Back last September, when I wondered if the dollar was the new Schrute Buck, it was actually pretty strong compared to where the dollar is now, and where it seems to be heading (chart). Eventually, if a country decides it's going to ignore the lessons of history and have guns and butter and houses and all kinds of stuff and low taxes as well because, hey, the money can always be borrowed, it will turn its currency into Schrute Bucks of ever decreasing value.
Meanwhile Alan Greenspan, the former Wizard of the Fed who was the economic architect of our current situation, sent another one of his missives from afar explaining the markets are inherently unpredictable, new forces are at work, and besides, we will never have a perfect model of risk.
But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling – the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve. Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioural responses as non-rational. But forecasters’ concerns should be not whether human response is rational or irrational, only that it is observable and systematic.Translation: It's not my fault.
This, to me, is the large missing “explanatory variable” in both risk-management and macroeconometric models. Current practice is to introduce notions of “animal spirits”, as John Maynard Keynes put it, through “add factors”. That is, we arbitrarily change the outcome of our model’s equations. Add-factoring, however, is an implicit recognition that models, as we currently employ them, are structurally deficient; it does not sufficiently address the problem of the missing variable.
Someday we'll look back and wonder how so many people took this wizard so seriously for so long. Remember when the Wizard of Oz took off in his balloon and left Dorothy behind? At least she could tap her magic slippers together and wake up from her dream. We don't have any magic slippers, just those incredible shrinking Schrute Bucks, and we seem to be trapped in a nightmare with no end in sight.