Risk Management

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Heisenberg’s Uncertainty Principle and Unintended Consequences in Finance How likely is it that the very scrutiny of current financial variables by banks influences future economic behavior and outcomes?

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Heisenberg’s Uncertainty Principle and Unintended Consequences in Finance

 

by Eben Maré, Associate Professor, University of Pretoria

Central banks have their jobs cut out for them! They measure a set of economic variables (such as inflation and employment), on a historical basis, and use those results combined with monetary policy to influence the future behaviour of the economy.

Without trying to complicate matters, we are reminded of the Heisenberg uncertainty principle in quantum mechanics which states, in layman’s terms, that we are unable to measure physical properties (for example, velocity and momentum) of a particle without affecting the particle.

In essence, our actions (today) will have an effect (potentially adverse) on our intended future outcomes. Targeting one specific economic variable will influence economic behaviour and outcomes.

Let’s discuss a highly relevant example – the US monetary policy. In response to the 2008 credit crunch, the US Federal Reserve embarked on its so-called quantitative easing programme in November 2008. As a consequence, Federal Reserve assets (a combination of mortgage backed securities, treasury notes and bank debt) peaked at USD4.5tr at the time the programme was halted in February 2014 (see Figure 1).

The combination of quantitative easing and low interest rates has had a clear benefit as shown in Figure 2. The unemployment rate has dropped and stock market volatility has realised approximately 10% annually, significantly lower than the long-term average of approximately 20%.

It stands to reason that the success of the US Federal Reserve’s quantitative easing programme has been the creation of confidence and stability.

In Heisenberg’s terms, the central bank’s policy actions (very low rates and quantitative easing) have created a stable economic environment but the financial market’s reaction (low asset volatility and extended asset valuations) could be seen as a side-reaction (leading to potential excess exuberance and risk taking).

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