Relevant and even prescient commentary on news, politics and the economy.

Exit Pollster Hell

Robert Waldmann

update: OK after getting burned in 200 and 2004 (to paraphrase our President:fool me once shame on you fool me uh fool … you can fool me twice) only a fool would believe in exit polls tonight (and note the obvious below). But I just can’t help myself.

Looks like the exit pollers are downplaying them everyone wants to tell me how the 71 votes counted in Georgia split. has average exit polls from the MSM financer/suppressors of exit polls.

Don’t start celebrating now, or, if you do, don’t blame me — blame

update 2: According to the exit polls which you should not trust it is McCain by one (1) in Mississippi. Oh my. For what it’s worth Obama is 9.5% above the Pollster trend from regular non exit polls. If I were Senator Wicker I would be worried, but I’m not so I don’t pay attention to exit polls.

notes the obvious.

This is going to be a longgggg day for exit pollsters. Given early voting, they are going to have to pool results from exit polls and earlier results from people who said they voted early in regular polls. This will not be possible without a wild guess.

They have data on how many people voted early and (bad) data on for whom they voted. The data from polls on early voters is based on a much smaller sample size than exit polls and is not based on a balanced sample of polling places, but it is still relatively OK compared to the number they just don’t have.

They will have information on total early votes and on the percentages of Tuesday votes by candidate, but they will just have to guess Tuesday turnout. I suppose they can ask at their sample polling places, but they will only have a number they can use after polls close (and they typically want to release exit polls the instant polls close).

Since it appears that a much larger fraction of early voters have voted for Obama than will Tuesday voters this will be critical. Assuming total turnout equal to 2004 turnout is a recipe for extreme embarrassment.

I’m sure they have some plan (I’m sure they all have different plans).

I’m not sure I’ll believe anything until actual votes are counted (tomorrow night looks like a longgg night over here at EST + 6 hours).

WaPo on AIG

Robert Waldmann

read Carol Leonnig’s article which quotes many people arguing that the feds should have let AIG file for chapter 11. The point of the complainers is simple, the takeover has been very (realtively) good for counterparties but not so good for the treasury or, it is alleged, AIG shareholders. I don’t see how people can claim that shareholders would have ended up with something after bankruptcy proceedings, but it is costly to the treasury. Oddly no one mentions that the deal was great for Goldman Sachs, I guess that simple observation is too scurrilous for the Post.

I was interested in the discussion of what AIG did wrong.

AIG’s Financial Products division is the primary villain in the company’s free-fall. It made tens of billions of disastrously bad bets on mortgage investments but may not have carefully hedged those bets or properly estimated its risk.

OK this is simple, there is risk that can’t be hedged by everyone. Someone has to bear aggregate risk. The idea that risk is a problem that can be solved, if one hedges rationally is, uhm, crazy. The idea of an insurance company buying insurance is odd. AIG uhm insures people, helps them hedge, bears risk.

In this case, they took on risk that they shouldn’t have taken on, but there is no reason to think that there was a rational equilibrium in which AIG wrote CDS and then hedged them by shorting the underlying assets.

One can make money by bearing risk or by outsmarting other people. Why would anyone expect an insurance company to be able to outsmart the financial services sector ?

Someone somewhere on the web notes (without naming names) two eminent economists who said that the housing bubble wouldn’t be a huge problem as losses from bad mortgages would only be around $400 billion (similar to the losses when the dot com bubble burst) and the net value of derivatives is zero.

So, assuming people are rational, they will only have an unpleasant surprise similar to 2000.

However, if everyone thinks they are beating the market, because of their clever derivatives trading strategies, the moment of truth for derivatives (bankruptcy in the case of CDSs) will be a very painful shock. The fact that the total supply of derivatives is zero doesn’t mean that the total perceived expected value of derivatives positions is zero.

Similarly if everyone thinks they have hedged aggregate risk by buying and selling derivatives, a mere $400 billion hit which people rated as hedged but it wasn’t can be much more damaging than a $400 billion hit which people knew they might bear.

The argument is that if everyone were rational except for the people writing mortgage contract, then everything will be more or less OK is true, but the hypothesis can’t be reconciled with the volume of trade in derivatives.

Behavioral Economics and Conservatism

David Brooks has noticed the increasing popularity of behavioral economics. He argues that it would be a mistake to allow the recognition that people aren’t perfectly rational to convince us that policy makers should intervene more in the economy, since they aren’t rational either. My reaction is that, of course, the level of sophistication required to play it safe is less than the level of sophistication required to beat the market and so support for prudential regulations does not require the assumption that the regulators are smarter than market participants.

Matthew Yglesias demonstrates (again) that he is a genius and that a degree in philosophy can be an excellent preparation for economic analysis. He considers the ban on interstate banking — clearly not an optimal policy — and argues that concerns about human irrationality might have convinced us to keep it

when we’re looking at a regulatory regime that seems to be working okay, and the regulated parties start saying we need tweaks x and y and z and oh there’s no danger there we should be very suspicious. We shouldn’t count on being to fine-tune our results to perfection,

Oddly he entitles his post “The case for crude measures” and concludes “we should either lean in with a heavy hand or else stay away.” His reasoning has nothing to do with this conclusion. He is arguing in favor of conservatism. If something has existed for a long time and seems to be working okay, we shouldn’t change it — even if it is a regulation.

This argument makes sense (and was made by Edmund Burke some time ago I might add). It may have seemed to some people, including economists (one of the groups detested by Burke) that economic theory gave us a simple guide to optimal regulation. It may have seemed to some of them that optimal regulation was no regulation. These people are radicals who trust their own reasoning more than the wisdom of the ages.

Behavioral economics teaches us two things. First it is much more difficult to understand the economy than it would be if we could count on it to be in Nash equilibrium, so we should be cautious about our theories including our theories based on a particular hypothesis about irrationality. Second, we’re not rational either, so we should be humble. Both support conservatism.

The strange thing is that Brooks doesn’t seem to remember what conservatism originally was. He suggests that it tells us we should regulate — that is odd since economies have traditionally been regulated and respect for tradition and things the have been found to serve and work okay would suggest we continue to regulate it. This is particularly odd, because Brooks is unusual among contemporary American conservatives, because he leaves no doubt that he has actually read Burke and, in large part, agrees with him.

Odd that he uses the old old conservative argument in the defense of radical free market experimentation.

Given the polls, it is not odd that Yglesias doesn’t want to admit that a strong case can be made for actual conservatism as I’m sure he believes that it will in the near future become again the ally of right wingness after having spent 8 to 28 years as its nearly effective adversary (that is the least weak of the pathetically weak hindrances to right wing lunacy).

Hedge fund crisis on shedule

Robert Waldmann

In a particularly silly op-ed Sebastian Mallaby argued that deregulation wasn’t the cause of the financial crisis and presented as evidence the fact that hedge funds, which are regulated even less than investment banks, are doing fine.

Of course the reason that there wasn’t a run on hedge funds is that investors can’t cash in whenever they want to. Mallaby wrote his op-ed just before some (not all) investors had an opportunity to take their money out.

Unsurprisingly, as predicted here, the crisis has spread to hedge funds having been delayed only by the fact that they aren’t bank like, do not borrow short term and are vulnerable only to slow runs (a walks ?)

Selling equity in your house

Robert Waldmann

was working on a post about how financial innovation is profitable and pernicious. The ideas are that profitable new financial instruments are used to evade prudential regulations and to make financial markets more confusing so unsophisticated investors can be fleeced.

Then I thought of a kind of financial innovation which might be profitable and useful.

One financial innovation which would have been useful if it had taken off is the Shiller local home price bond. This is an instrument indexed to home prices in a locality (that is to say I won’t be able to explain it any more clearly. I’m sure shiller can. Use google scholar). This is something local governments should sell as their property tax revenues depend on local real estate values. That risk can be delocalized, that is, diversified, with benefits both the the local citizens and investors who hold a diversified portfolio of real estate indexed bonds. Good idea. Not profitable.

One financial innovation which caused trouble is the home equity loan. This enabled people to risk foreclosure. It contributed to the current crisis (less than sub-prime first mortgages but some). Atrios has a theory. He thinks that the problem is that people thought they were selling part of their home to the bank, not using part of their home as collateral on a loan. They didn’t understand that the bank bore risk only in the case of foreclosure.

OK so how could people sell part of their home to a bank ? It sure wouldn’t work to say the bank owns 10% of this home and gets some interest rate times the assessed value of the home. First home assessors would make out like bandits. Second the adverse selection and moral hazard problems would be huge.

OK ex Prof Black meet Prof Shiller — the Shiller bond is the instrument which enables home owners to shift the risk to someone else without creating huge state verification costs and agency problems.

The deal is as follows.
Bank give Ms and Mr J. Doe some cash $Z.
Ms and Mr J. Doe owe the bank a constant alpha times the Shiller price index for their locality. Ms and Mr Doe must pay an interest rate of x% (should be indexed but hey let’s not be too innovative make it a fixed nominal interest rate) times their debt plus y% of the outstanding debt each year. So debt in dollars changes with this payment then with the change in the index. y% of the house is collateral.

This way if the local economy tanks and house prices fall, the bank bears the burden (which they can pass on to MBS buying suckers of course). If there is a housing bubble without an increase in wages, the Does have a cash flow problem. They also have equity in their home again so they can sell another bit to another bank to meet their payments.

I think, in this way, it is possible for homeowners to hedge that part of their house price risk that they don’t personally control (doesn’t depend on whether they maintain their house) or have private information on (doesn’t depend on whatever the hell is happening with our plumbing which I don’t know exactly what it is but it will cost the owner(s) of the house where I am typing quite a bit).

That way they can borrow without leveraging up and increasing the risk of foreclosures.

Also works for the thrifty as the bank can agree to pay a constant amount of cash to the Does each year in exchange for the house price indexed flow (which is naturally hedged by new equity generated by changes in local housing prices).

update: I still don’t have a post dumping on financial innovation, but I do have a title “Structured by Cows ?”.

Did Lehman Manage that ?

Robert Waldmann

had a post entitled “How did Lehman manage That?” asking how Lehman’s debt could sell for about ten cents on the dollar. A commenter told me I was confused and that Lehman’s accountants would have warned investors if there was anything, along the line of the things I imagined, lurking in their detailed balance sheet. I claim that the argument must be that Lehman debt couldn’t possible sell for 10 cents on the dollar as anything which can cut the value of assets by ten or increase the value of debts by ten (or one down root ten and one up root ten or whatever) would have been flagged. That is Lehman didn’t do that.

Lehman managed that.

There was something lurking somewhere in their assets and their liabilities. I have no idea if it was self CD insurance (my fantasy). Whatever it was any competent and honest accountant should have flagged it. Now I don’t blame any particular accounting firm (which you note as remained nameless) because I think that financial innovation has made responsible accounting impossible. No one is competent to audit the books of modern financial operators.

The Wrong Crisis

Robert Waldmann

What isn’t going on in financial markets ?

There are various theories of the financial crisis which suggest simple solutions and have the only defect that they are fantasies.

1) The only problem is mark to market accounting.

Market prices for mortgage backed securities (MBS) are very low because of a panic. Banks are required to list assets on their balance sheet at market prices. Banks appear to have negative equity (debt greater than assets) because of this silly rule. This caused the crisis.

This seems to be the theory of a weird left right alliance including Rep Darrel Issa (R Calif.). It is based on the idea that ideologue Congress persons can price assets better than professionals. The assets include MBS but also debt and shares of banks. This is fairly clearly a wish fulfillment fantasy. The idea is that if we resolutely say everything is fine, everything will be fine.

2) The problem is adverse selection in the MBS market and mark to market accounting.

Here there is a theory better than “I know best” for why MBS market prices are below the average hold to maturity value of MBSs. MBSs are worth less than was thought a year ago, but some of them are worse than others. For one thing, the value depends on the standards of the initiator of the underlying mortgage e.g. are they liars’ loans or normal loans. Owners of such MBSs know more about them than potential buyers. Therefore, the stuff that is for sale is the most toxic of the toxic securities. Therefore the market price is the price for the worst of the worst of MBSs. Therefore it would be irrational to sell anything which is only semi toxic. There is a separating equilibrium with low volume of trade and very low prices. Applying such prices to all MBSs understates their value.

Now without irrationality this shouldn’t matter. People who know that the stuff for sale is the worst of the worst should also know that the other stuff is better no ? Here market participants are required to be sophisticated when they buy and sell MBSs and unsophisticated when they read balance sheets.

3) The problem is mark to market, adverse selection and capital controls.

Ah now a regulation which is definitely unsophisticated. The rule is that Assets minus debt divided by debt must be over some number. If this rule is applied along with the principle that assets are marked to market it can cause two equilibria one with high asset prices and non binding capital controls and one with low asset prices and binding capital controls.

Here the problem is that all entities must be equally exposed to MBS risk and initially equally close to the capital requirement. In the real world different entities have different capital requirements. In particular capital requirements for investment banks (set by the SEC and relaxed in 2004) are much looser than capital requirements for commercial banks. Also hedge funds’ capital requirements are set by their counter-parties and are (if this is still true) about 2%. Plus Warren Buffet had $5 billion to spare. Note that the firms with the most flexible capital requirements are the ones that no longer exist. A problem for the theory.

More importantly,
binding capital requirements should cause a flow of assets from the firms with binding requirements to the ones with some slack. This flow would, among other things, make markets thick, volume high, markets unfrozen and adverse selection drowned in the flood of liquidation by firms with binding capital requirements (note the argument works fine and the metaphor isn’t even mixed). It is very hard to have a market frozen by adverse selection with market prices below the value of the average asset causing, via mark to market and regulations some firms to have to liquidate large amounts of assets. Firms that have to liquidate eliminate the separating only the worst of the worst is for sale equilibrium.

If agents are forced to sell assets at fire sale prices any agent who isn’t in the same bind should be buying at fire sale prices. It’s just not true that all entities in the world have binding capital controls. The explanation is nice in theory, but doesn’t fit the facts.

Now all these theories would imply that the original Paulson plan could work without a huge transfer from the public to banks. However, they don’t make sense.ù

Furthermore they are totally false for two more simple reasons which I put after the jump for no particular reason.

The theories assume that banks actually mark assets to market. They are supposed to, but they don’t. Page 81 of the September 20-26th Economist notes that at the end of 2007 Bank of America, Citigroup, HSBC, JP Morgan, Lehman Brothers, Morgan Stanley and Merrill Lynch marked less than half of their assets to market (which UBS Credit Suisse, Duetsche Bank and Goldman Sachs market more than half of their assets to market with Goldman Sachs over 75%). Sorry no link. I am working from uhm ink on deceased trees. Note first that uhm not quite all assets are marked to market. Note also which investment banks are still independent firms.

Finally, if markets are frozen and the market price makes a huge difference to balance sheets, it is easy and almost legal to manipulate the market price. Bank A can tell bank B “we will buy 1% of your toxic sludge for twice the current price if you buy an equal amount of our toxic sludge.” Then both can mark to that agreed price and make their balance sheets look fine (this is the favorite technique of Italian soccer teams who don’t trade players. Each buys the contract of a player for the other and they state an absurdly high price. They sometimes run out of cash with fine looking balance sheets). Now transactions which count as the market to mark too are supposed to be arms length, but no one is going to be picky in the middle of a crisis.

In fact, such a transaction would work without fraud if adverse selection were really a problem. Bank A could say “I will buy some of your MBSs but I pick which ones (at random)” that way, the expected value would be the average value of MBSs not the value of the worst of the worst. Still not quite arms length, but not obviously fiddling the price, since it would be a sensible transaction even if balance sheets didn’t matter.

Now some might think that the idea that fraudulent prices can be created when markets freeze is a fantasy. I think it has happened. The assets were long term calls options on European stock indices. Long Term Capital Management was short these assets. When it seemed fairly likely that LTCM would fail and be liquidated and when they had to liquidate to keep the balances of their REPO accounts above zero (they were excused from the 2% rule by counterparties) these assets suddenly became very risky and the market froze up. The market price became the list price chosen by brokers who knew that no one was buying or selling. The same brokers were LTCM counterparties. The list price of the options became absurdly huge. The counterparties were about to gain the right to seize the extremely valuable LTCM short positions (can seize when the mark to market value of LTCMs account at a bank is negative even if the hold for a month value is huge). It is alleged, without proof, that investment bank brokerages listed the absurd price then secretly traded at a reasonable price. Fact is that the market price was absurd and it was absurd in a direction helpful to the investment banks.

The crisis ended when the President of the New York Federal Reserve Bank, William McDonough told the investment banks to cut the crap and, in effect, divide up LTCM equally among them. It is very bad for an investment bank to anger the New York Fed. Bear Stearns was the only investment bank which refused to co-operate.

more on Mallaby

Robert Waldmann

Looks like I should have put the post to which the post below links here. Thanks for clicking the link. I will try to add up by adding a point here.

Sebastian Mallaby argues that deregulation did not cause the crisis, because hedge funds are regulated even less than investment banks. Based on something I read somewhere on the web, I noted that it is hard for hedge funds to get in trouble during a quarter as their investors can’t pull out money (it can be done LTCM managed but it is hard).

Now I will make another argument. The anti Sebastian (let’s call him archer) argues that regulations were fine on January 20 1993 and that the changes from then till now made the crisis possible (or at least worse than it would otherwise be). The changes would be de-regulation and a failure to create new regulations to deal with new financial instruments. Roughly the Commodities Futures modernization act of 2000 and the 2004 decision to allow investment banks to increase leverage.

Now this has nothing to do with hedge funds. They existed and were regulated in 1993 and they exist under roughly ?) the same regulations now.

The point is that regulations do not fall out of the sky. They are created because of a perceived need for regulation. A type of firm might be lightly regulated because of neglect. If so, relatively good performance by that type of firm is a sign that regulation is bad. Rather more likely a type of firm might be lightly regulated because legislators and regulators think that it is not dangerous. Mom and pop book stores have played a minor role in the crisis. They are lightly regulated. Does this prove Mallaby’s point ? I think the answer is obviously no.

So, if hedge funds played a minor role in the crisis, would that prove Mallaby’s point ? I would say it is just as obviously no.

Banks are highly regulated, because, by their nature, they are at risk of bank runs. They borrow short term and invest long term. Their creditors make small investments and, rationally, do not invest large amounts of money in looking out for their investment.

Hedge funds borrow medium term and in huge chunks of at least $100 million. Therefore the logic of banking regulation implies (and has implied since the first hedge fund was founded) that there is little need to regulate hedge funds.

The change in regulation concerns banks and insurance companies. If the crisis were confined to sectors where regulation changed, that would tend to be evidence that the change in regulation contributed to the problem.

If the crisis also affected firms which no one had ever argued should be regulated (as we will probably learn it did) that would tend to be evidence against the hypothesis of the advocates of keeping regulation the way it was in 1992.

The idea that support for the logic of the old regulatory strategy is proof that it was no good is so silly that only a top pundit could think of it.

General Equilibrium theory and Finance

Robert Waldmann

I wrote a post below on how economic theory as presented to the public and economic theory are very different. In particular, even given the standard super strong assumptions, economic theory does *not* imply that Laissez faire is the best policy, does not imply that market outcomes are even Pareto efficient (a very weak statement anyway) does not imply that financial innovation can’t hurt everyone and certainly does not imply that financial markets can’t freeze up.

In this post I will write about general equilibrium theory [more on that after the jump] and assume symmetric information.

Furthermore I will talk about Pareto efficiency. [more after the jump].

I will assume that markets are incomplete. This is obvious. For markets to be complete, there must be a security (or portfolio) which pays positive value in any conceivable contingency and otherwise pays zero. It must be possible to buy in effect “an umbrella if it is raining” separately from “an umbrella if it is not raining”. No one has ever suggested that markets are approximately complete. To have any connection with reality, general equilibrium theory must concern economies with incomplete markets.

All that aside the conclusions of the literature is that

1) Generically (definition of generically after the jump) the market outcome is not constrained Pareto efficient. This means that the government can make everyone better off by restricting free market exchange on financial markets forbidding people to make mutually beneficial trades at a market clearing price.

2) If markets were complete the outcome would be Pareto efficient. However the introduction of a new security does not necessarily cause a Pareto improvement. In fact, for an open set of economies (definition after the jump) banning trading in a security causes a Pareto improvement. Generically, if markets are incomplete, there is a security whose introduction will make everyone worse off.

3) with incomplete markets sunspots (variables which have no effects on tastes or technology) can cause prices to change. Outcomes can occur with a sunspot that couldn’t possible occur without a sunspot. I don’t remember if this is generically true of just true for an open set of economies.

4) it is easy to write down a model in which the volume of trade is zero. In standard models agents who do not maximize welfare are introduced to cause trading volume to be greater than zero. It is possible to write a model in which there is some trading even if everyone is rational (for example due to life cycle saving and dis-saving or people hedging against risk in their labor income). No one writes such models as they give trading volume vastly lower than, say, current volume with markets that are “frozen” and have “seized up.”

Roughly none of the claims about general equilibrium with complete markets apply to general equilibrium with incomplete markets. The exceptions are not strange cases, rather the claims are true only if there are extraordinary coincidences.

General Equilibrium theory is extreme even as economic theory goes

I will therefore assume that agents have rational expectations — that is they know the probability of any conceivable event — and that they are price takers, that is there is perfect competition. I will assume that there are no non-pecuniary externalities like pollution (the only externality is that my demand affects the price that you have to pay too). I will also assume symmetric information although there is a large literature (founded by Robert Lucas) on general equilibrium with asymmetric information). Thus the assumptions are the very strong ones typically criticized by people who say that the support for laissez faire (libertarianism in English) from economic theory is irrelevant the real world.

Is it Pareto efficient is not an interesting question (as stressed I might add by Kenneth Arrow who proved the first welfare theorem and said it was no big deal).

This has little to do with efficiency in the normal sense of the word. An outcome is Pareto efficient unless it is possible to make someone better off without hurting anyone. Slavery was Pareto efficient if it helped the slave owners. The statement that an outcome is Pareto efficient tells us essentially nothing. In particular if we have two outcomes and one is Pareto efficient and the other isn’t that tells us nothing of interest. It certainly doesn’t at all mean that the Pareto efficient outcome is a Pareto improvement over the other outcome.

uh oh. I have to define what general equilibrium theorists mean when they say “an economy”

1) an economy includes a set of agents each of which has a utility function. The agents rationally maximize their expected utility.
2) Each agent has an initial endowment of goods and maybe abilities
3) There is a production possibilities set describing how goods and abilities can be used to produce goods.

In particular all the results mentioned above are for “fruit tree” economies in which no one works. Instead the production is of the form of fruit trees which produce goods by themselves. Typically the models have 2 periods (I think this assumption isn’t really restrictive). In period zero people start with endowments of fruit trees. They trade them. One can short sell a fruit tree.
In period 1 the trees produce the fruit. People exchange fruit. Then they eat it.

Clearly this is a very special case of general equilibrium and the fact that the standard results for a 1 period model (no fruit trees) don’t hold is especially striking.

Open: Actually this is an abstract concept. Given a set we can define a “topology” which is the set of open subsets of the set. The only rules are
1. the whole set is open
2. the empty set is open
3. The intersection of a finite number of open sets is open
4. The union of any set of open sets is open.

in general equilibrium theory “open” has a standard relatively narrow defintion. It always (almost always ?) means that if we take an economy in the set, there is an epsilon so low that if we change the endowments of goods initially owned by agents so that the largest over i and j change in the endowment of good j owned by agent i is less than epsilon the new economy with new endowments is in the set of economies.

So something is true of an open set of economies means I can take a little from this guy and give to that gal and it will still be true.

dense: a subset of a set is dense if for any point in the set, for any open set containing that point, there is an element of the subset in that set. For example rational numbers are a dense subset of real numbers.

Generically: Roughly something is true generically if it is true except in knife edge cases of extraordinary coincidences. Consider the set of pairs of real numbers. Generically the two numbers are not equal, only by an amazing coincidence would they happen to be equal.

Formally a statement is true generically if it is true for an open and dense subset of economies. In practice what is shown is if we have an economy for which it is true we can make little transfers of endowements so small that it is still true after the transfers. For any case in which it is not true for any epsilon, there are transfers where the biggest amount of any good given to or taken from anyone is less than epsilon such that after the transfers the statement becomes true.

Another way of saying it is that if we have a set and an open and dense subset, the complement of the subset (the points in the set which aren’t in the subset) has measure zero for any measure based on the topology of the set.

What’s Wrong with Economic Theory as Presented to the Public ?

Robert Waldmann

I have a very low opinion of economic theory. I think that its survival is the result of a bait and switch where the core principles (roughtly Nash equilibrium) can’t be proven false, because they have no implications, and, given the fact that they have not been proven false, economists attempt to convince people of the joint implications of the core principles and further assumptions which are known to be false. Fortunately, very few people pay much attention to economic theory.

To continue the diatribe, the implications of economic theory as presented by right wing economists are the implications of models which are about 50 years old now. They depend on assumptions which no one claims are approximately valid. In particular, the traditional application to finance of economic theory, that is general equilibrium theory, (generically) gives the standard results only if markets are complete — that is there is a contingent claim for every conceivable contingency (including say this pays 1 unit of numeraire good if it is snowing on Mars or if Robert Waldmann stubs his toe between 6:55 EST of October 3 2008 and 7 EST).

With incomplete markets, the market outcome is generically (that is except for a set of economies with measure zero) constrained Pareto inefficient (that means that there are legal restrictions on peoples positions in financial markets which make everyone better off).

Also, there is no claim based on economic theory that financial market prices reflect fundamentals. A large set of general equilibrium economies *with complete markets* have multiple equilibria. Which equilibrium occurs is not determined by fundamentals (tastes and technology). With incomplete markets payoff irrelevant signals (sunspots) can affect prices in general (I think generically).

The conclusions of economic theory as presented by many or perhaps most economists do not follow from current economic theory, but rather from the 50 year old efforts at mathematical economic theory.

Thus the New York Times Op-ed page is not to be blamed for publishing an op-ed full of false claims about economic theory written by Mark Buchanan a physicist. I won’t excerpt, read it if you want. My objections after the jump.

Bachman has no idea what he is talking about.

First he has no idea of what economists mean when we say “equilibrium”. He just assumes that we mean stable steady state (which is what we used to mean 50 years ago). Now we mean Nash equilibrium or Walrasian General equilibrium which is nothing of the kind. He should check on recent developments in general equilbrium theory in the past 30 years. He will find the word “sunspot”. He will find that general equilbrium theorists argue that there are “equilibria” in which market prices jump around with no relevant news (based on irrelevant news that has nothing to do with tastes or technology). That is, the view of general equilibrium theorists is the exact opposite of the view Buchanan attributes to them.

He will also note that general equilibrium theorists conclude that market equilbria are generically not constrained Pareto efficient — the theorists who showed that are Herakles Polimarchakas and John Geanokoplos (hey where did I just read that name ?).

Finally the bit about how economists don’t use computer simulations is, if possible, even more wrong than the rest of the op-ed. It is like saying economists refuse to use mathematics or have no use for the theory of statistics.

I’d say that Buchanan demonstrates complete ignorance about what economic theorists have been doing in the, depending on the paragraph of the op-ed, past 30 to 50 years.

By now I’m tempted to just post my explanation of why I won’t post. I think I will.

On the other hand, while Buchanan doesn’t know anything about current economic theory, I think he does have a sense about how economic theory affects the political debate. There is a general view that, according to economic theorists, laissez faire is the best policy. Pro-market politicians are a bit reassured by this and pro-regulation and egalitarian politicians probably think they are fighting against the false prevailing economic theory. In fact, many economists argue that economic theory shows (if they are delusional about the scientific standing of economic theory) or suggests that the market is socially efficient. This is just not true at all. In particular someone who confuses “Pareto efficient” and “efficient” can claim this about markets with rational agents, perfect competition and *complete markets*. It is hard to explain what complete markets would look like, because an economy with complete markets is so totally unlike the real world. No one has ever argued that markets are approximately complete and no general equilibrium theorist has ever argued that this is a matter of less than critical importance.

The problem is, I think, that when they talk to non economists, many economists pretend that traditional economic theory is a good approximation to reality. By “traditional” I mean 50 year old. The fact that the conclusions are the result of strong assumptions made for tractability and are known to not hold without these assumptions is irrelevant. In the case of financial market equilibrium, the assumptions are not just the core assumptions of rationality and old assumptions of perfect competition but the totally crazy assumption of complete markets.

Once a model has been put in textbooks, it becomes immortal invulnerable not only to the data (which can prove it is not a true statement about the world but no one ever thought it was) but also to further theoretical analysis.

Buchanan should have talked more to Geanakoplos before shooting his keyboard off. The Times should have checked claims about current economic theory with an economist before printing them, but I think the worse problem is that economists who are also libertarian ideologues are lying about the current state of economic theory, not only its very weak scientific standing, but the fact that, even if it were all absolutely true, their policy recommendations do not at all follow from current economic theory.