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The Authority Fallacy, Or The Quarles Quandary

By Jeffrey Snider

In early September 2007, just a month after the eurodollar system broke and still weeks before the FOMC would finally see the need to do something, anything, private equity firm Carlyle Group added six new “senior investment professionals” intending on making investments in global banking and insurance. The timing was, well, suspect.

Among those added to the firm was Randal Quarles, a former Treasury official in the Bush administration who had become Undersecretary for Domestic Finance. In that position, Quarles had delivered a speech in New York in May 2006 addressing the irregularities becoming undeniable throughout markets. It was, to say the least, an auspicious time to be talking his book.

It was, in reading it this much later, a far more realistic assessment than most that had been offered particularly by anyone in any official capacity. He addressed the potential issues with the GSE’s starting with their role in the then housing bubble mania, admitting quite frankly, “The concentration of risk inherent in these portfolios along with the GSEs’ thin capital structure are an important policy concern and a high priority for the Treasury.”  Priority in name only, apparently.

In addition, the Undersecretary identified low risk and volatility largely for what they could potentially represent underlying everything, meaning asset bubble conditions. Following on that, his speech referred directly to mortgage payments and again bubbles, before finally speaking about foreign holdings of UST securities.

Still, despite all that, Undersecretary Quarles remained quite optimistic. In conclusion, he said:

I would like to close by just noting that the potential tail risks I’ve talked about today are just that–possibilities but not likely outcomes. Fundamentally, the economy is strong, the financial sector is healthy, and our future looks bright. We will surely face challenges in the future, but we can take comfort in the knowledge that our economy and financial system have proven remarkably resilient to all manner of adverse shocks in the past. And I can assure you that my colleagues and I at the Treasury are doing everything in our power to make our financial system even more resilient in the future.

We might be tempted to dismiss the statement as bland boilerplate, the kind of upbeat assessment any political official is almost always obliged to give. But given that just a little over a year later he ended up at Carlyle focusing on investments in banks and insurance at the worst possible time, might we take his 2006 statement at face value?

Carlyle though perhaps not a household name should be one. It was direct in line between the serious funding and dollar issues that erupted in early 2008 ultimately ending in the failure of Bear Stearns. It was one of its larger “funds” which days before Bear failed was repossessed by creditors for liquidation, representing the kind of serious escalation no one believed possible (not with Bernanke’s constant assurances).

CCC had invested in “highly rated mortgage instruments”, a fact which scared the pants off everyone for good reason. If “highly rated” meant little against illiquidity and insolvency, then everything was fair game; or, the exact opposite of what Randal Quarles assured everyone was the case in 2006. The system wasn’t resilient at all but fraught with risks no one seemed to able or even interested enough to understand even from the inside, let alone officials who could offer no answers about anything.

In July last year, Quarles after moving on from Carlyle was nominated to be one of those officials again. Submitted by President Trump to a position at the FOMC, in October he was approved by the Senate to join that body as a voting policymaker. In that capacity, just two days ago, FOMC member Randal Quarles assured us:

I am fairly optimistic about the current state of the economy. Along many dimensions, it has been quite some time since the economic environment has looked as favorable as it does now.

Markets knee-jerked on his statement, though it’s not really clear why other than the analogy I used yesterday. Randal Quarles, like all the others at the FOMC, has exhausted his basis for authority especially on the topic of money and economy. If he had anything useful to say, it would have been said before Carlyle and Bear Stearns.

Perhaps he’s learned since then; after all, quite a bit of time has passed for all manner of useful reflection on the substantial mistakes. But the idea “the economic environment has looked as favorable as it does now” stands out for all the (obviously) wrong reasons. Where’s any reasonable context for his assertion?

Though GDP was revised for Q4 2017 today, and real GDP in that quarter still less than 3%, this holds no bearing on the assessment. As usual, the issue really isn’t the downside, it’s what really looks to be a clear ceiling on the upside as well as what that says about broken symmetry.

We can see it somewhat more clearly in terms of nominal growth, setting aside all the debate about inflation. In truth, the story isn’t any different for nominal GDP as real GDP, it just avoids the more controversial notions related to things like the PCE Deflator. In other words, even in nominal terms the economy today is substantially worse than compared to the last upturn in 2014 (which didn’t come out as acceleration, either), having already and for ten years dangerously underperformed all continuously optimistic official predictions.

Where’s this acceleration supposed to come from? Nominal GDP in Q4 rose at less than 5%, a level that in the middle 2000’s when Quarles was acknowledging risks via bubbles was a floor for economic growth. In 2014, nominal GDP was at least expanding by 6% and 7%; over the past almost four years since, it hasn’t registered better than 5% but the one time in Q3 2017, and even then just barely.

Of course, the two issues are entirely related. Broken symmetry and a lower ceiling for growth are products of the same (monetary) problem, the very one that put Carlyle briefly on the front pages before it was completely overshadowed by Bear Stearns.

These are the people who have been brought in to run the Federal Reserve ten years after the monetary system broke and the global economy with it. The sort of empty suits who knew little or nothing about what was going on when it was going on (which is astounding given his job at Treasury, Undersecretary for Domestic Finance, but explains a whole lot about what happened and continues to), and by all outward appearances have learned nothing from everything in between then and now. Is it really too much to ask that whomever takes one of these jobs is actually competent within the area they are assigned?

That’s not what happens, of course. You get a job as Undersecretary for Domestic Finance for other reasons and because of only the title you are forever treated as an expert on everything related to domestic finance. You can and do fail upward.

Randal Quarles is optimistic about things; again. Why would anyone care? The only reason is pedigree, and that’s nothing but a logical fallacy (appeal to authority, in this case where authority is conferred via title only).

Until he or someone like him acknowledges symmetry, and then realizes what that means, there’s nothing useful to be taken from his assessments. We are left to believe that an economic boom just shows up tomorrow out of nowhere. Shockingly, I remain unconvinced for a whole bunch of reasons.