Saturday, November 15, 2008

More Soros

Soros' central observation is that markets do not necessarily function properly, even when left to themselves. He is not referring to the usual causes cited for market failure, such as imperfect competition, externalities, information asymmetry, etc. Instead, he is attacking the fundamental assumption that markets are reliable processors of information, that they can be depended on to generate price signals which indicate how resources should be allocated within society.

New York Review of Books: ...This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

More excerpts below.

...the current crisis differs from the various financial crises that preceded it. I base that assertion on the hypothesis that the explosion of the US housing bubble acted as the detonator for a much larger "super-bubble" that has been developing since the 1980s. The underlying trend in the super-bubble has been the ever-increasing use of credit and leverage. Credit—whether extended to consumers or speculators or banks—has been growing at a much faster rate than the GDP ever since the end of World War II. But the rate of growth accelerated and took on the characteristics of a bubble when it was reinforced by a misconception that became dominant in 1980 when Ronald Reagan became president and Margaret Thatcher was prime minister in the United Kingdom.

The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect.

Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.

Since market fundamentalism is built on false assumptions, its adoption in the 1980s as the guiding principle of economic policy was bound to have negative consequences. Indeed, we have experienced a series of financial crises since then, but the adverse consequences were suffered principally by the countries that lie on the periphery of the global financial system, not by those at the center. The system is under the control of the developed countries, especially the United States, which enjoys veto rights in the International Monetary Fund.

Whenever a crisis endangered the prosperity of the United States—as for example the savings and loan crisis in the late 1980s, or the collapse of the hedge fund Long Term Capital Management in 1998—the authorities intervened, finding ways for the failing institutions to merge with others and providing monetary and fiscal stimulus when the pace of economic activity was endangered. Thus the periodic crises served, in effect, as successful tests that reinforced both the underlying trend of ever-greater credit expansion and the prevailing misconception that financial markets should be left to their own devices.

It was of course the intervention of the financial authorities that made the tests successful, not the ability of financial markets to correct their own excesses. But it was convenient for investors and governments to deceive themselves. The relative safety and stability of the United States, compared to the countries at the periphery, allowed the United States to suck up the savings of the rest of the world and run a current account deficit that reached nearly 7 percent of GNP at its peak in the first quarter of 2006. Eventually even the Federal Reserve and other regulators succumbed to the market fundamentalist ideology and abdicated their responsibility to regulate. ...

Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and "managing" risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion. But the increased use of financial engineering set in motion a process of boom and bust. ...

It should be emphasized that this interpretation of the current situation does not necessarily follow from my model of boom and bust. Had the financial authorities succeeded in containing the subprime crisis—as they thought at the time they would be able to do—this would have been seen as just another successful test instead of the reversal point.

...Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used. Such regulation should be a high priority of the new Obama administration. It is all the more necessary because financial engineering often aims at circumventing regulations.

Take for example credit default swaps (CDSs), instruments intended to insure against the possibility of bonds and other forms of debt going into default, and whose price captures the perceived risk of such a possibility occurring. These instruments grew like Topsy because they required much less capital than owning or shorting the underlying bonds. Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of the underlying bonds and five times the entire US national debt. Yet the market in credit default swaps has remained entirely unregulated. AIG, the insurance company, lost a fortune selling credit default swaps as a form of insurance and had to be bailed out, costing the Treasury $126 billion so far. Although the CDS market may be eventually saved from the meltdown that has occurred in many other markets, the sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system.

Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical. The financial industry has already dropped from 25 percent of total market capitalization to 16 percent. This ratio is unlikely to recover to anywhere near its previous high; indeed, it is likely to end lower. This may be considered a healthy adjustment, but not by those who are losing their jobs.

In view of the tremendous losses suffered by the general public, there is a real danger that excessive deregulation will be succeeded by punitive reregulation. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism. As I have suggested, regulators are not only human but also bureaucratic and susceptible to lobbying and corruption. It is to be hoped that the reforms outlined here will preempt a regulatory overkill.


Jeff K. said...

In Soros' article, he seems to fault not only the lack of regulation of complex financial instruments, but also (to a degree) the instruments themselves. He particularly singles out poor modeling of risk associated with large leverage. Steve, what do you make of this? I know that you have some amount of respect for (and interest in) these instruments, or at least the math behind them.

Steve Hsu said...

It was a mistake to assume that mortgage defaults would be uncorrelated. Without this assumption securitization does not necessarily reduce risk. If the previous sentence doesn't make sense you might think about why an insurer can accurately predict the number of car accidents per month for a huge population of people but not for a small population. (I should probably write a post about this some day...)

In some cases efforts were made to ensure that the mix of mortgages in a CDO represented different geographical regions, with the idea that defaults in, e.g., Florida would be uncorrelated with those in, e.g., Ohio. But the problem is that modelers just assumed that there was no nation-wide housing bubble. If a nationwide bubble popped then all default rates would go up together, which is what happened. (This neglects the additional problems of outright fraud, using recent bubble data to estimate probabilities, etc. -- see the slides of my talk on the financial crisis for more details.)

But you can't blame the quants alone for the (binary) assumption that there was no national housing bubble -- almost all "experts" (economists) at the time thought that there were, at worst, only regional bubbles.

See, e.g.,

Steve Hsu said...


Rereading your comment I now realize you were asking a more general question about whether one can estimate the risks associated with a highly leveraged position which may include lots of derivatives. The answer is that as the leverage and complexity go up the uncertainty in any estimate also goes way up, so the reasonable thing is for regulators to be extra conservative in margin requirements.

I've been told by many quants that the fancy math is almost always used by management as a rationale to justify taking higher leverage.

Anonymous said...

Soros has a voice because he made a lot of money. I do not find his thoughts intellectually compelling. They take the proverbial hind site view.

Soros' assertion that markets are not perfect is obvious and not debated by most economists. We all understand that our theories are simplifications of reality. Markets typically out perform other mechanisms when information is distributed through a system. The conclusion that a regulated solution would have outperformed the market is highly debatable. Soros offers no reason to conclude a regulated market out performs unregulated markets.

I notice Steve that you keep sympathies for regulatory solutions. Why? Did not the regulations on the books not do enough harm. Did not the governments decision to create the GSEs do enough harm? The elite chose a "good" we all should embrace and thus passed legislation.

Did not the decision to define asset classes banks had to hold provide a major impetus for CDS to be abused? Banks were prohibited from owning the same assets they could "buy" via the CDSs.

Does not the current TARP mess suggest that no one really knows what is going on?

I would suggest the material issue is why we think humanity can manage all systems without any undesirable outcomes. As a one who is sympathetic to Knightian uncertainty, I find those who "beleieve" a market can be perfectly circumscribed as foolish.

Finally, I have a real issue with using the money of future tax payers to fund rampant policy speculation.

Steve Hsu said...

> They take the proverbial hind site view.

Actually, he *predicted* this crisis, albeit after crying wolf once or twice too early (Roubini did the same).

Regarding the broader point about regulation, I agree that we don't know with high confidence which of two policy regimes will perform better.

Now to my heterodox heterodoxy: always estimate costs and benefits when making a decision. A little calculation is in order: suppose unfettered markets lead to systemic crises every 20 years that cost 15% of GDP to clean up. I think that's an upper bound: a $2 trillion (current dollars) crisis every 20 years.

Easy Question: What growth rate advantage (additional GDP growth rate per annum) would savage, unfettered markets need to generate to justify these occasional disasters?

Answer: an additional .1 percent annual GDP growth would be more than enough. That is, an unregulated economy whose growth rate was .1 percent higher would, even after paying for each 20 year crisis, be richer than the heavily regulated comparator which avoided the crises but had a lower growth rate.

Hard Question: would additional regulation decrease economic growth rates by that amount or more?

Unless you think you can evaluate the relative GDP growth effects of two different policy regimes with accuracy of better than .1 percent, then the intellectually honest answer to the policy question is -- I don't know -- no shouting, no shaking your fist, no lecturing other people, no writing op eds, just I don't know. Correct the things that are obviously stupid, but don't overstate your confidence level about additional policy changes.

(Note I'm aware that distributional issues are also important. In the most recent era gains went mostly to a small number of top earners whereas the cost of the bailout will be spread over the whole tax base.)

Anonymous said...

I see we have pretty much made up our mind to not consider the possibility that this failure was an externality imposed upon the market by misguided policy decisions between a populist government and its stake holders. Not that it seems to matter, but that kind of shuts out what a lot of good economists have to say about this issue.

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