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(also posted at: http://watchingtheherd.blogspot.com/2008/12/occams-razor-and... )

When the Numbers Don’t Add Up...

...check who’s doing the adding.


That should be the motto for all Americans as politicians, business executives and economists pitch their solutions for reversing (or at least halting) the current economic collapse. Virtually all players involved in the system now all claim that the overwhelming complexity of our "modern" financial system and the blizzard of new-fangled financial instruments made anticipating the timing and magnitude of any potential correction within the system almost impossible. Given the magnitude of the problem that’s now evident, the unpredictability seems highly suspect in retrospect.

Occam’s Razor is a term for an approach to solving problems which attempts to avoid distractions by eliminating factors that have no observable or proven impact on the phenomena being explained or problem being solved. In plain language, it basically says when faced with a choice between an explanation or theory that could be a cross between a Rube Goldberg machine (#1) and M.C. Escher drawing (#2) versus an explanation involving five variables and basic arithmetic, the simple solution with the arithmetic might be the better starting point.

It turns out Rube Goldberg machines, Escher drawings and Occam’s Razor – more specifically, the failure to apply the principle to information provided us – have everything to do with the meltdown we’re now experiencing. Experts and individual consumers alike both saw signs that segments of the economy weren’t performing well yet classic measures of those segments weren’t "adding up":

* consumers saw low reported inflation, yet skyrocketing housing prices
* consumers were granted ever larger lines of credit despite a lack of growth in real income
* consumers enjoyed the trappings of higher levels of wealth but their credit balances increased year after year
* experts saw vast bundles of securities of unverified provenance and divergent risk levels blended together and magically emerge with top quality AAA ratings
* experts saw massive credit injections towards the end of the cycle, yet saw little increase in reported IN-flation
* experts now see massive contractions in lending, yet don’t see the expected DE-flation

It’s certainly possible that the explanation for all of these ordinarily contradictory signs of economic health boils down to an otherwise PERFECTLY healthy economy with an unexpectedly high level of positive feedback between the second order derivative of increased lending (or the rate of change in the rate of change of lending) and its impact on future credit evaluations which sparked a change in risk assessment which altered behavior of consumers who decided to defer new car purchases for 15.7 months, shifting the demand curve out in time on the manufacturing sector which triggered a faster than expected loss of jobs which triggered mortgage defaults which triggered the collapse of the derivate markets which … ZZZZZZZZZZZZZZZZZZ

Or…

It’s possible that virtually all of the damage arose from a single (intentional) change in procedures used to fudge --- I mean "report" --- inflation back in the 1980s. It’s possible that the economy has been collapsing for over two years but recognition of the effort in the ER on the part of the Federal Reserve to revive the patient was delayed by a single (intentional) change in statistical reporting in March 2006.

Fudging Inflation

In the case of inflation reporting, a decision made during the Reagan Administration in 1983 alter inflation calculations by replacing actual dollars spent on home mortgages with a number referred to as "owner’s equivalent rent". Documentation of the original public or actual justification for this change is hard to find. Maybe they thought rapidly rising home prices acted as "investments" for homeowners (like stock appreciation) and therefore only the "real" value of the home – whatever THAT is – should be counted. More cynically, maybe this was a ploy to create a quick win against "inflation", reduce union expectations of future inflation, and reduce growth in labor costs. Maybe it was a ploy to begin cutting growth in payments for CPI based entitlements, a ploy formally adopted by Clinton and Greenspan in the 1990s.

The motivation for the change might be fuzzy but the impact on inflation statistics every since could not be more clear. (#3)

* the housing portion of inflation has never equated to more than 6% since 1983
* prior to the change, housing prices contributed nearly HALF of the total rate of inflation
* by 2008, housing prices only contributed roughly 25% of the drastically massaged, drastically lower inflation reported (see the graph at the link)

Fudging the Money Supply

In the taxonomy of money, M0 is physical currency sitting in bank vaults and individual wallets. M1 includes M0 plus balances of checking accounts and travelers checks. M2 includes M1 plus savings account balances, CDs less than $100,000 and money market account balances. M3 is M2 plus CDs over $100,000 and other institutional accounts and loans between banks. When the overall economy experiences real (non-inflationary) growth, the M3 number which reflects all "money" in the system will grow roughly in proportion to the real growth rate of the economy.

Those following money supply statistics were thrown a curve ball on March 23, 2006 when the Federal Reserve Bank decided to stop reporting M3 statistics. The rationale cited by the Fed at the time now seems criminally negligent or stupid in hindsight (#4):

M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits.

Hmmmm. "has not played a role in the monetary policy process for many years." Maybe not but the decision to STOP reporting it precisely in March of 2006 appears to be a definite part of the Fed’s strategy in attempting to prop up a collapsing system without spooking the herd about skyrocketing amounts of dollars entering the money supply through massive credit infusions to member banks.

What did the change mean for investors and consumers? Using consistent numbers for the money supply would have reflected more "dollars" in the economy chasing the same goods, which is the definition of inflation. If you thought your 3 percent raise kept you at bay with inflation, you were actually losing ground. If you thought investment gains of 7-10 percent still put you three or four percent ahead in real terms, you actually may have lost money. Instead of interest rates jumping upward sharply and providing a signal to marginal borrowers to avoid taking on additional debt, interest rates remained relatively low, tempting more borrowers into the pool.


(Un-) Do the Math

Neither of these changes is being discussed here because they are recent news. Both were widely reported when they took place. Still, no one lobbied to undo them, even when personal or professional experience (housing prices doubling but 5% inflation??? Triple-A rated investments with skyrocketing CDO risk premiums???) clearly indicated something was wrong.

Why?

Maybe Americans were just stupid enough to not realize this WASN’T rocket science and that one didn’t need calculus and a degree in Finance to realize housing can’t double in five years and only see 3 percent inflation. Maybe Greenspan successfully hypnotized politicians and bankers with Rube Goldberg language and bored everyone to the point of never going back to basic arithmetic to figure out we’re going broke one HELOC and sub-prime loan at a time.

The lesson should be painfully clear now. No action taken by a major corporation or Congress requires analysis beyond a five year time horizon or math beyond what you can do on a simple calculator to determine if it makes sense. No one in a position to make most of these decisions sees more than a 10-page PowerPoint presentation justifying a decision and even that ten pages includes a title page and table of contents. If you can’t understand the revenues and expenses or costs and benefits of a solution after a ten minute explanation, it’s probably not you, it’s the model or the person proposing it that needs work.

If Congress really wanted to lay the groundwork for improving trust in the markets and liquidity in the financial system, there is no better place to start than undoing all of the bogus adjustments and outright distortions made to the numbers that act as the dashboard for the economy. There may be no more important numbers to correct than the data for inflation and the money supply. Until the distortion of these numbers is corrected, it’s impossible to calculate the true "value" of any long term proposal for fixing the economy.


WTH

=============================

#1) http://www.rubegoldberg.com/gallery_02.php

#2) http://www.mcescher.com/Gallery/back-bmp/LW389.jpg

#3) http://www.marketoracle.co.uk/Article4018.html

#4) http://www.federalreserve.gov/releases/h6/discm3.htm
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No. of Recommendations: 54
Nice post, WTH.

To take the concept in a slightly different direction:

1. How did the financial sector get into such trouble?
a. The Fed and the CEOs of the major banks didn't see it coming.
b. They created an epic bubble for personal gain.


2. How did our economy et so amazingly messed up?
a. Managing the economy for maximum sustained growth is extremely difficult.
b. People in power benefit from booms and busts.


3. Why are we bailing out large companies and industries instead of playing by the rules?
a. Giving money to these companies is really good for everyone else and there's no other way to protect the rest of the economy from their failures.
b. Politicians give perks to their contributors when they can get away with it.



In all four cases, I'll take b, as the simple, obvious explanation. People in power often abuse the financial and political systems for personal gain. Power corrupts.

To distract people from the obvious explanations and provide cover for their corrupt acts, we get elaborate, confusing theories to explain things that are really quite simple.
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To distract people from the obvious explanations and provide cover for their corrupt acts, we get elaborate, confusing theories to explain things that are really quite simple.

Just wanted to emphasize that point a bit. (smile)

I honestly don't think you could find more than 2% of the people who worked on Wall Street who could actually EXPLAIN how all these complicated investment "vehicles" were supposed to work. Even at gunpoint. However, they didn't actually HAVE to work as actual financial tools. They were tools of obfuscation, not finance. The HELOC might be another key stroke of genius on the part of the finance wizards. The widespread adoption of HELOCs by average Americans produced a false sense of comfort and understanding in complex financial arrangements and debt that made it that much easier to take the next step and take no-money-down loans to buy additional properties to flip, etc. At that point, we're off to the races.


WTH
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I would add one further link regarding government statistic reporting:

http://www.shadowstats.com/section/primers
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The problem with housing (in case someone else hasn't mentioned this) is that for inflation purposes, it was the cost of housing that was used but the rental rate of housing and rental rates were low, except in certain areas like San Francisco where it paid to rent rather than buy.

I'm so sure that this was bad because buying a house is not something we consume every day or month or (at least most of us) year. And housing is not like an automobile where after 15 or 20 years it may not be worth anything. True, the house may not be worth what you paid for it, but it won't be worth nothing (Actually, not quite true because I knew of a lady who had a house in West Virginia that wouldn't sell at any price. I think she gave it to a church.).

brucedoe
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"Maybe Americans were just stupid enough to not realize this WASN’T rocket science and that one didn’t need calculus and a degree in Finance to realize housing can’t double in five years and only see 3 percent inflation"

I think we should consider how it was that we were ollectively 'stupid' enough to allow this to happen on such a large scale. I think it is the result of some variation of cognitive dissonance and/or wishful thinking that causes us to filter out the information that does not match what we want to believe.

I will offer myself up as an example of how easy it is for us to deceive ourselves on a mass scale.

When my wife and I paid $X for our home 7 years ago, I was concerned that we were overpaying but we decided to take the risk anyway. We paid roughly $1/3X down and borrowed roughly $2/3 of X. About two years ago our assessment went to roughly 1.5 times X and I looked into challenging it. How could our modest, one story brick house be worth $1.5 times X? The realtor ran comparables and told us that it was worth at least that, so we gave up the challenge. Zillow had our house at $two times X by then based on 'comparable' sales.

I did not comprehend how bogus those numbers were because of low interest rates, loose monetary policy, fudged inflation numbers, and gosh knows what else.

Even I, who should have known better, concluded that my house 'must' be worth that because all the 'comparables' were selling for that, and more.

Reality should have told me to take the money and run but I weanted to believe that I had 'made' a more than fifty percent gain on that house in five or six years and I accepted the assessment and 'comparables' to 'prove' it. Now zillow says that my house has fallen in price by 20% from its high of two years ago, is worth less than the assessment, and is dropping by thousands of dollars per month. This is also based on 'comparables'.

I should know better, but I didn't allow myself to see how much of my wealth was phantom because I preferred the fantasy that I was finally getting ahead after practicing law and saving for nearly 30 years.

Same story with my IRA and trading accounts. They were rising rapidly for that same seven year period, and I preferred the fantasy that I was finally getting ahead as opposed to the reality that I was barely keeping up with inflation, if that. Now they have fallen even farther in value than my home, and now you tell me that my savings is losing more to inflation than I realized due to fudged inflation figures over the last quarter century.

I tend to believe your figures without researching them and to accept that I was likely allowing myself to be duped because of some form of cognitive dissonance. I suspect a lot of people still do not yet understand or accept their plight.

We expected and planned for a hurricane, but not for Katrina.

And we trusted numbers that made us feel like we were getting ahead. We didn't plan for Katrina because we did not receive accurate warnings.
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Interestingly, if you increase the value of our home from September, 2000 to the summer of 2006 by 10%, you get (roughly) the high that zillow said our house was worth at its peak, and if you increase the value of our home by 5% over that same period, you get about the same number that zillow presently says it is worth.

If it falls by another 25% from here, it will be worth about what I paid for it.

It may yet turn out that I 'overpaid' when I bought over 7 years ago. It's easy to make fun of all those people who were not 'prudent' investors without admitting that we are they.
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ooh that one is gonna live in infamy and on my board......luv'ed it WTH....

KBM (appreciative)
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And we trusted numbers that made us feel like we were getting ahead. We didn't plan for Katrina because we did not receive accurate warnings.

Well know that because of the fact that returns were predictably bad over the last 5 (and ten years), retunrs going forward are very good, as valuations are about HALF of what they were when I wrote this post:

http://boards.fool.com/Message.asp?mid=19712096&sort=thr...

The danger today is in abandoning the stock market. If you do that, you may never recover from it financially.

If you are interested in getting more of a handle on what actually drives returns in the stock market, I recommend the weekly Hussman column:

http://www.hussman.net/wmc/wmc081124.htm
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OK,here is the simple version of Occam's Razon: All things being equal, the most simple explanation is probably true. How does this affect your explanation, which is quite long.
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OK,here is the simple version of Occam's Razon: All things being equal, the most simple explanation is probably true. How does this affect your explanation, which is quite long.

Yes, that's the simple version. It is also the incorrect version.
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OK,here is the simple version of Occam's Razon: All things being equal, the most simple explanation is probably true. How does this affect your explanation, which is quite long.

=======================

The point of the piece was to serve up a contrast between convoluted, complicated explanations for the current meltdown and two very simple changes in government reporting of key financial data that could explain the same result.

Here's the WTH corollary to the concept of Occam's Razor.

Ask the wrong questions and you get the wrong answers.

If the media and the public get distracted by convoluted, complicated and otherwise INCORRECT theories as to what caused this crisis, the solutions identified to mitigate the effects and/or prevent it from happening again will be nearly assured of failing.

Disclosure of the Madoff ponzi scheme in the past week adds one other simple cause for the meltdown -- flat out fraud and corruption by well-known, well-connected individuals and firms operating in broad daylight and allowed to do so for years because of an utter failure to enforce basic regulations.


WTH
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