Error Correction in the Political Economy




                             In broad terms… (Fed) policy has been generally formulated in 

                             a forward looking manner with price stability and economic

                             stability serving as implicit or explicit guides.


                                                                       Athanasios Orphanides

                                                  Historical Monetary Policy Analysis and the Taylor Rule            




In the previous article, we suggested that the U.S. stock market error corrects rather than mean reverts. The main cointegrating regression is almost entirely descriptive over the long-run. Why is this so?


Granger (1981) mentions three possible short-term error correcting processes:


1)      Arbitrage, that is the buy and selling of an identical asset in separate markets. This concept is appropriate for short-term trading rather than investing; it is unlikely to be a factor over the long-term.


2)      The input and output of a process with memory, such as the cars entering and leaving the Lincoln Tunnel.


3)      Optimal forecasts when the differenced variables are Gaussian.


The long-term error correction that we have measured in the U.S. stock market over a period of years is not likely to originate from any of these three sources. Where does the cointegration between the willingness of investors to buy stocks and future industrial capacity utilization come from? This article discusses the responses of the wider society to a changing world.


The political system of the United States is not often thought of as error correcting. Yet the world’s first large-scale democracy has survived and prospered, not only because of the values upon which the nation was founded, but also because of the practical institutional arrangements that enable the nation to respond appropriately to environmental challenges. The U.S. political system works by balancing interest against interest or, in the case of the markets, opinion against opinion.


The Declaration of Independence of 1776 states according to Enlightenment values that the government was founded to secure “Life, Liberty, and the pursuit of Happiness.” To secure these values, the Declaration and the Constitution of 1787 incorporated three basic principles:


1)      The Rule of Law


The Rule of Law is the major source of a durable community consensus. The legal system is an arrangement of shared power between referee judges, who administer the rules of contest, and juries of citizens, who assess the objective facts from the arguments of the interested litigants and apply these facts to relevant law. The Rule of Law enables the settlement of differences under a regime of ordered liberty.     


2)      The Balance of Powers


The founders of the Republic sought to preserve the freedoms of the citizenry. A principal means was the Balance of Powers, the division of government into three co-equal branches, with the legislature itself further divided. However, the founders of the government also recognized the need for effective action. In the Federalist Papers, Madison (1788) wrote that the reason of the public emerges from the checks and balances provided by the constitutional process.


To illustrate the rationality of this process: You are deciding whether or not to buy a stock. List on a T account all the pros and then all the cons and make your decision on the balance.


A further balance of power between the government and society results from a pluralist society comprised of many different groups that can form a majority in the political system described above. The error correcting argument for pluralism is that it allows within society a wide range of reforming responses that are useful as the external environment changes.


3)      Popular Sovereignty


The people are the ultimate source of authority, which they exercise at election time.



How is this relevant to the market system? Yearly error correction in the U.S. stock market accomplishes this task only somewhat. Why does market error correction occur in the long-term? We have described a set of interlocking societal checks and balances. A major regulator of the U.S. stock market is the countercyclical policy of the Federal Reserve. The Fed’s monetary policy modulates the economy, thus increasing economic predictability.


Major events, however, will vary with each economic cycle. The regression therefore calculates an equilibrium level that the market will eventually cross as the result of error correction, rather than a more placid Gaussian mean that the market will quickly revert to, absent events. The stock market is neither chaotic, nor is it precisely Gaussian. The long-term willingness of investors to buy stocks is cointegrated with a Fed modulated industrial capacity utilization.


The Federal Reserve system was founded in 1913 to, among other things, conduct the nation’s monetary policy. The resulting management process is definitely not Gaussian, also requiring good judgment.* Consider Alan Greenspan’s July 20, 2004 semiannual “Monetary Policy Report to the Congress.”


     “Economic developments in the United States have generally been quite

       favorable in 2004, lending increasing support to the view that the

       expansion is self-sustaining…What does seem clear is that the concerns

       about the remote possibility of deflation that had been critical in the

       deliberations of the Federal Open Market Committee (FOMC) last year

       can now be safely set aside…As we attempt to assess and manage these

       risks, we need, as always, to be prepared for the unexpected and to

       respond promptly and flexibly as situations warrant. But although our   

       actions need to be flexible, our objectives are not. For twenty-five

       years, the Federal Reserve has worked to reestablish price stability

       on a sustained basis.” 


             Error correction requires both the Balance of Powers, providing advice

             and consent, and the prescience to chart the course.








 *  Can monetary policy be conducted according to the Taylor rule, which assumes that

       the relevant economic parameters are perfectly known at the time?


       The Taylor rule states:


                                   i = 2 +  p + ½ (p- 2) + ½ (q-q*)


                        where: i is the nominal fed funds rate

                                   p is the rate of inflation

                                   (p-2) is the difference between actual and targeted inflation of 2%

                                   (q-q*) is the present output gap of the economy, stated in percents.

                                   If the equilibrium real interest rate is 2% and inflation is 2%,

                                   and there are no errors to correct, the nominal fed funds rate

                                   should be 4%.


      Since the Fed considers important both economic growth and the control of inflation, 

      deviations from economic output and the targeted inflation rate have equal weights.

      Orphanides (2003) writes that the Taylor rule, and its variants, are useful organizing 

      devices to describe Fed policy, after the fact. However, the model tracked actual

       Fed policy most accurately during the late 1970s, encompassing the Great Inflation,

       but would not have prevented it. The largest deviations from this model appeared

       during the more favorable 1960s and during the Volker years.