They Believe These Variables May Be Below Acceptable

They Believe These Variables May Be Below Acceptable

They Believe These Variables May Be Below Acceptable

Copyright © 2023 by Brooke Bigley

All rights reserved

TABLE OF CONTENTS

CHAPTER 1 : EVERYONE OWNS A CENTRAL BANK

CHAPTER 2 : BUILD AN ECOSYSTEM

CHAPTER 3 : NEW PERSPECTIVE ON STARTING A CAREER

CHAPTER 4 : WHAT REMAINS

CHAPTER 5 : CENTRAL BANKING AND EUROFIGHTER OPERATIONS

CHAPTER 1 : EVERYONE OWNS A CENTRAL BANK

Every modern economy has a central bank. America has the Federal Reserve, Britain has the Bank of England, Europe has the newly established European Central Bank, and Japan has the Bank of Japan. These central banks are the most powerful institutions in the modern world. Their moves determine the interest rates we earn in bank accounts and the cost of collateral. These moves indirectly affect the value of our homes, pensions and the cost of everyday necessities. Their policy decisions have the potential to spur economic growth or recession. These decisions create job opportunities or can even influence election results.

When properly managed, central bank policies can promote economic achievement and raise people's living standards. When mismanaged, central banks have the ability to trigger economic recession, deflation, stagflation, financial turmoil or hyperinflation as we see today in Zimbabwe and Germany in recent years. The 1920s brought social and economic collapse.

It is no exaggeration to say that the heads of central banks have more control over daily life than all politicians except a handful of senior elected officials(1). Despite this, central bank governors(2) remain separate from the balances and controls of the democratic system. Nowhere in the world are the heads of central banks directly elected by the people, and once appointed to this position, they often tend to work in their own way and avoid being influenced by political pressures. Today, establishing a central bank management mechanism outside the control of an elected government is considered one of the prerequisites for a successful capitalist economy.

In recent years, people have become increasingly aware of the importance of central banks for economic stability. Central bank interest rates are now regularly reported on the evening news and therefore also dominate the economics pages of newspapers. The group of financial analysts even used the most absurd statements of senior central bank officials to explain the transformation of lush forests into bare hills in tasteless reports.( 3) Bankers and fund managers, including our pension managers, risk billions of dollars betting on how central banks will adjust policies in the future and sometimes they even bet on how the tone of central bank speeches will be adjusted.

2.2. Increased confusion

Ignoring the importance of these agencies and a thorough survey of their working mechanisms, awareness of the role of central banks among the population is still very vague. Few people understand why central banks change interest rates or can explain the importance of central bank independence from political control. And surprisingly few even among financial experts and economists can adequately explain why central banks exist. Fewer still can say clearly what makes good or bad central bank policy.

2.3. Difference of opinion

Ignoring the purposes and methods of central banks is forgivable; Even the central bank governors themselves cannot agree on the goals they are pursuing and how to achieve them. Today, the two most powerful central banks are the Federal Reserve and the European Central Bank. These two agencies have the common goal of achieving price stability. However, this consensus also reveals their different methods of pursuing common goals. The European Central Bank always believes that the design of monetary policies needs to focus on the money supply side. At monthly press conferences, European Central Bank officials dutifully report the latest M3 figures(4), recording the EU's rate of monetary growth. The European Central Bank also continuously affirms that these data are the basis for them to decide on the method and time to change interest rates; When the money supply increases too high, interest rates must increase; when the supply decreases, interest rates also need to be reduced. On the other side of the Atlantic, in the offices of the US Federal Reserve, the argument is perhaps a little different, here it is believed that the M3 data is not necessary, not worth recording and certainly should not be used for policy making.(5) Controlling monetary policy is the task of the central bank, but central bank governors often disagree on the factors that change the money supply . The disagreement over the role of money supply growth in central bank policy is a sign that industry experts cannot fully understand the purpose of central banks. This defect arises from an unconditional belief in the notion of efficient markets, which I will explain below.

After more than a decade of analyzing central bank policies on both sides of the Atlantic, I believe the different elements in the policy strategies of the Federal Reserve and the European Central Bank can be illustrated as follows.

The United States Federal Reserve does not believe there is excessive monetary growth, credit creation, or asset inflation. However, they believe these variables may be below acceptable levels. As a result, the Federal Reserve's monetary policy is described as one in which policy is used to its maximum extent to avoid or prevent credit contraction or asset price deflation but is not used to avoid credit expansion or asset price inflation. This theory is boiled down to the idea that asset bubbles cannot be identified before they burst, and only then can and should central banks intervene.

On the contrary, the European Central Bank believes that money supply growth may exceed; This is consistent with excess credit creation and also consistent with excessive asset inflation. However, there is still reluctance to acknowledge the link between excessive money supply growth and excessive asset price inflation.

The result of the two differing views is that the Federal Reserve sees its role as resisting any contraction of credit, while the European Central Bank sees its role as resisting any contraction of credit. Excessive credit expansion. I have certainly touched a nerve on both sides of the Atlantic by highlighting differences in respectable monetary policies in such a blatant way while ignoring so many other great consensuses. I apologize for this, but the difference in monetary policy strategy is an important part of the story of the current and past credit crunch, so it is worth mentioning.(6)

2.4. Should central banks exist or not?

While focusing the discussion on central banks controlling risks, we have overlooked a difficult and interesting question: Why do Central Banks exist? Central banks use interest rate policy to control capital markets. But economic theory has shown us that markets are efficient and should be left to their own devices. So why do we still need Central Bank governors to manage interest rates? Clearly, we need to trust markets to set interest rates without resorting to Soviet-style central planning of capital markets.

It is a strange paradox that today's central banks are generally run by economists who subscribe to theories that their mandate is unnecessary and even useless. destroy prosperity. This is certainly not a widely discussed topic among respected economists. However, it is also a matter worth pondering.

If central banks are necessary because of the inherent instability in financial markets, then managing these institutions using efficient market principles is akin to conscripting a person into the military. If you are against your religion, you must join the army; The result will be that they are not willing to perceive the problem.

2.5. Efficient Market Theory - like flipping a coin

Fortunately, the Efficient Market Theory still leaves us with a way to test its effectiveness. We have touched on this topic before when discussing difficult issues, but now we should consider it a little more.

The story of the Efficient Market Theory is as follows: All assets have exact prices. If we can predict future asset price movements with certainty, we can almost certainly make a profit by buying or selling that asset. But if it is possible to make a certain profit by buying or selling that asset, then the current price of that asset is clearly not accurate. Therefore, according to the Efficient Market Theory, predicting asset prices is impossible.

The next step of this theory is an excellent move. Because we cannot predict the exact direction of the asset's next change, it is certain that the asset price change will be either upward or downward. And since there are only two possible changes in the asset, the probability of price increasing is 50% and the probability of price decreasing is 50%. According to the Efficient Market Theory, these possibilities are always true and occur everywhere.(7) Even if we cannot be sure to benefit from price changes, price changes still change. has equal probability in both directions.(8)

When we put the above analysis together, we will get great results that help model price movements and through that, we can control price fluctuations very simply, like like tossing a coin: the front side is that the price will increase, with a 50% probability of happening; The downside is that the price will decrease, with a probability of 50%. And fortunately, we just need to inherit the research results of mathematicians and physicists and apply it to see how things will change when controlled by completely random processes.(9 )

If asset prices change according to random processes, going up and down in a series of small steps, we know these changes can be reproduced in mathematical models called normal probability distributions. or Gaussian probability distribution.

Convince yourself that the probability distribution of asset price movements will be favorable because normal distributions are easy to study. Using a normal distribution we need just one simple number that allows us to predict the entire probability distribution of future asset returns. The number we need is a measure of the range of events due to spread, also known as the standard deviation. This is equivalent to finding the mean of fluctuating random events; Large fluctuations imply a spread distribution with a wide range of asset turnover probabilities, which would be a flat bell-shaped normal distribution.

2.6. Coin Flips and Volatility - Foundations of options trading

After the Efficient Market Theory helps us shape the probability distribution of asset returns, what remains is to determine the width of the distribution. Determining the range of probability distributions was done by measuring the standard deviation of historical fluctuations in asset prices. According to what the Efficient Market Theory believes, what we need to do is measure the average of past random price fluctuations and hope that prices will repeat those fluctuations in the future.

As soon as this evaluation is done, we will know the distribution of future asset returns, spanning all events. From theory we will also know about the shape and from old data we will know about the range of the distribution. The breakthrough in asset price modeling opens up countless opportunities. Banks, asset managers, insurance companies, regulators and everyone concerned about financial risks can use these distributions to calculate the likelihood of loss. . This discovery also makes the development of the options trading industry just one small step away. A business that divides these distributions into different parts quite effectively and sells them to investors. Conservative investors may choose to buy insurance for the bottom parts of the revenue distribution, helping to protect their portfolios from losses while some other optimistic and aggressive investors choose to sell that distribution.

2.7. Test the hypothesis

In fact, the Efficient Market Theory can be converted to well-known probability distributions, and there are ways in which we can test its accuracy. Over time, we have the ability to record asset price movements and, if markets are efficient, we will feed the collected metrics into an asset revenue distribution model and compare the distributions. Coordinate that with previous predictions. We could be this way if the statistical predictions of the Efficient Market Theory were supported by good evidence. These tests, repeated across asset markets, have given us a picture of asset price turnover that clearly contradicts the theory of Efficient Market Theory.

While Bear Stearns and Northern Rock help confirm the failures of the Efficient Market Theory, the best illustration of this problem is the story of the hedge fund Long Term Capital Management (LTCM). Excerpt from Roger Lowenstein:

The fund's brains are a group of intellectuals, PhDs, and certified arbitrage traders. A lot of them are professors. Two people have won Nobel Prizes. All are wise people.(10)

The LTCM Fund is managed by respected economists who were responsible for developing the Efficient Market Theory. But why are Nobel laureates based on the Efficient Market Theory wasting their time in a company whose purpose is to predict what they themselves consider unpredictable?

If LTCM had not succeeded in finding profits, the Efficient Market Theory would probably not have been affected much, but this is not what happened. First, LTCM generated huge profits, quadrupling its asset value, consistently over a four-year period. Then, in just a few weeks, he lost everything and lost more than the total profits of the previous period. LTCM disproved the Efficient Market Theory in two ways: first by generating impossible profits, then by incurring losses as a result of unexpected and seemingly impossible market fluctuations. possibility of happening.

LTCM's story is similar to the story of Albert Einstein working with Richard Feynman to disprove their own physics theory. They succeeded but then the world continued to progress as if nothing had happened, still believing in those disproved doctrines.

2.8. Believable moment

Market ideas that will work:

1.      Asset price bubbles do not exist; Prices always reflect the true value of all types of assets.

2.      When markets are free to operate, they will determine their own stable equilibrium.

3.      That state of balance is the optimal state.

4.      The movements of individual asset prices are unpredictable (random).

5.      However, the distribution describes predictable asset price movements.

As pointed out, the only thing worth noting in this whole story is that the data do not agree with the theory. We will not be able to find markets with a normal distribution. We see countless major market disruptions and, frankly, we have never observed any stable equilibrium in the financial markets.(11)

2.9. Rejecting a theory will lead to a more effective theory

We have looked at the Efficient Market Theory together. We have also recognized that it is a respectable theory of the free market school, then we have also refined the ideas of that theory into testing market behavior, and then this theory has refuted itself.

With such strong scientific evidence against it, the Efficient Market Theory fairy tale should be left behind and we need to find a better theory. That was the path laid out by Keynes in the 1930s when he observed that the Great Depression did not show that markets would spontaneously move toward optimal equilibrium, forcing him to develop a theory The new economics rejected the ideas of the Efficient Market Theory.(12) This is also what Minsky did with the Theory of Financial Instability.(13) On the other side, mathematician Benoit Mandelbrot - famous in the field of fractal geometry - also disagreed with the Efficient Market Theory, developed a model to describe market dynamics that replaced the suggestions of Brownian random motion theory.(14)

2.10. Two schools or one madhouse

While Keynes and then Minsky moved in the same direction to create a new alternative theory describing how the world works that was consistent with the empirical evidence, another group followed. in the opposite direction, trying to hold on to the ideas of market efficiency and the views of the free market school.

The second group has a different explanation for why market operations are inconsistent with the Efficient Market Theory. One condition for the market to operate effectively is that it needs to be completely free to operate without any intervention or influence. If there are external forces influencing and pushing market prices up, such as government intervention, the market cannot be expected to operate effectively. The rescue card theory of the Efficient Market Theory comes from the idea that financial markets are not free markets but are still influenced by the government and central banks. This leads to an interesting explanation: boom-bust cycles in asset prices and non-normal asset turnover distributions are clearly not market failures, but rather, they arise. due to central bank interventions.

2.10.1. Friedman School - Central banks make markets inefficient

If one subscribes to the Efficient Market Theory and at the same time is always influenced by epistemic rigor, then the inevitable conclusion is that central banks should be abolished. If markets can optimize themselves, then free market participants should be allowed to set interest rates. Banks must be free to lend and borrow as they see fit, and be guided by the supply and