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Physicist, Startup Founder, Blogger, Dad

Sunday, February 12, 2012

History is impossible

... and economic history is even harder.

Andy Lo (MIT) explains that economists have yet to agree on the causes and consequences of and remedies for the recent financial crisis. This is a must read. I hope to provide further comments when I have more time.

Although I covered the housing bubble (which I called a bubble as early as 2004) and ensuing financial crisis in great detail on this blog, I've spent very little time discussing books about the crisis. That's because many (most?) of the authors (who, as Lo points out, tend to disagree strongly with each other) are rehearsing their own priors rather than seeking truth. My talk on the financial crisis.

Reading About the Financial Crisis: A 21-Book Review

Andrew W. Lo

Abstract
The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of 21 books on the crisis, 11 written by academics, and 10 written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed.

From the introduction:

... Six decades later, Kurosawa’s message of multiple truths couldn’t be more relevant as we sift through the wreckage of the worst financial crisis since the Great Depression. Even the Financial Crisis Inquiry Commission—a prestigious bipartisan committee of 10 experts with subpoena power who deliberated for 18 months, interviewed over 700 witnesses, and held 19 days of public hearings—presented three different conclusions in its final report. Apparently, it’s complicated.

To illustrate just how complicated it can get, consider the following “facts” that have become part of the folk wisdom of the crisis:

1. The devotion to the Efficient Markets Hypothesis led investors astray [CERTAINLY TRUE], causing them to ignore the possibility that securitized debt was mispriced and that the real-estate bubble could burst. [TOO STRONG]

2. Wall Street compensation contracts were too focused on short-term trading profits rather than longer-term incentives. Also, there was excessive risk-taking because these CEOs were betting with other people’s money, not their own. [CEOS DID NOT KNOW WHAT WAS GOING ON -- HAVE TO LOOK AT INCENTIVES OF LOWER LEVEL PEOPLE]

3. Investment banks greatly increased their leverage in the years leading up to the crisis, thanks to a rule change by the U.S. Securities and Exchange Commission (SEC). [REPORTEDLY TRUE... BUT SEE THE PAPER FOR INTERESTING DETAILS]

While each of these claims seems perfectly plausible, especially in light of the events of 2007–2009, the empirical evidence isn’t as clear. ...

From the conclusions:

There are several observations to be made from the number and variety of narratives that the authors in this review have proffered. The most obvious is that there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it. But what may be more disconcerting for most economists is the fact that we can’t even agree on all the facts. Did CEOs take too much risk, or were they acting as they were incentivized to act? [NOT CEOS, LOWER LEVEL TRADERS; YES] Was there too much leverage in the system? [YES] Did regulators do their jobs [NO] or was forbearance a significant factor? [REGULATORS DID NOT UNDERSTAND CDOS OR CDS] Was the Fed’s low interest-rate policy responsible for the housing bubble [PARTIALLY, BUT GSES LIKE FANNIE DESERVE MUCH MORE BLAME], or did other factors cause housing prices to skyrocket? [ANIMAL SPIRITS; IRRATIONAL EXUBERANCE; BOUNDED COGNITION] Was liquidity the issue with respect to the run on the repo market, or was it more of a solvency issue among a handful of “problem” banks? [IT WAS FEAR AND COMPLEXITY]

[THERE WAS REGULATORY CAPTURE TO GET THE CASINO GAMES GOING IN THE FIRST PLACE, BUT NO "TOO BIG TO FAIL" MORAL HAZARD. ONLY ACADEMICS AND JOURNALISTS COULD THINK SO. DURING THE CRISIS REAL FINANCIERS WERE SCARED OUT OF THEIR MINDS AND HAD NO FAITH IN A GOVT BAILOUT. (I WAS ON THE PHONE WITH LOTS OF THEM.) MANY PEOPLE, FROM CEOS DOWN TO MD LEVEL AND BELOW TRADERS, LOST MUCH OR MOST OF THEIR NET WORTH IN THE COLLAPSE. DOES THAT SOUND LIKE MORAL HAZARD? ACADEMIC ECONOMISTS HAVE A CUTE THEORY (OR IDEOLOGY) AND WANT TO CONFIRM IT. STUPIDITY EXPLAINS A LOT MORE THAN CONSPIRACY.]

For financial economists—who are used to dealing with precise concepts such as no-arbitrage conditions, portfolio optimization, linear risk/reward trade-offs, and dynamic hedging strategies—this is a terribly frustrating state of affairs. Many of us like to think of financial economics as a science [ONLY IN THE MOST LIMITED SENSE], but complex events like the financial crisis suggest that this conceit may be more wishful thinking than reality. John Maynard Keynes had even greater ambitions for economics when he wrote, “If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid”. Instead, we’re now more likely to be thought of as astrologers, making pronouncements and predictions without any basis in fact or empirical evidence.

To make this contrast more stark, compare the authoritative and conclusive accident reports of the National Transportation Safety Board—which investigates and documents the who-what-when-where-and-why of every single plane crash—with the 21 separate and sometimes inconsistent accounts of the financial crisis we’ve just reviewed (and more books are surely forthcoming). Why is there such a difference? The answer is simple: complexity and human behavior. ...

See also Physics Envy by Lo and Mueller.

Noted added: I think the movie Margin Call knows more than the worst 10 of these 21 books ;-)

15 comments:

Francesco Tranchedino said...

The articles I find most fascinating are those that suggest that there are bigger and longer term causes behind the current crisis.
Recently one was linked from the FT website:http://ftalphaville.ft.com/blog/2012/02/07/872361/global-liquidity-fail-the-role-of-skewed-incentives/ http://www.ecb.europa.eu/press/key/date/2012/html/sp120206.en.html 

Then all the players would be just pawns in a bigger game. But I'm not an economist ...

Steve Sailer said...

"To make this contrast more stark, compare the authoritative and conclusive accident reports of the National Transportation Safety Board"

Okay, but look at the Challenger Commission as a closer analogy. The fix was in until the low-level engineers got to Feynman and had him dunk the O-ring in his ice water on TV.

steve hsu said...

I meant specifically moral hazard affecting decision making by bank CEOs or their mortgage traders. I do not believe these guys took on extra risk specifically because they thought they were going to be bailed out. The *firms* may have been bailed out, but these individuals lost huges amounts of money in the collapse (value of equity went to zero).

Bobdisqus said...

http://www.youtube.com/watch?v=6Rwcbsn19c0

jmct said...

What I think leads all these economists astray is that the crisis in toto was caused by a multitude of truly independent causes, all of which were necessary, but none of which were singly sufficient, to make the thing happen. To understand it, one has to know a lot of independent, disjointed, and not logically related facts about how the world of finance works, none of which stem from one single thing, and there was no single cause that made all the other necessary causes occur. Economists don't like stuff like this, they like elegant explanations, economists don't really think about how to get the world right in order to act in it, they write papers to impress their peers and no matter what the topic, an economics paper is an economics paper first and foremost, just like a TV news program is a TV show first and foremost. A 'good' paper, that will be lionized by their peers, will be about some sort of single idea or factor, that has very complicated wide reaching effects, rather than a simple thing, like the crisis, that has rather complicated and wide ranging, disjointed and independent causes that all happened to be present in 2008. Just for one example, the crisis started in the commercial paper market, and if one doesn't understand how commercial paper works, what it's for, and how money market funds are like money creating, fractional reserve banks, and also, were completely unregulated just like a bank in the 1800's, you cannot understand how it got started. An intelligent narrative, as in one that has something to do with reality, will be a very bad 'story', too much going on without any sort of unifying theme. I guess that is kind of like physics envy.

LondonYoung said...

Commercial paper ...  an ultra important aspect of this crisis and, yet, given so little respect.  *Maybe* all financial crises involve a cascade of solvent investors unable to roll the short term debt that they are using to fund illiquid assets.

Richard Seiter said...

Thanks for the reply.  I see what you are saying, but am not convinced that they understood the scale/likelihood of the downside risk they were taking.  If they did not fully understand the risks I think the moral hazard argument can still apply.  I think many of these people may have been making decisions subject to moral hazard and assumed the scope of the fallout would not reach them.  Maybe I am being too cynical...

An analogy I am pondering.  IMHO the quickest route to being the victim of a con man is to think you are conning someone else (if you are at a poker table and can't identify the sucker you are him).  The conned person after the fact is full of "woe is me, look what they have done to me" (and has usually sustained real damage) but during the con is thinking they are getting a great deal (and usually think they are getting the better of someone else). (as an aside, this is one of the reasons I often lack sympathy for people seeking "victim status")

P.S. Any news from your colloquium?

Richard Seiter said...

I'm not sure the emphasis on specific causes is well placed.  I think the defining characteristic of a bubble is the building up of an unstable state.  I think being able to identify this unstable state (and why the state became unstable, identifying those causes is important IMHO) is more important than attempting to explain the specific events that caused the crash to happen.  I think the specific events which caused the crash can almost be viewed as a coincidence.  Any of a number of possible events could have resulted in a crash given where we were.   Similar events at a different time may result in negligible effects.

Richard Seiter said...

I think you are onto something but would characterize it as a cascade of insolvent investors (whether temporarily due to financing problems or truly insolvent).  I would add a major shift in investor psychology to your theory as well.  It seems to me the transition from "X is safe/can only go up" to "X is risky/can only go down" is a key component of any crash.

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LaurentMelchiorTellier said...

I fear there is a massive grey zone overlap between conspiracy and stupidity. 

David Coughlin said...

 Just for my own curiosity, are you in a position to make on thoughts like this?

Ken Condon said...

Indeed LY we both would like to hear more thoughts from you on this and your cryptic comment on commercial paper. I have only a superficial knowledge about these important credit instruments but I remember when Leman “broke the buck” and added fuel to the fire in the 2008 financial crisis that still haunts us to this day.

http://online.wsj.com/article/SB122169845959750475.html

SethTS said...

"Solvent investors unable to roll the short term debt ...fund[ing] illiquid assets"

You seem to be describing the dynamics of traditional bank runs (eg. Diamond-Dybvig for econs) as applied to the shadow banking system (which you happen to be associating with the commercial paper market, which 'can't get no respect').

Yes, all financial crises are like this.  We can't achieve consensus about this because the argument about causes is always infiltrated by interested parties in an (informally defined) bankruptcy proceeding.  Thus the stupidity/cupidity of German bankers gets blamed on greedy Greek pensioners, etc.  While the question of 'who gets to hold the bag' is negotiated via power relations, the rhetoric built around it always relies on obscuring the chain of events to preserve the perceived 'justice' of the outcome. 

Ethel said...

Keep it up. Keep blogging. Looking to reading your next post.

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