One of my favourite topics – indeed, in a way, the basis of my current research – is looking at how we tend to accept the declarations of other people as true without bothering to think on the issue for ourselves. This is often a perfectly rational thing to do, as thinking carefully about things is both difficult and time consuming, often resulting in several possible answers that serve to increase our confusion, not lessen it. If we can find somebody we trust to do the thinking for us and then tell us their conclusions, that can leave us free to put our time to work in other areas.
The trick is in that “trust” component. To my mind, we not only tend to accept the views of people widely accepted to be experts, but also of anybody that we believe knows more than us on the topic. This is one of the key reasons why I am not convinced by the “wisdom of crowds” theory and it’s big brother in financial markets, the efficient market hypothesis. I’m happy to accept that they might work when individual opinions are independent of each other, but they rarely are.
Via Greg Mankiw, I’ve just discovered a fantastic example of a person who is not an expert on a topic, but definitely more knowledgeable than most people, who nevertheless got something entirely wrong. The person is Mark Hulbert, who is no slouch in the commentary department. Here is his article over at MarketWatch:
I had argued in previous columns that inflation might not be heating up, despite evidence to the contrary from lots of different sources …
I had based my argument on the narrowing yield spread between regular Treasury bonds and the special type of Treasuries known as TIPS. The only apparent difference between these two kinds of Treasury securities is that TIPS’ interest rates are protected against changes in the inflation rate. So I had assumed that we can deduce the bond market’s expectations of future inflation by comparing their yields.
… My argument appeared to make perfect sense, and I certainly was not the only one that was making it. But I now believe that I was wrong. Interpreted correctly, the message of the bond market actually is that inflation is indeed going up.
… My education came courtesy of Stephen Cecchetti, a former director of research at the New York Fed and currently professor of global finance at Brandeis University. In an interview, Cecchetti pointed out that other factors must be introduced into the equation when deducing the market’s inflationary expectations from the spread between the yields on TIPS and regular Treasuries.
The most important of these other factors right now is the relative size of the markets for TIPS and regular Treasury securities. Whereas the market for the latter is huge — larger, in fact, than the equity market — the TIPS market is several orders of magnitude smaller. This means that, relative to regular Treasuries, TIPS yields must be higher to compensate investors for this relative illiquidity.
And that, in turn, means that the spread between the yields on regular Treasuries and TIPS will understate the bond market’s expectations of future inflation.
Complicating factors even more is that this so-called illiquidity premium is not constant. So economists have had to devise elaborate econometric models to adjust for it and other factors. And those models are showing inflationary expectations to have dramatically worsened in recent months.
I have never met Mr. Hulbert, nor read any of his other articles. I cannot claim that I wouldn’t have made the same mistake and I have to tip my hat to him for being willing to face up to it. There are remarkably few people who would do that.