Being Bullish and Bearing the Risk

“There is something about jumping a horse over a fence, something that makes you feel good. Perhaps it’s the risk, the gamble. In any event it’s a thing I need.”  –  William Faulkner

As a child I took many risks. At times, I calculated in my own mind the risk vs rewards. But there were times when I decided to just “run with it.” Visiting my grandparents at their ranch, I recall playing with the cows, chickens, pigs and goats. But the bull caught my eye. Why? The bull was separated from the rest chained inside a corral and stone fence. We were warned not to go near it.

I had two choices: Play it safe with the little chicks or challenge the bull. True to my nature, I found my way into the corral on top of the fence. I imagine had it been a bronco, I’d just as easily chosen to mount it. Speaking of decisions and risks brings me to Peter L. Bernstein, John von Neumann, Oskar Morgenstern, and Daniel Bernoulli.

Facing Decision-Making and Economic Uncertainty

John von Neumann and Oskar Morgenstern delved into what Peter L. Bernstein notes “the individual making a choice between two combinations of events instead of between two single possibilities.” The “certainty equivalent” derived from Daniel Bernoulli and which Bernstein notes is “the essence of risk aversion…how far we are willing to go in making decisions that may provoke others to make decisions that will have adverse consequences for us.” Agreed, but it is also important to consider that fear of uncertainty can render you powerless to act. Moreover, it is critical to understand the difference between stability and certainty.

Certainty eludes our world; promoting a stable economy does not. Such stability starts with a monetary system. Consider that “Congress created the Fed to forge a better monetary system,” according to J. Bruce in Money for Nothing – Inside the Federal Reserve. If we agree this was the intent, then it presumes that as it stood the system needed overhaul. I believe such a maneuver should prevail, notwithstanding the negative outcomes some argue still endure as a consequence of economists.

Mohamed El-Erian, Chief Economic Adviser at Allianz offered his critique of economists in The Guardian March 11^th article “Economists must think broader – or risk becoming irrelevant.” He points to several concerns including failed predictions and the U.S. Federal Reserve’s communication strategy. To be sure, El-Erian’s economics education paired with managing the endowment of Harvard University and duo roles of CEO and co-chief investment officer at PIMCO, qualify him to offer his commentary.

However, I have some reservations with El-Erian’s argument: “Leading practitioners failed to predict the 2008 global financial crisis…” Where was El-Erian then? It appears his interests lied elsewhere. During the 2008 financial and economic crises, El-Erian lead PIMCO in its global operations reportedly doubling the company’s assets all the while banks were being bailed out by the government. It is interesting to note that it was not until the “economic dust” settled in late 2012 that President Obama appointed El-Erian to lead in global development. 

Predictive analytics has its critics. Although it can provide useful information and assess risk, its foretelling of the future is questionable. There is an inherent risk within economic cycles whereby recessions cannot be averted. Alas, some individuals do not make calculated risks or worse, refuse to learn, as J. Bruce notes, “Lehman CEO never did learn about risk.” To be fair, the same could be said of some economists and world leaders.

Second, El-Erian does not consider “The existence of a financial crisis may indeed reflect a failure of regulation, but a failure of macroeconomists to predict the crisis need not mean that the macroeconomists have failed to do their job” according to S.D. Williamson. I concur. Not only does deregulation continue but the mere mention of the word “REGULATION” is frowned upon.

On advising the Fed, El-Erian notes that “greater input from economists outside of the Fed is both appropriate and necessary for ensuring an optimal policy outcome.” This line of thinking defeats the purpose of an independent Fed, the banks’ bank. He neglects to realize that the Fed was set up to represent banks. Indeed, “While politicians debated, the fed acted. It used its political independence and unlimited power to create money to provide trillions of dollars in loans to corporations of all kinds (TARP- FED Rescue $3.95 Trillion) dwarphing the Congressional aid that followed” according to J. Bruce.

Also, let’s not forget that the Federal Reserve System is a century in the making. According to Janet Yellen, former President of the Federal Reserve, “the Fed was set up in 1913, to provide liquidity to the financial systems as a whole at a time when you have a financial panic.” In other words, the Fed was created as a back-up system for the imminent response of a scared community liquidating their bank assets in reaction to a crash.

Recall, “The Panic of 1907” set a precedent and served as a catalyst which called for a decentralized banking system to address the crisis. It is important to note, that “a crisis is a systemic event; it involves the banking system, not this or that bank” according to Gorton & Metrick.

Economists have been critiqued on multiple fronts, rightly and wrongly, but at times unfairly. El-Erian points to “the profession’s embrace of simplistic theoretical assumptions and excessive reliance on mathematical techniques that prize elegance over real-world applicability.” I take exception with El-Erian’s argument as it applies to the profession as a whole and his neglect to recognize that from the blackboard and its elegant theories arose brilliant minds who earned the Nobel Prize.

El-Erian points to economists’ failure of not being open to other approaches, “particularly those offered by behavioral science and game theory.” I referenced two above, John von Neumann and Oskar Morgenstern, but there are others whose research I follow: David Hirshleifer*, Amos Tversky, Daniel Kahneman, John Nash, and Eyal Winter. Clearly, the failure comes not from economists inside academia, but from outside economists similar to Mr. El-Erian whom it readily appears are busy profiting from “real-world applicability.”

From his arguments, El-Erian does not appear to “prize elegance.” Instead, he readily appears to prize “real-world applicability”, judging from his past and current role at Allianz, parent company to PIMCO. In respect to Presidents hiring outside economists as Obama did with El-Erian, it raises the question, Does Peter Navarro*, Assistant to the President and Director of the Office of Trade and Manufacturing Policy “prize elegance over real-world applicability”? 

I have enjoyed the “real-world applicability” of my knowledge and skills. Still, I respect and prize the elegant theories, formulas, and equations passed on to me from brilliant minds. More importantly, I’ve learned when to apply elegance and when to apply real-world brute force to obtain the prize.

Speaking of prizes, let’s get back to the bull. Excited and seeing the bull could not come anywhere near where I stood on the fence, I removed my little red winter coat and in the spirit of a Matador flanked it yelling “Toro, Toro.”  Ole!  Yes, the bull charged towards me but was halted by the restraints. Certainly, my actions not only provoked the bull but my father to make his decision of which I bore the painful consequences. 

Today, that little girl continues to not play it safe riding horses and facing bulls. What does it feel like? Ask the winner of a steeplechase race or the Matador “El Juli.”  I ask you, wouldn’t you rather bear the risk and be a “bull in the ring than cattle in the slaughterhouse”?

*Full Disclosure:  In my role as Faculty Assistant, 2007-2011, at the Paul Merage School of Business, University of California, Irvine, I assisted Prof. David Hirshleifer and Prof. Peter Navarro.