The practical man must follow the branch approach – the science of muddling through.

TO BE NOTED: From the FT:

"History vindicates the science of muddling through

Published: April 14 2009 21:07 | Last updated: April 14 2009 21:07

When I was a student, Penguin published several collections of classic articles on economics and business. They were an indispensable resource. The first book on business strategy I ever read was the title in that series edited by Dr H. Igor Ansoff. Recently I re-opened it and understood how much changes in the way we think about business strategy – and how much remains the same.

Only one article found there is still widely cited. It was written by the American political scientist Charles Lindblom and published in 1959 under the title The Science of Muddling Through. Prof Lindblom contrasted what he called the “root” method of decision-making with the “branch” approach. The root method required comprehensive evaluation of options in the light of defined objectives. The branch method involved building out, step-by-step and by small degrees, from the current situation. Prof Lindblom claimed “the root method is in fact not usable for complex policy questions”. The practical man must follow the branch approach – the science of muddling through.

Ansoff included Prof Lindblom’s article mainly to poke fun at those who acted on this advice. He told students the article was instructive, since “it describes a widely prevalent state of practice in business and government organisations”. We can imagine sniggering MBA students.

They would be chortling when Ansoff turned his attention to France’s Saint-Gobain, the glass and materials group. “Saint-Gobain, for all the modernity of its headquarters building, will remain something of an old lady, likely to move only with the slow deliberate steps of great age.”

America, and Ansoff, were pointing to the road ahead. Prof Lindblom, he explained, “is wrong when he claims the ‘root’ method to be impossible”. Ansoff’s analysis of TRW, the US conglomerate, “shows how one of the world’s most dynamic corporations goes about a methodical exploration of wide vistas of opportunities in the process of formulating its corporate strategy”. The future held no bounds. Senior management “feels that the corporation hasn’t begun to exploit the opportunities they believe that TRW is equipped, for example, to play a three-sided role in technological programmes for the solution to such pressing problems as urban renewal, mass transportation, and pollution”.

But Ansoff’s highest praise was reserved for Litton Industries, another US conglomerate. Litton – “a proverbial success story by any conceivable yardstick” – was the creation of Tex Thornton, the leader of the “whiz kids”. This group of brilliant young men had made an important contribution to US military organisation in the second world war. A letter from Thornton to Henry Ford II led Ford to hire the entire group to help the Ford Motor Company recover from the chaos left by war and its irascible founder. Robert McNamara, the most famous whiz kid, was the company’s president before being recruited by John Kennedy as US defence secretary.

Ansoff died in 2002. History has not been kind to him, or to the whiz kids. Even as Ansoff was putting together his collection in 1968, the future of Litton Industries was being questioned. Like many acquisitive conglomerates, it experienced a rapid ascent and sharp fall. Its reputation and share price rose steadily before a setback to earnings made its stock less attractive. Acquisitions became impossible. The business gradually unwound. Tex Thornton is today forgotten, McNamara was driven from the defence department by public hostility and his private doubts. He went on to preside over a substantial expansion of lending – much of it never repaid – at the World Bank. Today, he reminisces on his experiences – and the virtues of muddling through.

TRW, like Litton, would be forced to slim operations and ambition and return to its modest roots in automobile parts supply. Saint-Gobain, by contrast, is a successful multinational, with 200,000 employees worldwide. Prof Lindblom, still muddling through at 92, celebrates the 50th anniversary of his article. We should celebrate too – and applaud the relevance of his insight.

Post and read comments at www.ft.com/kay

johnkay@johnkay.com"

"Sadly, that's about as scientific as we've been able to get."

From Tyler Cowen:

"The best argument I've read *for* the stimulus

It comes not from a professional economist but from Warren Buffet, here goes:

SG: But there is debate about whether there should be fiscal stimulus, whether tax cuts work or not. There is all of this academic debate among economists. What do you think? Is that the right way to go with stimulus and tax cuts?

WB: The answer is nobody knows( TRUE ). The economists don’t know( TRUE ). All you know is you throw everything at it( TRUE ) and whether it’s more effective if you’re fighting a fire to be concentrating the water flow on this part or that part. You’re going to use every weapon you have in fighting it. And people, they do not know exactly what the effects are( TRUE ). Economists like to talk about it, but in the end they’ve been very, very wrong and most of them in recent years on this. We don’t know the perfect answers on it. What we do know is to stand by and do nothing is a terrible mistake( I AGREE ) or to follow Hoover-like policies would be a mistake and we don’t know how effective in the short run we don’t know how effective this will be and how quickly things will right themselves. We do know over time the American machine works wonderfully and it will work wonderfully again.

Sadly, that's about as scientific as we've been able to get."

I agree. I simply see this as being human. I wish people would remember that.

"If those models worked, we wouldn't be where we are now. "

Arnold Kling with a good post:

"James Hamilton writes,

Will [purchases of mortgage securities and other assets by the Fed] succeed if we just do it on a sufficiently large scale? I'm not at all convinced that it would. Our standard finance models treat interest rate spreads as governed primarily by fundamentals such as default risk and only secondarily by the volume of buyers or sellers.

Oh, please. "Our standard finance models" have absolutely nothing to say about crazy de-leveraging. If those models worked, we wouldn't be where we are now.( HOW TRUE )

If the Fed brings the parrot back to life, and mark-to-market accounting of mortgage-backed securities and other non-Treasury bonds starts making bank balance sheets look stronger rather than weaker, the de-leveraging process could be interrupted or even reversed.

There are worrisome excesses in the real economy--too many houses, too many shopping malls. But if the Fed has managed to pull the financial sector out of its de-leveraging death spiral, we can look forward to a finite recession, which would be a lot better than Great Depression II."

That's about it. We're doing the best we can, but nothing is certain, or written. We could call this "Trial And Error", "The Kitchen Sink", or "Pragmatism". I like the last one because it sounds philosophic and has associations with an American Philosophical Movement.

"The Fed will continue to make it up as it goes"

I read the FOMC Statement and was going to scan what there was to scan, but this redaction by David Merkel on the Aleph Blog is fun, and, he disagrees with me:

"Redacted FOMC Statement

The Federal Open Market Committee decided today to lower its establish a target range for the federal funds rate 50 basis pointsof 0 to 1/4 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

Since the Committee’s last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters to levels consistent with price stability.

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee Federal Reserve will monitor economic and financial developments carefully and will act as needed to promoteemploy all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice ChairmanChristine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 5075-basis-point decrease in the discount rate to 1-1/4/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.

The Upshot

• We’re done with Fed Funds in entire. ( GOOD. IT WAS WORTH A SHOT )
  
• On to quantitative easing. (Japan had the advantage of running a current account surplus… how will it work for us with a deficit?) ( PICK UP THE PACE )
  
• The princely rate of 1/4% gets paid on all reserve balances at the Fed, both required and excess. ( HIGHLY COMICAL )
  
• The Fed is looking at deflation, not price stability. ( AS IT SHOULD )
  
• The Fed will possibly invest more into long Treasuries, with uncertain prospects. ( LIFE IS UNCERTAIN )
  
• The Fed will continue to make it up as it goes, and keep expanding its balance sheet, adding liquidity where it wills, and replace functions of the private lending markets in the name of fixing the lending markets. ( THAT'S ABOUT IT. ONLY, THE PRIVATE LENDING MARKETS WANT HELP. THEY PAID FOR IT, AND THEY'RE GETTING IT. WHAT WORRIES THEM IS BEING LEFT ON THEIR OWN )

Oddly, I believe that my plan is more likely to get us to where he and I both want to go.

"Walter Bagehot. “The business of banking,” he wrote, “ought to be simple: if is hard, it is wrong”.

Yesterday, I disputed the notion that Low-Information Assets allow more Trust than High-Information Assets. I said that Trust, which Banks need to survive, is never to be taken for granted, and that investors always need to be aware of a Bank' s financial status. Here's Tony Jackson in the FT:

"What are banks for? In normal times, the question would seem redundant. But, with the banks now drifting rudderless in a sea of popular resentment, the answers are alarmingly vague.

Precisely to whom do banks owe their first duty of care? Is it to their shareholders, their depositors or their borrowers? Or all of those?

The thought was partly prompted by a recent letter to this paper from a retired British banking grandee, Sir Ronald Grierson. “A bank is a bank,” he wrote, “and, if the security of its depositors is not its main concern, it should be required to adopt another name. Members of the public are entitled to take this for granted.”

I do not agree with this. We have just learned that such an attitude is not wise. But, together with this notion of Low-Information assets engendering more Trust, I can already see where many of us went wrong.

"Under UK law as it presently stands, Sir Ronald is, strictly speaking, wrong about that. At present – though this is to change – a UK bank is just another company. As such, its primary duty is to its owners."

Is this a surprise?

"More of that in a moment. First, how has the banks’ duty to shareholders been discharged in practice?

In two words, stunningly badly. UK bank shares are almost all below their level of five years ago, in most cases disastrously so. Many may never recover previous peaks."

Job well done.

"To be fair, shareholders sometimes tried to exercise their own duty of control, if ineffectually. For years, they resisted the acquisitive ambitions of Royal Bank of Scotland, only to lose their resolve at the top of the cycle. RBS’s resulting ABN Amro purchase is one main reason for its subsequent collapse into state ownership."

Job well done.

"The same recklessness characterised many borrowers. A depressing number of now-bankrupt companies made big debt-financed acquisitions at the peak of the boom. Others, such as Chrysler and EMI, are in crisis because the banks lent vast sums at the last minute to an equally reckless private equity industry."

Job well done.

"So, in general, you might think, let the borrower beware. The snag is, of course, that too much lending leads inevitably to too little, thus posing systemic threats to the economy – a problem now being urgently addressed by various governments."

If it's inevitable, how come people seemed unprepared? Of course, I don't believe that many were that surprised.

"Nor are all borrowers in the same category. I recently found myself perusing the personal ads on a supermarket notice board in the English Midlands. A striking number were for “house sharing” – seeking other families to move in and share the financial burden.

There is the plain sense here of a duty foregone. Most people know little or nothing of finance. But banks are accredited experts. If a bank says you are good for a loan, it is putting that expertise into practice.

To borrow Sir Ronald’s phrase, you are entitled to take that for granted. And, if the result is a choice between sharing your home with strangers or losing it, you are entitled to feel aggrieved."

You cannot take anything for granted. You should assess the competence of the bank that you put money in, or borrow money from. You are legally and morally entitled to your business with the bank being on the up and up.

"Let us now revert to the depositors. It might seem extraordinary that the UK has no special provisions to protect them from collapse, as opposed to insuring them after it. Most other countries, from the US and Japan to Mexico and South Korea, have had such provisions for many years."

I'm assuming he means the FDIC. Can we imagine how much worse this crisis would be without it? I assume that many free market followers would end it, although I don't hear many calling for it in this crisis.

"The usual method is a so-called “resolution regime”, whereby, if a bank seems in danger, the state intervenes and takes it into protection. It is then sold on, usually to a healthier bank. The implicit assumption is that the interests of depositors trump those of shareholders or creditors."

I believe that this is true.

"In the UK, as Sir Ronald also observed, that task was performed by the Bank of England until its independence in 1997. In the ensuing reshuffle of responsibilities, that part got left out. It is now being reinstated under legislation due for completion in February. But it took the collapse of Northern Rock to bring it about."

I believe that we have that here.

"This is the more extraordinary because, as Professor Julian Franks of the London Business School observes, the UK has had just such a regime for its utilities ever since they were privatised in the 1980s. And a bank is nothing if it is not a utility.

Both the electricity and water regulators, for instance, have powers of last resort to protect customers. If an electricity supplier goes bust, the regulator takes it over and sells it on. This happened in October to a small supplier with some 40,000 customers, Energy4Business. There was no fuss, no publicity. It was routine."

Are Banks like a Utility?

"This all leaves a worrying sense of muddle. In both the UK and US, the response of the authorities to the banking crisis has been piecemeal and uncertain, at least partly because there is no clear sense of priorities. It all badly needs sorting out."

This is true. There is a difference between Pragmatism and Trial and Error, and lurching backwards and forwards in a manner that signals unpreparedness and incompetence.

"Let the last word on this go to the Victorian banker and commentator Walter Bagehot. “The business of banking,” he wrote, “ought to be simple: if is hard, it is wrong”.

Ditto for the legal framework. Lawmakers take note."

As per usual, Bagehot is correct, and his statement is simply a version of Searle's Sagacity.

"The Federal Reserve took two new steps to unfreeze credit for homebuyers, consumers and small businesses"

I was going to talk about a portrait of Bernanke I just read, but I can't get past Bloomberg, the FT, and the NY Times much these days. Too much good stuff. From Bloomberg ( Who owns this site? It's excellent.):

"The Federal Reserve took two new steps to unfreeze credit for homebuyers, consumers and small businesses, committing up to $800 billion. "

That's one small step for homebuyers, two...

"The central bank will purchase as much as $600 billion in debt issued or backed by government-chartered housing-finance companies. It will also set up a program of $200 billion to support consumer and small-business loans, the Fed said in statements today in Washington. "

I hate to harp on this, but this sounds like a credit stimulus plan, which I was arguing TARP should be, and Paulson just said "no" to. So, the Fed will:
1) Buy up to, it doesn't say it will, $600 billion in debt to help housing
2) Start a new program, which will outlive all of us, with $200 billion for average people and small businesses.

How about:
3) Give $100 billion to Don the libertarian Democrat to fund his blog and publish his novels, thereby rendering humanity giddy with joy.

"With today’s announcement, the central bank is starting to use some of the unorthodox policy tools that Chairman Ben S. Bernanke outlined as a Fed governor six years ago. Policy makers are aiming to prevent a financial collapse and stamp out the threat of deflation. "

Unorthodox Policy Tools. That has comic potential. That must mean that they've never done this before, and perhaps had denied in the strongest terms that they ever would do it.

“They’re trying to put funds into the system, trying to unfreeze these markets,” said William Poole, the former St. Louis Fed president, in an interview with Bloomberg Television. “Clearly, the Fed and the Treasury are beginning to take a large amount of credit risk.”

Poole again! What the hell. Does he comment for a living? Or is he just a useful fiction, like "The man in the street"? At least he's not qualifying every sentence, although, by saying "trying", he's making damned sure nobody holds him to account as predicting that these moves will work.

"The Fed will purchase up to $100 billion in direct debt of Fannie Mae, Freddie Mac and the Federal Home Loan Banks and up to $500 billion of mortgage-backed securities backed by Fannie, Freddie and Ginnie Mae, the statement said. Treasury Secretary Henry Paulson said at a press conference that $200 billion is just the “starting point” for the asset-backed securities program.

“The economy is turning down pretty dramatically,” he said. “It’s very important that lending continue to be available.”

Too bad the banks can't do any lending, Hank. Didn't Dana Perino claim that's what banks are for? And we all know that she's a walking dictionary. I need to cut Dana some slack.

Anyway, it looks like that $600 billion is going to Fannie/Freddie, that lucky couple.

“This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally,” the Fed said. "

So:
1) We give $600 billion to Fannie/Freddie, then:
2) The cost of buying a house will go down and
3) There will be more mortgages,then:
4) The housing market should stabilize ( I just had to look up the spelling of "stabilize" ), then:
5) The economy will get better

I hope so as well.

"Fannie and Freddie bonds rallied. The yield premium on Fannie Mae’s five-year debt over similar-maturity Treasuries tumbled 21.5 basis points to 114.7 basis points as of 8:35 a.m. in New York, according to data compiled by Bloomberg. A basis point is 0.01 percentage point. "

"Hear Hear!", they cried, on the steps of Federal Reserve building ( I actually looked it up to verify that it had steps. I never do that in my novels. In writing my novels, I just say to myself, "Well, if it doesn't, it should". )

“The cheaper that they could issue their debt, the more aggressively they should be able to buy mortgages in the secondary market,” said Alan Bosworth, director of agency trading at Vining Sparks in Memphis, Tennessee. "

I suppose that they could also afford to buy more.

"The Fed may hold the Fannie and Freddie debt and securities until they mature or sell them, with plans to be determined, government officials said on a conference call with reporters. "

Just get the money back.

"The U.S. officials, speaking on condition of anonymity, said they don’t see the Fed purchases of mortgage bonds as a way of “quantitative easing,” or using central bank policy to add reserves to the banking system when interest rates are very low, even though the purchases will have that effect. "

Why didn't they just ask Poole? He's not shy.

"Quantitative easing was a tool of monetary policy that the Bank of Japan used to fight deflation in the early 2000s.

The BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. More recently, the BOJ has also been flooding commercial banks with excess liquidity to promote private lending, leaving commercial banks with large stocks of excess reserves, and therefore little risk of a liquidity shortage.^[1]

The BOJ accomplished this by buying much more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities, equities and extended the terms of its commercial paper purchasing operation."

I'm not sure why, if it's going to have that effect, it wouldn't be considered a positive side effect.

"Separately, under the new Term Asset-Backed Securities Loan Facility, the Fed will lend up to $200 billion on a non-recourse basis to holders of AAA rated asset-backed securities backed by “newly and recently originated” loans, such as for education, automobiles, credit cards and loans guaranteed by the Small Business Administration, the Fed said.

The Fed hopes to have the TALF running by February. Traditional investors in the asset-backed securities include securities lenders and bank-affiliated conduits, the government officials said.

The asset-backed securities program is similar to the Fed’s effort to bring down the cost of financing for commercial paper, the short-term debt companies issue to finance payrolls and other expenses, because it goes beyond banks."

The TALF is just Program 2 above.

“What the Fed has been trying to do is get a sense of what works and what doesn’t work,” said Derrick Wulf, who helps manage $70 billion in mostly fixed-income assets at Dwight Asset Management Co. in Burlington, Vermont. “One of the things that has worked is the commercial paper facility.”

Trial and error. That's the modus.

"Under the new lending program, known as the TALF, the New York Fed will auction a fixed amount of loans each month for a one-year term. Assets will be held in a special-purpose vehicle to be created by the Fed. The program will stop making new loans on Dec. 31, 2009, unless the Fed Board of Governors extends it.

Lenders providing credit under the TALF “must have agreed to comply with, or already be subject to,” executive- compensation restrictions in the October bailout law, the statement said."

More on TALF. I'm just keeping it for reference.

"The Fed will start buying the direct debt of government- sponsored enterprises -- Fannie, Freddie and a dozen federal home loan banks -- through primary dealers in government debt from next week. The purchases of mortgage-backed securities will be done through asset managers, and officials aim to begin the effort by year-end.

Purchases of both types of debt “are expected to take place over several quarters,” the Fed said."

That's the time frame.

Since it's trial and error, could someone please a tab on the results?