Is the Fed a Cult? – Part 1

Neo-classical economics: An approach to economics that relates supply and demand to an individual’s rationality and his or her ability to maximize utility or profit. – Investopedia1

The Fed is a cult based on neo-classical economic beliefs that are based upon false assumptions. Like all cults, it has many followers who have great faith in its pronouncements even when those pronouncements are clear evidence of false logic and disturbed rationality. In this article, we will take a look at various forms of human thought bias and irrationality which are arguably manifest in the way the Federal Reserve thinks and operates.

I was annoyed and dismayed but not unduly surprised when I came across an article claiming that, despite the events of 2008, neo-classical theory still dominates economics courses in UK universities2. We cannot expect professors to change their teaching and thinking overnight, but surely six years after the global financial crisis (GFC) which the theory’s models failed to predict – even though it was something which appeared inevitable to me and to a small band of others – it’s time to at least look at different ways of understanding the economy.

Even more alarming is that the US Federal Reserve seems to be trapped on the same dogmatic path. The conclusions from its latest Federal Open Market Committee meeting3 are that its QE money-creation policy is working, despite economic indicators such as trade and employment suggesting otherwise.

False Assumptions

The issue is that neo-classical economics has always made certain assumptions in order to model how we use money. The publisher and editor of the excellent BOOM Finance and Economics website suggests the modern form of this theory is based on three false assumptions:

1. The study of economics is an ‘ethics free zone’;

2. Mankind tends to make rational decisions;

3. Banks, debt and money can be excluded from any analysis of the economy.

Yet, if you ask anyone who is not an economist their opinion on these three assumptions, it is likely they will immediately tell you that being ethical in life is very important and that ethical considerations are especially important in making decisions.

They may also tell you that most human beings are obviously irrational (a brief look at the history books will confirm this). Finally, they will tell you that banks, money and debt are the most important things to watch in an economy.

Common Human Faults

I would add some more human characteristics to this:

1. That humans also tend to become emotionally committed to their poor decisions (even when such decisions are obviously faulty). They cling to their (unrealized) losses while irrationally continuing to hope for gains. This is an aspect of Daniel Kahneman’s Prospect Theory – the “triumph of hope over adversity” – (Kahneman was awarded the Nobel Prize in Economics 2002 for his work in defining this particular cognitive bias). The Fed’s Cult has most of us buying into the hope that they’re doing the right thing on this basis.

2. Humans tend towards using only induction as their preferred method of logical inference without an intuitive understanding or practical experience of the two other means of logical inference – abduction (“Sherlock Holmes’ elementary logic”) and deduction. A tendency towards only using induction generates beliefs in broad correlations without differentiating causations (one of the main bases of the Freakonomics books4).

3. When confronted with two conflicting views of reality, most human beings tend to react defensively to defend the view that most closely resembles their own. They exhibit fear, anxiety and possibly aggression – this reaction is termed cognitive dissonance. Most humans have an inherent inability to consider two conflicting views of reality without experiencing internal conflict. This helps the Fed’s Cult to endure.

The founder of the post-WWII economic structure, John Maynard Keynes, acknowledged the undue impact people, such as those in charge at the Fed, have on our lives:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.”

Problems in Decision-Making

The editor and publisher of BOOM highlights the need to “incorporate demonstrations of operational decision making by competent professionals who are constantly mindful of the ethical aspect of their decisions and the immediate and long-term consequences. This process can be loosely described as ‘breaking down the silos’ and could also occur within certain professions where silos exist intra-professionally.”

Does that sound like the Fed? Growing up in academic ivory towers in a broken belief system like economics or in an institution like the Fed encourages silos; hence the Fed has a cult built around the egocentricity and hubris of its modern day leaders. For many years after they almost destroyed the global economy by orchestrating the excess of the 1920s and 1930s, central bankers were social and economic pariahs with limited power and no prestige – nobody (not even themselves) took them seriously and consequently they had much less power to do harm.

Hubris Definition of Hubris5

Hubris (also hybris, from ancient Greek), means extreme pride or arrogance. Hubris often indicates a loss of contact with reality and an overestimation of one’s own competence, accomplishments or capabilities, especially when the person exhibiting it is in a position of power. The adjectival form of the noun hubris is “hubristic”.

This tendency is commonly found in persons who have achieved power. “I am here – therefore, ipso facto, I must be best placed to make these decisions.” Hubris often indicates a loss of contact with reality and an overestimation of one’s own competence. It begets certainty and inductive reasoning. History is replete with examples of intelligent and, in some cases, highly competent, capable individuals whose climb up and conquest of the greasy pole imbued them with such hubris that it blinded them to ethics and consequence.

To be continued…

Footnotes:

1 http://www.investopedia .com/terms/n/neoclassical.asp

2 http://www.theguardian .com/commentisfree/2013/oct/28/economics-students-neoclassical-theory

3 http://www.federalreserve .gov/newsevents/press/monetary/20140917a.htm

4 http://freakonomics.com/books/

5 http://en.wikipedia.org/wiki/Hubris