Economics a la Wittgenstein

By Adam Millers, undergraduate at the University of Iowa

Regarding a random attempt at novelty; i.e. a Wittgensteinian interpretation of US monetary policy

If you demand a rule from which it follows that there can’t have been a miscalculation here, the answer is that we did not learn this through a rule, but by learning to calculate.

-From “On Certainty,” Ludwig Wittgenstein (44.)

…and if that quote made you think “oh, like the Federal Reserve,” then congratulations– you’ve stumbled across a blog post that might actually interest you.

Wittgenstein and Language Games

First off– for those insufficiently inspired by the careful examination of semantics to carefully examine them, Ludwig Wittgenstein was a 20th century Austrian philosopher of great renown.  Much of his legacy is attributable to an incident involving Karl Popper and a poker, but he had some notable ideas as well.  Some of these were attached to what I would say was one of his central theses (and please be sure to note that I am not seeking to misrepresent myself as a serious student of Wittgenstein here); i.e. the idea that language is fundamentally arbitrary, and that the meaning we derive from it is subsequently contingent on the framework within which it is used.  Another way to put it, in Wittgenstein’s own words, is that the words to which we ascribe intrinsic meaning can only be understood as “a complicated network of similarities overlapping and criss-crossing,” and that our perception of reality, as represented by its manifestation in this language, is every bit as jaded…

Now that being said, while I do sincerely recommend reading Wittgenstein– he’s considerably more coherent than Hegel and every bit as valid a talking point in the coffeehouse –I’m sure you won’t, and so that’s probably enough on Wittgenstein and language games.  (The links should get you off to a good start if you do, in fact, find any/all of the above to be intriguing).

The Federal Reserve and Language Games

Both philosophy and economics are faced with the task of applying logic to the illogical.  Former Chairman of the Federal Reserve Ben Bernanke put it well when he responded to a question regarding his confidence going into QE with the answer: “The problem is that QE works in practice, but doesn’t work in theory.”  (In hindsight, perhaps we’ll allow him that one– but it does beg the question: why was the central bank implementing policy that it didn’t expect to work?)  Likewise, Heraclitus famously quipped that “one cannot step twice in the same river” (although he also claimed that the world is made of fire– so don’t be too surprised when ‘the same river’ allows you to take two or maybe even three steps in it).  Bearing in mind the inherent similarity of the two disciplines, it should come as no surprise that the Federal Reserve, as the nominal “center” of American economics, has taken a page from Wittgenstein in its recent approach to policy.

The policy in question is forward guidanceand the description provided on the Federal Reserve homepage would appear to provide us with our first example of a “language game” as it ironically begins with “clear communication is always important in central banking.”  So you can follow the link for more, but forward guidance is basically, well, exactly what it sounds like it would be– the Federal Reserve provides (vanishingly little) guidance as to what they intend to do going forward.  Now here’s a little tangent, but if we put on our philosopher hats for a moment, would it perhaps be possible to pose as a question for the metaphysicians the following:

If the action prescribed by forward guidance is contingent upon the satisfaction of certain as-of-yet unfulfilled criteria, then does forward guidance address the nature of the action itself or the logical fulfillment of said criteria?

(Block quotes used for dramatic effect).

By the way, that could very well mean absolutely nothing.  Sometimes we play language games with ourselves…


A Misplaced Preface

So everybody knows about QE, right?  Real quick– the Federal Reserve wanted to stimulate economic growth and, with its limited arsenal of tools, decided that this could be most effectively accomplished by buying trillions of dollars of Treasury securities.  The liquid money paid by the Federal Reserve for the relatively illiquid Treasury securities would then be lendable to businesses to invest in new workers and equipment (and here you may see that this post is also relevant to the ongoing discussion of TLTRO).

Now an additional consequence of this massive bond-buying spree involved the market for the bonds that were being bought.  Let’s consider these consequences by breaking it down into pieces:

  • The value of a Treasury security (security = financial instrument representative of some form of debt) can be simplified as: the interest that the security pays divided by the price of the security.

Interest paid by security / Price paid for security  = Yield (net value, more or less) of security

  • When it comes to the price of the security, think of the classic supply-demand dynamic: an increase in demand relative to supply will raise the price charged per unit supplied.  So with the Federal Reserve (artificially) increasing demand to the tune of those trillions of dollars, the price on the securities increased, and the yield decreased.

Demand up = Price up = Yield down

  • For the sake of simplicity, let us equate the reduced yield on these Treasury securities with a proportional decrease in general rates on the market.  We can refer to these “general rates on the market” in the abbreviated form “rates” from here on out.

So then the “additional consequence” was to lower rates.  Now this would seem to play perfectly into the Federal Reserve’s theory (hmm Bernanke) because:

  • Lower rates mean that it will cost the businesses less to borrow all that new money received by the banks who sold Treasury securities to the Federal Reserve.
  • Lower rates mean that investors will be more willing to invest in riskier securities because of the higher yields.

and, perhaps most importantly of all,

  • The overall effect of the lower rate environment is the facilitation of a cheap expansion of liquidity, mediated by and to some extent contained within the financial sector.

Expanded (and expanding) liquidity combined with a willingness to invest in riskier securities means that the riskier securities will effectively become less risky, as a corollary of the capital reallocation from other areas of the market into those securities.  So here is the full chain:

Demand for Treasury securities increased (Fed buys securities)

Yield on Treasury securities decreases (because the increased demand caused an increase in price)

Yield on other securities [like stocks and bonds] starts to decrease (everyone other than the Fed buys these securities)

The price on all those securities [stocks and bonds] increases

Now the key takeaway is the thread that connects Point A to Point B: the Fed buys securities and, as a result, the price of stocks and bonds increases. 

This is, by the way, a very simplified explanation.

Language Games and Rate Hikes

That was quite a tangent.

Back to the idea of forward guidance as a language game– we now know that the Federal Reserve possesses (and has implemented) the power to inflate the prices of securities on the market.  They did this by lowering rates (using QE).  But one thing that you may be asking yourself is: if the prices of stocks and bonds go up when the Fed buys all those Treasury securities, then what happens when the Fed sells them?  Good question.

(Note: for those of you who are more acquainted with monetary policy or whatever, please let “open market sale of Treasuries” suffice as a catch-all for whatever ridiculously convoluted games the Fed would likely play with repo markets and discount windows.  That is something for Taylor Beguhn to soliloquize about).

Basically, the artificially inflated asset prices should fall.  Some will fall more than others, especially long-duration bonds that don’t pay back the initial investment for a long time and are most susceptible to changes in rates.  Does that make sense?  I think it should, if you just apply the logic from the previous section in a slightly modified reverse order.  Let’s just skip to the key takeaway here and say that for investors and market participants in general, an increase in rates by the Fed will be really significant, mostly because of how significant the preceding decrease was.

And that’s why forward guidance is so important.  At least that’s my opinion.  There isn’t a convincing case for the contention that by outlining what it intends to do given certain criteria, those criteria will somehow be more likely to… I honestly don’t know the correct word here but –“do whatever criteria do.”  So then forward guidance is really directed at “the folks with lots of money” who pumped “lots of money” into the banks to buy the Treasury securities that were then sold to the Fed during QE.  Because those folks are the same ones who, on some level, want to make sure that all this expanded liquidity ends up expanding their own.

So what “clear communication” does the Fed have for these folks?  That it will wait “patiently.”

What does that mean?  There are several traditional definitions for you, but now we have this Federal Reserve language game too.  Now “patiently” is quantifiable in terms of asset pricing models and option-adjusted spreads and other financial arcanum that would make Merriam Webster renounce the family business.  Now “considerable time” means “mid-2015,” or (if you had looked to Eurodollar swap options as your oracle) in December 2014 (whoops!).

Thank You, Wittgenstein…

…for teaching the Federal Reserve how easy it is to take advantage of the human penchant for reading between the lines.  And thank you also for reminding us that whatever we find between those lines is no more meaningful than the lines themselves.  Because, at the end of the day, both the action and the criteria are language games… inflation, whether core CPI or some permutation of the Michigan consumer sentiment index, is not tangible… for all we know, Janet Yellen could be talking about blowing up 2% of a balloon.

Does it make sense to exclude changes in the price of energy and food in the calculation of the overall purchasing power of the dollar?  There is an argument that it does, I would imagine, and presumably another argument that it doesn’t– but the key here is that they are arguments.  To borrow from a long line of philosophical inquiry: there is a substantial disparity between what we can assert about the world and what we can truly know to exist in it.  This rationale is applied to justify skepticism regarding whether or not your right hand is in fact a real thing; how much less pedantic does that rationale become when applied to something as tenuous as currency value?

And, as a brief aside on inflation, shouldn’t there be some (extensive) accomodation for the historical lows in oil prices?  It’s estimated that for every decrease of 1 cent in the price of oil, consumer discretionary spending expands by $1 billion.  That means a potential $50-60 billion dollar increase in consumer discretionary spending from the recent downtrend.  Now, granted, consumer discretionary spending and inflation are both language games in the purest sense, but even within the parameters of those games (or the larger-scale game that encapsulates them both), I get this unsettling sensation that the doves aren’t quite taking the big picture into consideration; the Fed is rushing for a first down without trying for the touchdown.  And this is probably wrong, but if PCE doesn’t decline as much as the substantive net residual impact of declining energy prices, doesn’t that mean there is latent inflation embedded in some subset of the difference between the latter and the former?  Key takeaway: what is inflation?  Does the Fed know?  And how can you make inflation, as the infinite abstraction that it seems to be, the basis of your “clear communication” (i.e. language game) if you don’t even know what the former is…?

Well then what about unemployment?  We have the Phillips Curve, and sure, that’s pretty cut and dry… but not when you add in labor force participation, and cyclicality of employment, and demographic fluctuations… What about the Baby Boomer generation retiring and the paradigm shift in the US support ratio?  Let’s go full circle– doesn’t that have a massive effect on the distribution of spending habits, and thus inflation?  Context, man, it’s “a complicated network of similarities overlapping and criss-crossing” and somewhere along the line it becomes necessary to just lay down the law and establish a framework for the meaning of the things you say that doesn’t conform to the changes in the meaning of the things you’re saying those things about.

Whatever, the semantics don’t matter because we’re not inspired to examine them carefully (remember?)– that’s something you have to resign yourself to, as an economist, if you hope to have any chance of staking a claim with conviction.    I mean, doesn’t it make sense that the Fed’s forward guidance is a language game?  To answer a question I posed earlier, if we take the stance that forward guidance addresses the logical fulfillment of certain criteria, and those criteria are comprised of language games of their own– well then what do we expect from the forward guidance?

What do we expect when we try to apply logic to the illogical?

One more time (for dramatic effect)

If you demand a rule from which it follows that there can’t have been a miscalculation here, the answer is that we did not learn this through a rule, but by learning to calculate.

-From “On Certainty,” Ludwig Wittgenstein (44.)

P.S. Thanks for reading.  Consider this a supplement to the TLTRO discussion; I’m still trying to figure out what I was talking about in the first installment of the latter.  Too much coffee, I guess.


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