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Is The Fed In Love With Their Sunk Costs?

It sure seems that the old “sunk costs” theory explains some of the Fed’s continuing fascination with the endless quantitative easing (QE) programs. After all, it’s just human nature and so it would be difficult to dismiss the idea out of hand. “Sunk costs” is, of course a fairly old and generally accepted form of analysis. It essentially states that once an item is purchased, the faith and confidence in that item increases:

The most widely cited study on the topic is titled The Psychology of Sunk Costs“ by Arkes and Blumer (1985), and it summarizes the difficulty we all have on this issue with the following explanation:

“One reason why people may wish to throw good money after bad is that to stop investing would constitute an admission that the prior money was wasted.”

Isn’t that the truth!

Zero Hedge has a great article on this topic positing that this may be effecting Fed behavior. And as I have always thought that the Fed has been using a circular logic calculation in their policies these past 4 years, this naturally makes perfect sense to me. Now as many of you know, the “sunk costs” idea applies to everything one purchases. But it is always the most expensive decisions that get the most attention and are also the most interesting. We have all walked out of a movie theatre and wondered what the studio could possibly have been thinking with that awful movie. I mean they have seen the script, they have seen the early footage, the directing, acting and so on. They just had to know that the movie they were making was a certifiable stinker right? Why not just cut their losses while there is still time and move on?

At the same time, can any organization really back away from such an important “Investment” and consider it “Sunk money”? The beginning of the Arkes & Blumer paper actually highlights the one arena where one can use the psychological errors of “Sunk cost” accounting to some benefit: politics. As it turns out, politicians will often make the argument that a given project needs further investment because so much has already gone into it.

And that is it in a nutshell. Just like the politician in the above example, the “purchase” itself bolsters belief  in the project. Because of the costs already sunk into the film, the movie executive is prone to believe in the project no matter what dreck he is reviewing on a daily basis. That same basic psychology is, of course very apt in the investment world. We have all heard the warning about not “falling in love” with a stock. The reason this advice is constantly being preached is that almost everyone does, in fact, fall in love (or at least a lot of like) with their stock purchase. It’s just human nature. Which brings us to the Fed. Are they just being stubborn at this point? I mean they can’t possibly believe that QE is still a wonderful idea, can they? Now, to be fair, the analogy isn’t perfect in the Fed’s case in that they have painted themselves into a bit of a corner. Ending QE, or even “tapering” some of their activity could send the markets into near panic, as was seen recently when the concept was not much more than a rumor. Still, it is reasonable to think that “sunk costs” may play a role in their thinking:

…It knows that even as the Fed “Tapers” the size of its monthly bond purchases, it probably will keep the program in place longer than most investors expect. After all, if it cuts back too much or too fast, all that prior “Sunk” investment will be wasted, right? And even if they claim to be able to fine-tune the amounts purchased, wouldn’t they lose some of their credibility if they zigged when the economy zagged? It is almost enough to make you feel a little sorry for the Fed.

Ok, well you are going to have to speak for yourself there bub–I’m having trouble feeling sorry for the Fed.

But the point is a good one. The markets are well aware the jam the Fed has put themselves into and will react with ferocity to nearly any attempt to change its policies. So, unlike that hapless movie mogul, the Fed might lose even more money if it tries to cut its losses now. Ok, maybe I do feel a little sorry for the Fed. –Nah.