Wednesday, November 30, 2011

Alan Greenspan's nirvana

I wrote a post a while back exploring some of the silliest things economists were saying before the crisis about how financial engineering was making our economy more robust, stable, efficient, wonderful, beautiful, intelligent, self-regulating, and so on. The markets were, R. Glenn Hubbard and William Dudley were convinced, even leading to better governance by punishing bad governmental decisions. [How that could be the case when markets have a relentless focus on the very short term is hard to fathom, but they indeed did assert this]..

Paul Krugman has recently undertaken a similar exercise in silliness mining -- in this case going through the hallucinations of Alan Greenspan. The Chairman of the Fed was evidently drinking the very same Kool-Aid:
Deregulation and the newer information technologies have joined, in the United States and elsewhere, to advance flexibility in the financial sector. Financial stability may turn out to have been the most important contributor to the evident significant gains in economic stability over the past two decades.

Historically, banks have been at the forefront of financial intermediation, in part because their ability to leverage offers an efficient source of funding. But in periods of severe financial stress, such leverage too often brought down banking institutions and, in some cases, precipitated financial crises that led to recession or worse. But recent regulatory reform, coupled with innovative technologies, has stimulated the development of financial products, such as asset-backed securities, collateral loan obligations, and credit default swaps, that facilitate the dispersion of risk.

Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply credit protection.

These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago.

As Krugman notes, this can all be translated into ordinary language: "Thanks to securitization, CDOs, and AIG, nothing bad can happen!"

Bail out everyone

I had wondered about this idea a couple years ago -- but that's all I did, wondered about it. The idea is that when banks need bailing out -- and sadly, we seem stuck with that problem for the moment -- we shouldn't bail them out directly, but indirectly. For example, just give every single person in the US $1,000. Or maybe a voucher for $1,000 that they have to spend somewhere, or put in a bank. This quickly amounts to $300 billion infused into the economy, a large portion of which would end up in banks. So cash would be pumped into the banks too, but only through people first.

You can imagine all kinds of ways to play around with such a scheme. Paying off some of peoples' mortgages. The amount injected could be much larger. Perhaps similar funds would be injected directly into banks and other businesses as well. Mark Thoma has thought through some of the details. But I'm quite surprised this is the first I've heard about any idea even remotely like this. It seems like a much better idea than just giving money to the bankers who created the problem in the first place. Why don't we hear more about such possibilities?

Modern European Tragedy

The endgame playing out in Europe is a tragedy in the usual sense, but also in the sense of Greek tragedy -- downfall brought about ironically through the very efforts, perhaps even well intentioned, of those ultimately afflicted. It's terrible to see Europe looming toward disaster, but also utterly fascinating that everyone involved -- Greeks, Germans, French, the European Central Bank -- has acted in what they thought was their own interest, yet those very actions have led the collective to a likely outcome much worse for all. A tragedy of the commons.

Philosopher Simon Critchley has written a brilliant essay exploring this theme more generally. Among the most poetic analyses of the situation I have seen:
The euro was the very project that was meant to unify Europe and turn a rough amalgam of states in a free market arrangement into a genuine social, cultural and economic unity. But it has ended up disunifying the region and creating perverse effects, such as the spectacular rise of the populist right in countries like the Netherlands, for just about every member state, even dear old Finland.

What makes this a tragedy is that we knew some of this all along — economic seers of various stripes had so prophesied — and still we conspired with it out of arrogance, dogma and complacency.  European leaders — technocrats whom Paul Krugman dubbed this week “boring cruel romantics” — ignored warnings that the euro was a politically motivated project that would simply not work given the diversity of economies that the system was meant to cover. The seers, indeed, said it would fail; politicians across Europe ignored the warnings because it didn’t fit their version of the fantasy of Europe as a counterweight to United States’ hegemony. Bad deals were made, some lies were told, the peoples of the various member countries were bludgeoned into compliance often without being consulted, and now the proverbial chickens are coming home to roost.

But we heard nothing and saw nothing, for shame. The tragic truth that we see unspooling in the desperate attempts to shore up the European Union while accepting no responsibility for the unfolding disaster is something that we both willed and that threatens to now destroy the union in its present form.

The euro is a vast boomerang that is busy knocking over millions of people. European leaders, in their blindness, continue to act as if that were not the case.

Monday, November 28, 2011

The end of the Euro?

Three interesting articles on what now seems to be considered an increasingly likely event -- the end of the Euro (in its current form, although some version might arise from the ashes).

First, Gavyn Davies speculates on several possible scenarios for the collapse of the Euro. It might persist as the new currency of a smaller union including Germany and The Netherlands (in which case the value of the Euro would rise significantly), or it might persist as the new currency of the periphery countries after Germany bolts (in which case the value of the Euro would fall significantly). Or the Europeans might finally find a way through the ongoing nightmare. Not betting on that one.

Second, Satyajit Das goes into a little more detail, and I think rightly sees some cultural issues as ultimately being most important. The three logical possibilities are easy to list:
The latest plan has bought time, though far less than generally assumed. The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults. 
 Germany may be largely in favour of solution number 1. But the smaller periphery countries, and perhaps France as well, will favour solution number 2. Hence, we may by default find Europe hurtling inexorably into "solution" number 3 -- sovereign defaults:
The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow printing money. This assumes that a cost-benefit analysis indicate that this would be less costly than a disorderly break-up of the Euro-zone and an integrated European monetary system. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.

Unless restructuring of the Euro, fiscal union or debt monetisation can be considered, sovereign defaults may be the only option available.
Perhaps it betrays a little bit of anarchy in my own soul, but I'm rooting quite hard for sovereign defaults. I wish the Greeks had gone ahead with their referendum. For all the complaining about the slack morals of the Greek taxpayer, every debt-creating transaction has two sides -- and the creditors (French and German banks) bear as much responsibility as the debtors.

Then again, the end is likely to bring some severe social misery, not to mention riots (the UK is already advising its European embassies on the likelihood). A third article by Simon Johnson and Peter Boone points ominously in this direction, essentially echoing Davies' analysis in bleaker language:
The path of the euro zone is becoming clear. As conditions in Europe worsen, there will be fewer euro-denominated assets that investors can safely buy. Bank runs and large-scale capital flight out of Europe are likely.

Devaluation can help growth but the associated inflation hurts many people and the debt restructurings, if not handled properly, could be immensely disruptive. Some nations will need to leave the euro zone. There is no painless solution.

Ultimately, an integrated currency area may remain in Europe, albeit with fewer countries and more fiscal centralization. The Germans will force the weaker countries out of the euro area or, more likely, Germany and some others will leave the euro to form their own currency. The euro zone could be expanded again later, but only after much deeper political, economic and fiscal integration.

Tragedy awaits. European politicians are likely to stall until markets force a chaotic end upon them. Let’s hope they are planning quietly to keep disorder from turning into chaos.

Friday, November 18, 2011

Are economists good scientists?

I've had no time to post recently for several reasons, mostly the urgent need to work on a book closely related to this blog. The deadline is getting closer. I hope to resume something like my previous posting frequency soon.

But I would like to point everyone to a fascinating recent analysis of economists' opinions about the scientific method (that seems the best term for it, at least). Ole Rogeberg, a reader of this blog, alerted me to some work by himself and Hans Melberg in which they surveyed economists to see how much they looked to actual empirical tests of a theory's predictions in judging the value of a theory. The answer, it turns out, is -- not much. Internal consistency seems to be more important than empirical test.

This even for a theory -- the theory of "rational addiction", which seeks to explain heroin addiction and other life destroying addictions as the consequence of fully rational choices on the part of individuals as they maximize their expected utility over their lifetimes -- which on the face of it seems highly unlikely, making the burden of empirical evidence (one would think) even higher. Some history. Gary Becker (Nobel Prize) of the University of Chicago is famous for his efforts to push the neo-classical framework into every last corner of human life. He (and many followers) have applied the trusted old recipe of utility maximization to understand (they claim) everything from crime to patterns of having children to addiction. You may see a slobbering shivering drunk or junkie in an alleyway in winter and think -- like most people -- there goes someone trapped in some very destructive behavioural feedback controlled by the interaction of addictive physical substances, emotions and so on. Not Becker. It's all quite rational, he argues.

Now, Rogeberg and Melberg. Here's their abstract:
This paper reports on results from a survey of views on the theory of rational addiction among academics who have contributed to this research. The topic is important because if the literature is viewed by its participants as an intellectual game, then policy makers should be aware of this so as not to derive actual policy from misleading models. A majority of the respondents believe the literature is a success story that demonstrates the power of economic reasoning. At the same time, they also believe the empirical evidence to be weak, and they disagree both on the type of evidence that would validate the theory and the policy implications. These results shed light on how many economists think about model building, evidence requirements and the policy relevance of their work.
Now, in any area of science there are disgreements over what evidence really counts as important. I've certainly learned this from following 20 years of research on high temperature superconductivity, where every new paper with "knock down" evidence for some claim tends to be immediately countered by someone else claiming this evidence actually shows something quite different. The materials are complex as is the physics, and so far it just doesn't seem possible to bring clarity to the subject.

But in high-Tc research, theorists are under no illusion that they understand. They readily admit that they have no good theory. The same attitude doesn't seem to have been common in economics. Rogeberg and Melberg have also described their survey work in this clearly written paper in a less technical style.

A few more choice excerpts from their (full) paper below:
The core of the causal insight claims from rational addiction research is that people behave in a certain way (i.e. exhibit addictive behavior) because they face and solve a specific type of choice problem. Yet rational addiction researchers show no interest in empirically examining the actual choice problem – the preferences, beliefs, and choice processes – of the people whose behavior they claim to be explaining. Becker has even suggested that the rational choice process occurs at some subconscious level that the acting subject is unaware of, making human introspection irrelevant and leaving us no known way to gather relevant data...

The claim of causal insight, then, involves the claim that a choice problem people neither face nor would be able to solve prescribes an optimal consumption plan no one is aware of having. The gradual implementation of this unknown plan is then claimed to be the actual explanation for why people over time smoke more than they should according to the plans they actually thought they had. To quote Bertrand Russell out of context, this ‘is one of those views which are so absurd that only very learned men could possibly adopt them’ (Russell 1995, p. 110).
On the nature of reasoning in rational addiction models (this is Nobel Prize winning stuff, by the way):
[The addict]... looks strange because he sits down at (the first) period, surveys future income, production technologies, investment/addiction functions and consumption preferences over his lifetime to period T, maximizes the discounted value of his expected utility and decides to be an alcoholic. That’s the way he will get the greatest satisfaction out of life. (Winston 1980, p. 302)


Monday, November 7, 2011

ISDA: Stop Making Sense

The following is a response I just posted on Bloomberg to some criticism last week coming from the International Swaps and Derivatives Association. They took issue with some things I had written in my latest Bloomberg column. I think their comment was partially fair, and also partially misleading, so I thought some clarification would be useful. The text below is identical to what appears (or will very shortly) in Bloomberg:


My most recent Bloomberg column on the network of credit default swaps contracts provoked a comment from the International Swaps and Derivatives Association, Inc. The group objected to my characterization of the network of outstanding CDS contracts as "hidden" and potentially a source of trouble. I'd like to address their concerns, and also raise some questions.

Contrary to the association's claim, I am aware of the existence of the Depository Trust & Clearing Corporation. I'll admit to having underestimated how much their project to create a warehouse of information on CDS contracts has developed in the past few years; my statement that these contracts are not "recorded by any central repository" was too strong, as a partial repository does exist, and the DTCC deserves great credit for creating it.

However, it is not clear that this repository gives such a complete picture of outstanding CDS linkages that we can all relax.

For example, DTCC's repository covers 98 percent of all outstanding CDS contracts, not 100 percent. Asking why may or may not be a quibble. After all, a map showing 98 percent of the largest 300 cities in the U.S. could leave out New York, Los Angeles, Chicago, Houston and Philadelphia. Moreover, the simple number of contracts tells us nothing about the values listed on those contracts. In principle, the missing 2 percent of contracts could represent a significant fraction of the outstanding value of CDS contracts.

More importantly, when thinking about potentially cascading risks in a complex network, fine details of the network topology -- its architecture or wiring diagram -- matter a lot. Indeed, the CDS contracts that put American Insurance Group Inc. in grave danger in 2008 represented a tiny fraction -- much less than 1 percent -- of the total number of outstanding CDS contracts.

Hence, it would be interesting to know why the repository holds only 98 percent rather than 100 percent. There may be a very simple and reassuring answer, but it's not readily apparent from DTCC's description of the repository.

Also, there is another issue which makes "fully transparent" not quite the right phrase for this network of contracts, even if we suppose the 98 percent leaves out nothing of importance.

The DTCC commendably makes its data available to regulators. Still, it appears that the full network of interdependencies created by CDS contracts may remain opaque to regulators, because DTCC, according to its own description, enables...
"... each regulator to access reports tailored to their specific entitlements as a market regulator, prudential or primary supervisor, or central bank. These detailed reports are created for each regulator to show only the CDS data relevant to its jurisdiction, regulated entities or currency, at the appropriate level of aggregation."
This would imply, for example, that regulators in the U.S. can look and see which of their banks have sold CDS on, say, a big German bank. But the health of the U.S. banks then depends directly on the health of that German bank, which may in turn have sold CDS on Greek or Italian debt or any number of other things. The DTCC data on the latter CDS contracts would, apparently, not be available to U.S. regulators, being out of their jurisdiction.

The point is that a financial institution is at risk not only from contracts it has entered into, but also from contracts that its many counterparties have entered into (this is the whole idea of systemic risk linked to the possibility of contagion). Credible tests of the financial network's resilience require a truly global analysis of the potential pathways along which distress (particularly from outright counterparty failures) may spread. It's not clear that any regulator has the full data on which such an analysis can be based.

None of this, by any means, is meant as a criticism of DTCC or what it has done in the past few years. The 98 percent figure is impressive, and let's hope the 98 percent soon becomes 100 percent and the DTCC finds a way to make ALL information in the repository available to regulators everywhere. Even better would be full disclosure to the public.

Of course, nothing in the comment from the International Swaps and Derivatives Association changes the main point of my column, which was that it is incorrect to believe that more CDS contracts -- or, more generally, more financial interdependencies of any kind, including links created by other derivatives such as interest-rate swaps -- automatically lead to better risk-sharing and a safer banking system. More apparent risk-sharing can actually mean more systemic risk and less overall banking safety.

(Mark Buchanan is a Bloomberg View columnist.)

Wednesday, November 2, 2011

Building a financial system that works for the real economy

I highly recommend this video of a talk given recently by Sony Kapoor at the Global Systems Dynamics Workshop in Berlin. As it happens, I was there and got to see the talk in person; it's funny and very insightful. Kapoor used to work at Lehman Bros (well before it's collapse), and eventually quit investment banking to do more useful things -- he now works at Re-define, a think tank on public policy.

I tried to embed the video here but failed. There seems to be embed protection on it for some reason.

There were a number of other great talks at the meeting as well, all available on video here.

There are markets... and markets...

John Kay makes a very good point -- that the ideology and rhetoric surrounding the allegedly wonderful properties of markets has taken us a long way from where we ought to be. We need a more balanced perspective on what markets do well and what they do not do well, where they are useful and where they are not:
A semantic confusion leads us to use the word market to describe both the process which puts food on our table and the activity of gambling in credit default swaps. That confusion has enabled people to claim the virtues of the former for the latter.
 In his book Extreme Money, Satyajit Das makes a closely related point which, I'm sure, many economists and finance people will probably find incomprehensible:
Banks are utilities matching borrowers and savers, providing payment services, facilitating hedging etc. The value added comes from reducing the cost of doing so. Paul Volcker questioned the role of finance: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence. US financial services increased its share of value added from 2% to 6.5% but Is that a reflection of your financial innovation, or just a reflection of what you’re paid?”

The idea of financial services as a driver of economic growth is absurd – it’s a bit like looking at a car’s gearbox as the basis for propulsion. But financiers don’t necessarily agree with this assessment, unsurprisingly.