Wednesday, February 25, 2009

Deprogramming the cult of the Efficient Market

Another great EconTalk podcast, this time a discussion with Alan Meltzer of CMU, a leading expert on monetary policy and the history of the Federal Reserve, and a confidante of officials like Alan Greenspan.

At about minute 45 of the podcast we are treated to a revealing 10 minute dialog between Meltzer, a member of the cult of Efficient Markets (EM), and recovering cult member Russ Roberts (host of EconTalk and GMU econ professor), who is starting to realize that reality diverges from the teachings of the cult. Meltzer's thesis is that reckless behavior by bank executives was largely driven by expectations that they would be bailed out in case of disaster. He claims this crisis was caused by moral hazard and the banksters knew full well the risks they were taking. (And the pension funds and sovereign wealth funds that also bought the toxic stuff? Were they expecting a bailout too?) Russ wonders whether top executives really understood the structured finance of mortgages, perhaps neglected fat tail events, perhaps were irrationally overconfident. Roberts' points sound very "behavioral" and not at all EM.

Meltzer cannot bear to admit that the market is not all-knowing. Throughout most of the podcast he steadfastly maintains that current share prices of banks give an implicit (and more accurate than any other) valuation of the complex mortgage securities on their books. This is about as nutty as the thinking that got us into the crisis in the first place! The markets have been valuing CDO tranches from the beginning; why did they get it so wrong for so long? Now people trading bank equity have got it right? (How many are just gambling on probabilities of different rescue / nationalization outcomes?) Meltzer even mentions that the Fed rescue of LTCM was a source of moral hazard, neglecting the fact that the investors and principals were completely wiped out in the rescue.

Russ has made great progress in his thinking during the last few years of doing EconTalk interviews. It's a tribute to his intellectual honesty and common sense that he can, at this advanced age, overcome the conditioning he received from his education within the Chicago EM cult. Most cult members are more like Meltzer. He cannot abandon the faith, even in the face of a market failure of these historical proportions.

But of course it is Meltzer I see on national TV, holding forth with utter certainty on the crisis. For some reason it is he, not Russ, who gets to make expert predictions.


Ian Smith said...

The purpose of the EM is to explain to professors themselves why they aren't rich. It is an excuse. "Everyone who's made a fortune in the market was just lucky."

Horatio said...

Are any economists proposing moral hazard and inefficient markets as causes for the crisis? You'd have to be blind not to see government and market failure in what's happening now.

Unknown said...

Isn't a typical case of insufficient negative feedback in the control-loop?

CW said...

The insufficient negative feedback was bought and paid for.

From The End of the Financial World as We Know It, By Michael Lewis and David Einhorn (NY Times op-ed, 1/3/2009):

Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O’Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup’s chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower — had stood up and said “this business is irresponsible and we are not going to participate in it” — he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he’d be replaced by someone willing to make money from the credit bubble.

OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.

The credit-rating agencies, for instance.

................ ... ... .... . . . .

Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”

The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.

These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.

The Achilles' heel of the efficient market hypothesis is that many of participants in the market don't care about efficiency; they care about making money, any goddamn way they can. If they can accumulate power and stack the game in a way they imagine to be their favor, that's what they'll do—never mind the consequences.

Uncle Al said...

Mathematical economics is equilibrium thermodynamics using the calculus. Economics has positive feedback, territory where delta-epsilon smoothing fails: 1637 Netherlands and tulips, Hunt brothers and silver, Milton Friedman and "Whip Inflation Now!", his Chicago Boys and Chile; Merton, Scholes, and Long-Term Capital Management, America's debt orgy climax. Real World economics is Prigogine non-equilibrium thermodynamics, Mandelbrot fractals, Feigenbaum constants, chaos theory.

The Market is not Efficient. The Market is Corrupt. Practitioners are compelled to do the right things for a quiet cut of the action. When the marekt is 90% corruption... you get what you paid for. How is that not Efficient, Wall Street or Head Start?

CW said...

From NPR:
More Undergrads Signing Up For Econ 101

Why? Well, it's not because they're hot to go into the financial services industry...

CW said...

Also see This American Life's newest installment in their series on the financial crisis, anchored as usual by Alex Blumberg and Adam Davidson.

(I think it's about time to call this a depression, folks.)

kurt9 said...

I actually think Metzer's analysis of the problem is mostly correct. Where I differ with him is that I am not certain that the Wall Street execs were fully aware of the risks that they were taking.

Markets are not perfect, but they are better than government bureaucracy at making decisions.

Steve Hsu said...

> Markets are not perfect, but they are better than government bureaucracy at making decisions.

I actually agreed with most of Meltzer's points, and I agree with what you wrote above -- *most of the time* markets do better than government. But that does not mean we cannot (easily) identify big screw ups or limitations.

The 10 minutes of the interview I emphasized really highlighted that Meltzer is a cult member (has wildly strong priors), not a scientist. Cult members can be correct in their claims, but we cannot trust their method of reasoning.

Eva said...

I remain doubtful about Roberts' "deprogramming". IMO he plays devil's advocate whenever he is challenging his fellow deciples. Not that I agree with his positions in principle, I just think that if we can ease suffering in the present we shouldn't wait for markets to do it "eventually", just because we've subscribed to the efficiency paradigm.

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