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Seeking Alpha

Tuesday, April 01, 2008

April Fools Everywhere

By Steven C. Ferguson - Sr. Analyst, Econometrics

Fool in the Shower

Observing the latent effect that monetary policy can have on economic growth, Nobel-laureate Milton Friedman coined the well-known metaphor of "The Fool in the Shower." In the metaphor, the unsuspecting bather turns the shower's water spigot toward "Hot" expecting warm water to flow immediately. When it does not, he opens the spigot fully only to be scalded, then again over-reacts by turning the handle back to cold. Friedman's "fool in the shower" apparently cannot comprehend the effect of what economists term "recognition lag."

For engineers and scientists, this apparent response lag between an input and observed output is often understood to be the somewhat-unremarkable result of energy storage in a dynamic system. For example, current can flow through an electrical circuit and be stored as a charge on a battery, or fluid can flow through a hydraulic circuit and be accumulated under pressure. In like manner, it is only natural to expect that money might flow through an economic system and be stored over time in the form of price increase and asset appreciation. Again, as Friedman noted: "Inflation is always and everywhere a monetary problem," so that when excess money and credit flows freely for too long we eventually see both price inflation and asset "bubbles."

Statistics Don't Lie, but Statisticians can be Fooled

What would be remarkable in the field of science or engineering is if practitioners were to assume that any or all causal relationships were predominantly algebraic in nature and thus rely on statistical regression analysis to explain those relationships. And yet, despite the warnings to the contrary from Mr. Friedman, it would seem that many economists still look for the proverbial water to get hot immediately. As an example, one such well-educated economist (for whom I have a great deal of respect and whose recommendations I generally heed) wrote concerning the effect of money supply on asset appreciation:

"Statistically speaking, the growth rate of the money supply has an exceedingly small correlation with the stock market's subsequent performance. In the vast majority of cases, I found no statistically significant correlation between the stock market and any of the money supply's growth rates. In each of those few cases in which a modest statistical relationship did show up in the data, there was an inverse correlation between the growth rate of the money supply and the stock market's subsequent performance." - Mark Hulbert

Whether and how stock prices respond to changes in money supply may in fact be open to debate. Indeed, despite massive liquidity injections from Central Banks here and abroad, stock market indices do appear to be negatively correlated with the flow of taxpayers' money into a banking black hole. Despite this short-term response, market pundits routinely state expectations that these actions will eventually have a positive impact on stock prices. But to expect in either case that any possible response would be best understood through the exclusive application of statistical analysis would seem fallacious, or, in keeping with the theme of the day, foolacious. Instead, complicated causal interactions and dynamic relationships should be assumed.

For example, when the Fed supplies more fiat money, the resulting flow may first make its way into or out of many possible stores of wealth: real estate, commodities, currencies, precious metals, objects d'art, baseball cards or even beanie babies (where the latter proved to have a very low coefficient of wealth capacitance). The relative rate of appreciation might depend on supply, demand and perceived versus expected value. Or, money might trickle down to businesses, borrowers, consumers or even entrepreneurs, although these Main Street beneficiaries seem increasingly unlikely to be recipients. One thing is certain: in the context of today's global economy, capital markets and internet connectivity, the money supply is much less likely to stay within any specific geographical or market boundaries.

Fool at the Commode

If the late Mr. Friedman were commenting today on the complex, global nature of economies and markets, perhaps his analogy would extend beyond the fool in the shower. Maybe he would think beyond the tiled walls of his personal shower stall and turn his attention to the interconnected plumbing system. Maybe before taking his shower, he would consider how little hot water might be left in the tank from previous uses. Maybe he would ponder the caustic
water supply that could cause the very plumbing itself to disintegrate. Or maybe he would warn of the fool at the commode who would unwittingly (or even maliciously) scald other unsuspecting bathers by flushing a whole bunch of cold water down the drain.

Perhaps Mr. Friedman would then point out that any supposition of global decoupling is a transient myth. Perhaps he would once again call attention to the possible hazards of what The Greek calls "fishtail economics" that would spin with world economy out of control. Maybe he would warn against turning the hot and cold water on and off abruptly, completely out of phase with unmodeled market dynamics. Perhaps he would warn of the potential for a massive hyperinflationary-induced depression, and put a stop to the fool at the commode before he flushes the world economy down the toilet.

Please welcome Steven Ferguson to "The Greek" and your regular reading. We expect you will enjoy his dynamic insight. Steve welcomes your comments and questions, so please let us know what you think by clicking the comment link below the article at the site. (disclosure)

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