Macro Matters and Orthodoxy

Quantivity disliked undergrad macroecon, as it was largely a waste of time: fancy theory lacking compelling evidence, amplified by no consensus within the field à la saltwater versus freshwater.

Few folks could be blamed for such flippancy, as it was mostly harmless throughout the great moderation. In fact, traders took apparent pride in their ignorance of macro—except the global macro guys, obviously. Then, along came a credit crisis.

With that swan, Quantivity concluded it was high time to formulate a systematic macro perspective: a “top down” complement to calibrate “bottom up” quant models. Quantivity brought great humility to this effort, due to both intrinsic complexity and comparatively weaker background in macro.

This post kicks off a few thoughts derived from this effort; hopefully a welcome addition alongside micro analysis. Two caveats are worth noting. First, confirmation bias is particularly dangerous with macro, and thus emphasis is placed on broadly considering diverse viewpoints. Second, these thoughts are posted with a bit of trepidation, given intense desire to avoid politics and policymaking.

Understanding macro is built from formulating intuition around two themes:

• Combining both backward- and forward-looking perspectives
• Contextualizing sovereign and institutional politics within those joint perspectives, in real-time

Backward-looking perspective requires careful study of economic history—admittedly, not a topic many folks enjoy reading at bedtime. Much more empirically challenging is the statistical rarity of credit crises; only twice in the past century: globally 1927 – 1934 and in Japan 1989 – 2005.

The following are excellent long form introductions (ignore Koo’s ridiculous title):

• Does Central Bank Independence Frustrate the Optimal Fiscal-Monetary Policy Mix in a Liquidity Trap?, by McCulley and Pozsar (2012)
• Holy Grail of Macroeconomics, by Koo (2011)
• Has Financial Development Made the World Riskier?, by Rajan (2005)

The first two eloquently summarize history and key dynamics of the current macroeconomic climate, including credit crisis, balance sheet recession, and liquidity trap. Rajan presents a shockingly prescient perspective on the impact and dangers caused by financial development, equally applicable today as in 2005.

Arguably the most important collective insight is the remarkably important role which economic orthodoxy plays among market participants (including regulators). McCulley and Pozsar (p. 3) nicely summarize as:

Intellectual paralysis borne of inertia from dogma that, in the present circumstances, do not apply.

Neatly tucked into this definition are three fundamental scaffolds:

• Dogma: understanding what is the prevailing conventional economic “wisdom” among market participants, in sufficient detail to trade on it; in other words, economic theory, market structure, regulation, secular demographic trends, sociopolitical context, etc.
• Present circumstances: accessing and understanding real-time economic data and analysis, again in sufficient detail; in other words, market data and corresponding econometric analysis
• Applicability: speculating when dogmatic wisdom is applicable to present circumstances, versus when it is not and thus resulting in intellectual inertia

Although in a new guise, these three boil down to a familiar trading concept: contrarian versus trend following. When dogma is appropriate for present circumstances, then follow the trend; if not, then go contrarian. The challenge is having to make this call in real-time based on incomplete information, simultaneously understanding all three in sufficient confidence to risk capital.

Towards this end, FRED is a nice source for macro data. Given data, next is building intuition and understanding of dogmatic applicability via analysis and synthesis while seeking to minimize confirmation bias.

The blogosphere is as good source for this as any (certainly better than nearly all sell side research), although much of it suffers from varying degrees of partisanship and politicking. A few exemplar blogs, from the roll, include:

• Econbrowser, by James Hamilton
• Interfluidity, by Steve Waldman
• Macro Man

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