Deus Ex Macchiato

It struck me over the weekend that there is a spectrum of views on the responsibilities of economists. At one end, you could claim that it is like mathematics: the economist announces the rules at the start of their work, and derives some results from those rules. As long as the results mathematically follow from the rules, all is well. The work may be boring or irrelevant, but as long as it is technically correct, then all is well.

At the other end, you could claim that economics is about the economy as it is, or plausibly could be. Simplified economic models are only of interest in so far as they give meaningful insight into real world problems. In this view, the economist’s primary duty is to inform policy, and their work is only useful insofar as it gives good advice about that.

The reader may have guessed that I am of the latter school of thought. I suspect however that many economists aren’t. What really bugs me though – more than that, what I think is irresponsible – is when mini-models which bear little relationship to reality are claimed as giving some insight into policy. That’s like advising on the war on Afghanistan based on having finished a shoot ‘em up like Call of Duty. Forget about an ethics pledge for MBAs, we need one for professional economists.

Posted in: Economic Theory by David /
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Naked Capitalism quote an article by Pimco’s global strategic adviser Richard Clarida and CEO Mohamed El-Erian in the FT. They point out that the expectations of future economic conditions are much wider than normal. From here they make two leaps, neither foolish but leaps nevertheless.

• They assume that not only are expectations more volatile, but they are fatter tailed. In other words, a normal distribution is a less good model. This may well be true, but Clarida and El-Erian don’t present any evidence for it.

• They also assume – and this is a bigger leap – that this means that actual returns will be fatter tailed. Now this seems intuitively plausible, given the degree of economic uncertainty at the moment, but it is an assumption. We could be on the edge of a low-volatility high-growth phase: this is unlikely, perhaps, but it is possible.

Let’s run with it, though, and assume the Pimco guys are right. They suggest five implications:

First, investing based on “mean reversion” will be less compelling. Even though flatter distributions with fatter tails have means, the constituency for mean reversion investing will shrink as those means will be much less often realised in practice. A world where the realised return rarely equals the expected valuation creates a bigger demand for liquid, default-free assets; it also lowers the demand for more volatile asset classes such as equities. These shifts are already taking place.

This makes sense. The problem is there just aren’t enough safe assets, and attempts to manufacture them by the private sector have proved catastrophic. One very useful thing that governments could do is to increase the supply of very low risk bonds. World Bank issued twenty and thirty year linkers in GBP, EUR, USD, CHF and JPY anyone?

Second, frequent “risk on/risk off” fluctuations in investors’ sentiment are here to stay. Investors, based on 25 years of rules of thumb that “worked” during the great moderation, thought they knew more about the distribution of risk than they in fact did.

Again, I think that this is right, but I don’t know. Andrew Haldane has produced some useful pictures of the actual return distributions during various periods before: I would love to see what distributions look like for the last year or so.

Third, tail hedging will become more important. An understandable consequence of the crisis is less trust in diversification as the sole mitigator for portfolio risk. We are already seeing increased investor interest in tail hedging, though the phenomenon is still limited to a small set of investors.

The problem is tail hedging is really difficult, as counterparty risk is a big issue in the tail. Finding the right hedge is hard enough: finding a counterparty willing to sell it to you who is sure to be around in a tail event is even more difficult.

Fourth, historical benchmarks and correlations will be challenged. In this new “unusually uncertain” world, many investors will need to fundamentally rethink the design of benchmarks and the role of asset class correlations in implementing their investment strategies. The investment industry is yet to give sufficient attention to this.

That is very true: many investors are still comfortable with correlation-based models that simply don’t work very well. Diversification is getting harder to get, and conventional wisdom about balanced portfolios is increasingly out of date.

Finally, less credit will be available to sustain leverage and high valuations. Even apart from the inevitable response to regulatory actions aimed at derisking banks, a world of flatter and fatter distributions will reduce available supply of leverage to finance trades and balance sheet expansion.

I was chatting to someone from a major investment bank yesterday about prime brokerage. Our conclusion was that it is not clear that this business makes sense at the moment, because the returns from providing leverage are simply not high enough. If we are right, then leverage costs are going to rise for hedge funds. This is certainly part of the trend Clarida and El-Erian identify. Low leverage, long tail protection, and skeptical about diversification: this is the new normal in investment management.

Update. Matthew Lynn has a related (if whimsical) take here.

Corporate bonds are a better bet than most government bonds. Would you rather have your money in Vodafone Group Plc, with millions of customers paying their mobile-phone bills every month? Or in U.K. government bonds, with a weak economy, a massive welfare bill and a budget deficit equal to more than 10 percent of gross domestic product?

Small companies are safer than blue chips. Just think of the problems that BP Plc has run into in the past few months. Giant enterprises can run into giant trouble. The smaller businesses can flourish under the radar.

Private-equity and hedge funds beat bank deposits. It was the banks that ran into trouble in the credit crunch, not the alternative-investment industry.

We don’t know precisely what will emerge as “safe” once the dust has settled on both the credit crunch and the sovereign-debt crisis. But emerging markets are safer than developed ones, equities beat property, and corporate bonds are preferable to government notes.

Now, some of those examples are foolish. But the broader idea that what is safe is changing is reasonable. The conventional wisdom will have to be updated.

Posted in: Economic Theory, Hedge Funds, Risk Management by David /
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DeLisle Worrell, Governor of the Central Bank of Barbados, had these sensible words to say in a speech recently:

Traditional Economics remains trapped in a time warp defined by the concepts that Leon Walras borrowed from the physics he knew at the time of the development of the marginalist theory of market economics which underpins the classical, keynesian, neoclassical and new keynesian views of the world. At that time only the first law of thermodynamics – the conservation of energy – was known. The notion of equilibrium is a form of expression of the first law. Physics subsequently discovered the second law – that entropy (disorder or randomness) is always increasing. The implication of the second law is that if the system were ever to reach equilibrium it would be dead.

In other words, equilibrium models of social systems are models of dead systems. No real economy is anywhere close to equilibrium in the physical sense. (This is a point that we have made before: see for instance here or here.) Mr. Worrell then suggests that ‘viewing the economy as a complex adaptive system provides us with a new set of tools, techniques and theories for explaining economic phenomena.’ Now if the governor of the Central Bank of Barbados can talk sense like that, why can’t we have it from the central bankers of larger countries?

Posted in: Economic Theory by David /
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Here’s an interesting conjecture from the Futurist. First he points out that we have had a massive stimulus, yet this has not lead to inflation. Remember, $1T of liquidity and an essentially zero FED funds rate have not lead to any prospect of inflation. Now you all I am sure know the conventional explanations of this, but bear with the Futurist while he gives you a novel one.

A technology company exists under the reality that all inventory depreciates very quickly (at over 10% per quarter in many cases), and that price drops will shrink revenues unless unit sales rise enough to offset it (and assuming that enough unit inventory was even produced). This results in the constant pressure to create new and improved products every few months just to occupy prime price points, without which revenues would plunge within just a year. Yet, high-tech companies have built hugely profitable businesses around these peculiar challenges, and at least 8 such US companies have market capitalizations over $100 Billion. 6 of those 8 are headquartered in Silicon Valley.

Now, here is the point to ponder : We have never had a significant technology sector while also facing the fears (warranted or otherwise) of high inflation. When high inflation vanished in 1982, the technology sector was too tiny to be considered a significant contributor to macroeconomic statistics. In an environment of high inflation combined with a large technology industry, however, major consumer retail pricepoints, such as $99.99 or $199.99, become more affordable. The same also applies to enterprise-class customers. Thus, demand creeps upwards even as cost to produce the products goes down on the same Impact of Computing curve. This allows a technology company the ability to postpone price drops and expand margins, or to sell more volume at the same nominal dollar price. Hence, higher inflation causes the revenues and/or margins of technology companies to rise, which means their earnings-per-share certainly surges.

So what we are seeing is the gigantic amount of liquidity created by the Federal Reserve is instead cycling through technology companies and increasing their earnings. The products they sell, in turn, increase productivity and promptly push inflation back down. Every uptick in inflation merely guarantees its own pushback, and the 1.5% of GDP that mops up all the liquidity and creates this form of ‘good’ deflation can be termed as the ‘Techno-Sponge’. So how much liquidity can the Techno-Sponge absorb before saturation?

Now I have no idea whether this is even half way to true. But it is an interesting idea. Certainly tech spending, unlike magnums of Krug (so déclassé – I prefer Salon), can increase productivity. If that creates more wealth, then you can have growth without inflation, especially if the basket that defines inflation is tech heavy.

Posted in: Economic Theory, Inflation by David /
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From Steve Randy Waldman at Interfluidity:

I feel about the financial sector the same way I would feel about my morphine dealer after looking down to find piranha feeding between my ribs.

That’s a little unfair, but you take his point. However much you might despise bankers (and I like a good few of them) you cannot but admit that right now, we need banks. More specifically, we need banks to provide credit or we are all what a professional economist would call ’screwed’.

Posted in: Economic Theory, Fun by David /
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Just to remind ourselves how unnecessary the Osborne deficit fetishism is, here’s the long view of UK net public debt

Posted in: Economic Theory, Politics by David /
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Andrew Lo and Mark Mueller have a new paper which has a very nice explanation of an idea that I have long held, namely the importance of distinguishing between those situations where you know the form of the distribution and it suffices to estimate its parameters, and those situations where the parameters change over time.

I gave the example of a dice with sides between n and n+5. If you know n is fixed, then it does not take many observations to know what n is. Once you have seen a 10 and a 15, for instance, you know n = 10. But if n itself varies, then you are in a much more difficult situation. Seeing a 10 and a 15 does not prove that n = 10 since it might have been 8 for the first observation and 11 for the second. Even if n only varies slowly, you need a lot more data to make good statistical estimates.

Lo and Mueller propose a more detailed hierarchy of model uncertainty as follows. I will use my dice rather than their examples as illustrations.

• Level 1: complete certainty. The dice has 5 on every one of its sides.
• Level 2: risk with (Knightian) uncertainty. Standard six sided dice. The probability of each outcome is fully known.
• Level 3: fully reducible uncertainty. Six sided dice with each of the numbers between n and n+5 on one of the sides. n is unknown but it is fixed and therefore can be precisely deduced with enough observations.
• Level 4: partially reducible uncertainty. Six sided dice with each of the numbers between n and n+5 on one of the sides. n is unknown and with some fairly low probability may go up or down by one each throw. Here we know something about the path of n from observing the dice rolls, but we can never be certain what it is at any point in time. The distribution of outcomes can therefore never be completely known.
• Level 5: irreducible uncertainty. Completely random numbers on the sides of the dice which change on every throw. We know nothing.

Like Lo, I think that in finance we often pretend to be in level 2 when in fact we are in level 3 or 4.

Posted in: Economic Theory, Mathematics and Science by David /
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I have an embarrassing confession. I have never understood the concept of fractional reserve banking. Or, at least, while I could follow the argument easily enough, when I tried to write the corresponding accounting entries, I couldn’t. This was filed under `things I will figure out at some point’ until recently, when I read a post at the Big Picture pointing out that the M1 money multiplier is now less than one. Clearly there is something fishy about the whole ‘new reserves create even more new money’ story.

What’s going on? The first point to notice that the money does not have ‘central bank money’ and ‘bank money’ printed on it (or attached to balances for that matter). So any story that relies on distinguishing between them must not be the whole truth. The second is to note that the reserve fraction is zero in some countries for some deposits: demand deposits require zero reserves in the US for example. Hence theoretically infinite leverage is possible, and any account that claims that the reserve ratio limits the supply of credit is false. Third, note that reserves are not the constraint on credit: capital is. So that must enter into the story too.

With that in mind, let’s try to see how credit creates money – in the sense of increasing the measure of broad money. Suppose you start with a house worth £100. Your assets are £100, your liabilities are zero, and so your net worth is £100. Now suppose you get a mortgage on that house for £80. That gives you £80 in addition to the house, deposited in an account at your bank. Your liabilities are now the £80 mortgage, and your net worth has not changed. The money supply has increased.

Now think of the bank’s accounting. It has added an asset to its balance sheet – the mortgage – and a corresponding liability – a deposit of the money it has lent you. If you move that deposit, by spending it say, then it must replace that deposit with other funding. It also allocates some of its capital to support the capital requirement on the mortgage.

What stops the bank creating new broad money like this forever is regulation. Once capital requirements rise to be nearly as large as the bank’s actual capital, it has to stop (or get more capital).

Central bank intervention comes into the process when there are not enough deposits or interbank money around to support the credit that the banks want to make and are well enough capitalised to make. Then the central bank creates new money via open market operations (essentially repoing old securities for new money). This fills the gap between assets the banks want to create (new loans) and liabilities that they cannot attract (scarce funding).

Reserve requirements are essentially a funding liquidity risk reduction tool. By imposing reserve requirements on some types of deposit, banks are forced to stay somewhat liquid. If there is any way of funding the bank which does not have a reserve requirement (such as issueing CP) then reserve requirements cannot completely constrain credit creation.

What new central bank money does not always do, then, is create credit. If a bank’s reserves grow, then that increases the asset side of its balance sheet. The corresponding liability in modern open market operations is a liability to the central bank. If those increased reserves allow it to take more of a certain type of deposit, then those deposits come from somewhere. It may be that the bank creates credit after obtaining central bank money and the liability matching the new loan is in the form of deposit account which requires a reserve, but that is by no means guaranteed.

In this version of the story then the money multiplier is the ratio of newly created broad money – mostly credit – to central bank money. It is greater than one if the banks are well enough capitalised to create lots of loans, and can find people they want to lend to at spreads they like. But if they can’t – as now – pumping in more central bank money won’t necessarily increase broad money that much. Instead banks will hoard the money until they have solved their capital problems and there are more attractive risks around.

Fractional reserve banking, then, is a useful theory if all bank liabilities require reserves and if capital is not a limit on credit creation. This could have been true once. But it certainly isn’t today. Shouldn’t we be teaching economics students a rather more accurate version of the story?

(Linkage: There is a different [German school kids?] account of the story from Naked Capitalism here: the comments to that article reference this post, which some may find helpful. This link is useful too as the accounting behind the story is discussed.)

Posted in: Economic Theory by David /
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Senator Ted Kaufman writes: I start by asking a simple question: Given that deregulation caused the crisis, why don’t we go back to the statutory and regulatory frameworks of the past that were proven successes in ensuring financial stability? It is a reasonable question. There are three components to the answer: First, the finanical system is different. We have securitisation, the big arbitrage tool for Basel 1; we have more internationalised banking and a different profile of lending; and we have different policies from central banks. That in turn is because the economy is different. It has different needs. Large corporates in particular demand a wider range of services. Moreover we are unwilling to accept a large fraction of society being denied credit as they were in the past. We are less tolerant of boom and bust: we want both high growth and stability. There is a real danger of looking back with rose tinted spectacles (if not without our heads). The regulatory system was not perfect in the days before OTC derivatives when Glass Steagall still ruled. (See here for a short list of financial crises in the last forty years.) As Dave said in the comments to a previous post, we need to design a regulatory system for the future, not for the past.

Posted in: Economic Theory, Photography, Regulation by David /
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Two contradictory signals. First from the FT:

Regulators have ordered UK banks to run a new round of tougher stress tests that assume the economy will endure a double-dip recession that would force unemployment up to 13.3 per cent.

The banks will be required to prove that their tier core one capital ratio – a key measure of banking safety – would stay above 4 per cent even if the economy contracted an additional 2.3 per cent for a total fall of 8.1 per cent from the boom, the Financial Services Authority said in its annual Financial Risk Outlook.

(The full document is here.)

Next from the FSA themselves:

the FSA said that it would not tighten quantitative standards before economic recovery is assured given that all firms were experiencing a market-wide stress. The FSA committed to giving a further update in the first quarter of 2010.

The FSA believes that it would be premature to increase liquidity requirements across the industry at the current time. This position will be reviewed later on in the year with a further announcement in Q4, 2010.

At first blush, this is odd. Stronger stress tests but no liquidity requirement (yet). But perhaps it is not so strange: the FSA is concerned about the possibility of a doble dip recession, and knows that banks have enough to worry about without meeting the liquidity requirements too. They have to balance making the banking system sounder with discouraging lending and hence making that double dip more likely. The news, then, is broadly positive: the stress tests probably won’t have much of a capital impact on most people, and the delay in the liquidity requirements will be very welcome for many banks.

Posted in: Economic Theory, Liquidity and liquidity risk, Regulation by David /
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One habit that characterises the thoughtful trader or economic theorist is doubt. We see this time and again. Here for instance is Krugman, talking about the controversy of Malaysian capital controls in the late 90s:

In a more cosmic sense, though, the Malaysia story does illustrate just how totally wrong what passes for financial wisdom often turns out to be.

On the same day, we find the Big Picture asking this question:

more importantly, what might you be VERY wrong about?

Beunza and Stark, meanwhile, looking at fairly simple arb trading, say:

Through ethnographic observations in the derivatives trading room of a major investment bank, we found that traders use models… to look out for possible errors in their financial estimates.

Posting will likely be light next week as I am away, so let me leave you with some encouragement to be reflexive: what financial estimate might you have been horribly wrong about? It is a good question.

Posted in: Economic Theory, Information Fusion by David /
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Phil Hogan’s review of The Age of Absurdity in Sunday’s Observer made me realise that I had not explained myself very well a few days ago when I was talking about the baby boomer generation and pensions. Let me try again. First, Hogan:

Modern life … has deepening our cravings and at the same time heightening our delusions of importance as individuals. Not only are we rabid in our unsustainable demands for gourmet living, eternal youth, fame and a hundred varieties of sex, but we have been encouraged – by a post-1970s “rights” culture that has created a zero-tolerance sensitivity to any perceived inequality, slight or grievance – into believing that to want something is to deserve it.

What has this got to do with pensions? Well, three things.

1. The sense of entitlement has made it politically impossible not to make bigger and bigger promises. In some sense this is a good thing: looking after the elderly is a sign of civilisation.
2. However, because of the competing sense of entitlement of the current generation, these promises have not been funded. That has created an intergenerational tension that – at currently mortality and economic growth rates at least – is not resolvable. At least one generation is going to end up very unhappy, and possibly more than one.
3. At the same time, increasing selfishness has made the situation worse, in that structures have been designed which offer a bad balance between pensions risk and pension return.

That last point should be elaborated.

Suppose you have the choice of two pension schemes: one of which gives the return distribution in solid blue; the other the one in dotted green. The dotted green distribution has a higher average pension, but more volatility, and hence a higher probability of underfunding. It’s riskier. Most people, given the importance of their pensions as a fraction of their assets, would opt for the pension in blue.

Now though suppose that there is a backstop at the level indicated by the dotted line. Then the situation changes: we might well decide to take the extra risk, given that catastrophic underfunding is protected against.

Collective pension schemes provide two forms of diversification. Firstly they have asset diversification – by investing for many people together, they can access asset classes which require high minimum investments, such as some alternative investments. Secondly they have temporal diversification – we only need enough money to pay claims as they become due, not cohort by cohort, so periods of markets falls are offset to some degree by later or earlier rises. Mean reversion in asset prices works in the pensioner’s favour. Moreover regulation usually means that some form of backstop is provided for collective schemes either from the sponsoring company, or the state, or both.

Thus collective pensions can take greater risk than individual ones. If you are investing just for yourself, you rationally should take less risk and hence expect a lower return than if you participate in a collective scheme. This is downside of selfishness: if you don’t want your funds to be available to help other people, then your expected return is lower. No matter what your political persuasion, you should want the red flag flying over your pension fund.

Posted in: Economic Theory, Pensions, Politics by David /
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We begin with something interesting, if wrong. Did Woodstock hippies lead to US financial collapse? (HT the Economist’s View). The sense in which there might be something to this rhetorical (at least in the author’s mind) question is that changes in morality which started in the 60s in some sense contributed to the current crisis. But so too did flows of money which intensified with the rise of the baby boomer generation, combined with other social and political changes.

Consider the big picture:

• Morality first. There is no doubt that the attitude to debt has changed. North Americans, in particular, used to view repaying debt as more of a moral obligation than they do now. Thus we get more opportunistic (negative equity related) defaults than we used to. This was not a major driver of the credit crunch, but it did have an effect.
• Baby boomer pensions were a major cause. Those dang hippies were just too successful: they made all this money which needed a home. Government bond yields were derisory, so some of this cash was sucked into AAA rated ABS. The same goes for the riches of the newly industrialising BRICS. This wave of hot money, more than hippy morality, was a key crunch driver.
• Transactional, as opposed to relationship capitalism led to the originate-to-distribute model and so to making loans without worrying about whether they would perform. That is not a 1960s invention: it dates back at least to the 19th century, and arguably much further.
• Finally, wealth growth. If GDP keeps growing, and you can tax it at more or less a constant rate, you don’t have to fund current promises as the future will pay. This mañana attitude to government and pension finance allowed higher levels of consumption during the good times. But now times are not good, we need (in Interfluidity’s apposite phrase) ‘redistribution for which there is no overt legal framework or political consensus’.

The make love not war generation didn’t help, then, but it was not permissiveness that was primarily to blame: it was systemic weaknesses in Anglo Saxon capitalism that interacted with a wave of hot money to create the Crunch and its damaging aftermath.

Posted in: Economic Theory, Mother of all Bailouts, Pensions, Politics by David /
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A recent paper by Cecchetti et al. The Future of Public Debt has been widely noticed: see for instance here for Ritholtz or here for the Econgrapher. The paper is certainly thought provoking. In particular, it points out that the time bomb of ageing populations is not confined to Japan:

The current expansionary fiscal policy has coincided with rising, and largely unfunded, age-related spending. Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply. Interestingly, this rise is concentrated in countries such as Japan, Spain, Italy and Greece, which are already laden with relatively high debts. Added to population ageing is the problem posed by rising health care costs.

An ageing population who have been promised a lot combined with slower growth and hence less tax income gives a problem. A big problem in some countries, as these promises are simply unaffordable:

What can we conclude? The authors are clear:

fiscal problems facing industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis on fiscal balances. As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population

Clearly first world governments are not going to let interest service payments get to 10% of GDP without a struggle. That means some of (perhaps all of) reduced pensions and health care, lower public spending, and increased taxation. Reducing the real value of liabilities makes sense too, so expect somewhat higher inflation eventually – but not for a while. Intergenerational wealth transfer is going to become a key political issue in the developed economies, too. There are interesting times ahead…

Posted in: Credit, Economic Theory, Insurance and Actuarial Practice by David /
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I have been meaning to write a post for a while about the one thing that unites American commentators from the left and the right, namely how screwed the Euro is. It is truly amazing that despite the success of the Eurozone, the appreciation of the Euro against the dollar (and sterling), and the enormous successes of the single market, that many commentators, especially Americans, seize on any opportunity to rubbish Europe. However I can’t be bothered (frankly) to gather the quotes I need, so in the spirit of blind prejudice that I am claim characterises the other side, I’ll just present a lovely little piece from the Big Picture using data from Businessweek:

In the midst of a good nag, Europe’s voters are the biggest obstacle to ambitions to become more dynamic and successful, the Economist stumbles on a truth:

… lots of Europeans do not want to live in the most dynamic and competitive economy in the world. They prefer to work fewer hours than Americans or Japanese (about 10% fewer, on average), to take long holidays, and to retire as soon as possible.

Honestly, reader, do you really blame them? Who aspires to spend more hours in the office? Who doesn’t like holidays?

If economists persist in tutting and sucking their teeth when people decide that economic growth is not the most important thing in the world ever, then they display a rather shallow understanding of people, as well as of economics.

Posted in: Economic Theory, Philosophy and Hedonics by David /
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Rajiv Sethi writes:

In a series of papers starting with Promises Promises in 1997, John Geanakoplos has been developing general equilibrium models of asset pricing in which collateral, leverage and default play a central role… The latest paper in the sequence is The Leverage Cycle, to be published later this year in the NBER Macroeconomics Annual. Among the many insights contained there is the following: the price of an asset at any point in time is determined not simply by the stream of revenues it is expected to yield, but also by the manner in which wealth is distributed across individuals with varying beliefs, and the extent to which these individuals have access to leverage. As a result, a relatively modest decline in expectations about future revenues can result in a crash in asset prices because of two amplifying mechanisms: changes in the degree of equilibrium leverage, and the bankruptcy of those who hold the most optimistic beliefs.

Sethi is right: this is important work. What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ‘29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?

Posted in: Clearing and Collateral, Economic Theory by David /
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Felix Salmon has a good post on the problems of classical free trade thinking when applied to food:

In a Ricardian world it makes sense for Ohio to overwhelmingly grow corn and soy, since growing corn and soy is what it does best. And because of economies of scale, it makes sense to grow just one type of each, on farms of mind-boggling size. Ohio can then trade all that corn and soy for the food it wants to eat, and everybody is better off.

Except in reality it doesn’t work like that. Monocultures are naturally prone to disastrous outbreaks of disease, which can wipe out an entire crop…

A system of globalized agriculture can break down, as we saw during the commodity boom of 2008. As the price of soy and rice and wheat soared, exporters started hoarding rather than selling, and importers couldn’t obtain necessary supplies at any price. As the World Bank’s Ngozi Okonjo-Iweala noted, Ukraine had 5 million tons of surplus wheat, but the international food markets were very thin, and it was extremely difficult to get that wheat exported. The system didn’t work like it was meant to: when put to a real-world test, it broke down.

The problems are severe enough, but they are not the only ones. Firstly transport costs are not constant, and indeed are likely to increase significantly in a carbon-constrained world. Second, even if it is cheap enough, some people (like me) don’t want to eat asparagus from Peru in the middle of the UK winter. Third, the varieties the megafarms grow are typically not the tastiest, and anyway have probably been dosed with nasty chemicals to improve their shelf life. A stick of easy to grow, long lasting asparagus from Peru is simply not fungible with native British asparagus varieties grown organically. Thus the theory of comparative advantage breaks down as we are not comparing like with like. Finally, locally produced food is less likely to disappear for political reasons or because changes in the FX rate makes importing them no longer attractive: if you want to be sure of your apple supplies, buy ones from the farm down the road.

All of this is leading, haltingly, to a new localism. It is very hard to be a complete localvore, but trying to increase the amount of locally grown food and drink you buy makes sense. It will be tastier, it’s good for your carbon budget, it keeps money in the local community, and it doesn’t hand power to global agribusiness.

Posted in: Economic Theory by David /
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There is an interesting letter in the current LRB from Wilhelm Schneider:

… In many cases it is true that the ‘future’ (of chemical processes, say) can be precisely predicted on the basis of the laws of nature, and engineers take advantage of those fortunate circumstances. But there are also counter-examples: it is notoriously difficult, for example, to predict the exact time an earthquake will occur.

Should predicting the occurrence of financial crises in any case be the aim of an economic theory? Those of us who work in engineering have adopted a more modest, though still challenging, approach. In aerodynamics, for instance, we investigate how to get turbulent air flows under control, instead of trying to predict ‘catastrophic’ events.

That is a useful distinction I think. Predicting a crisis seems to be a difficult problem. Building the system in such a way that crises are less likely seems to be simpler. Now often it turns out that seemingly hard problems are simple and vice versa (AI cracked `diagnosing heart disease’ very quickly; building a robot that could walk turned out to be a much harder problem) — but still, tackling the simpler problem seems sensible.

Posted in: Economic Theory, Mathematics and Science by David /
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“The defining characteristics of having E are qualitative impairments of social communication and interaction, along with restricted and repetitive activities and interests. Individual symptoms occur in the general population and appear not to associate highly, without a sharp line separating pathological severity from common traits… A high percentage of individuals with E show unusual abilities.”

Would you say that E = “a PhD is economics” was one reasonable assumption? In fact of course E is “autism spectrum disorder”: the text I have used is from wikipedia. But hopefully the point is made – economists, like many academics, often display behaviours that hint at Asperger’s syndrome. There is nothing wrong with that of course.

However, as Jonathan Hopkin points out, it does mean that using assumptions about how economists behave to derive broader conclusions about how the wider populace behaves is fraught with danger. In particular many behavioural economics experiments are done on economics students – because they are easy for the experimenters to get their hands on. (I wonder if economics departments have ethics committees the way psychology departments do?)

A particular issue is that economists by definition are more attuned to money than most people. They think about it all the time. Thus they do things that most of us wouldn’t think of, like driving from more than half an hour each way to save a trivial amount on their groceries*.

Policy derived from the behaviour of this biased sub-population may well be bad policy if their behaviour is assumed to apply to us all. Or as Hopkins says

… the assumptions behind this behaviour also end up underpinning predictive and normative models of social dynamics, which can inform policy decisions. These policy decisions constrain behaviour, undermining the social ties that people value.

*Once you factor in the price of petrol, this is of course economically illiterate.

Posted in: Economic Theory by David /
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I used to quite like Felix Salmon’s writing but lately his writing has become worse and his arguments less cogent. A recent piece There’s no tradeoff between dynamism and safety is a good example.

We start off with something eminently sensible, from the mouth of someone else:

Raghuram Rajan tells the WSJ’s Mark Whitehouse that when it comes to capitalism, there’s a natural tradeoff between security, on the one hand, and dynamism, on the other.

In other words, at any given time you can have higher growth with a larger chance of a bust, or lower growth with more stability.

Salmon misunderstands the claim, and opposes his idea of it thus:

The dynamism of capitalism is largely a function of safety nets, dispersed risk, and limited downside. The limited-liability joint-stock company run by professional managers is a both a driver of dynamism and an exercise in maximizing the safety of as many principals as possible.

No, the dynamism is largely a function of efficient capital allocation. The fundamental problem of financial stability is how to permit this without cooking in crunch producing instabilities. Highly leveraged banks permit faster growth, for instance, at the risk of a banking crisis. Similarly joint stock companies encourage risk taking but they too bake leverage into the system. (In fact there is a good argument that Islamic finance, with its insistence on equity type risk taking in any financing, is fundamentally more stable than Western style joint stock companies.)

Salmon next adds a complete non sequitur.

A large reason for the excesses of the financial-services industry over the past decade is the insane level of bankers’ pay.

This may or may not be true, but in any event there is no argument to support the claim. ‘A large reason’ is also rather clumsy: a case of my reason is bigger than yours perhaps? Moreover the claim that reducing bankers pay would in and of itself, without any other measures, enhance financial stability seems more vindictive than theoretically well founded.

There are no quick fixes for financial stability. You need to understand how the system works, and (re-) write the rules of it to make the dynamics you want more likely and the ones you don’t less likely. It would be wonderful if you could do that and still keep the level of growth of the economy high, but I very much doubt that you can.

Posted in: Economic Theory, Rules by David /
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In Sunday’s Observer, Will Hutton makes some poignant observations:

The City of London is now too big and too risky for a country our size. It is not just that bailing it out has cost £850bn, as the National Audit Office reported, and that the recession it imposed has led to the biggest ever increase in peacetime public borrowing. For years it has crowded out exporters and manufacturers. Money has flowed into the City forcing the pound up to crazy levels, and making it hard for exporters to compete, while at the same time generating credit flows that have made property, construction and financial services the routes to quick profits. Under City influence the alpha and omega of business life has become keeping up the share price. Innovation and investment can go hang.

It should be no surprise that half the growth between 1997 and 2007 came from finance, construction and property. Over the same period, manufacturing shrank from 20% to 12% of our national output…

Britain has to do three strategic things that are interlinked. It has to shrink the City of London, stimulate the non-City of London parts of the economy to plug the gap, and manage down this year’s expected £175bn-£180bn public deficit quickly enough to maintain financial confidence but not so fast it damages the recovery.

I have argued this line before: see for instance here, here or here. But now this idea seems to be gaining wider circulation. Even Peter Mandelson appears to understand that a sound economy usually involves more than passing around money and building. It may be that there is more rejoicing in heaven over one sinner who repents than over ninety-nine righteous people who don’t need to repent, but I fear this particular conversion may be too little, too late. In its last months, Labour and its followers are rediscovering their heritage: perhaps if they had remembered it a little earlier, the UK would be in a better state, and they would have a better chance of retaining power.

Posted in: Economic Theory, Politics by David /
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A frequent correspondent sent me a link to Phillip’s Economic Computer, a wonderful analogue device designed to illustrate the flow of money within the economy. And that got me thinking…

A very rough and brutal sketch of Keynes’ classical account of the savings trap is that if people save too much, rather than consume, then the velocity of money drops, inventory builds up, growth falls (and even goes negative) as businesses cut back on production. A standard account of the liquidity trap by Krugman is here.

How does the Phillip’s device help? Well, it points out a truth that is often hard to see, namely that money can only be created or destroyed by the central bank. Credit cannot be ‘created’ without funding; money cannot disappear. These days, rather little money is stored in mattresses or bank vaults: most of it is in the form of bank deposits, securities, or other investments. And of course those assets are someone else’s liabilities, i.e. funding for them. Thus these days your choice is not between putting your cash under the bed and spending it: it is between putting it in a bank – which will lend it to someone else – and spending it. In this sense saving is not quite as bad as in the classical Keynesian account, as it provides funding for corporations and individuals who do want to engage in economic activity. Even buying government bonds is not useless as the government spends the money on something.

Now of course the increase in economic activity provided by a dollar of spending on goods may be rather more than that provided by a dollar of bank deposits. But it is worth noting that the dollar of bank deposits are not useless: the bank has to do something with your money, and that something probably has positive economic value. Anything else would cause funds to build up rather too fast at the bank – something the Phillip’s computer would model as water flooding out…

Posted in: Economic Theory, Liquidity and liquidity risk by David /
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A nice slant from Salon: the president is a prisoner of the cult of neoliberalism.

Posted in: Economic Theory, Politics by David /
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There has been a fair amount of discussion recently about financial innovation. Willem Buiter has suggested that new financial products should have a licensing regime akin to drugs, and Felix Salmon has written provocatively on the link (or lack thereof) betweeen innovation and economic growth. This should be read in the context of David Warsh’s work on Knowledge and the Wealth of Nations, a work that this post from Science Blogs reminded me of.

So, what do we know? First that certain infrastructures help innovations generate wealth. The ability to profit from a good idea helps, as does the ability to finance development. Hence patents and joint stock companies. Education is necessary, and law which gives certainty of ownership is also helpful.

Next, we know that most innovation does not produce growth. A lot of it isn’t harmful, but there are many, many dead ends. Markets are sometimes (but not always) good at sorting out which ideas are useful.

Now to specifically financial innovation. The point of financial innovation is to produce products which meet specific needs better (more cheaply, more accurately), and thus often to lower the cost of finance. Some innovations have worked out: a good example would be the convertible bond, which allows companies to monetise the volatility in their stock price. Others have been more or less useless but benign. Credit spread options are a good example here: in the early days of credit derivatives, these were a competitor with CDS as standard credit risk transfer products. CDS turned out to work rather better, and so credit spread options faded into illiquidity without doing anyone any harm.

Are there genuinely harmful wholesale financial products? I am still not sure that there are. I certainly can’t think of one*. If firms are required to keep enough capital against the risk of a product; to value it properly; and to document it carefully, then why should trading be constrained? Isn’t product licensing just a route to a less efficient economy?

*Tradable emissions permits come pretty close though.

Update. There is a nice rebuttal of the `innovation causes crises’ meme from the Economics of Contempt here.

Posted in: Economic Theory, Intellectual Capital by David /
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As I write this, Manchester United are on the verge of their champion’s league final with Barcelona. I’m cheering for Barca, but I have to admit that Man U are a success. They are one of Europe’s great teams, for now at least.

Let’s compare them with RBS. If Man U screw up – say Ronaldo goes to Real Madrid, they overpay for Tevez who then breaks a leg, and Rooney gets even fatter and loses it – then Man U’s bond holders will probably suffer. Another team – the far more worthy Liverpool for instance – will win the Championship. There will be gnashing of teeth. But the fall of this particular champion won’t cause much more than a surge in beer sales as fans drown their sorrows. The problems at RBS, on the other hand, left the UK tax payer with a lot of risk, cost them a lot of money and severely restricted the supply of credit to the UK economy, with hideous economic consequences. We simply could not afford to let RBS fail.

In other words, then, some firms’ size is a problem for the economy, and some aren’t. (Man U’s size and spending power might be a problem for football, but that is a different story.) If you have firms whose size and market position makes them effectively too big to fail, then you already have a problem. Superivising them isn’t the issue: stopping them getting that big is.

John Kay takes up the next part of the story in the FT. If large, systemic providers are inevitable, or at least if we have them at the moment, we need to ensure that their functions survive their failure, whatever the cost to shareholders and the restriction on companies’ freedom of action.

There should be a clear distinction in public policy between the requirement for essential activities to survive and the continued existence of particular companies engaged in their provision. There are many services we cannot do without – the electricity grid and the water supply, the transport system and the telecommunications network. These activities are every bit as necessary to our personal and business lives as the banking sector and at least as interconnected. Even a brief hiatus in their supply is intolerable.

But the need to keep the water flowing does not establish a need to keep the water company in business. We do not mind if one chain of high street shops closes its doors, because there are many other places to buy our clothes and groceries. Other industries are different. We cannot contemplate keeping aircraft circling over London while the liquidator of Heathrow Airport Ltd finds the way to his office.

In all industries where there is or might be a dominant position in the supply of essential public services, there needs to be a special resolution regime. The key requirement is that assets that are needed for the continued provision of these services can be quickly separated from the organisations engaged in their supply. The businesses involved must be required to operate in such a way that such a separation is possible.

This implies of course that there is a big difference between the big boys and the rest. The state promises to intervene in their affairs and seize their assets far sooner than it would for a less important player. If this threat is credible, not only would it be good for the economy, it also might encourage firms not to get too large. Lots of small, competitive firms are good.

Update. 2-0. Thank you Barca. The look on Ronaldo’s face is priceless.

Posted in: Economic Theory by David /
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In a comment on the non-classical cost benefit analysis post of a few days ago (a title, I think you will agree, of gigantic pretention), Dave said:

I agree with your conclusions: that uncertainty and moral hazard can make CBA unreliable and sometimes it is better to rely on qualitative objectives.

But I disagree with your applying these to systemic risk. Firstly, with systemic risk it is the “worst-case scenario” that is important. If regulators had used the great depression as the worst case scenario, they wouldn’t have been far wrong.

Often, though, the worst case scenario can be hard to identify. The worst case scenario in much of finance for instance is that all claims are worthless and all liabilities come due immediately. We might as well all go home if that comes true, and barricade the doors. ‘Plausible’ worst cases have a nasty habit of turning out to be too optimistic: wasn’t it David Viniar from Goldman who said that 2008 was much worse than the most pessimistic scenario they looked at?

Secondly, I can’t see how systemic risk regulation would cause bankers to take greater risks. So, I don’t see where moral hazard fits in.

Fair enough – bankers are not people riding bikes. (Quite literally, usually – Wall Street tends to view cycling to work as only marginally less strange than coming by elephant.) So probably bankers did not take more risk because they were regulated. Some of them did, however, take as much as they could subject to regulation, because that was the way to maximise returns to shareholders.

Thirdly, how do you take a “moral” position on systemic risk? I don’t think this gets you very far.

Well, I think that the key idea of Anglo-Saxon capitalism – that the first and only duty of a firm is to its shareholders – is simply immoral. Of course, like any ethical judgement, you can disagree with that. But I also think, and I’d like to think that I can prove, that a system that has a wider burden of responsibilities, including a responsibility to the financial system, would be less likely to go into crisis, cost the taxpayer less over the cycle, and deliver slower but less volatile growth.

Finally, the main impact of systemic risk regulation would be to encourage smaller banking/trading institutions. I would think that this a good thing in itself. And I disagree with James Kwak that “countercylical measures in a boom dampen economic growth”. Surely the opposite is true (in the long run).

Absolutely. We need a lot of small banks, not a small number of large ones. The hard part is how we get to there from here.

Posted in: Cost Benefit Analysis, Economic Theory, Regulation by David /
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Matthew Lynn, in a typically opinionated and wrong-headed piece on Bloomberg, thinks

The British economy is becoming increasingly French.

Why which he means

It will have a huge tax burden to carry, a state that is the dominant actor in the economy, and a system whose resources are managed more by some kind of national plan than the free hand of the market. The government is now explicitly emulating France, with its national champions.

Sadly this leaves out the good parts about the French economy: the generous welfare system; good education and health care; job security (at least for some); rational working hours for many. No, the UK isn’t becoming French. It is becoming much worse: French for big companies, but American for ordinary workers. That’s like having Italian railways and Swiss fashion.

Posted in: Economic Theory, Photography by David /
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Edmund Phelps has a very good article in the FT which harmonises with many of the preoccupations of this blog.

In countries operating a largely capitalist system, there does not appear to be a wide understanding among its actors and overseers of either its advantages or its hazards… Capitalism is not the “free market” or laisser faire – a system of zero government “plus the constable”. Capitalist systems function less well without state protection of investors, lenders and companies against monopoly, deception and fraud.

In order to understand a system, you need to understand its behaviour, and how changing the rules which constrain that behaviour constrain the dynamics. There is no more a ‘right’ set of rules for something as complicated as a market as a ‘right’ set for a mobile telephony or a ball game. Some rules produce more efficient or interesting behaviours: some suffer significant disadvantages.

In essence, capitalist systems are a mechanism by which economies may generate growth in knowledge – with much uncertainty in the process, owing to the incompleteness of knowledge.

Growth in infrastructure too: roads and factories and such like. The knowledge moreover is encapsulated in conventions, or rules of the system: a mobile phone is useless without a network of towers that it can communicate with. Capitalism attempts to solve a massive collection of coordination problems – and often (as with the worldwide phone system), it succeeds.

Well into the 20th century, scholars viewed economic advances as resulting from commercial innovations enabled by the discoveries of scientists – discoveries that come from outside the economy and out of the blue. Why then did capitalist economies benefit more than others? … [Hayek] felt free to suppose that, thanks to the specialised insights each acquires, a manager or employee may one day “imagine” a commercial departure – one that could not be inferred or envisioned by people outside the individual’s line of work. Then he portrays a well-functioning capitalist system as a broad-based, bottom-up organism that gives diverse new ideas opportunities to compete for development and, with luck, adoption in the marketplace. That “discovery procedure” makes it far more innovative than the top-down systems of socialism or corporatism.

This is of course an important (and well understood) point. However most wealth, in the general sense, is created not by true blue skies innovation, but by inside-the-system thinking. 3G phones are possible because we already have second generation infrastructure: ABS only makes sense under some assumptions about road surfaces and driving conditions and so on. Thus the role of capitalism is not just to act as an evolutionary force allowing great new ideas to generate wealth. It must also provide infrastructure – pensions, banking, law, transport, health care and the rest – within which incremental development can take place. There are many non-optimal local maxima here: the US healthcare system is a good example. Phelps makes this point less forcefully:

Well-functioning capitalist economies, with their high propensity to innovate, could arise only when serviceable institutions were in place.

Note however that there is an inherent volatility in capitalism.

From the outset, the biggest downside was that creative ventures caused uncertainty not only for the entrepreneurs themselves but also for everyone else in the global economy. Swings in venture activity created a fluctuating economic environment.

You can have slow wealth creation with little variation, or faster wealth creation with significant setbacks. But we do not know how to generate fast low volatility wealth creation, even assuming that this was generally considered to be desirable. Moreover there has never been a broad discussion of how much volatility is tolerable. Is an economy that grows at 4% on average over the long run but suffers vicious multi-year recessions occasionally better or worse than one that grows at 3% with much shallower pullbacks?

Investors have proved terrible at addressing these issues not least because they were reluctant to admit to the possibility of setback which was baked into the dynamics of the system.

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down.

We urgently need to develop a sense not just of the likely near term path of the economy, but also the possible paths – the kind of thing that it might do. If, as I suspect, highly undesirable paths are still somewhat likely, we need to rewrite the rules to make them much less probable.

Posted in: Economic Theory, Rules by David /
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Let’s score Nassim Taleb’s latest set of ex cathedra pronouncements:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.

Fair point. Score one.

2. No socialisation of losses and privatisation of gains.

Exactly. Otherwise moral hazard is enormous and banking is profitable with little risk. Score one.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

No. Firstly nearly everyone who knows enough to be helpful was driving (or at least helping to navigate) the bus. And secondly most people even if they did not like the driving, weren’t in a position to do anything about it. We cannot afford to get rid of all of our experts, even if they have been wrong in the past. Score zero.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.

It depends on the bonus. One year bonuses with no clawback based on mark to market profits clearly provide bad incentives. But multiyear bonuses with clawbacks based on realised gains may provide a good incentive. Score half.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products.

No. Balance complexity with appropriate technology. Complex products can be appropriate, simple products can be inappropriate. It depends. Score zero.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it.

No. It is enough to ensure that risk takers genuinely bear the consequences of their actions and that there is sufficient capital in the system for the risks being taken. If you ban dynamite, tunneling gets much more expensive. You just want to be sure it is civil engineers not terrorists who have the dynamite. Score zero.

7. Only Ponzi schemes should depend on confidence.

Nonsense. No one knows what a financial system that is not confidence sensitive might be like. That is an unsolved problem in finance. Score zero (with the judge contemplating taking away a mark for idiocy).

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial.

It depends. Allowing firms to increase leverage is insane, and no regulator I know is permitting that (unless you could accounting games which result in over-stating capital). But governments can and should increase their borrowing at times like these. Score half.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require.

So what, prey, do you suggest people use to save for retirement? Given I know of no asset whatsoever that does not fluctuate in value, this is a real question. Score zero.

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

The sheer cliche density of that paragraph alone deserve a minus five.

Posted in: Economic Theory, Mother of all Bailouts by David /
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Simon Johnson has an excellent article in the current issue of The Atlantic magazine. His basic premise, as an ex-IMF chief economist, is that crony capitalism is a fundamental part of many emerging market crises, and it is only when the cronies are forced to take some pain that the crisis can be resolved. Furthermore he argues that this kind of coup, whereby power has been seized by a small group who manipulate the economy for personal profit, took place in the US during the Clinton and Bush years. Thus the Quiet Coup of the article’s title. Go and read the whole thing: it is quite persuasive.

Posted in: Economic Theory, Mother of all Bailouts by David /
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Greg Mankiw writes some complacent nonsense:

At Harvard, we have not instituted any radical reforms in the introductory economics curriculum in response to recent events. We have had some guest speakers, such as John Campbell and Andrei Shleifer, give excellent and well received lectures about the current crisis to assure students that, despite all the uncertainties, economists really are on the case and that the tools of economics are useful in trying to figure out what is going on. But nothing in the current situation makes the basic lessons of economics irrelevant. And the basic lessons are where education needs to begin.

Let’s rewrite it, to make more reasonable:

At Harvard, we have realised the economics has been singularly unhelpful in predicting recent economic events, or in providing advice on how to deal with them. In response to this, we have instituted radical reform in economics teaching and research, reaching out to mathematicians, physicists, computer scientists, systems biologists and others who seem to have useful things to say about interacting systems like the economy. We believe that the tools of economics are rather unhelpful in trying to figure out what is going on, and we are urgently trying to improve them.

Update. Harvey Mansfield has a nice summary of what is required:

What has happened in the last few months should give them [i.e. economists] pause. It should make them consider the necessity of looking at economics from the outside, at how it looks and behaves as a whole. There’s no way to do this from within economics–no way to formulate an equation that will correctly predict the failure of equations to predict. The idea of prediction itself has to come into question. Prediction is designed to reduce the role of chance in our lives, eliminating unpleasant surprise and replacing it with gratitude and satisfaction. But somehow it doesn’t have this effect.

Posted in: Economic Theory by David /
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No, not a post on my recent engagement with Pilates. Instead I am going to be a little Englander for a moment. This isn’t out of prejudice: it is more a consideration of self sufficiency.

What’s the problem with being an exporter? It is that if your clients stop buying, your economy runs into a wall. Look at Japan.

The problem with being an importer is that it is easy to import inflation.

A measure of self sufficiency therefore has some interest. The problem for the UK is that, with a few exceptions (cars, killing machines) we killed out manufacturing industry, making progress towards self sufficiency very difficult. It also makes our natural shortage of material much worse from a country risk perspective.

Therefore part of any long term financial stability plan should be the revival of manufacturing, especially engineering-based manufacturing, at the expense of financial services. It isn’t impossible: Thatcher only killed manufacturing in the 1980s, and there are still some good engineers left (although many of them are retiring). This story is a tiny ray of light in that regard. But much, much more is needed.

Posted in: Economic Theory, Engineering by David /
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There is a growing meme at the moment on the failure of academic economics. Anatole Kaletsky has a piece in the Times which reminds of the responsibility economists bear using Keynes’ famous quote:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

He points the finger at the rational expectations and efficient market hypotheses, arguing that the impact of these two ideas has been `dire’, then says:

The prevailing academic orthodoxy has to be recognised as a blind alley. Economics will have to revert to a genuine competition between diverse intellectual approaches – such as behavioural psychology, sociology, control engineering and the mathematics of chaos theory.

So economics is on the brink of a paradigm shift. We are where astronomy was when Copernicus realised that the Earth revolves around the Sun. The academic economics of the past 20 years is comparable to pre-Copernican astronomy, with its mysterious heavenly cogs, epicycles and wheels within wheels or maybe even astrology, with its faith in star signs.

For my money, this is overly optimistic. Revolution is direly needed, but there will be massive resistance to change. (One is reminded of the similar useless and career-serving complexity in string theory.)

Meanwhile Willem Buiter uses a long and persuasive FT blog to flesh out the details of the failings of macroeconomics. Buiter questions the complete markets assumption, pointing out that the characteristic issue of the crunch — illiquidity — cannot even be addressed once that assumption is made.

He is also particularly good on how economists have simplified their theory so that they can work with it, abandoning any hope of realism for mathematical tractability. The simplest form of uncertainty (Gaussian random walks) was assumed; equations were linearised; equilibrium was assumed. (Buiter does not dwell on the last of these, but it is very important: one of the big issues in dynamic general equilibrium models is the `e’ word, given that the frequency of shocks is large compared with the relaxation time of the model.)

Buiter is scathing about the use of these models to set policy:

The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models that were then let loose on actual numerical policy analysis, was a major step backwards.

The final nail is added by The Financial Crisis and the Systemic Failure of Academic Economics, a paper by David Colander et al. (Link via debtdeflation.com.) This goes over the same themes, stressing the need for someone, somewhere, to do some work on macro models which are useful for making policy. Perhaps academic economists are not actually the right people to do this – it may be that the Copernican revolution in economics comes from the theory of complex dynamical systems (the bastard son of chaos theory) or systems biology. Perhaps we will see a new experimentalism, with models being built which actually capture aspects of the economy, rather than aspects of economic theory. But certainly there is a huge problem waiting to be solved, and there should be kudos for anyone who can make a significant contribution to solving it.

Update. The New York Times has a piece on the lack of movement in academic economics so far. It isn’t surprising. Change will require a reasonable number of young economists to say I am Spartacus, and that hasn’t happened yet.

Posted in: Economic Theory by David /
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Paul Krugman, who I normally have a lot of respect for, writes:

The figure above plots … It’s not a perfect fit — this is economics, not physics,…

(Emphasis mine.) Honestly, what other academic discipline could dismiss the inaccuracy of a theory with an airy `this is not physics?’ Economists wonder why many people think that they are little better than cultists. Krugman’s piece displays a large part of the reason: economists can’t predict much and they are not even embarrassed by that.

Posted in: Economic Theory by David /
2 Comments

John Quiggin has a nice series on economic doctrines that have been refuted by the Crunch. Part 1 is here. Go read: it’s good.

Posted in: Economic Theory by David /
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Jeff Frankels has a nice picture on his blog. I like it a lot, but I think it is slightly at error, so here’s my version, a slight modification of Jeff’s original:

(Click for a larger version.)

Posted in: Economic Theory by David /
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From Paul Krugman, offered as a public service post:

The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.

Posted in: Economic Theory by David /
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Gavin Davies has a nice summary in the Guardian of Irving Fisher’s debt deflation theory. I’ll edit slightly:

Deflation is defined as a pervasive decline in the general price level… When such a decline starts, three very dangerous things can happen.

First, real (inflation-adjusted) interest rates rise, and the central bank becomes powerless to prevent this, because it cannot reduce the level of nominal interest rates below zero. As the rate of deflation gets larger, the real rate of interest actually increases, and this perversely tightens the stance of monetary policy.

Second, the real level of debt in the economy also rises. Most debt is denominated in fixed nominal quantities (£100 for instance), so when the price of goods declines, more goods are needed to pay down the same quantity of debt.

Third, consumers – expecting price declines to continue – delay purchases because the real value of cash is likely to be higher in the future. This reduces demand, pushing the economy further into depression.

Monetary policy does not work in this regime: a fiscal stimulus is needed. Thus the central bank prints money (inflation not being a concern) and the government spends it on something, ideally something useful. Green Keynes anyone?

Update. Krugman has more on the same topic in the NYT here. As he says, to pull us out of this downward spiral, the federal government will have to provide economic stimulus in the form of higher spending and greater aid to those in distress.

Posted in: Economic Theory by David /
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Finally the tide seems to be turning. Bernanke is talking about the need for central bankers to be mindful of asset price bubbles. Darling is reprioritising spending to produce a classic Keynesian stimulus. But isn’t it bizarre that we now have nationalised banks and privatised railways? If ever there was one industry that the state should control – must control – it is transport. (The revelation on Saturday that the reason Virgin trains are so crowded is nothing more than revenue optimisation only makes the case even more clear.) Now Alistair has (reluctantly and a little tardily) got the nationalisation bug, perhaps he could finally undo the evils of his predecessors and renationalise the tube and the railways. Let’s hear no more about internal markets in the health service or in education. Now is the time for the state to spend for the sake of us all.

Posted in: Economic Theory, Transport Policy by David /
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On the news at 1, sounding mildly crazed, he said: There was nothing wrong with Northern Rock. No, Tim, nothing but a run that would have led to bankruptcy if the Bank of England had not intervened as Lender of Last Resort. Honestly, these monetarists are so dangerous giving them a media platform at the moment is roughly akin to shouting fire in a crowded theatre.

Update. He’s at it again, saying to the BBC: “The way the government is going about it, they are effectively stealing from the shareholders. The long-run result will be to destroy the competitiveness of Britain’s most important industries,”. Again, no. Without government intervention, the shareholders would have nothing. There would be nothing to steal. The state is in fact being very generous letting shareholders keep any of the banks. It is probably politically expedient so to do, but it isn’t necessary. Without the state, HBOS and RBS would have been toast today. You can’t be competitive if you are insolvent.

Update. Did the BBC suddenly declare it discredited economist month? They had Madsen Pirie on the news this morning, decrying Keynesian stimulii. Of course he doesn’t want us to try it; of course the whole nauseating troop of monetarists are trying to get publicity: if spending our way out of recession does work, any vestige of reputation they might have left will disappear.

Posted in: Economic Theory by David /
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Sadly I don’t have time to address this properly, but I do want to make a quick connection between Ben Bernanke’s favourite theory of the Great Depression – Irving Fisher’s idea of debt deflation – and the current situation. Krugman is insightful here:

when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money.

For more historical context and comment, see The London Banker.

Posted in: Economic Theory by David /
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Larry Elliott in the Guardian has an article encouraging the Bank of England to cut rates. Larry is harsh with the Bank, accusing them of being asleep at the wheel, and he presents as evidence the Bank’s 2007 CPI prediction:

This shows a zero chance of inflation reaching 5% in 2008. If we now turn to the latest report, we find:

In other words, current CPI over 5% and likely to stay there for six months. For me this is not proof of the Bank’s guilt: this is just proof of how utterly unscientific economics is. After all, the Bank of England staff are neither ignorant nor lazy. They will have applied reasonable econometric tools in reasonable ways to get the first chart. The fact that reality turned out not just different from their prediction but completely outside the error bars simply shows that far too often when tested against reality, economics fails dismally.

Update. See here for a comprehensive account of the failure of economics. Or at least its failure to be funny.

Posted in: Economic Theory, Inflation by David /
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The other popular economics book I read on holiday was Tim Harford’s Undercover Economist. It’s an interesting if quick read, and I can entirely see how it stimulated admissions to undergraduate economics programmes. It strikes me, though, that Harford’s examples work best when the notion of price is unproblematic. He is presenting classical economics, so he assumes that prices are known and that all agents have a view as to the correct price for a good or service. Things get a lot more interesting once prices are not observable or when agents don’t know what the ‘right’ price is. As, umm, in the debt markets at the moment. The Big Picture has a related discussion concerning the failure of equilibrium economics.

I have several favorite examples of where markets simply get it wrong. When I spoke with the reporter on this, I used the credit crunch as exhibit A. It began in August 2007 (though some had been warning about it long before that). Despite all of the obvious problems that were forthcoming, after a minor wobble, stock markets raced ahead. By October 2007, both the Dow Industrials and the S&P500 had set all time highs. So much for that discounting mechanism.

We’ve seen that sort of extreme mispricing on a fairly regular basis. In March 2000, the market was essentially pricing stocks as if earnings didn’t matter, growth could continue far above historical levels indefinitely, and value was irrelevant.

My own view is that finance is not an equilibrium discipline, mostly, so while classical economics might work well in explaining the price of coffee – one of Harford’s examples – it does rather less well in asset allocation or explaining the return distribution of financial assets. Rather new news arrives faster than the market can restore equilibrium after the last perturbation, meaning that most of the time equilibrium is not a useful concept.

Posted in: Economic Theory, Financial Models by David /
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While I was away, perhaps slightly masochistically*, I read the new Soros book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means. It is not a particularly good summary of what happened, nor a detailed analysis of why it happened, but it does make an interesting point. Soros claims, I think very plausibly, that finance is reflexive, that is that the very study of it changes the object being studied. I have written about this before, but it is interesting to see Soros making much of the role of reflexity in the formation of asset price bubbles.

Of course, this feature of finance renders the received wisdom of classical economics rather suspect. In particular, models in finance are not time-stable in the same way that a good piece of science is, simply because the way market practitioners behave changes. The S&P return distribution with over half of all trades done by machine (2008) is unlikely to be the as that when most of the market went via floor traders (1988).

* ‘We read popular finance books so you don’t have to dot com’ has not, funnily enough, been registered as a domain name…

Posted in: Economic Theory, Financial Models by David /
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Jean-Claude Trichet made a speech in 2005 on Asset Price Bubbles and Monetary Policy. The full text is here. A few points leap out at me. Firstly Trichet raises the question as to whether there is such a thing as an asset price bubble:

I believe the NASDAQ valuation of the late 1990s was not excessive… [I] tend to believe that occasionally we observe behavioural patterns in financial markets, which can even be perfectly compatible with rationality from an individual investor’s perspective, but nevertheless lead to possibly large and increasing deviations of asset prices from their fundamental values, until the fragile edifice crumbles.

`Excessive’ is a difficult word and I can see why Trichet is cautious about using it. But certainly the fair value of debt securities is the result of many phenomena including funding premiums and liquidity premiums as well as long term default rates. Their spread can tighten leading to asset price growth if funding is cheap and liquidity is plentiful without this necessarily being irrational.

The problem knowing how much is too much means that Trichet is cautious about the possibility of identifying an asset price bubble:

I would argue that, yes, bubbles do exist, but that it is very hard to identify them with certainty and almost impossible to reach a consensus about whether a particular asset price boom period should be considered a bubble or not.

He suggests one definition of a bubble:

[There is] a warning signal when both the credit-to-income ratio and real aggregate asset prices simultaneously deviate from their trends by 4 percentage points and 40% respectively.

I agree, but I would have thought that liquidity and/or funding premiums and the availability of credit would also provide helpful warning signals. As Trichet says:

A bubble is more likely to develop when investors can leverage their positions by investing borrowed funds.

Interestingly (for 2005) Trichet points out the positive feedback in a bubble pricking of collateral:

A negative shock is likely to have a larger effect than a positive one. The reasons are that credit constraints can depend on the value of collateral and that in case of a financial crisis the whole financial intermediation process can in the worst case completely fail.

After those insights the conclusions are depressing:

With regard to the optimal monetary policy response to asset price bubbles, I would argue that its informational requirements and its possible – and difficult to assess – side-effects are in reality very onerous. Empirical evidence confirms the link between money and credit developments and asset price booms. Thus, a comprehensive monetary analysis will detect those risks to medium and long-run price stability…

I fully advocate the transparency of a central bank’s assessment of risks to financial stability and of its strategic thinking on asset price bubbles and monetary policy. The fact that our monetary analysis uses a comprehensive assessment of the liquidity situation that may, under certain circumstances, provide early information on developing financial instability is an important element in this endeavour.

In other words we will try to tell you when a bubble is inflating but, beyond targeting inflation, there is little we are going to do about it. And M. Trichet did indeed keep to the second part of that promise.

Posted in: Decision Making, Economic Theory, Inflation by David /
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I have two conjectures for today. The first is that Ambrose Evans-Pritchard needs to drink better Rioja. He presents a bearish blog in the Telegraph, backed by a second class Reserva. I would suggest at least a 904 GR for such musings, and ideally the Murrieta.

Secondly and rather more importantly, it can be suggested that the loss trajectory for European banks will be rather different from their American cousins. Suppose we believe Evans-Pritchard’s loss figures: $123bn for Eurozone banks compared to $144bn for the US, and ignore for a moment the rather important distinction between bank and non-bank risk holders. (The US has far more of the latter.) My guess would be that most of the US risk is fair value accounted. So the Americans have taken or are in the process of taking their losses. Most of the European risk is probably accural, so losses will depend on the bank’s projected loan loss reserves rather than current fair value. At very least that will spread them out over many years – remember RMBS is often 30 year paper. Moreover if actual experienced defaults are better than the current fair values predict then the losses will be lower.

One could argue that this cancer will eat away at the European banking system for many years, long after the Americans have taken their medicine and moved on. Or one could argue that right now it allows European banks to keep lending and hence to both protect Europe’s economy from the worst of the losses and make themselves some money to pay for the losses. But certainly the bearish case for Europe is less convincing than that for the U.S.

Posted in: Accounting, Economic Theory, Fair Value, Markets, Wine by David /
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I have held off for a couple of days on commenting on this document not least because it is large, dense, and worth reading carefully. There is an awful lot of information in the full text here — the executive summary is here. In this post I will comment on chapter 1: posts on subsequent chapters will follow later in the week.

My tuppence ha’penny:

• The headline credit crunch loss predicted by the IMF of $1T has received a lot of press, not least because it is rather larger than the $460B some other commentators have been focussed on. Firstly no one really has any idea at this stage, and secondly it is half the estimated value destruction in the 1994 bond market crisis; so while it is a large number, we should not be too freaked by it.

• There is a lot of good information in the report. For instance this table showing the dependence of a number of European banks on wholesale funding, may be of use in selecting your next short. Just remember it is hard to make money shorting the Republic of France or its wholly controlled subsidiaries.

  

• According to the IMF there has been a massive rise in leverage of global banks. The report has this picture showing the growth of Bank assets and Basel 1 risk weighted assets, which I don’t understand.

  

  Here’s my problem. Consider the Basel 1 risk weights:
  

  Asset Class	Risk Weight
  Cash, Good quality sovereigns, Insured residential mortgages, short term commitments	0%
  Loans to banks and muni risk	20%
  Uninsured residential mortgages	50%
  Loans to banks and muni risk	20%
  All other loans	100%

  If assets are above 15T and RWA are at 5T the average risk weight is roughly 35%. How can that be given the preponderance of corporate and retail risk in the system? Remember RWA also includes derivatives risk which is off balance sheet and not included as an asset, so this number makes even less sense. If anyone can explain how the average Basel 1 risk weight for the banking system comes out at less than 50%, I should be very grateful. Certainly if the data above is correct, the IMF’s conclusion makes a lot of sense:

  Bank supervisors need to take more account of balance sheet leverage as they assess capital adequacy.

• The IMF seems to take a rather optimistic view of the effect of the credit crunch on the availability of credit. They forecast a slowing of the rate of growth of credit but not an outright contraction:
  

  The pace of credit growth in a squeeze would be reduced to a little over 4 percent of the outstanding private sector debt stock in the United States.

  I think that is wildly optimistic. Everything we are seeing from the retail and commercial mortgage markets, for instance, suggests that credit growth will be negative for the next half year at least.

• The IMF administers a richly deserved kicking to the monolines and their system of regulation:
  

  In the United States, the experience of the financial guarantors argues for reforms to U.S. insurance regulation.

  Responsibility currently resides with the states, which has impeded coordination of regulatory efforts across states and with federal bank and securities regulators where spillovers are now evident. A new strategy for regulation of the financial guarantor sector needs to be implemented, including a coherent approach to capital adequacy and new limits on financial guarantors’ activities.

Posted in: Basel, Economic Theory, Monoline, Regulation by David /
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It is possible to support the general theme of a body of work without thinking any particular part of it is interesting or successful. Susannah Clapp captures the phenomenon nicely in a Guardian review of the play Contains Violence at the Riverside studios. Here the audience sit on the roof of the theatre and observe the action in adjacent buildings through binoculars.

In Contains Violence the spectators aren’t in the same building as the actors. You make up your own long-shots and close-ups, using their binoculars to zoom in and out at will; the headphones, which are designed to lock you into the action (you hear not just conversation but the slosh of water, the ring of a phone, the crackle of paper, the clink of a keyboard), also protect you from the sound of other audience members and from street noise. You are, weirdly, much further away from the actors than usual but aurally much closer up. Beneath the imaginary acts of violence, as in a dreamlike backdrop, buses pass by silently, pedestrians bustle, and ambulances speed to real emergencies. Occasionally, a non-actor – a cleaner or late worker – gets snarled up accidentally in the action.

So far, so illuminating: this inside-outsideness sets you up to look quite differently at your surroundings – which is not something The Importance of Being Earnest will usually help you do. But the exciting stuff has actually all happened before the show begins: this is a concept, an occasion, not a drama. Contains Violence has contrived the most thrilling of settings, but it doesn’t manage to convey a real story or any richness of expression.

In other words, great idea, poor use of it. I feel the same way about quantitative hedonics. The idea of trying to use rigourous (OK, quasi-rigourous) economics to argue about happiness without all the usual moral biases or imposition of arbitrary utility functions is a good one. Most of the work in the area, however, disappoints. A good example is given by Jeremy Waldon in his review of Sunstein’s Worse Case Scenarios in the LRB:

[Sunstein] is reluctant to abandon a method of measuring losses by how much people would pay to avoid them, even though it is hopelessly flawed by the fact that poor people would pay less simply because they have less. (We measure the value of a life by asking how much people would pay to avoid its loss, under various scenarios. Now, as a matter of fact, a poor person will not pay $100,000 to avoid a 10 per cent chance of death from cancer, because the poor person has no access to $100,000; so a poor person’s life must be worth less than a million dollars; and so it is not clear how the government can justify imposing taxes for a scheme that spends many millions of dollars to avoid this sort of hazard. That’s the sort of argument this book is inclined to defend.)

On this basis preventing jeering at polo matches is a much more important aim than giving clean water to sub-Saharan Africa since polo players are wealthy and will certainly pay a lot to increase their comfort slightly, whereas the citizens of sub-Saharan Africa are mostly (in dollars a day terms) very poor. So Waldon has a point: cash only works as a measure if we are comparing the happiness of people with roughly the same amount of disposable income. Even percentage of disposable income does not mean much to people who don’t have any. So how can we compare two regulations or two pieces of charity or whatever rigourously in terms of their outcomes? That, it seems to me, is an important question for quantitative hedonics.

Posted in: Cost Benefit Analysis, Economic Theory, Philosophy and Hedonics by David /
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Equity Private is posting again. That is the cause for some celebration. Her creativity have obviously been refreshed by an absence from the blogosphere (what an ugly word) and she has some acerbic gems at the moment. My favourites:

My own disposition is towards limited market efficiency–prices reflect all sufficiently scrutinized information, subject to sufficiently saturating capital. This implies two major sources of pricing error:

1. Insufficient distribution of material information.
2. Insufficient capital applied by those in possession of material information.

This seems so obviously true that I wouldn’t remark on it but for the sheer prevalence of the opposing view – unlimited market efficiency, aka not long enough out of business school disease. As we move further into the crunch, 2. is becoming an important driver of investment opportunities, so one might hope that the wisdom of the doctrine of limited efficiency will become more readily apparent.

Ms. Private then goes on to discuss those strategies (such as buying AAA yielding Libor + 40) that appear to generate alpha, i.e. return without risk.

The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand is not to invest. Or, to emphasize the commenter of earlier fame [Alea]:

If you couldn’t determine the conditions under which the transaction would lose money, you didn’t execute.

Follow that? If you don’t understand what you are buying, don’t buy. Quite simple. Or so you would think.

Cheap debt does not cause losses. Being on the wrong side of information asymmetry does. When structures are complex, falling back to a careful look at incentives often is the best (and only) behavioral prediction mechanism.

So true. But, just as with ‘86 Lafite vs. the ‘85, just because something is obviously worse doesn’t mean that some people won’t buy it.

Posted in: Economic Theory, Rules, Worst case scenarios by David /
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In the financial markets there is nothing really new. Some vaguely good news:

• The ABCP market has expanded a little, for the first time since August 2007;
• The 3m swap spread has come in a little; and
• Despite all the talk, a major monoline has not yet defaulted or even lost its AAA.

Meanwhile the realignment is continuing:

• The VIX is up;
• Shares are broadly down although they are still bizarrely high compared with bond spreads;
• Corporate defaults are expected to rise according to Citi and JPM and the iTraxx is a little wider;
• The rerating and downgrading of CDO tranches continues; and
• The tightening of the ABX over Christmas was temporary.

Posted in: ABS, Commercial Paper, Economic Theory, Markets by David /
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The Baltic Dry Index is an index covering bulk shipping rates. It is calculated by the Baltic Exchange and is the most commonly quoted proxy for the price of moving dry goods by sea. What is interesting is what has been happening to the BDI over the last few years.

Take another look at that. The BDI in 2007 hit roughly six times its 2002 level. The lag in the arb between the level of the BDI and the price of ships is of course reasonably long (about two years according to Slate), but still, this is an interesting trend. There has clearly been an awfully big spike in intercontinental trade and lots of new ships are coming on line. Now consider the most recent data from investmenttools.com:

The BDI is hard to manipulate as it is based on the prices needed to hire real ships to move real cargos. As cyclical indicators go, this one appears to be screaming ‘bubble breaking, get short’.

Posted in: Economic Theory, Markets by David /
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I am currently reading The Last Tycoons, an excellent book about the rise of Lazard Frères. Felix Rohatyn is a prominent character in the book: he was one of Lazard’s best known bankers in the 70s and 80s, perhaps one of the best known investment bankers in the world. One quote from Felix particularly struck me:

I believe in the free market, but I do not believe in laissez-faire. I do not believe that, at the end of the 20th century, in complicated advanced industrial societies, an absolute free market system exists or is desirable. If it does not exist, I do not think we should pretend we can cure the problems we have with simply free-market solutions.

Isn’t that an interesting thing for one of the most talented M&A bankers of all time to say?

Update. Naked Capitalism refers back to an earlier post re-examining the benefits of free trade from a developmental perspective, which in turn reminded me of my own riff on the topic. It would be nice after the crisis is over to look at some of these free market failures in detail. My suspicion is still that the lack of alignment of interests between mortgagees, mortgage originators, and securitisation buyers was one of the major, perhaps the major cause.

Posted in: Economic Theory, Markets by David /
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Alea reports a talk that James Simons, founder of Renaissance Technologies, gave at NYU recently. Simons is a highly successful quant investor so his remarks are interesting. The part of the Alea article that really piqued my interest was:

[...] perhaps the most interesting observation came in response to a question posed by the moderator, Nobel Prize-winner Robert Engle: “Why don’t you publish your research, the theory behind your trading methods? If not while you are active in the markets, perhaps later on.”

Simons’ reply – there is nothing to publish. Quantitative investment is not physics. The markets have no fundamental, set-in-stone truths, no immutable laws. Financial “truth” changes constantly, so that a new paper would be needed almost every week.

The implication is that there is no eternal theorem of finance that could serve as an infallible guide through all the ages. Indeed, there can be no Einstein or Newton of finance. Even the math genius raking in $1 billion and consistently generating 30%-plus annual returns wouldn’t qualify. The terrain is just too lawless.

Simon’s view seems to me to be obviously true, although I don’t quite agree with the Alea spin. It isn’t that there is no law, it is that the law changes as the behaviour of market participants change. Yesterday’s arb is today’s theorem is tomorrow’s unrealistic simplification. As I said over a year ago, mostly the market trades based on the current orthodoxy. But big news changes that orthodoxy – as is happening at the moment in the liquidity markets, and so to make a lot of money you need to be willing to keep changing your theory of asset prices.

This neatly brings me to a related topic, the non-equilibrium nature of financial markets. In retrospect, Walras’ idea of an auctioneer groping towards equilibrium (word of the week – tâtonnement) is really unhelpful because it suggests that there is enough time for this process to be completed and equilibrium reached before the next piece of news hits the market. I don’t think this is true. Rather I conjecture that the process is much more like a game of tetherball, with each new news item changing people’s opinions and hence moving the market long before equilibrium is reached from the previous piece. The ball almost never hangs by the pole, so any theory which analyses where it will come to rest isn’t much use in determining who is going to win the game.

The last piece of the puzzle is the primary role of transactions. There are no prices without transactions to establish them – lots of transactions. So it is only opinions about asset prices which lead to trading that matter. You can be right for a long period about the fundamentals, but if your assumption about how fundamentals lead to trading is wrong then you will lose money. For example I called the weakness of Japan completely correctly through the 2nd half of the 1990s and first half of 2000s, but I was wrong for extended periods on dollar/yen because I hadn’t accounted for the actions of the BoJ and other market participants beliefs about the BoJ. To make a lot of money you need to predict what most other market participants trading-related beliefs will be and get your position on before they do. Predicting fundamentals is only useful if they will influence future trading: on the flip side, predicting wrong beliefs is just as good as predicting right ones if they pertain for long enough for you to make money.

Posted in: Economic Theory, Financial Models, Quantitative Trading by David /
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The news that bids for Northern Rock are considerably below the current share price is hardly surprising but it does remind us that equity is a residual interest. It only has value if the firm can pay its debt in a timely fashion. Every so often shareholders forget that. Then when a firm fails, they clamour for restitution, as with Metronet or Railtrack: doubtless it will be the same with Northern Rock. These claims undermine the financial system: the logic is totally spurious. If equity holders want the returns that come from owning a residual interest, then they should take the risk, and bear any losses in silence. If they don’t want that risk, they should not buy equity.

The priority now, as James Harding puts it in the Times, is first to depositors and the financial system, and last to shareholders. The best option may well be nationalisation. It certainly won’t be something that leaves tax payers with exposure and grants a return to shareholders.

Posted in: Bank Run, Economic Theory by David /
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Some tedious blogger who I won’t glorify with a link challenged Paul Krugman to admit that Mrs. Thatcher was ‘good for the UK economy’. That made me wonder how you would tell. At first it doesn’t seem difficult: there are a number of indicators of which perhaps GDP is the most obvious, and Thatcher the Milk Snatcher did indeed have policies which seem to have resulted in faster GDP growth.

However thinking about it for a moment it is obvious how to produce higher GDP growth: don’t spend on infrastructure and instead use the money to stimulate the economy. In the long term you reduce growth as the education system, transport and utility infrastructure can’t support the needs of the economy and you have to raise taxes high to fix them. But in the short term you get an upswing.

My gut instinct is that that is what happened under Thatcher: her government chronically underspent on the NHS, universities, schools, railways and so on. This allowed her to cut taxes which stimulated the economy for a few years. But because the workforce is undereducated, you can’t get around quickly and conveniently, and so on, eventually these constraints start to bite and growth is slower than it would have been if essential services had been maintained and improved. The present value of future earnings is lower without proper investment as any good private equity person knows. Of course measuring this long term decrease in potential GDP is enormously difficult to measure, but the phenomenon is certainly there. So perhaps even on economic grounds history will judge that Thatcher does not score that well.

Posted in: Economic Theory, Political Metrics by David /
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Stolen more or less wholesale from Naked Capitalism:

Dani Rodrik has [...] set forth the conditions that have to be in place for trade liberalization to enhance economic performance (short answer, a lot); in another [post], he reviewed the analyses that claimed that our current trading system produced large economic gains and found the logic to be badly flawed.

Rodrik in turn refers to Deconstructing the Argument for Free Trade, an excellent paper by Robert Driskill. In particular Driskill begins by asking what the metric is:

What does it mean for a change in economic circumstances to be “good for the nation as a whole”?

He then goes on to review various possible metrics, and discuss their advantages and disadvantages. Encouragingly, he ends not with a conclusion but a methodological recommendation:

Trade economists should [...] be forthright about the epistemological basis of their policy advocacy of free trade.

In other words, be clear about why you claim something is a good idea, not just that it is one.

Posted in: Economic Theory, Political Metrics by David /
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Paul Krugman uses the term ‘Wile E. Coyote’ moment for when traders find a currency level is unsupported by fundamentals and it drops precipitously. Certainly some currencies display very fat tails: they tend to have long periods of stability, followed by one or more greater than five s.d. moves. (The interested reader may at this point wish to fit the Generalised Pareto Distribution to twenty or more years worth of dollar/yen returns, and compare the GPD VAR with the normal one at 99.99%: typically it’s very roughly four times higher.)

Krugman further suggests that a Wile E. Coyote moment may be approaching for the dollar. This is more than just suggesting that the dollar will fall: the fall has to be steep to qualify. Tanta over on Calculated Risk has some supporting evidence (which is a little glib but bear with me):

Bear in mind that the principal channel through which Fed policy affects domestic demand is via housing. If a burst housing bubble is part of the economic problem, the Fed’s leverage over the economy will be greatly reduced, and even a zero Fed funds rate might have only modest stimulative effect.

The problem is too many people are talking about this possibility: many currency strategists expect dollar weakening, so existing dollar shorts will tend to make large falls much less likely. The macroeconomic picture is not encouraging for the dollar, it’s true. As Long or Short Capital put it, albeit amusingly bluntly:

I challenge you to find one measure of wealth OTHER THAN THE DOLLAR which shows the US economy as worth more now than in 2001. If I wanted to buy our country it would cost me 30% fewer euros today than it did in 2001, it would cost me less bars of gold, less barrels of oil, less ounces of copper, less btu’s of natural gas, less cubic feet of lumber, less of almost anything that has intrinsic value. Yet you keep reporting GDP growth, why? Because your quick fix is to effectively print more money so that in dollar units everything is getting more “valuable”. But guess what, to the 95% of the world that doesn’t use dollars the true value of the US economy has been shrinking, rapidly.

Moreover, central banks, notably asian central banks, are not buying enough dollars to provide a floor. As Brad Setser says:

The world’s key central banks have concluded that they have more reserves than they need, and are rapidly losing interest in adding to their dollar reserves. China’s central bank has made it known that it thinks it has enough reserves. Some in China think the PBoC already has far more reserves than it needs. Korea’s central bank has indicated — at various points in time — that it has more than enough salted away. The ADB agrees.

Still, currencies are often a long way from macro-economic equilibrium, and the U.S. has historically shown an astonishing ability to grow out of difficulties. Despite the fundamentals then instinct suggests that while one might not want to be short dollars yet. That just leaves buying the potential to benefit from a Wile E. moment via the options market. Perhaps selling short term downside gamma (in the belief that Wile E. will take a while to arrive at the cliff) generating cash to pay for a longer-dated further from the money position might be interesting.

I’m sure a salesperson will soon christen this ‘the Coyote trade’: look for a range of North American mammal structured notes at your friendly investment bank shortly.

Posted in: Derivatives, Hedging and Convexity, Economic Theory, FX, Financial Models by David /
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Well not quite. But here’s the thing. Roubini Economics Monitor discusses the distinction between risk (in his terms variability in outcomes that can be estimated statistically) and uncertainty (unknown or unmeasurable outcomes). The basic idea in this article is that risk can be priced but uncertainty can’t:

Economists distinguish between “Risk” and “Uncertainty”: the former can be priced by financial markets while the latter cannot. The distinction between the two was made by the famous economist Frank H. Knight in his seminal book, Risk, Uncertainty, and Profit (1921). In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”.

This is all very well but unhelpful as in these terms the financial markets have no risk, just uncertainty. We never know that our modelling is right and we have correctly estimated risk because we don’t know what random process the underlying is following. We don’t known what lies beneath. We just hope for the best and under ordinary conditions mostly we are right.

Structuring does not add to uncertainty, it just translate an unknown return distribution into an unknown P/L distribution in a deterministic way. Thus while this quote correctly describes some of the RMBS market:

First, you take a bunch of shaky and risky subprime mortgages and repackage them into pass throughs; then you repackage these PTs in different (equity, mezzanine, senior) tranches of cash CDOs that receive a misleading investment grade rating by the rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (CDO squareds) out of these CDOs … then you stuff some of these tranches into SIVs or into ABCP conduits or [even] into money market funds.

It does not effect the epistemology of the situation. What we are seeing now is a combination of leverage (which again purely deterministically magnifies any modelling errors) and model risk producing a liquidity crisis as people have suddenly noticed how uncertain the value of their securities is. That doesn’t mean it wasn’t uncertain earlier, just that they didn’t know it was uncertain. Those unknown unknowns have become known unknowns, and that is why we have a problem.

Posted in: Economic Theory, Financial Models, Liquidity and liquidity risk, Markets by admin /
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I’ll start with an effective way to create hap- piness. Lays’ ketchup flavour crisps and Mouton Rothschild 1985. Yes, I know it sounds like a strange combination but it actually really works. So, if that is practical hedonics, what’s quantitative hedonics?

Economists are starting to broaden the idea of cost, in particular talking about the cost of happiness. Quantitative hedonics, then, is an attempt to measure misery or its inverse, joy. The basic idea is easy enough: if you rate your happiness sitting in the garden this morning at 6/10 without an ice cream and 7/10 with one, and an ice cream costs £1, then it costs £1 to increase your happiness 10%.

Nick Cohen in today’s Observer discusses an example of this: the cost of aircraft noise. Clearly being overflown makes people miserable. How much should the airlines pay to compensate the people they inflict this on? Obviously one cannot get an unequivocal answer, but even an estimate is interesting.

This view of the world suggests a different way at looking at some problematic modern situations. For instance recently the New York Times had a discussion of babies on public transport. One side took the view that a screaming child make the whole experience miserable for everyone: the other that they had a perfect right to travel with their child no matter how noisy. It would be interesting of debating whether it is acceptable to travel with a screaming infant what the hedonic cost of doing so was. Perhaps if this added onto the parent’s ticket their decision to travel might be different?

Posted in: Cost Benefit Analysis, Economic Theory, Philosophy and Hedonics by admin /
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An interesting post on the Street Light Blog, on currency misalignments, suggests an interesting question: is economics an equilibrium discipline? The very idea of a misaligned FX rate suggests that the natural state is an aligned one: perhaps the fundamentals move faster than the markets adjust, so FX is never in equilibrium. Perhaps (in the language of statistical mechanics) the relaxation time is much longer than the average time between forcings. Actually that makes a lot of sense…

Update. Paul Krugman seems to agree, at least in a limited context:

A free-market economy can get trapped for an extended period in a bad equilibrium in which good things are not demanded because they have never been supplied, and are not supplied because not enough people demand them

Posted in: Economic Theory, FX by admin /
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A recent Bloomberg article referring to the AEI-Brookings Institute paper Has Economic Analysis Improved Regulatory Decisions? made me think again about cost benefit analysis.

The paper condemns both the quality of cost benefit analysis used in determining the impact of regulation and the `tenuous’ use made by policy makers of that analysis. Undoubtedly that is partly for political or hegemonic reasons – cost benefit analysis sometimes comes to the `wrong’ conclusions – but I suspect it is also partly because the conclusions of a cost benefit analysis are sometimes not believed. The analyst may be at fault here for not stating the margin of error?

Error bars are common in experimental science: the fine structure constant, for instance, is known to roughly one part in a billion, and in any precise discussion we would state not 1/alpha = 137.035999710 but rather 1/alpha = 137.035999710(96) meaning that the reciprocal of alpha could be as high as 137.035999796 or as low as 137.035999624.

In cost benefit analysis this could be a very useful tool, especially as the error bars are much larger. To take the first example that google coughed up, an amusing cost benefit analysis of different law schools (where the cost is the fees and the benefit is the increase in expected salary after going to the school), the problem is that while the costs are fixed, the benefits aren’t. Not only do different individuals earn different amounts despite having the same education, speciality counts so that (in the perverse world in which we live) a tax lawyer earns more than a criminal defender. Moreover the reputation of various law schools will change over time effecting not just the earnings of current graduate but also those of past ones.

An even better example is one of the next hits, a discussion of the cost benefit analysis of rebuilding New Orleans after Katrina given its obvious hurricane risk. Here not only is the benefit uncertain, but so too is the cost. Any analysis with error bars would suggest at best ‘case not proven’: that, rather than ‘cost > benefit’ or ‘cost < benefit' is often the best that we can conclude since it will often be the case that the intervals [cost - possible error in cost, cost + possible error in cost] and [benefit - possible
error in benefit, benefit + possible error in benefit] intersect.

Posted in: Cost Benefit Analysis, Decision Making, Economic Theory by David /
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In some situations the free market seems to work reasonably well – the equity markets in ordinary conditions for the largest companies, for instance. In others, the unfettered market (at least as currently set up) does not seem to be as efficient: the internal market in the NHS might be one example, the monopolistic behaviour of some corporations is another. So when does the market work well?

Some thoughts about things which help:

• There are a lot of items which are broadly the same, and these are transacted often. A market price only means something if price discovery is useful to other market participants. Thus the market price of a stock (and the near certainty of liquidity at that price) is useful information to other owners of that stock. The market price of the only sculpture ever made by a particular artist is of lesser interest to other market participants as it gives almost no information about transactions they might be able to make.
• There are a variety of different independent willing buyers and willing sellers of the same (or very similar) item. Because otherwise the price can be distorted by the operation of monopolies on one or both sides. This is not necessarily to disadvantage of the buyers, but it does mean that the free market model may not be appropriate.
• The costs of providing a market are not too high. It may be that there are situations where transaction, marketing or other costs are so high that having a range of providers does not make sense. I suggest this might well be the case for something like railways: a single system is better than a choice between competing alternatives.
• A public marketplace is acceptable to most market participants. In some markets it may well be that the advantages of a visible price are outweighed by the disadvantages of being seen to transact. Market participants may value privacy highly.
• There is not an unacceptable level of moral hazard or information asymmetry in participating in the market. Thus for instance buyers are comfortable that sellers are not selling because they know something bad about the item which the buyer cannot easily discover.
• The market is not thought to be easily manipulable. Market participants tend to shun markets that are seen as unfair.
• The market is not illegal and actively policed. Although arguably the market for certain drugs is a counterexample.

Posted in: Economic Theory, Liquidity and liquidity risk, Markets, Rules by David /
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There is an absolutely fascinating article in the current LRB about happiness and the hedonic treadmill. Briefly (and sadly you will have to buy the magazine as the full article is only online for LRB subscribers) it appears that Avner Offer has shown, at least to the reviewer’s satisfaction, that growing GDP beyond a certain point leads to decreasing happiness. Extra income is not Pareto optimal. Now if this Easterlin paradox is really true (and what is new about Offer’s book is apparently the wealth of detailed econometric evidence), this does pose some interesting challenges about what to do about it.

Posted in: Economic Theory, Philosophy and Hedonics by David /
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I have just been reading an interesting article by Paul Krugman. Partly it is a discussion of The Theory of Comparative Advantage (yes, I had to look it up, embarrassingly: try this if you do too) and how poorly understood it is; but partly it is an (understandable) cri de coeur about the failure of supposed intellectuals to take simple economic models seriously. Perhaps it struck a chord because I saw a similar complaint earlier, at Overcoming Bias:

Consider how differently the public treats physics and economics. Physicists can say that this week they think the universe has eleven dimensions, three of which are purple, and two of which are twisted clockwise, and reporters will quote them unskeptically, saying “Isn’t that cool!” But if economists say, as they have for centuries, that a minimum wage raises unemployment, reporters treat them skeptically and feel they need to find a contrary quote to “balance” their story.

In short we, the ungrateful general populace, do not take economic models and their outputs seriously. Well, following that sage of economics Homer Simpson, Duh. Yes people don’t have the same respect for economic predictions as for ones from the physical sciences. Some reasons could include

• Physics has a long and glorious history of successful predictions about the world. Economics has, I suggest, explained rather less about its corner of reality and some of its recent predictions have turned out to be wrong.
• In Physics if experiment repeatedly and consistently fails to confirm a theory, then the theory is reworked to fit the facts. In Economics if a theory is repeatedly falsified, there seems to be rather more effort spent on explaining why those facts aren’t relevant than on figuring out what’s wrong. Moreover Economics has a relatively small ‘experimental’ community devoted to testing theories given the number of theorists.
• Physics embraces complexity. It acknowledged the existence of chaotic dynamics early, for instance, and it has tried to find appropriate models of these systems. Similarly, philosophically problematic though quantum mechanics is, physicists are engaging with it. Economists seem to shun complexity and cling to principles like the rational self interested agent that seem to have little predictive power (vide Behavioural Finance) and whose day could well be past.

Uncomfortable though this may be to Economists, until they have something like the success of Physics to tuck under their belts, they aren’t going to get something like the same amount of respect.

Posted in: Complexity, Economic Theory, Financial Models by David /
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…my favourite post of the week is Do Helping Professions Help? from the often readable Overcoming Bias. I like it because it asks a hard question about the system in a way that displays a delicate understanding of the rules.

Posted in: Economic Theory by David /
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A little while ago I was in Hong Kong (cue gratuitous Blade Runner themed pictures of the city at night). On the way back, I read a paper Dilemmas of an Economic Theorist. It was probably a good thing that I was on a plane at the time: the spluttering of disbelief that such egocentric ramblings was published in a peer reviewed journal would probably have disturbed my neighbours if I had been at home. As it was I took another swig of Cathay’s Bonnes Mares and composed a list of objections:

• Firstly this paper seems entirely ignorant of any philosophy of science. While economics clearly isn’t scientific, one might at least hope one of the referees had heard of Popper if not Lukacs. Anyway. The author poses the ‘problem’: Should we abandon a model if it produces absurd conclusions or should we regard a model as a very limited set of assumptions that will inevitably fail in some contexts? This simply shows the importance of defining a domain of applicability. Then if the model doesn’t work within the domain, you have falsified it. It’s wrong. Move on.
• The next ‘dilemma’ is even more absurd. Should our models be judged according to experimental results? What else are you going to judge them on? How nicely they are typeset? Whether they give you a warm and fuzzy feeling when you cuddle them? That such a question is posed in an eminent journal just shows how deeply screwed some academic economics is.



• Finally we have Do we have the right to offer advice or to make statements that are intended to influence the real world?

Ignoring the temptation to suggest on the basis of the foregoing economists have no right to enter a university let alone try to influence the real world, what else is economics for?

Show me an economist who is willing to put his own money on a trading strategy based on his theorists, and I’ll respect him – Soros is the obvious example. Show me one who is trying to help a country improve its growth, or ameliorate poverty, or any other laudable objective, and I’ll respect her too. But an academic who write papers as fatuous as Dilemmas of an Economic Theorist? Even the famously polite Chinese might have a problem finding something good to say about him.

Posted in: Economic Theory, Philosophy and Hedonics by David /
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A recent article in Salon (watching an ad required to enter) nicely captures one of the preoccupations of this blog. It begins with a discussion of an essay by Devesh Kapur, The Knowledge Bank. Paraphrasing slightly, Kapur suggests that economic consultants are not primarily motivated by finding successful outcomes:

The very nature of academia means that researchers [...] are not accountable for the consequences [of their work] in the sense that it responds to professional incentives, not to development payoffs. These professional incentives place a large positive premium in academic papers on the novelty of ideas, methodological innovation, generalizability and parsimonious explanations. Detailed country and sector knowledge, an acknowledgment that the ideas may be sensible but not especially novel, that uncertainty and complexity rather than parsimony are perhaps the ground reality, are all poor country-cousins of research that purports to find universal truths.

Kapur is talking about the social sciences in general and developmental economics in particular, but the conclusions hold much more broadly. As Salon says:

One of the clearest fault-lines in economic debates [...] is between those who believe they know one answer that fits all questions, and those who believe every question deserves a different answer — that what works for Singapore may not work for Somalia, that the circumstances of Bangladesh require a different approach than the conditions of Brazil. It’s a fault-line that transcends ideological differences between right and left, free trader and protectionist. On one side, a willingness to accept complexity and uncertainty also concedes that one may not know what the answer to a given question is; on the other, the rightness of the answer is taken as a given, and it’s the implementation that must be at fault; it’s never “I don’t know” and always “how did you screw it up?”

This is a lovely summary of a ubiquitous fallacy: just because we sometimes have to pretend that the world is simple to get on doesn’t mean we have to believe it. Incrementalism — trying something you think might work, seeing what happens, and adjusting your strategy based on the outcome — is surely the only rational response to a complex, partially comprehended reality. Bangladesh is different from Brazil, and 2006 Britain from 1990 Britain, for that matter. Yesterday’s remedies might work, but we should approach their application with a suitable sense of humility.

Posted in: Complexity, Economic Theory, Rules by David /
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From the Guardian: World Bank president Paul Wolfowitz denied that there was a row with Britain, despite the announcement earlier this week by Hilary Benn, the international development secretary, that Britain would withhold £50m of funding unless the Bank started to lend money to poor countries without onerous strings attached.

This rang an ominous bell as I have just been doing some work on country risk. The problem is that ‘open market’, ‘transparency’, ‘corruption’ and so on are relative terms: what they mean depends on where you are standing. On man’s big risk is another’s irrationally and delightfully high spread.

Hilary Benn apparently believes that Wolfowitz has been rather laxer with some countries whose friendship the U.S. values, like Pakistan, than others. I have no view on this, but I do know that however you decide to write sovereign loan covenants, if you are the World Bank someone is going to be upset with you. Perhaps the answer is to negociate with all of the potential borrowers simultaneously, so at least there is a standard hurdle for everyone? But of course if Benn is right, that is the last thing Wolfowitz would agree too. At least, though, let us agree it is a game where, rightly or wrongly, the guy with the money makes the rules. And of course those rules determine when sovereign default is rational. For Pakistan, it probably isn’t. Other states, treated differently, may have another view.

Posted in: Economic Theory, Politics, Sovereign Default by David /
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I’ve just seen an amusing programme on BBC2, ‘Trust me, I’m an economist’. It applies, albeit in a rather trite way, ideas of game theory, strategy and incentive structures to ‘real life’ situations. And it isn’t bad. Really. Considering. Given it is television.

Posted in: Economic Theory, Media and Popular Culture by David /
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Reading papers outside your discipline is good, and I’ve just found a corker, The Big, Bad Wolf and the Rational Market: Portfolio Insurance, the 1987 Crash and the Performativity of Economics by Donald MacKenzie in the Sociology Department at Edinburgh. He makes several interesting points.

Firstly he suggests treating finance as (a) historically variable in its verisimilitude; (b) dependent for its verisimilitude on institutional and technological conditions; and (c) implicitly a historical project, incorporated into efforts to transform its object of study, the financial markets. No surprises so far, but rather nicely put. MacKenzie then introduces the term ‘performative’ for utterances that make themselves true, giving as examples the naming of a ship or the Black Scholes theory of option pricing. (Of course before Black Scholes, the warrant markets traded rather far from Black Scholes prices, a fact that cost Black, Scholes and Merton rather a lot of money. It was only once their theory became established that the markets came in line, modulo the smile.)

Then MacKenzie goes on to point out that the 1989 crash fits rather poorly within any of the standard Brownian motion based models of asset price dynamics, but it does mirror somewhat startlingly the initial falls of the Dow Crash of 1929.

Personally I think MacKenzie over emphasises the potential role of portfolio insurance in the Black Monday crash. He suggests that once markets were close to or beyond the protection bounds of CPPI strategies being executed by market participants, further falls were inevitable. While this is clearly true, it remains unclear if there was sufficient activity in this area to explain much of the Black Monday fall, at least compared with the activities of the large stock funds, investment managers (many of whom were aware of the comparison between the run up to Black Monday and the run up to the 1929 events before the fact), and indeed anyone else with a stop loss.

MacKenzie quotes Leland, one of the fathers of portfolio insurance, on the topic of information. Leland contents that if investors had known how much of the Black Monday selling was caused by programme selling, that is automatic selling under CPPI or options hedging, market participants would have been reassured and the fall would not have been so severe as ‘judgement’ investors would have been more willing to buy into the fall. This is an interesting claim: a devious experiment would be needed to test it, but the results would be fascinating.

Finally, MacKenzie comments on the market’s performativity. To summarise a rather complex conclusion in a few sentences, he suggests that banks have an interest in making the markets as like the model as possible and that this process is dangerous in that it gives confidence in the stability of model applicability over time that may not be justified. It is almost as if we are saying ‘the model works unless there are big jumps’, then hedging so that big jumps are less likely but, if they happen, they will become bigger. Mathematical Finance is performative around the money, then, and antiperformative in the wings. Scarey.

Posted in: Economic Theory, Financial Models by David /
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Given the budget is close, let’s talk Economics. Here’s a model of how to win a Nobel prize in that esteemed discipline. Come up with a macro economic theory, publish it, have it suffiently well accepted that governments use it to set monetary policy.

This is difficult, of course, but at least the programme is clear. It is a model from science: discover something, publish it, help explain the world, add to knowledge.

But what if that was not possible? What if Economics is fundamentally different from Physics, in that the very act of discovering something and using it makes it less likely to correctly predict future behaviour? It could be that the economy does not just change fast, the dynamics change too. The way to understand it next year won’t be the way to understand last year, not just because we will know more, but because last year’s theories won’t work any more.

Posted in: Economic Theory, Mathematics and Science by David /
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