Skidelsky, Against Economics (NY Review of Books)

From the NY Review of Books, an article entitled Against Economics, which reviews the recent book by Robert Skidelsky.

Money and Government: The Past and Future of Economics

Robert Skidelsky
Yale University Press

... Before long, the Bank of England (the British equivalent of the Federal Reserve, whose economists are most free to speak their minds since they are not formally part of the government) rolled out an elaborate official report called “Money Creation in the Modern Economy,” replete with videos and animations, making the same point: existing economics textbooks, and particularly the reigning monetarist orthodoxy, are wrong. The heterodox economists are right. Private banks create money. Central banks like the Bank of England create money as well, but monetarists are entirely wrong to insist that their proper function is to control the money supply. In fact, central banks do not in any sense control the money supply; their main function is to set the interest rate—to determine how much private banks can charge for the money they create. Almost all public debate on these subjects is therefore based on false premises. For example, if what the Bank of England was saying were true, government borrowing didn’t divert funds from the private sector; it created entirely new money that had not existed before.

[[ Certainly central banks influence the money supply, but the degree to which they control animal spirits, lending practices and standards, the price of credit risk in general, etc. via a single part of the yield curve is highly debatable, dependent on many factors such as investor psychology and recent events, etc. etc.  There is no doubt this is a complex question worthy of deep analysis ... 

At any instant in time there is a certain level of tolerance for borrowing from the future (private and public debt), and merely by changing this level of tolerance one can in effect create money out of thin air ... This level of tolerance is a completely emergent phenomenon and no one fully controls it. ]]

... one of the most significant books to come out of the UK in recent years would have to be Robert Skidelsky’s Money and Government: The Past and Future of Economics. Ostensibly an attempt to answer the question of why mainstream economics rendered itself so useless in the years immediately before and after the crisis of 2008, it is really an attempt to retell the history of the economic discipline through a consideration of the two things—money and government—that most economists least like to talk about.

On the question of whether academic economists understand how the world works, I'll just reiterate that at the time of the last financial crisis (circa 2007-2008) I became aware through direct experience that many very prominent economists did not know what a Credit Default Swap was, did not know how the credit markets actually worked, did not know how credit risk was priced. Instead, their mental model consisted of coarse graining over all of this activity (quants, traders, mobs, speculators, thieves, fraudsters) as simply a (more or less) rational and efficient market not worthy of deep inspection.

They will all deny it now, of course. But I was there.


Note added: In the 1990s, in part due to the collapse of the Soviet empire and resulting mass emigration of top scientists to the West, there were very few opportunities in theoretical physics and related fields for young researchers. Consequently large numbers of extremely talented people left the field (largely against their will) and perhaps most of them ended up in finance. As might be expected a large number of big brains began thinking about previously obscure topics such as options pricing (derivatives, Black Scholes), credit risk, the yield curve, etc. Immediately it was noted, by myself and others, that methods from imaginary time quantum mechanics, path integrals, etc., could be applied to the pricing of derivatives -- especially exotic derivatives which had, up to that time, required significant computational resources to simulate.

The yield curve and credit derivatives are especially challenging problems. One reason is that they deal with a potentially infinite (if a continuous curve is assumed) number of degrees of freedom. As one of my former Caltech-Harvard collaborators (by the 1990s a quant-trader, now a hedge fund magnate) described it, modeling the yield curve compared to pricing equity derivatives is like quantum field theory compared to simple quantum mechanics.

In modeling the yield curve one immediately asks: what are the underlying dynamics? What are reasonable consistency conditions? What is the impact of a "shock" like a change in the Fed funds rate? A moment of reflection reveals that market psychology plays a huge role in setting the model parameters... A bit of historical investigation shows radical changes in the yield curve (and, consequently, the effective "money supply") over time. One can in effect create money out of thin air!

Tyler Cowen on Efficient Markets (video)

Tyler Cowen explains the basics of the Efficient Market Hypothesis. For a deeper exploration, see Tyler Cowen and rationality, which links to his paper How economists think about rationality.

Tyler Cowen and rationality [my comments]: ... The excerpt below deals with rationality in finance theory and strong and weak versions of efficient markets. I believe the weak version; the strong version is nonsense. (See, e.g, here for a discussion of limits to arbitrage that permit long lasting financial bubbles. In other words, capital markets are demonstrably far from perfect, as defined below by Cowen.)

Although you might think the strong version of EMH is only important to traders and finance specialists, it is also very much related to the idea that markets are good optimizers of resource allocation for society. Do markets accurately reflect the "fundamental value of corporations"? See related discussion here.

...

As you can tell from my comments, I do not believe there is any unique basis for "rationality" in economics. Humans are flawed information processing units produced by the random vagaries of evolution. Not only are we different from each other, but these differences arise both from genes and the individual paths taken through life. Can a complex system comprised of such creatures be modeled through simple equations describing a few coarse grained variables? In some rare cases, perhaps yes, but in most cases, I would guess no. Finance theory already adopts this perspective in insisting on a stochastic (random) component in any model of security prices. Over sufficiently long timescales even the properties of the random component are not constant! (Hence, stochastic volatility, etc.)

EMH vs Macro, Fischer Black

Arnold Kling on the tension between macroeconomics and the Efficient Markets Hypothesis (EMH). I'm surprised this isn't more often noticed by economists. But I suppose macro types don't tend to think deeply about finance (at least, not before the recent crisis; how many macro types actually understand Black-Scholes-Merton?) and vice versa. I was shocked at the beginning of the credit crisis to meet famous macroeconomists who didn't know what a credit default swap was, and I still often meet finance types who laugh at macro models.

askblog: Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. ...

I prefer a third way of looking at things, which might be expressed in the work by Frydman and Goldberg. That is, there is no reason for all participants in markets to be using the same model. They have different information sets. The EMH is a useful guide to everyone, because it serves as a reminder that it is unwise to assume that your information set is somehow superior. However, it is not correct to impose “rational expectations,” in which everyone uses the same model.

... Incidentally, I recently re-read Perry Mehrling’s biography of Fischer Black. Black was perhaps the first economist to think about the contrast between modern finance theory and conventional macro, and Black was the first and perhaps the only one to attempt to recast macro entirely in terms of modern finance.

More thoughts on EMH here. My comments on Mehrling's bio and Fischer Black are here.

... on the topic of finance books, I highly recommend this biography of Fischer Black, which I should have reviewed here long ago. Fischer was yet another outsider (his background was in theoretical physics) to finance who made an important contribution. Unlike Kelly, he was accorded mainstream recognition (professorship at Chicago and partnership at Goldman) during his career. The most impressive thing about Black was his ability to think deeply and independently -- beyond the conventional wisdom. There are some very intriguing passages in the book about his views on money and banking which are, I think, quite unconventional to mainstream economics.

... Black was both an undergrad and grad student at Harvard in physics. He didn't really complete his PhD in physics, but sort of drifted into AI-related stuff(!) at MIT, under cover of math or applied math.

The bio says the only course he ever had trouble with was Schwinger's course on advanced quantum. The biographer suggests Black did poorly due to lack of interest, but I find that hard to believe given the subject matter, the lecturer and the times ;-)

Black's point of view was clearly that of a physicist or applied mathematician. He really was a fascinating guy, and the biographer, being an academic economist, can appreciate a lot of Black's thinking -- it's not an entirely superficial book despite being non-technical.

After reading the book, I don't feel so bad about questioning some of the fundamental assumptions made by academic economists. Black was asking some of the very same questions during his career.

The benevolence of financiers

Olivier Desbarres is (now former) head of Asia FX strategy at Barclays. Condolences to my friends in finance who have to work with people like this. Struggle not with monsters, lest ye become a monster!

(In anticipation of comments: yes, people from all walks of life have meltdowns, but anyone familiar with global finance can detect authentic banker arrogance in this guy...)

Careful observation reveals it's disproportionately sociopaths at (and near) the top.





What a tremendous misallocation of human capital. See The illusion of skill.

Akerloff on Efficient Markets Hypothesis

I particularly like his comments (@13 min or so) on Snake Oil and financial assets. When market participants are exuberant (overly confident) it is natural for firms to create and market new assets that are overpriced relative to actual value, or have dangerous risk-return tradeoffs. For the latest example, in natural gas drilling rights during the recent boom (now a bust), see here.

See also Venn diagram for economics.

The cover illustration of Akerloff and Shiller's book. Are there any economists outside of Chicago who still don't believe in "animal spirits"?

AIG accounting

It looks like Treasury will make a profit on its AIG bailout stake. As I emphasized in 2008, markets were clearly not pricing credit-related assets properly during the crisis. Strong EMH supporters take note (see also here).

NYTimes: ... The Treasury Department announced it planned to sell $18 billion of its A.I.G. stake, putting it on a path to actually turn a profit. It was a remarkable feat and one that nobody — including Treasury Secretary Timothy F. Geithner — anticipated four years ago at the peak of the crisis during the $180 billion bailout of the company.

"Nobody"? -- not so fast! Here's what I wrote in 2008:

If -- and it's a big if -- AIG's actual CDS payouts are limited, the government and taxpayers stand to make a lot of money over the next 3-5 years. When markets return to normal the profitable ordinary insurance parts of AIG can be liquidated to pay off the bridge loan. In that scenario the big losers are AIG shareholders -- the government, as the lender of last resort, will have bought a distressed AIG for a song.

More AIG stuff here. Misuse of EMH arguments can hurt your brain.

Iterated Prisoner's Dilemma is an Ultimatum Game

Amazing new results on iterated prisoner's dilemma (IPD) by Bill Press (Numerical Recipes) and Freeman Dyson. There is something new under the sun. Once again, physicists invade adjacent field and add value.

Extortion and cooperation in the Prisoner’s Dilemma (June 18, 2012) 

The two-player Iterated Prisoner’s Dilemma game is a model for both sentient and evolutionary behaviors, especially including the emergence of cooperation. It is generally assumed that there exists no simple ultimatum strategy whereby one player can enforce a unilateral claim to an unfair share of rewards. Here, we show that such strategies unexpectedly do exist. In particular, a player X who is witting of these strategies can (i) deterministically set her opponent Y’s score, independently of his strategy or response, or (ii) enforce an extortionate linear relation between her and his scores. Against such a player, an evolutionary player’s best response is to accede to the extortion. Only a player with a theory of mind about his opponent can do better, in which case Iterated Prisoner’s Dilemma is an Ultimatum Game.

Accompanying commentary in PNAS. See these comments by Press and Dyson.

[[Press]] I was originally wondering about a much more modest question that, annoyingly, I couldn’t find already answered in the Prisoner’s Dilemma literature. ... The story now becomes one of symbiosis between computer and human intelligence: The computer could find instances, but not generalize them. I knew that the exact complement of computer intelligence, as yin to yang, is Freeman-Dyson-intelligence. So I showed what I had to Freeman. A day later, he sent me an email with the general result, equations 1-7 in our paper, all worked out. These equations immediately expose all the ZD strategies, including the successful extortionate ones. 

... The successful extortionate strategies have been mathematically present in IPD from the moment that Axelrod defined the game; they just went, seemingly, unnoticed. On a planet in another galaxy, seven million years ago, Axelrod-Prime independently invented the same IPD game. He (it?) was of a species several times more intelligent than Homo sapiens [[i.e., like Dyson!]] and so recognized immediately that, between sentient players, the IPD game is dominated by an obvious extortionate strategy. Hence, for Axelrod-Prime, IPD was just another instantiation of the well-studied Ultimatum Game. He (it?) thus never bothered to publish it.

The history of IPD shows that bounded cognition prevented the dominant strategies from being discovered for over 60 years, despite significant attention from game theorists, computer scientists, economists, evolutionary biologists, etc. Press and Dyson have shown that IPD is effectively an ultimatum game, which is very different from the Tit for Tat stories told by generations of people who worked on IPD (Axelrod, Dawkins, etc., etc.).

How can we expect markets populated by apes to find optimal solutions in finite time under realistic conditions, when the underlying parameters of the game (unlike in IPD) are constantly changing? You cannot think of a simpler quasi-realistic game of cooperation and defection than IPD, yet the game was not understood properly until Dyson investigated it! Economists should think deeply about the history of the academic study of IPD, and what it implies about rationality, heuristics, "efficient" markets (i.e., everyone can be wrong for a long, long time). 

For evolutionary biologists: Dyson clearly thinks this result has implications for multilevel (group vs individual selection):

... Cooperation loses and defection wins. The ZD strategies confirm this conclusion and make it sharper. ... The system evolved to give cooperative tribes an advantage over non-cooperative tribes, using punishment to give cooperation an evolutionary advantage within the tribe. This double selection of tribes and individuals goes way beyond the Prisoners' Dilemma model.

See also What use is game theory? and Plenty of room at the top.

Zero-Determinant Strategies in the Iterated Prisoner’s Dilemma provides a pedagogical summary of the new results.

The Hedge Fund Mirage

Bounded rationality even for the most "sophisticated" capital allocators of all: pension funds, wealthy individuals, private wealth managers. Financial services are incorrectly priced, both by sophisticated investors, and by society.

See also The truth about venture capital.

If you are interested in a sick story, search on Alphonse Fletcher or on Alphonse Fletcher chair gates west pao  :-(

Economist: “The Hedge Fund Mirage” attacks the Wall Street worshippers’ blind adulation. Simon Lack, who spent 23 years at JPMorgan, an investment bank, selecting hedge funds to invest in, grew tired of the free hand that investors all too often gave managers. He has written a provocative book questioning a central tenet of the hedge-fund industry: its performance is always worth paying for. The promise of superior performance is wrong, he says. Of course some investors make a killing, but on average hedge funds have underperformed even risk-free Treasury bills. This is because the bulk of investors’ capital has flooded in over the past ten years, whereas hedge funds performed best when the industry was smaller than it is now. What is more, it is hard to know how hedge funds actually fare, since indices that track industry performance tend to overstate the returns. Funds that do badly or implode are not usually included in the indices at all.  

Why would any client continue to pay for such mediocre returns? One reason is that hedge-fund managers are incredibly good salesmen. In addition, industry insiders who are all too aware of hedge funds’ shortcomings choose not to expose them, Mr Lack argues. Moreover, the common fee structure, in which hedge-fund managers keep 2% of assets as a “management” fee to cover expenses and 20% of profits generated by performance, has made many managers rich, but not their clients. Mr Lack calculates that hedge-fund managers have kept around 84% of profits generated, with investors only getting 16% since 1998. “Where are the customers’ yachts?” is the title of one chapter. What is worse, the disastrous dive of equity markets in 2008 may have wiped out all the profits that hedge funds have ever generated for investors.  

Mr Lack places a good deal of the blame for this on investors who fail to ask tough enough questions and have not grasped that they “want yesterday’s returns without yesterday’s risk”. They invest money with the biggest, best-known funds “that look nothing like those whose aggregate performance” they want to emulate. Instead investors should stand up to managers, negotiate more favourable terms and put their money into smaller funds, which tend to perform better.

The truth about venture capital

The excerpt below is from the Kauffman Foundation's report on venture investing. I'd like to see a similar report for hedge and private equity funds. If you believe in efficient markets and rational sophisticated investors (i.e., pension funds, endowments, the super wealthy), you have to explain why they continue to invest in underperforming asset classes and pay exorbitant fees. My explanation is that apes are not smart. Alpha is hard to detect and it's easier to believe a story (narrative sales pitch) than the numbers (esp. if the numbers are hard to obtain or require a bit of brainpower to interpret). Financial services are incorrectly priced, both by sophisticated investors, and by society. Via Ben Lorica.

EXECUTIVE SUMMARY 

Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years. 

The Kauffman Foundation investment team analyzed our twenty-year history of venture investing experience in nearly 100 VC funds with some of the most notable and exclusive partnership “brands” and concluded that the Limited Partner (LP) investment model is broken. Limited Partners—foundations, endowments, and state pension fund—invest too much capital in underperforming venture capital funds on frequently mis-aligned terms. 

Our research suggests that investors like us succumb time and again to narrative fallacies, a well-studied behavioral finance bias. We found in our own portfolio that: 

 Only twenty of 100 venture funds generated returns that beat a public-market equivalent by more than 3 percent annually, and half of those began investing prior to 1995.

 The majority of funds—sixty-two out of 100—failed to exceed returns available from the public markets, after fees and carry were paid. 

 There is not consistent evidence of a J-curve in venture investing since 1997; the typical Kauffman Foundation venture fund reported peak internal rates of return (IRRs) and investment multiples early in a fund’s life (while still in the typical sixty-month investment period), followed by serial fundraising in month twenty-seven. 

 Only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index. 

 Of eighty-eight venture funds in our sample, sixty-six failed to deliver expected venture rates of return in the first twenty-seven months (prior to serial fundraises). The cumulative effect of fees, carry, and the uneven nature of venture investing ultimately left us with sixty-nine funds (78 percent) that did not achieve returns sufficient to reward us for patient, expensive, longterm investing. 

Investment committees and trustees should shoulder blame for the broken LP investment model, as they have created the conditions for the chronic misallocation of capital. ...

See earlier post How to run a hedge fund.

Rethinking Finance

Mark Thoma points me to an interesting conference: Rethinking Finance.

Burton Malkiel's paper defines EMH to mean (roughly) "it's hard to beat the market, but of course prices could be way off at any particular time" (yes, Virginia, there are bubbles). This is what I refer to as a weak version of EMH.

Arnold Kling highlights the following talks (click through for links):

Foote, Girardi, and Willen ask whether, given expectations for ever-rising house prices, the institutional and regulatory details make any difference. If people expect house prices to rise faster than the rate of interest, then that creates in their minds a profit opportunity. One way or the other, the market will develop the financial instruments that allow people to exploit that apparent opportunity. I do not think I can endorse this view, but it is interesting.

Thomas Philippon asks how the financial sector came to be as large and profitable as it did. He argues that it is not because finance became more efficient or added more value to the economy. [ "In the absence of evidence that increased trading led to either better prices or better risk sharing, we would have to conclude that the finance industry's share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billions for the U.S. alone." ]

Brad DeLong asks why economists could not predict and explain the economic downturn. He argues that financial panics, in which the market's assessment of the safety of financial assets changes sharply and suddenly, are rare events that are outside the realm of typical theoretical models and statistical analysis. I am left with further questions. Which is abnormal, the faith that people had in financial assets before the crisis, or the lack of faith that people had after the crisis? And does government intervention to try to supply safe assets constitute the solution or the problem?

Two honest economists

I highly recommend this podcast discussion between Russ Roberts and John Quiggin (of Crooked Timber) about Quiggin's recent book Zombie Economics. Both parties did a good job of putting aside priors and having an enlightening conversation. Quiggin argues that many economic theories such as the Great Moderation, the efficient markets hypothesis and others have been discredited by recent events and should be relegated to the graveyard.

I think at one point both participants agreed that (or at least entertained the idea that) economics doesn't make progress like a real science. Probably too strong a critique, but at least very honest.

US to nearly break even on TARP?

Is anyone paying attention to the facts? Do voters' attention spans extend back two years? Can academic economists learn from actual events?

The main costs from TARP will come from bailing out the auto companies and insurer AIG, not banks.

NYTimes: Even as voters rage and candidates put up ads against government bailouts, the reviled mother of them all — the $700 billion lifeline to banks, insurance and auto companies — will expire after Sunday at a fraction of that cost and could conceivably earn taxpayers a profit.

... The Treasury never tapped the full $700 billion. It committed $470 billion and to date has disbursed $387 billion, mostly to hundreds of banks and later to A.I.G., to the auto industry — Chrysler, General Motors, the G.M. financing company and suppliers — and to what is, so far, an unsuccessful effort to help homeowners avoid foreclosures.

When Mr. Obama took office, the financial system remained so weak that his first budget indicated the Treasury might need another $750 billion for TARP. The administration soon dropped that idea as Mr. Geithner overhauled the rescue program and the banking system stabilized. Still, by mid-2009, the administration projected that TARP could lose $341 billion, a figure that reflected new commitments to A.I.G. and the auto industry.

The Congressional Budget Office, which had a slightly higher loss estimate initially, in August reduced that to $66 billion.

Now Treasury reckons that taxpayers will lose less than $50 billion at worst, but at best could break even or even make money. Its best-case scenarios, however, assume that A.I.G. and the auto companies will remain profitable and that Treasury will get a good price as it sells its corporate shares in coming years.

“We’d have to be very lucky to have both A.I.G. and the auto companies pay us back in full,” Mr. Elliott said.

... By any measure, TARP’s final tally will be less than even its advocates expected amid the crisis. But the program remains a big loser politically.

See this post from September 2008, during the heat of the TARP debate:

... The following false conundrum has been stated recently by numerous analysts, including Paul Krugman: "if Treasury wants to recapitalize banks it has to overpay for toxic assets, to the detriment of taxpayers; if it wants to pay fair prices for the assets then banks won't benefit." There is no conundrum if markets, at this instant in time, are systematically underpricing mortgage assets.

When the Internet bubble burst in the early years of this century, investors were so gun shy and under so much pressure that they would not pay even rationally justifiable prices for stakes in technology companies. Smart investors who were willing to put capital at risk could buy assets at fire sale prices and made huge profits. This is nothing more than fear and herd mentality at work. If herd thinking can lead to overpricing of assets, why not underpricing immediately following a collapse?

Markets overshoot on both the up- and the down-side!

These points are obvious to any trader... it's the academics with equilibrium intuitions who are struggling to understand!

... To understand, it helps to have seen the collapse of a financial bubble firsthand. If you haven't (as, I suspect is the case with most academic economists), you are likely to cling to the idea that the market price of an asset is a good forecast of its actual value. However, this is completely wrong in the wake of a collapse. (And, certainly, the predictive power of the market price cannot hold at all times -- it is likely to be most wrong at the peak and in the aftermath of a bubble.)

Buy high, sell low

A contrarian strategy ("the average investor is stupid") would have paid off pretty well over the last decade. Ah, the wisdom of markets :-)

WSJ: [A recent research report] calculates that mutual fund investors [over the last decade] bought into the Standard & Poor's 500-stock index at an average of 1,434. That's close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171. [Note an actual contrarian strategy would have performed better than random buying.]

... Human beings are hard-wired to run with the herd. For millions of years, when the herd stampeded, the smartest move wasn't the hang around and wait to see why. It was to run.

And that's how they act on the stock market as well. But when it comes to investing, it's a bad idea. Your feelings are a bad guide. And there is no safety in numbers.

I am frequently surprised at how many people still give in to their instincts in these matters. During the housing boom, anything I wrote questioning house prices automatically drew scathing reactions. ...

Physics Envy

A reader referred me to this excellent paper by Andy Lo and Mark Mueller. Mark and I were both Harvard postdocs at the same time. I seem to remember long conversations about both physics and finance in the Dunster dining room :-)

Warning: Physics Envy May be Hazardous to Your Wealth!

The quantitative aspirations of economists and financial analysts have for many years been based on the belief that it should be possible to build models of economic systems - and financial markets in particular - that are as predictive as those in physics. While this perspective has led to a number of important breakthroughs in economics, physics envy has also created a false sense of mathematical precision in some cases. We speculate on the origins of physics envy, and then describe an alternate perspective of economic behavior based on a new taxonomy of uncertainty. We illustrate the relevance of this taxonomy with two concrete examples: the classical harmonic oscillator with some new twists that make physics look more like economics, and a quantitative equity market-neutral strategy. We conclude by offering a new interpretation of tail events, proposing an uncertainty checklist with which our taxonomy can be implemented, and considering the role that quants played in the current financial crisis.

While physics envy might be a problem for economists or theoretical biologists, making physics your career (as opposed to becoming a quant, as Mark did) is certainly hazardous to your net worth!

The Chicago School and the financial crisis

New Yorker economics correspondent John Cassidy has a very balanced piece about the impact of the credit crisis on thinking at The Chicago School. He also uses the term apostasy to describe Posner's turn toward Keynes.

In the article, Heckman, Becker and Rajan seem the most reasonable. Fama is obviously clinging to his priors and Lucas refused to talk to Cassidy.

Cassidy makes additional remarks on his blog, and promises in the near future to publish more detailed notes on the interviews he did with the Chicago economists.

... For people interested in the subject, and there seems to be a lot of you, the good news is that I’m planning on posting here much fuller versions of the interviews I did in Chicago, with the likes of Gene Fama, Gary Becker, and Richard Posner, who recently converted to Keynesianism. It’s the nature of long-form magazine journalism that a lot of interesting stuff gets left out of the finished article, but, thanks to the Web, there’s no reason it shouldn’t appear in some form. Plus, I think it’s a good time to let the Chicago economists speak for themselves. Over the last couple of years, they have taken a battering at the hands of myself, Paul Krugman, Joe Stiglitz, and others. Having just finished writing a book entitled “How Markets Fail,” I went to the Windy City eager to learn first hand how the critiques of Chicago economics were being received. Some of what I was told, I don’t agree with, but at this time of intellectual tumult I think it makes fascinating reading.

In the article Posner notes that few economists knew anything about how real financial markets work. This is certainly true in my experience. In particular, they were naive about individual incentives within the system (see Greenspan comments), and very few academics (with perhaps one or two exceptions; video) had any idea what a CDO or CDS was before 2008. I can't resist a little sniping here. If you want to ask someone about electrons, or how to build a quantum logic gate, or how to fabricate nanostructures, you can't do much better than to head to your local research university and talk to a physics professor. Strangely, if I wanted to learn something about credit markets or securitization or the risk from speculative bubbles, I would have been better off talking to a former physicist on Wall St. than to almost any professor in an economics department or business school. I'm not exaggerating -- I've done both many times. Posner also says:

"Well, one possibility is that they [the economists] have learned nothing [from the financial crisis] ... Because -- how should I put it -- because market correctives work very slowly in dealing with academic markets. Professors have tenure. ... It takes a great deal to drive them out of their accustomed way of doing business."

For more, see my talk on the financial crisis.

Krugman: the Economists have no clothes

Only Nixon could go to China, and only Paul Krugman could write this mea culpa for the discipline of economics.

There was a bubble in housing -- everybody knows that now. There was a bubble in finance itself -- the financial share of national income reached an all-time high just before the crisis; not too many people know this. There was even an academic bubble in the field of economics: the perceived quality of results in the field, reflected in the salaries and prestige of economics professors (e.g., relative to other social scientists), was as inflated as the price of any McMansion -- surely every university dean must understand this now? (Bayesian / Machine Learning comment: do these guys ever update? Or is it "All priors, all the time"?)

I suggest reading the whole thing. I've only excerpted the last three paragraphs below. (See also related essay by Richard Posner and this interview with Bill Janeway.)

How Did Economists Get It So Wrong?: ... So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.

Related posts on Krugman's article from two thoughtful economists, Brad DeLong: Which economists got it so wrong? , Where does macro go from here? and Arnold Kling: Krugman vs Blanchard.

God save the Queen, and the economists

Richard Posner writes in the Atlantic. Read the whole thing!

I doubt academic economists are to blame for the crisis in any direct sense -- the real perps are on Wall Street and Main Street -- but they do deserve blame for the "ideological capture" of regulators and policy makers, many of whom, through years of indoctrination in undergraduate and professional school courses have come to believe in a semi-strong version of efficient markets (see below). The academics also deserve blame for intellectual dishonesty if they fail to admit that we know almost nothing about macroeconomics and that the profession itself cannot agree on what caused the crisis and how best to recover.

Will Economists Escape a Whipping?

It is remarkable how economists have been able to deflect blame for the economic crisis that erupted last September with the sudden collapse of the international banking industry and that continues to afflict the world's economies. Last November, Queen Elizabeth visited the London School of Economics and asked the faculty why "nobody [had] noticed [before September 2008] that the credit crunch was on its way?" ...

Yesterday, another letter to the Queen, this one dated August 10 and signed by ten English and Australian economists, was released ..., also responding to the Queen's question ... The August 10 letter states that "their overall analysis is inadequate because it fails to acknowledge any deficiency in the training or culture of economists themselves." The nub of their criticism is that "in recent years economics has turned virtually into a branch of applied mathematics, and has...become detached from real-world institutions and events." They criticize economics education as excessively narrow, "to the detriment of any synthetic vision," and fault Besley and Hennessy for saying nothing about "the typical omission of psychology, philosophy or economic history from the current education of economists" and for mentioning neither "the highly questionable belief in universal 'rationality' nor the 'efficient markets hypothesis.'"

A more focused criticism would, in my opinion, be more effective. The Queen was asking about the failure to foresee the financial collapse of last September, rather than about the health of modern economics in the large. That failure was I think due in significant part to a concept of rationality that exaggerates the amount of information that people have about the future, even experts, and to a disregard of economic factors that don't lend themselves to expression in mathematical models, or are intractable to formal analysis. The efficient markets theory, when understood not as teaching merely that markets are hard to beat even for experts and therefore passive management of a diversified portfolio of assets is likely to outperform a strategy of picking underpriced stocks or other securities to buy and overpriced ones to sell, but as demonstrating that asset prices are always an adequate gauge of value--that there are not asset "bubbles"--blinded most economists to the housing bubble of the early 2000s and the stock market bubble that expanded with it. In modeling the business cycle, economists not only ignored, because difficult to accommodate in their mathematical models, vital institutional detail (such as the rise of the "shadow banking industry," which is what mainly collapsed last September)--often indeed ignoring money itself, on the ground that it doesn't really affect the "real" (that is, the nonfinancial) economy. They also ignored key concepts in Keynes's analysis of the business cycle, such as hoarding and uncertainty and business confidence ("animal spirits") and worker resistance to nominal (as distinct from real) wage reductions in depressions. Lessons of economic history were ignored, too, leading to a belief that there would never be another depression, let alone a collapse of the banking industry. Even when the collapse occurred, in September, many macroeconomists denied that it would lead to anything worse than a mild recession; the measures that the government has taken to recover from what has turned into a depression owe little to post-Keynesian economic thinking; and the economists cannot agree on what further, if anything, should be done, and which of the government's recovery measures has worked or will work.

Besley and Hennessy's letter, when first published, was described in some quarters as a letter of "apology" by English economists. It was not that; nor is the August 10 letter--the latter is a denunciation of mainstream economics.

The notion of a profession's apologizing for its failure in a letter to the monarch is charming, however. It would be an apology to the nation, personified in its monarch. The English monarch does not exercise political power, but does personify the nation, and it is easier to write a letter to a person than to a nation.

The English economics profession failed the United Kingdom; the American economics profession failed the United States. Not that the profession should be equated to its macroeconomic and financial divisions. The study of business cycles is only a small part of modern economics. Other areas of economics bear significantly on the study of business cycles, such as labor economics, without being implicated in the failures of response to the current crisis. But the control of the business cycle had until the present crisis been regarded as a principal triumph of modern economics and justification for regarding economics as the queen of the social sciences. We have no monarch; the President is not a personification of the nation but rather the head of the national government; there is no one to write the letter of apology to. No matter. The urgent need is for the part of the profession that concerns itself with business cycles to acknowledge its inadequacies and reorient its training and research.

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.)

More algorithm wars

Some time ago I posted about two MIT-trained former physicists who were sued by Renaissance for theft of trade secrets related to algorithmic trading and market making. Reportedly, Belopolsky and Volfbeyn won their court case and are now printing money at a well-known hedge fund. The Bloomberg article below is about a former Goldman employee who may have made off with code used in prop trading and market making.

The story is also covered in the WSJ (whose reporters and editors don't know the difference between "code" and "codes" -- as in software vs cryptographic keys), where it is revealed that Aleynikov was paid $400k per year at Goldman and left to join a fund in Chicago which offered him three times as much.

Goldman Trading-Code Investment Put at Risk by Theft
2009-07-06 23:18:39.529 GMT

July 6 (Bloomberg) -- Goldman Sachs Group Inc. may lose its investment in a proprietary trading code and millions of dollars from increased competition if software allegedly stolen by an ex-employee gets into the wrong hands, a prosecutor said.

Sergey Aleynikov, an ex-Goldman Sachs computer programmer, was arrested July 3 after arriving at Liberty International Airport in Newark, New Jersey, U.S. officials said. Aleynikov, 39, who has dual American and Russian citizenship, is charged in a criminal complaint with stealing the trading software. At a court appearance July 4 in Manhattan, Assistant U.S. Attorney Joseph Facciponti told a federal judge that Aleynikov’s alleged theft poses a risk to U.S. markets. Aleynikov transferred the code, which is worth millions of dollars, to a computer server in Germany, and others may have had access to it, Facciponti said, adding that New York-based Goldman Sachs may be harmed if the software is disseminated. ...

The prosecutor added, “Once it is out there, anybody will be able to use this, and their market share will be adversely affected.” The proprietary code lets the firm do “sophisticated, high-speed and high-volume trades on various stock and commodities markets,” prosecutors said in court papers. The trades generate “many millions of dollars” each year.

... “Someone stealing that code is basically stealing the way that Goldman Sachs makes money in the equity marketplace,” said Larry Tabb, founder of TABB Group, a financial-market research and advisory firm. “The more sophisticated market makers -- and Goldman is one of them -- spend significant amounts of money developing software that’s extremely fast and can analyze different execution strategies so they can be the first one to make a decision.”

Aleynikov studied applied mathematics at the Moscow Institute of Transportation Engineering before transferring to Rutgers University, where he received a bachelor’s degree in computer science in 1993 and a master’s of science degree, specializing in medical image processing and neural networks, in 1996, according to his profile on the social-networking site LinkedIn.

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.