Swap Spreads Refute Not Just Recovery, But Economics As A Science

Economics is a not a science. It tends to emulate the appearances by which outwardly hard sciences project in terms of rules and especially mathematical complications, but it does not conform. Karl Popper observed in 1972 that, “Whenever a theory appears to you as the only possible one, take this as a sign that you have neither understood the theory nor the problem which it was intended to solve.” Unfortunately, he also noted that, “no rational argument will have a rational effect on a man who does not want to adopt a rational attitude.” If you start from a preconceived notion and instead fit data to the theory, or attempt to do so, such is an action of bias; in economics that has taken religious proportions.

In this specific instance, I write not to refer to some relative triviality such as trend-cycle components within the BLS’ Job Openings data point, but rather the entire theory of monetarism itself. At the FOMC meeting in June 2003, a gathering that I have referred to time and again for good reason, Alan Greenspan specifically stated the orthodox understanding of monetary influence, all in the context of extenuating monetary circumstances (a threshold crossed only a few years after his unwavering declaration):

It’s really quite important to make a judgment as to whether, in fact, yield spreads off riskless instruments – which is what we have essentially been talking about – are independent of the level of the riskless rates themselves. The answer, I’m certain, is that they are not independent. But how their dependency functions and how those spreads behaved in earlier periods is something I think we’ll need to know more about.

The theory of QE is thus contained in this one paragraph; for if the central bank can influence the “riskless rate” they can influence everything thereafter. The reason for that theory of precision and control follows from the Fisherian inference of interest rates themselves as a basic, economic construct – that all investors behave as if there is a minimum interest rate and follow from that a positive spread for various attributes of risk. Because of this notion, central banks further believe preciseness because they think they can influence now both sides of that theoretical rate mechanism – the “riskless” portions, as QE buying of UST’s, and those spreads themselves (inflation expectations, for one).

However, economists take no note or gain no inquisitiveness on actually how that might work; it is taken as an article of faith that it just does. Even Greenspan above demonstrates that point, raising the question before dismissing as, “I’m certain” “that they are not independent.”