...basically, it seems to me, we're all flying blind. The markets are spiraling down, and our leading experts don't have much of a clue as to what to do.

Given that, one has to welcome the expected appointment to senior positions in the Obama administration of economists like Lawrence Summers, Timothy Geithner, Jason Furman, Peter Orszag, and Goolsbee himself. They're sober and competent people who know we face a real crisis -- and who, importantly, may be more willing than many of their colleagues to adjust their thinking early and often.

Indeed, one hopes they're not too invested in the findings of the economics profession of which they're such distinguished products -- because one suspects many of the conventional answers of that profession aren’t much applicable to the current situation. After all, wasn't it excessive confidence in complex economic models and sophisticated financial instruments on the part of people well educated in modern economics that helped get us into the current mess?

So I hope the best and the brightest who will be joining the new president will at least entertain the possibility that a lot of what they think they know is wrong. I trust they'll remember that successful economic policies in the past have pulled together elements from unlikely sources, and that they're as likely to find wisdom from reading political economists like Friedrich Hayek or Joseph Schumpeter, or Keynes himself, as from poring over the latest academic paper in a peer-refereed economics journal.

My puzzlement is driven by several assertions.

• Are our economic leaders flying blind?
• Were the economists overly enamored of complex economic models?
• Were the economists overly confident in sophisticated financial instruments?
• Is it as likely to find wisdom from Hayek or Schumpeter as in the latest academic paper?

On the first point, I think Kristol is on the most solid ground. So much of what has happened has been unprecedent in terms of institutions, although as Markus Brunnermeier has pointed out, the general outlines are remarkably similar to banking crises of the past. So, here I think reasonable people can certainly disagree whether it's ignorance, or failure to agree between Fed and the Bush Administration and components thereof.

What about complex models? First ask what exactly constitutes a complex model? Is Kristol alluding to models involving algebra? Or calculus? Or lots of equations? I think one could make the argument that the models weren't complex enough to capture important effects (asymmetric information, agency costs, etc.) despite the complexity along other dimensions.

Were economists overly confident in sophisticated financial instruments? Here I think it might be useful to discriminate between economists that work in the financial world, and those that work in academia. From the former group, I always heard a lot about "risk management" and sophisticated statistical models to price derivatives. From the latter, I heard a lot more skepticism, perhaps borne of ignorance. So, Kristol might be right, but I suspect his views are deeply influenced by the sample of economists he talked to.

By the way, I won't say I saw the full enormity of the leveraging problem, but at least I can truthfully say I was suspicious of the free lunch aspects of the net borrowing binge of the past decade. From my August 2005 Council on Foreign Relations report:

Although the likelihood of a "disorderly adjustment," is small,37 the potential consequences are so troubling that the possibility of economic disruption cannot be ignored. In addition to the threat of rising unemployment and declining income, sharp movements in asset prices and interest rates could also threaten the stability of the financial system. In the past, policymakers have been able to contain the threats of systemic crises, such as the crisis of Long Term Capital Management in 1998. That event was at least partly attributable to bets on interest rates movements that did not meet expectations. Markets for making bets are much larger and diverse than they were seven years ago. Some are very new and remain untested. The question is whether they are up to the task of distributing risks when low probability events occur.38 This open question should in itself give some additional weight to the case for action now, to avoid putting the world economy in the position of finding out the answer.

I'm confident it's quite easy to dig up plenty of quotes from other economists who were nervous.

Finally, the assertion that really caught my attention: That the likelihood of finding useful nuggets of economic wisdom in Schumpeter and Hayek is equal to that of finding it in the latest article in peer reviewed journals (I get the feeling he's making a perjorative remark about peer reviewed journals, but I'll let that slide).

Why do I think this is odd? Well, because the statement identifies modern economics as distinct from the great thinkers of the past. But in fact many of the works in the "peer reviewed journals" are not orthogonal to the works of the past, but like many other intellectual endeavors, based upon them. Open up the JPE or the QJE (or better yet, the NBER Working Paper series, and there are plenty allusions to "the greats", and ideas like "creative destruction". That being said, just like there has been plenty of thinking in political science since Machiavelli and The Prince (you'll get the allusion if you've read Dani Rodrik's take on Kristol's economics acumen), there's been a lot of insight developed in economics over the past hundred years. In this respect, the admonition to look backward sound good, but is less profound that it appears at first glance.

Quotable
In honor of today’s US Presidential Election finale, I thought a couple well-formed thoughts on voting would be appropriate. Enjoy.

“Vote: the instrument and symbol of a freeman's power to make a fool of himself and a wreck of his country.” -- Ambrose Bierce

“Perhaps the fact that we have seen millions voting themselves into complete dependence on a tyrant has made our generation understand that to choose one's government is not necessarily to secure freedom.”  – Friedrich Hayek

“Always vote for principle, though you may vote alone, and you may cherish the sweetest reflection that your vote is never lost.” – John Quincy Adams

“Anything important is never left to the vote of the people. We only get to vote on some man; we never get to vote on what he is to do.” -- Will Rogers
 

FX Trading – That Day is Finally Here 

November 4, 2008: Some of us might have been waiting for this day longer than others. Some of us may have been clamoring for it, while some of us may have been dreading its arrival. Either way, that day is here and a major change could be in order. That’s simply because ...

Today might be the day that marks the beginning of a legitimate US dollar correction!

Sure we’ve been open to this potential for the last several weeks, as we think a lasting correction is due before the US dollar can start on its next powerful leg of what we are expect could be a multi-year bull market.

Since July, a few days of indecision strung together have been the only reprieve within this powerful US dollar rally. So what’s going on today that might signal the start of something bigger?

Well, it’s a little something we like to call adverse price action. In other words, price action inconsistent with recently released economic matters. In this case, we learned that the Reserve Bank of Australia got a little rambunctious and cut interest rates by more than expected. Instead of bringing the benchmark rate down by 50 basis points, they went for 75 basis points.

Typically, the foreign exchange market is dominated in the near-term and long-term by interest rate dynamics. Lower interest rates, or expectations for interest rates to be cut, are negative for a currency; and vice versa.

But today, after the RBA’s earlier decision, the Australian dollar is rallying sharply. On a 60-minute chart, you can see that the Aussie popped above a near-term resistance level:

A breakout from these levels might offer up enough steam to move the Australian dollar higher for a while longer. After all, it has been beaten down as much or more than most other major currencies paired against the buck.

But it’s not only Australia’s dollar that’s pushing higher versus the greenback today. The entire pack, with exception of the yen, is considerably higher. And what’s important to note here is that the European Central Bank and the Bank of England are stepping back into the spotlight later this week. That’s when they’ll also be deciding on interest rates.

Expectations seem to be calling for a sizeable downward adjustment – 50 basis points – by each of the central banks. As of right now the seemingly contradicting price action of the euro and British pound could be buy-the-rumor-sell-the-news stuff. But we’ll have to keep watching through Thursday when these central banks make their announcements.

Until then, we’re voting for this elusive dollar correction to show its face. And if you’re note voting for the US dollar one way or the other, then ... well ... don’t worry about us holding it against you. It’s not necessarily your capitalist duty to vote.

Regards,

Jack&JR