The Human Variable

by

Ross M. Miller
Miller Risk Advisors
www.millerrisk.com
November 14, 2005

[This commentary  appears in the November/December 2005 issue of Financial Engineering News. This is the raw, unedited version of that commentary.]

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 serious consideration.

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 Economy.

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 Engineering News.