” which are realised (and valued) in S3. He describes the non-analytical state of mind which creates space for the unconscious to facilitate such signals: “when looking at these images, the best thing to do is relax; you’re getting into a zone”. In our case, such an approach does not mean that we replace investment analysis but rather that we complement it by using data in a different format. I have more to say about this in Chapter 9. It is also important to not ‘mechanise’ this process with incentives or punishments for meeting or missing deadlines (see Kounios and Beeman, 2015, p. 206).
Another strategy altogether, of course, is to be sceptical upfront of the instructions provided by the supervisors of our investment game. In fact, some of them have been moving the goal posts, almost like an open invite to angry gorillas. On that note, and as promised, my candidate for the scariest gorilla out there is misallocation. We generally do not see it yet, but it has already been on the court and will spoil the game for a long time to come. It is closely followed by the ‘damaged’ gorilla, representing the cracks in the foundation for the recent build-up in asset prices despite dismal fundamentals. That foundation is the trust in central banks and their policies but its cracks, appearing in currencies as the last bastion, are difficult to discern by most. Finally, the price for the ugliest gorilla goes to financial repression which is gradually encroaching in the global economy and will likely enter centre stage once those cracks open fully. Some stampede that could turn into! (See Chapter 11).
Chapter 5
On Methodology: Am I Healthy?
5.1
Introduction
I call this a chapter on methodology because, like the CVC, testing and treating the health of mind~bodies involve methods. Some methods are good, many others are bad. This chapter is about the methods of central banks, including their policies, which have had such an extraordinary impact on markets’ mind~bodies over the past decades. They represent mechanical economics most prominently, not only in theory but also in terms of how it is put into practice. To wit, and contrary to prevailing theory and practice, there is no separation (nor isolation) between the effects of monetary and macroprudential policies. As we have seen with the banking crisis in 2023, the monetary policy of raising rates impacts the macroprudential domain of financial stability. Contrary to physics, there is nothing “spooky” about such “action at a distance”. It is all consciously connected via exchanges. As I’ll explain, and in the spirit of Erasmus, Musil, and others, I could thus also have called this chapter “On Stupidity”.
Central bank policies and actions do not purely belong to either the real economy or the financial economy. Their so-called ‘transmission mechanisms’ intend to affect the former by manipulating the latter. We can interpret this in psychophysical terms. In Europe in particular transmission has not been working properly because animal spirits remained muted for a long time. Moreover, these policies have taken one-sided measures to quantitatively ease the pain of uncertainty, taking it out of the equation of qualitative experiences.
In the final analysis, central banks aspire to be the market’s homunculus and Laplace’s demon combined. As we discussed, there are many problems with assuming any success of some omniscience central command in minds. Throughout the book I regularly touch on this and related issues, but here I want to focus on two particular aspects that affect the market’s mind, namely dependencies and biases. I will close the chapter with a comment on supermen.
5.2
Dependencies
Everybody would like to find a way out of large-scale QE because it’s obvious that the economy can’t function like this forever. But after a junkie gets hooked on various substances, he finds it hard to come clean and this can only happen gradually, in fits and starts.
Adam Glapiński, President central bank Poland
So, at least some doctors, with PhDs in economics, seem to realise that they are dealing with an animate being, which means dependence, drugs and therapies are more than metaphorical. Throughout history, countries (e.g. Argentina), companies (e.g. airlines), and investors (e.g. hedge funds, and recently pension funds) have seen their share of relapses in that regard.
Dependence can be a dangerous condition because the sequence of cause and effect becomes blurry. An entity suffering from it loses free will and exhibits compulsive behaviour often fuelling the factors that cause the dependence. Its general meaning varies from subordination to addiction. For example, a dependency can be a territory subject to a state on which it does not border. In the EU this seemed to describe the relationship Greece had with Germany during the euro crisis. Another example is the dependencies on global supply chains which became contentious during the CVC.
Usually, however, we think of physical dependence. This is of a different kind and involves addiction to substances, including medicines. These have negative economic consequences as well. The opiate crisis in the US demonstrates this. It is at least as bad when the addiction is to drugs as these can inflict varying levels of harm.
We could also judge society’s debt overhang as a symptom of dependency. Mr Market shows symptoms of addiction and Governor Glapiński’s comment above suggests we should admit that we are dependent on cheap credit from central banks. Fair enough. But isn’t this overlooking a bigger problem? What about the dependency of the doctors themselves, especially considering their incentives?
In mind~matter terms we can make a distinction between material monetary policies, e.g. buying bonds, and mental monetary policies, e.g. forward guidance. In analogy with medical treatments, the former resemble medicines whereas the latter are more like therapies. Of course, any reader is free to decide whether monetary policies are healing or harmful. However, it is crucial to realise that in our reflexive economic world dependence is an appropriate concept because the distinction between cause and effect of a financial crisis is even less clear compared to an emergency in the medical world. Still, there is pretence in policy circles of knowing this.
Specifically, take the US Federal Reserve (Fed), for example. It is tasked to secure full employment, price stability and financial stability. Is unemployment the ‘true’ underlying economic factor on which monetary policy depends, in the sense that, e.g. based on the Phillips curve, it will cause the Fed to taper? Similar questions can be asked for the other two tasks. All three, explicitly or implicitly, form part of the Fed’s mandate but it remains unclear where they are along the fine line of cause and effect of monetary policy. More importantly, how do they relate to the tools the Fed has at its disposal? Apart from this operational aspect there is the broader institutional issue concerning the Fed’s (in)dependency, which is regularly challenged from many sides. Formally, it is allowed to function (by US Congress) if it operates within, and achieves the goals stated by, its mandate. But who sets these goals, or in the words of CNBC’s Rick Santelli: “Who does the Fed really work for?” Taking these leading questions I will try to make clear that the Fed’s ‘dependency’ problem is twofold.
First, viewed from an institutional point of view, the Fed is part of the financial system. Within this system it serves two masters, namely the US Treasury and the private banking sector. Figure 5.1 illustrates central bank ownership:
Source: Bank of England
Figure 5.1: Central Bank Ownership.
Ben Bernanke is on the record admitting that the Fed and the US Treasury are in tandem to manage inflation if this is required for price stability (see Subchapter 5.4). In addition the Fed serves the private sector banks, which was formalised in the most recent addition to its mandate, namely maintaining financial stability. Specifically, the Fed makes sure the private banks that are TBTF (Too-Big-To-Fail) do not do so. In short, the Fed does not work in isolation within its modus operandi nor is it independent.
Second, from an operational point of view, the Fed uses monetary tools, the most important of which are interest rate policy and QE/QT. The dependency between these tools is easily identified: the risk~return profile of the Fed’s balance sheet is heavily skewed because its bond holdings, which have grown in size to roughly US$ 8trillion, only ‘balance’ positively if interest rates do not rise. Apart from holding the bonds to maturity, and ignoring mark-to-market, the only way for the Fed to hedge this risk is if the US Treasury takes it on (again, see Subchapter 5.4).
What is more worrying, but also more difficult to grasp, is how these policies are actually causing the circumstances that trigger their use. The short summary is that the Fed has been explicitly targeting the financial markets with these policies. Consequently it has interfered in price discovery, going against psychophysical laws. Fed policies are likely to have contributed to the distorted allocation between minds (human capital) and machines (inanimate capital), thus skewing the distribution of income and wealth, exacerbating inequality. In turn, and combined with other misguided policies by fellow men-of-system, this contributed to real economy effects, like inflation of physical necessities (including energy) which hurt the poor the most and sustains the gap. To wit, the wealth effect mostly benefits the rich. As a side-effect, they continue to spend, whatever the costs, thereby becoming the marginal consumers who keep inflation stubbornly high. The problem, again, is that central bankers in general subscribe to the automaton doctrine of a mechanical worldview and do not give the impression they appreciate the complexity involved—via feedback loops, etc.—in their mind~matter manipulation.
Among the main consequences is that we got saddled with the wrong type of inflation. By manipulating interest rates, i.e. keeping them artificially low, the Fed promotes debt-fuelled risk taking (leveraged speculation) in financial assets. The flip side of sustaining these booms is the postponement of their busts. This kicking-the-can is required under such circumstances because those same assets constitute the collateral for the debt, while being the holdings in pensions. This strategy, ironically, jeopardises financial stability. During a June 2022 seminar, organised by the investment firm Gavekal, I submitted that in our leveraged economic system financial stability would dominate price stability if push would come to shove. This is exactly what subsequently happened during the UK’s LDI-crisis and the SVB and First Republic bank failures in the US a few months later. The BOE and the Fed (if only temporarily) abandoned their inflation fight and switched to bailing out, respectively, pension funds and banks. Mind you, UK pension funds had been ‘nudged’ for many years into the mechanical investment strategy of LDI by regulators, eagerly facilitated by investment firms. In general, as the late Sir Andrew Crockett of the Bank for International Settlements (BIS) warned:
