The Human Variable
Ross M. Miller
Miller Risk Advisors
November 14, 2005
[This commentary appears in the
November/December 2005 issue
of Financial Engineering News.
This is the raw, unedited version of that
Neither his official biography nor his Who's Who entry tells us what
his middle initial, if any, is. A casual Googling only complicates
matters. Columbia Business School indicates that "C" goes in the
middle. An alleged Trilateral Commission membership list from days past
gives "J." A smattering of bloggers maintain that it is
"V" for "Vague." I am inclined to believe that Alan
Greenspan's middle initial should be "R."
Though arguably the most powerful person in the world (and less
arguably the most powerful person in the financial world), the only trace
of Dr. Greenspan in many models is as a shadowy presence represented by
the letter "R"—usually in lower case and
often with a subscript, prime, hat, or superscript gracing it. This
letter, of course, stands for the celebrated "risk-free" rate of
return that makes a cameo appearance in any financial model worthy of
Dr. Greenspan, along with his fellow voting members of the Federal Open
Market Committee (FOMC), effectively determines the risk-free rate through
their targeting of the federal funds rate. Moreover, the often cryptic
pronouncements made in the statements issued after each FOMC meeting, as
well as those contained in Dr. G's statements before groups that range
from Congressional committees to Rotary chapters, help nail down the first
year or two of the yield curve.
Throughout his tenure as Fed Chairman, Alan Greenspan has been one of
the leading practitioners or the art and science of financial engineering
even if members of the profession rarely see things this way. Viewing
financial engineering on a more grandiose scale, Alan Greenspan spent the
last 18 years as "engineer" of the train known as The Global
A handful of financial engineers have received the honor of getting
their names associated with models they have developed. Alan Greenspan
trumps that feat and joins the rarefied company of true celebrities, such
as David Bowie (of "Bowie Bond" fame), by having a financial
instrument named after him—the Greenspan put. If
MasterCard ever does a commercial that features derivative securities,
this put, which is reputed to prop up the U.S. stock market, will be the
item that is "Priceless."
Despite being the recipient of numerous honors, Dr. Greenspan often
comes off as being stuck in the pre-Modigliani-Miller days of his youth.
He is more likely to cuddle up in bed with "Diffusion Indexes of
Industrial Production" than he is to hunch over a laptop to crunch
through a noisome differential equation. But even a casual glance at the
speeches that he has presented over the years, however, reveals that he
has been well ahead of the curve in recognizing the risks that involved an
increasingly complex global financial system. While Greenspan's monetary
moves garner all the headlines, the potentially destabilizing effects of
financial and technological change, and policies necessary for dealing
with them, is the repeated focus of his speeches.
Alan Greenspan also demonstrates an acute understanding the role of
expectations in financial markets. Whether or not he and his fellow FOMC
members have properly managed those expectations remains an open question.
It has been argued that by telegraphing the size and timing of every rate
hike for the past two years the FOMC has undermined its own effectiveness.
What Greenspan sees as the "conundrum" of yield-curve
perversions may be nothing more than the unintended consequence of a Fed
that has shifted from leading the financial markets to pandering to them.
Notwithstanding a conundrum or two, the financial markets are poised
for a graceful passing of the monetary baton to a new Fed chairman in a
few months. For much of the past decade, however, financial markets have
shown a dependence on Dr. Greenspan that is downright unhealthy. On
several occasions, rumors about his physical well-being that later turned
out to be wholly unfounded caused financial markets to swoon. Nonetheless,
a regime change at the Fed could well presage an overhaul in fixed-income
modeling at some point down the road.
Being such an important guy, you would think that Alan Greenspan (as
well as his eventual successor) would rate more than indirect
representation by a single variable that even when it is not assumed to be
constant tends to mosey along the real number line with stunning
stochastic simplicity. If financial engineering is to have a sound
scientific footing, one is almost forced to ignore the Fed regardless of
who is in charge and what he or she believes. Physical law, the ideal to
which most financial models aspire, remains unaltered even in the face of
such seemingly impossible occurrences as the Red Sox winning the World
Series. Why then should financial law, to the extent there is such a
thing, depend on who is running the Fed?
A close look at how the Fed has operated over the past few decades
shows the glimmer of a recognition that except during times of crises, the
less it enters the picture, the better it is for the economy. The best way
for the Fed to blend into the background is for it to behave as
mechanically as possible. To do that, it requires an unwavering goal—what
it refers to as a target.
For many years, the Fed targeted the money supply. Its efforts were
derailed, however, by the creation of new forms of money and faster ways
to move it. (These monetary inventions foreshadowed a stampede of
financial engineers to the U.S. Patent and Trademark Office that began
when Merrill Lynch received its. patent for a brokerage money market
account in 1982.) New varieties of money arose because banking regulations
collided head-on with market forces and the market ultimately won out.
Targeting the money supply, difficult as it may have been to put into
practice, at least had a body of monetary theory that supported it, and
Milton Friedman to champion it. The current policy of targeting the
federal fund rates, though a boon to parsimonious yield-curve models if
the Fed can be trusted to behave randomly, has less going for it. There is
little agreement as to whether a given fed funds rate is restrictive or
accommodating, much less when tightening or loosening is warranted.
Some Fed watchers believe that the new chairman may follow the lead of
most Europe central banks by adopting some version of inflation targeting,
though possibly without the charming inflation meter that graces the Swedish
central bank's home page. If this happens, it will likely turn into a
full employment act for fixed-income model builders.
Whoever the Fed's next chair is, he or she will likely preside over its
centennial in 2013. To say that the Fed was brought into being by Congress
in different times is a vast understatement—you
could get hard currency in 1913 that was backed with gold. Today's
currency, fancy colored paper with "Federal Reserve Note"
emblazoned on it seems quaint—of more use to drug
traffickers than it is to most bankers. Physical currency is destined to
fade away, replaced by charged particles. Monetary policy as we know it
could also disappear, with the financial markets taking the controls from
the Fed's still visible, though increasing transparent, hand.
Copyright 2005 by Miller Risk Advisors and Financial