Algebra is the new alchemy for central banks

Economic models.pngThe blog’s Boom, Gloom and the New Normal eBook highlights the impact of the ageing Western babyboomers on future demand patterns.

Yet central banks such as the US Federal Reserve and the European Central Bank believe demographics have nothing to do with demand. For them, as one former central banker told the blog “demand is a constant”.

They have invested years of effort, and $millions, in developing complex mathematical models of demand. The algebra behind these is the equivalent of the alchemists’ search for the philosophers’ stone, as shown in the example above from a May 2006 Fed paper .

But a mathematical model based on algebra cannot replicate human behaviour. Therefore the modeller needs to believe that human nature can safely be ignored as a input into the model.

Any reader who doubts this argument might like to read the latest speech by US Fed chief Ben Bernanke. It analyses the background to today’s economic weakness. And it then goes on to ask the critical question, “Why has this recovery been so slow and erratic?”

It answers this question by referring to the idea of ‘pent-up demand’.

This concept is a cornerstone of economic models, and was developed during the babyboomer-led supercycle, when interest rate changes really did lead to temporary ebbs and flows in demand for housing, autos etc:

• Higher mortgage rates led boomers to postpone major purchases
• Their demand quickly revived when interest rates were reduced
• Meantime, more boomers had also entered the 25-54 age group
• So the release of pent-up demand was even greater

The Federal Reserve and the European Central Bank have not changed their models since the end of the supercycle, to reflect changing demographics. So they believe that the same level of demand for housing, autos etc, still exists today.

On this basis, they have assumed that more buying of near-worthless Greek bonds, or more liquidity via a QE2 programme to boost financial markets, will ensure economic recovery in the end. They are sincere people, but the blog believes they are terribly wrong in this assumption.

As John Richardson, the co-author of Boom, Gloom and the New Normal has commented:

“If you’ve spent your whole career – and built your whole reputation – on pushing a particular model it must be really hard to stand back and say, ‘Wow, I’ve been wrong for the last few years and everything has changed’.

“Its probably easier for outsiders without any baggage to challenge conventional thinking – and probably easier for non-central bankers.

“We all need to get past the phase of thinking that ‘central bankers have lots of qualifications, have published books, and advised presidents and prime ministers, and so they must be right’.

“We also need to get past our own self-doubts, as it is really difficult for anyone less academically qualified than them (which is 99.9999% of us) to imagine that they could be wrong”.The need to challenge the power of the models is urgent. Until this happens, the global economy will get worse, not better.

About Paul Hodges

Paul Hodges is Chairman of International eChem, trusted commercial advisers to the global chemical industry. The aim of this blog is to share ideas about the influences that may shape the chemical industry over the next 12 – 18 months. It will try to look behind today’s headlines, to understand what may happen next in important issues such oil prices, economic growth and the environment. We may also have some fun, investigating a few of the more offbeat events that take place from time to time. Please do join me and share your thoughts. Between us, we will hopefully develop useful insights into the key factors that will drive the industry's future performance.

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