Friday, July 17, 2009

Against finance

Paul Krugman rails against Goldman's big quarterly numbers in yesterday's Times. He goes as far as to claim that Goldman's success is bad for America!

At the core of his argument is the following observation:

Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been “financialized.” The business of moving money around, of slicing, dicing and repackaging financial claims, has soared in importance compared with the actual production of useful stuff. The sector officially labeled “securities, commodity contracts and investments” has grown especially fast, from only 0.3 percent of G.D.P. in the late 1970s to 1.7 percent of G.D.P. in 2007.

Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? Financial firms, we now know, directed vast quantities of capital into the construction of unsellable houses and empty shopping malls. They increased risk rather than reducing it, and concentrated risk rather than spreading it. In effect, the industry was selling dangerous patent medicine to gullible consumers.

This point has not received enough attention in the volumes of analysis produced by the financial crisis. Some comments.

1. Markets and capitalism are good -- overall, they benefit society by providing (mostly) efficient allocation of scarce assets (including human, as well as other, capital).

We've just been through a bubble, with resulting misallocation of resources, but perhaps bubbles are an unavoidable side effect of capital markets, and perhaps their short term negative consequences are compensated by the long term benefits of market economics. Of course, it is beyond our capabilities to address this question with high confidence, so what is left is people arguing their priors. At the bottom of this post are some previous comments of mine on this topic.

2. Concentration of the control of wealth is inevitable, given advances in communications and information technology, the complexity of our economy, and cognitive limits of average people. By control I don't mean ownership, I mean investment and allocation decisions -- think mutual fund investors of modest means, but whose money is aggregated into a billion dollar fund controlled by a few investment professionals.

Given 1 and 2, I doubt Krugman really wants to eliminate the financial sector. His outrage is really motivated by populism, and relates to the following question:

3. How should these professionals be paid? How much value do their decisions actually add to the economy?

This is the fundamental question, also unanswered. Would less extravagant pay for money managers (e.g., as a consequence of more egalitarian cultural values) lead to reduced economic growth? By how much? (By the way, I don't think we can lay all the blame for the current crisis on the professionals -- millions of Americans participated in the housing bubble.)

Personally, I think Wall St. compensation practices need to be changed. I debated this and related points with a hedge fund manager in some previous posts: On the benevolence of financiers , Money talks.

Here's what I wrote in 2008 on topic 1 above. Can anyone do better than these estimates?

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. [That $2 trillion was an estimate for the direct housing bubble losses, but I can see now that the collapse of credit markets and of business and consumer confidence is going to increase that number substantially.]

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.)


Jeff K. said...

Your comments from 2008 reflect a viewpoint that is too insulated from the societal/personal effects of an economic bubble. Even if someone can prove that a particular economic policy leaves the GDP better off in the long run (in spite of the bubbles), one still needs to somehow take into account the personal stress, the emotional and social cost of bankruptcy and unemployment, and all the other negative side effects of bubbles that don't directly contribute to the GDP. These considerations are at the root of the somewhat more conservative or cautious economic policies and mores found in many western European countries.

ArC said...

Can we blame professionals for most of the bubble? After all, they were overwhelmingly responsible for the mortgage fraud:

"The FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds[1]."

Steve Hsu said...

Jeff: perhaps my view is too "autistic"? :-)

ArC: the "professionals" responsible for mortgage fraud are typical brokers who work in ordinary communities, not on Wall St. Krugman is really talking about the elite of the finance industry. In any case, it's my experience that most ordinary people accepted that home prices circa 2006 (whenever the peak of the bubble was) were fundamentally sound.

ArC said...

Steve - I think the fish rots from the head down. The culture of hiding bad loans / bad results didn't just filter up from the ground - in fact, as Black notes, responsible credit raters were told by their superiors _not_ to ask for the loan tapes.

(See also GS's breathtaking cynicism in changing their financial calendar this year to dump a billion dollars of loss in the orphaned month...)

(apologies if this is double-posted.)

Carson C. Chow said...

Isn't it fair to say that if the CDO wasn't invented, then there would not be the same demand for mortgages that drove the bubble?

Steve Hsu said...

Re: CDO's, yes, but they fall into the category of "innovative ways to spread and reduce risk" that Krugman mentions. My view is that they aren't inherently bad -- we just need to learn how to use them. Another example of short-term catastrophe (possibly) outweighed by long-term utility.

LondonYoung said...

"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."

hmmm, what does that mean? Don't the top earners increasingly pay most of the taxes anyway?

The IRS website has lots of stats on how the tax burden is distributed.

Steve Hsu said...

It's true that top earners pay most of the aggregate tax in the US. But the group of financiers who benefited from the recent "finance boom" is an even smaller (much smaller) subset than, say, the top 1 or 5 percent in income. The remainder might be businessmen, doctors, lawyers etc. who will shoulder the future tax burden of the bailout without receiving the earlier gains.

Apparently the finance boom isn't over for a few lucky firms and people :-)

Ian Smith said...

"...but perhaps bubbles are an unavoidable side effect of capital markets..."

Still trying to justify or "explain" the status quo.

It is a pass time of those who benefit and of those who don't benefit from the status quo.

It is to the benefit of the former and for the latter the persistent thought that the society they live in is "b*ll sh*t" and they are powerless to do anything about it is torture.

Steve. You're like a Boer who can't decide whether or not to leave Mafikeng for Joburg when, of course, you should just leave South Africa altogether.

Economics is the "science" of explaining why the way things are is exactly the way they should be.

The name Marx gave to this is "ideology". It is a reflex of every one I've ever known on all matters not just economic.

The only thing that makes GS's absurd pay possible is surplus value and exploitation even though GS does not do this itself (except perhaps with its "not ready for prime time" quants).

LondonYoung said...

So, for tax purposes, the U.S. has a couple of competing distributions among the wealthy, the financiers and the "other rich". And maybe financiers are getting away with something and sticking the bill to the plastic surgeons.

However, might I suggest that the biggest beneficiaries of U.S. financialization are actually the low earners. To wit - whatever America is doing, its unskilled workers have maintained a standard of living an order of magnitude above world equilibrium for what they have to offer. Financiers have achieved gains, but in a global economy where their education is increasingly valuable, that is not too remarkable. GS bankers are well bid at their U.S. pay levels to work in China, but not so for GM workers ...

On the flip-side (since a physics education tells you both sides of an equation balance) the actual costs of the financial bailout don't seem to be too related to bailing out Wall St. The big failures that look to permanently destroy federal capital are the agencies, fannie and freddie, insurance companies, and, likely, GM. So, there is a case to be made that those making off with the cash are middle class Americans who speculated on real estate. And just maybe the financiers are supporting one of the U.S.'s last competitive industries so that its unskilled laborers can live in 5000 sq ft houses and drive cars the size of apartments in China.

Not necessarily true, but a theory to try on for size.

Ian Smith said...

Since when is speculation a "skill"?

The talk of skills and wages is a meaningless tautology.

Skill is not the same as education. A PhD in medieval French literature requires enormous skill but is useless.

Wages aren't a combination of skill and the utility of that skill. Speculators have enormous skill but do nothing of any use.
The same is true of entertainers and most college professors.

What Steve does in his capacity as physics professor is impressive. BUT so is ventriloquism. Steve's profession is no more useful than Edgar Bergen's.

Steve Hsu said...

"To wit - whatever America is doing, its unskilled workers have maintained a standard of living an order of magnitude above world equilibrium for what they have to offer."

Equilibration takes time, we'll see where this ends up...

"Financiers have achieved gains, but in a global economy where their education is increasingly valuable, that is not too remarkable. GS bankers are well bid at their U.S. pay levels to work in China, but not so for GM workers ..."

But you are relying on the validity of current market pricing to make this argument. The broader Krugman point is that we, as a society, both here and abroad, have overvalued these financial skills (and still do). He's asking for the evidence that a society that is willing to pay much less for those skills would be worse off! (How that restructuring would be accomplished I do not know; but suppose financier pay was limited to that of doctors and lawyers -- what would be the effect on overall efficiency of the economy? Perhaps not much...)

LondonYoung said...

I guess we can combine these two points and ask "will we head towards equilibria"? It seems U.S. auto workers are paid above the global labor market. And, as you have blogged (add link here), financiers seem to be collecting economic rent.

Kruggy is asserting that finaciers have discovered a myopic inefficiency in society in that the public can be "played for suckers" because they can't look past the short term. And I guess he now wants to mobilize the government to regulate and protect against this myopia - thus bringing about an equilibrium in financier wages. I think you hit the nail on the head when you point out that knowing exactly what to do here requires predictive powers beyond what we possess.

Many of us have a strong prior that laissez-faire economic policies are best, and we ask for strong arguments before endorsing any regulation. I want to suggest that Western countries have a strong financial sector, and excessive regulation might damage that sector and hasten the arrival of other equilibria - like bringing the standard of living down across the board in the U.S. However, "I don't know". But, given my laissez faire prior, my standard is that Kruggy prove more regulation will make us better off even if I can't offer him evidence it will make us worse off.

Ian Smith said...

"the public can be "played for suckers" because they can't look past the short term."

If the bonuses at GS came from old-fashioned investment banking/money broking they might be legit. But the majority comes from trading.

Liquidity has been more than sufficient to keep transaction expenses de minimus for a decade, but volume has increased. At this point GS's trading has no more use than professional poker.

The 100% tax on cap gains of less than a year proposed by Buffet would make most of GS's "highly skilled" workforce less "skilled" than a parking lot attendant.

Siddharth Sharma said...

did i make an elementary math error or is your .1% estimate totally off the mark.

a 0.1% increase in growth over a 2% growth baseline yields a 2.9 % higher cumulative GDP growth over 20 years.

its nowhere close to the 20% that would compensate for a crash.

Steve Hsu said...

You have to look at the cumulative growth advantage and ask whether it adds up to enough to cover a one time "payment" of 15 percent of GDP.

At .1% larger growth rate economy A will have a 1% per annum larger economy than economy B after the first 10 years elapses. Just storing that 1% advantage over the following 10 years would allow them to pay for a (roughly) 10% of GDP crisis after another decade (at this point 20 years will have elapsed). But the 10% I obtained is clearly a lower bound on the real result due to a constant .1% growth percent advantage over 20 years. To get the real answer you have to use a bit of calculus.

Note the issue is whether you can pay $2 trillion to cover the crisis and still come out ahead of the regulated, slower-growing economy. Perhaps you thought I meant something else.

Siddharth Sharma said...

I get it. I misinterpreted what you were trying to say.

However, the kind of question you are proposing is sortof prototypical of the problems with the whole macroeconomic enterprise.

It isn't enough to figure out what that 'bomb' will cost one time.

It matters whether the bomb will leave a debt hangover large enough to put GDP in a contractionary spiral from t+20 years on.

It also matters to your argument if extra GDP ever really gets put aside for a rainy day. Historically, neither governments nor individuals do that and instead they do consumption and more borrowing.

So this effectively voids any further argumentation you do with the 0.1% estimate as being reflective of reality.

My point is that your line of argumentation is unusable as a reflection of reality, as it leaves out too many other parameters of 'savage free markets' vs 'controlled markets' debate, especially as it relates to financial markets.

Steve Hsu said...

Those are all further unknowables: chance of t+20 after effects, etc. At that level of reasoning we can just talk about a nonlinear system whose evolution we basically can't predict. So, they hardly detract from my argument that we should not make strong statements nor claim high confidence level deductions.

Don't forget, in my +.1 scenario the unregulated economy has a >2 percent larger GDP to give back relative to the regulated one, in addition to whatever excess was "saved" (from the viewpoint of personal utility it doesn't matter whether it was really saved -- people made use of the extra production, efficiency; they still have their big screen TV and fast laptop or whatever). That would cover a one year growth recession vs no recession. Also, I don't think we get a crisis as bad as this one every 20 years. It's been 80 years since the last one.

You could attack my assumptions at an even deeper level: some people doubt whether less regulation gets you more economic growth! (Or it's "unhealthy" growth or distribution problems, etc., etc.)

Certainly anyone like Krugman who wants to prescribe policy should claim to be able to determine all of the quantities/parameters discussed above to some degree of confidence. (How does regulation affect GDP growth at the .1 percent level of accuracy? The questions you raise are even harder!) Otherwise they are just talking their priors.

That's why economics is not a science.

Siddharth Sharma said...

Yes, i completely agree that economics is not a science and policy discourse is purely ideological, and i am not vouching for PKs positions as being rigorous in any way.

I am saying you sortof copied their mistake when you said that
"make policy only if you can predict policy effects within .1 % of GDP growth", as that .1% number itself is sufficiently non rigorous.

However, i'd like to point out that 2 episodes of free market financialism (1929 and 2007) have made it abundantly clear that at the very least leverage controls are due, and someone has to watch out when finance destroys information and claims efficiency. (ratings , complex mortgages etc)

Steve Hsu said...

Sorry, I misunderstood you.

I wasn't claiming that the .1 percent accuracy was the gold standard; it was just an illustrative calculation to show how far we are from high confidence levels for policy.

I do think some simple obvious things need to be fixed (ratings agencies, CDS regulation, perhaps leverage constraints, compensation schemes) but I think I indicated that in the fine print of the post under "Correct the things that are obviously stupid..."

Steve Hsu said...

BTW, this thread contains a mini illustration that confidence levels should be low.

If you knew LondonYoung's impressive background (as an actual finance practitioner, but with hard science training) you would probably agree his opinion should be weighted just as heavily as Krugman's! But they disagree completely...

Siddharth Sharma said...

I think what is common to finance and healthcare are 2 things :

a) High Profit expectations (the causes of which are a point of interest. in healthcare we probably have monotonically increasing demand and spending, in finance we have taxpayer backstopped risk taking)

leading to

b) Ridiculous fiscal inefficiencies [highly paid financiers / opulent offices / unreasonably opulent hospitals]

the labour market for financiers should work like any other, but it seems that optimism towards future profits makes sure the wages never depress for the 'best and the brightest'.

Strictly in theory, regulation could play some role in disciplining these sectors fiscally.

I am not laissez faire on this btw. I think its an open problem and we don't know enough yet.

Ian Smith said...

"If you knew LondonYoung's impressive background (as an actual finance practitioner, but with hard science training) you would probably agree his opinion should be weighted just as heavily as Krugman's!"

LondonYoung's doesn't have an opinion, and even if he did it could be ignored. All criminals claim they've been framed.

mock turtle said...

its sad to see intelligent people propound the idea that deregulation is worth the occasional melt down

no amount of entrepreneurial genius can compensate the national and world economy for the wholesale damage done by GS and other banksters

( see great depression 1929 thru 1945)

had not the taxpayers, ie the federal government stepped in goldman quite possibly would have been mortally wounded as a going concern...goldman would not have been alone

the government receivership and bailout of aig allowed for the pass thru of over 13 billion dollars from aig directly to goldman

make no mistake about it, all of goldmans protestations that this money didnt matter because of other hedging schemes is pure bs...failure on the part of the federal government to step in would have meant systemic financial collapse,and the collapse of a broad array of counterparties with a huge cascading events following

in 2008 goldman had an EBIT (op revenue) of a little less than 2 and 1/2 billion dollars...the loss of 13 billion from aig would have been devastating

and goldman would not have been alone as the universe of US financials who were by-in-large heavily "invested" in casino securitizations

dont worry about whether or not im right about this...the government has only delayed the inevitable...the toxic assets, or (legacy assets as geithner calls it are still out there

we as a society will be paying for this for a long time to come including a diminution of the middle class...we probably deserve it

Nameless said...

Krugman's outrage is not at all about professionals' salaries. It's wider than that. He is essentially asking, can we be sure that the existence of a financials industry on the scale of 1.7% of GDP adds ANYTHING, at all, to the rate of growth of the economy? Are we at all better off than we were back in the 80's, back when Goldman, Lehman, and Bear were relatively unknown Wall Street firms, with their hands tied behind their back by Glass-Steagal?

I recall browsing through mutual funds back in 2007. Supposedly diversified mutual funds consistently had "financials" as largest parts of their portfolios.

Financials didn't rise to 1.7% of GDP (and 30+% of most mutual funds' allocations) by financing innovative new real-world projects.

Imagine a scenario. Hedge fund A, owned by an investment company B, borrows a billion dollars from the bank C. It uses this money to fund a sophisticated stock market trading model that proves successful and allows the hedge fund to make 50% profit on the original investment. 20% of all gains are paid in salaries of bonuses and employees of A & B. This scheme contributes $100 million dollars to GDP. It does so by funneling $500 million from other market participants (regular investors like you and me, or perhaps pension funds) into the account of A & B, and then spending some of it.

Then hedge fund A goes against some other hedge fund, call it D, whose trading model is superior and whose response time is better, and it is wiped. Or perhaps some drastic event occurs in the global economy that makes a bunch of securities held by B worthless, and B has to declare bankruptcy. Its bankruptcy pulls the bank C. FDIC steps in, prints some money (or collects some taxes), and gives that money to C's depositors. Their original money by now firmly in A, D, someone else's pockets.

And that's really all there is to it. Evidence that any of this somehow helps grow the non-financial sector of our economy is not forthcoming.

LondonYoung said...

A bit on Michael's point on AIG - you might wanna check out this developing story -

When large derivative dealers trade with each other they typically agree to exchange margin so that on any given day neither owes anything to the other. Sometimes dealers will disagree on the value of their trades. GS has said that AIG owed them $10bio pre-bailout (in GS's opinion), and had given GS $7.5bio (AIG's opinion of the value) against this exposure. GS had purchased insurance from other large dealers for the $2.5bio balance.

AIG deals with the public too, of course, but the public pays premiums to AIG and holds no collateral. This is all "business as usual".

Now, let's look at what would happened if AIG had defaulted. For GS, the $7.5bio of collateral is "bankruptcy remote" and GS keeps it penny for penny. The insurance contracts pay off $2.5bio to GS and the right to pursue the claim against AIG passes to the counterparties. Mom and Pop who have purchased retail insurance from AIG are left with only a bankruptcy claim. So this is all very ugly, but absent further defaults, GS is left whole - no loss. But have no doubt, someone out there will be eating a big loss.

At this point in the discourse, most people have trouble understanding collateral and that it is bankruptcy remote (is this a skill? I guess so!), but let's say we have this one down. The next point people make is that letting AIG go under would have created a financial system meltdown that would have harmed GS such that GS could not collect all its $2.5bio insurance claim. Well, this is possible, but it is equivalent to saying that a large subset of JP Morgan, DeutscheBank, BNP, SocGen, Citibank, etc... all go bankrupt. However, we probably don't believe that even a full $2.5bio hit to GS would be lethal for it, so it is hard to say that a failure by AIG would have directly taken GS down.

The next point you might make is that if all these other banks went under it might have created a large enough set of other problems for GS so as to take it out. However this final claim, which is frequently made, is specific to GS in no way at all. But if you wanna say "maybe the U.S. bailed out AIG so that the entire world banking system didn't collapse", then yes, GS benefits from that just as does anyone in the economy with any exposure at all - like anyone who purchased Auto Insurance underwritten by AIG. So maybe a smart bailout avoids a situation like the depression which followed the Panic of 1837, but the beneficiaries of the bailout are likely not dominantly the banks. This is why administrations as diverse as G.W. Bush and Barry Obama have reached for identical bailout buckets.

The Kruggy regulation question should be "would compensation reforms stop the sort of loss-making trading that went on at AIG?" - and that may be, I don't know. And might it accidentally stop economically productive trading as well? Krugs sure doesn't think so.

LondonYoung said...

For SD Scientist - legislation is ahead of you on this one. It is already illegal for Bank C to use FDIC insured deposits to loan money for a hedge fund operation to either A or B. Regulations require that FDIC insured deposits be used only for "safe assets" - like mortgages.

In reality, the FDIC losses you're worried about ended up in the pockets of middle-class retirees who sold houses at inflated prices to over-mortgaged baby boomers.

LondonYoung said...

And for Siddarth - you bring up healthcare. Roughly speaking, the U.S., privately and publicly, spends 50% more, per capita, on healthcare than Western Europeans who provide universal coverage. And when I say "per capita", I don't mean per covered person, I mean per capita of all residents. In fact, U.S. government healthcare spending alone, per capita, is roughtly equivalent to what Western Europeans spend on universal coverage.

So, in theory, we should be able to reform healthcare in the U.S. and require no additional government spending at all. And, as the same time, free U.S. businesses from paying for private health plans. Now, THIS, would be a turbo boost to the U.S. economy - and at just the right time. It would really help our embattled manufacturers. However, Washington is producing plans that call for $1tri MORE spending and no relief at all for private employers. It is acutally pretty crazy.

It makes one wonder what sort of financial reform we can expect from them.

Ian Smith said...

"At this point in the discourse, most people have trouble understanding collateral and that it is bankruptcy remote (is this a skill? I guess so!)."

Yes of course it is. Investment banks DO carry on vital business which deserves high compensation. BUT that is not how GS in particular makes most of its profits.

The same is true of commercial banks. As anyone can see by looking at their income statements, there are few US banks today that do not make the majority of their income from fees. Without such BS commercial banks would be much less profitable; banking would be a commodity business.

David Coughlin said...

I missed this discussion, but I like LY if for no other reason than he said, "Many of us have a strong prior..."

I spend a fair bit of my time trying to convince people to look at the expectations in terms of priors and posteriors. Most people lack the metagame to look at their posteriors... and their priors are strongly influenced by their ideology [LY, eg].

Steve Hsu said...

Well, I've been blathering on about priors on this blog, hopefully other people come to see that they should do that meta-analysis on their own beliefs... :-)

Seth said...

Your take on the healthcare debate sounds about right to me. It baffles me that American corporate management haven't been up in arms for single payer healthcare for decades. My hypothesis is that they do not because of class loyalty to the insurance executives. They serve on each others' boards, attended the same boarding schools, play golf at the same country clubs, etc. Let's not rock the boat, you know.

As for financial regulation, the main thing is the leverage. We need a SWAT team, perhaps supplemented by some kind of industry "peer review" (if you could make it sufficiently confidential and adversarial) to analyze new securities and deal structures for their embedded leverage. As it is, we seem to get innovations that smuggle in leverage faster than the regulators can adapt. Then once it's obvious to everyone that the leverage is huge and dangerous, there's no regulating it out of existence because everyone is already too invested in the bubble to call it one.

It's almost a new dimension of contract law, properly understood. Call into question the enforceability of a contract when it involves derivative payouts that have not been subjected to this new peer review process.

It's a scary thing to propose, but that's the space you have to get into if you ever want to alter the human tendency -- so reliably demonstrated over centuries of banking -- to inflate bubbles.

Siddharth Sharma said...

On "against finance", Does anyone else also think that accounting is fundamental to the problems we face.

I don't think accounting is being scrutinized enough.

Since accounting directly feeds into valuations, remunerations etc, i get the feeling that accounting methods are completely broken for complex long term finance contracts.

I don't know enough to point out what is broken, but to me mark to market / not mark to market shouldn't be the only point of debate. Even that point has been casually swept under the carpet without scrutiny.

The current declarations of bank profits, i don't get it at all. To my mind, accounting systems which work for other industries don't work at all for finance, and are completely ignoring the fact that line items on the finance balance sheets are subject to major future variance (the variance itself is unpredictable enough to be not modelable).

I think finance needs a new kind of accounting, something which captures profit and loss (a large component of which are very often expectation values) with better accuracy.

Nothing has changed and AIG FP style gaffes are going to happen again.

Ian Smith said...

Mark to market is all that ruined AIG. None of its contracts triggered. Right?

Peter said...

As I understand, the thinking -- at least from Summers -- is that with prudential regulation you would actually get _higher_ growth. So instead of say 3% growth + crises, you get say 4% growth + no crises. This is a totally different proposition that comparing say 3% growth + crises with 2.9% growth + no crises. Summers talk here:

Steve Hsu said...

I don't suppose Summers provided any error estimates or probability distributions for his scenario in his talk, did he? Overconfidence is endemic...

Anon: it was collateral calls that killed AIG -- nothing triggered. At least, that was my understanding.

Ian Smith said...

"I don't suppose Summers provided any error estimates or probability distributions for his scenario in his talk, did he?"

Of course he didn't. This is economics Steve. As MacEnroe has said, "You can't be serious!"

It would be nice if real world problems were like those of science. But they aren't.

Nameless said...

It is already illegal for Bank C to use FDIC insured deposits to loan money for a hedge fund operation to either A or B. Regulations require that FDIC insured deposits be used only for "safe assets" - like mortgages.

In reality, the FDIC losses you're worried about ended up in the pockets of middle-class retirees who sold houses at inflated prices to over-mortgaged baby boomers.

Thanks for educating me. Live and learn :)

My point though is not that I'm worried about the FDIC losses, but rather that the whole thing seems like a bunch of money is being moved around by some middlemen, these middlemen get a cut every step of the way, and this cut is seen by the general public as directly contributing to GDP. And no one asks where this money comes from, when in reality it either comes from honest investors' pockets, or it is loaned somehow from someone, so that, when the amount of debt in the systems becomes unbearable, banks start to fold and loans start getting defaulted on. In the end, either the FDIC or the government step up to make these loans whole, or creditors have to eat the bill.

LondonYoung said...

SD Scientist - the biggest failures, the biggest losses - the things that are really gonna cost you money - haven't been bank middlemen ...

I strongly recommend the following piece from the House's Committee on Oversight and Government Reform. Decades after noise of bank earnings has died down, this will be the narrative in the history books:

Dave Bacon said...

LondonYoung: "The House's Committee on Oversight and Government Reform" is okay, but seems to have some glaring omissions when it comes to the role of Wall Street firms in the mortgage industry after the GSE accounting scandals. (And I'd also like to see it at least an acknowledgment of things like the 2002 white house conference on Increasing Home Ownership. It's not like it's that hard to take off the GOP blinders and try to honestly paint history.)

LondonYoung said...

Dave - it's a biased account, no doubt. I recommend it because I think people are forgetting this part of the story. I wouldn't recommend it if I thot the role of the banks wasn't already well covered.

There's a pretty good case to be made that the agencies were the largest cause of the problem and will go on to consume the most federal bailout resources. Now, maybe that's not true, but the story gets close to zero airtime.

If we are serious about reforming the system in the wake of a housing bubble, I can't see how we can proceed without confronting the fact that the U.S. has an official policy to encourage people to leverage up and buy real estate.

Dave Bacon said...

London: I definitely agree it doesn't get airplay. It's not politically popular (who wants to tell someone they shouldn't leverage themselves to death and buy a home? It's especially dangerous because there are all sorts of ways that race inequality plays into the story. Though blaming the CRA seems at least very debatable.)

I guess I'm always a little skeptical of finding "main causes" in crashes. I mean don't people still argue about what caused the 1987 crash? (Portfolio insurance / program trading seems to be the winner among popular accounts, but I seem to recall a study about the crash really originating in Hong Kong(?) which didn't have nearly as much of these two to cause the crash. In this later view I think something like different monetary policies between the US and world is blamed for the Hong Kong crash.)

Bubbles, it seems to me (who am completely unqualified to make this statement!), almost by definition require a confluence of factors (blind men leading blind men leading the original blind men?)

Ian Smith said...

There were crashes in Hong Kong and Australia which preceded the US crash.

LondonYoung said...

Dave - I agree 100%. Bubbles are devilishly difficult to understand - even with every advantage of hindsight. The Panic of 1837 is the most recent one that I feel we have a handle on!

If only we can keep this in mind as the Kruggy's of the world offer up their advice on how to reform the system. It does not take much bravery on his part to beat up on the unusually, but consistently, profitable GS. (By the way, can we expect him to comment on why near-identical competitor MS didn't make any money but still is paying out a much bigger fraction of their revenues to their loss-making staff? Is that good news for America?) It would be pretty brave, though, to attempt to address the causes of the housing bubble - I'm not holding my breath for any recommendations that we stop telling people to buy property by levering up.

As Steve began by saying, a healthy "I don't know" is often the appropriate response.

Kruggy thinks the "stimulus package" was too small. If we had taken that $870bio and sent the 100mm taxpayers a check for $8,700 each, do you think that would have helped the economy more, or less, than the package as enacted?

Ian Smith said...

"Bubbles are devilishly difficult to understand - even with every advantage of hindsight."

Only difficult to understand for those who don't know the difference between investment and speculation.

Bubbles both and crashes (negative bubbles) are cannot happen without those who buy in order to sell at a higher price rather than for income, aka, speculators.

Of course there are precious few such genuine investors left today, and instability will continue.

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