I recently read a research note written by a US bank’s chief economist, and it left me truly perplexed. My esteemed colleague examined the reported friction between board members at the Federal Reserve, paying particular attention to the tension said to exist between Fed Chairman Ben Bernanke and board members concerned about the long-term fallout from current US monetary policy.
His surprising conclusion was that if the Fed were to lose credibility, this would prompt an appreciation of the US dollar (yes, that’s right: an appreciation). I sent him an e-mail flagging this apparent error, but received an equally perplexing reply: “No, no, you read correctly: the less credible the Fed is, the more anxious market participants become and hence the more they will seek the dollar as a safe haven currency.” A discredited central bank as the catalyst for a strong currency – you must be kidding!
Surely this flies in the face of mainstream economic theory and its dearly held assumption that investors behave rationally. And yet, we must admit that the financial crisis has strained this model to the breaking point. Many other social sciences have been dismantling the concept of rationality for decades – you could say they have entered the postmodern age, where irrational thought and action are simply accepted as part of the landscape. Major postmodern thinkers, including late French philosopher Jacques Derrida, propose a worldview in which reason is no longer king. Is it time for economics to follow suit?
Without reason as our compass, we may start to fear that anything goes. But we would also do well to acknowledge that postmodernism seems particularly apt to describe behavior patterns seen during the crisis. Fads, fantasies and fashion have often played a more prominent role than dispassionate analysis based on facts. Fears and trends have followed all sorts of irrational trajectories.
If we concede that an element of irrationality helps drive the markets, have we declared economics scientifically bankrupt? The simple answer is no. But we do have to take another look at what we count as sound evidence when trying to make informed decisions about the future. It becomes crucial that we spot the risks stemming from irrationality in the markets, rather than placing blind faith in their rationality.
Economist John Maynard Keynes famously quipped that “the market can stay irrational longer than you can stay solvent.” Investors who don’t want to test this claim won’t speculate on rapidly rising interest rates just yet. But interest rates are indeed irrationally low – and governments have been on a wild spending spree – so investors must also resist the fashion for deflationism and those irrationally expensive government bonds.
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