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

The Meaning of "Monty Python and the Meaning of Life"

Robert Waldmann

Barry Ritholtz argues that the problem with mortgages was underwriting standards and not securitization. He appeals to the very great authority of Monty Python. Click the link.

Ritholtz seems not to be familiar with this new idea in economic theory called “Nash equilibrium”. Over -rated yes. Totally irrelevant not so much. One can not assume that underwriting standards are exogenous. If there had been no MBS, no firm would have underwritten those mortgages. It was exactly because it was possible to blend them, and then sell them to people who didn’t spin the mortgage tapes before buying, that the mortgages existed in the first place.

Let me work with his analogy. First, while I have great respect for the Monty Python team, few people have been killed by canned Salmon. Even blended into mousse, it kills fairly quickly and can be tracked back to the canner. The way bacteria work is that if you mix some contaminated stuff with other stuff you have trouble for sure. It doesn’t work that things seem fine until people notice.

At a way lower cultural level than Ritholtz I appeal to road runner cartoons. Wile E. Coyote runs along in mid air until he notices. Then he falls. As noted by everyone, this is the way financial markets really work. The non Monty Python quality humor is based on the fact that gravity doesn’t really work that way. Neither do bacteria. Analogies between rotten mortgages and rotten Salmon fail for this reason.

Notably, the ingredients in the Salmon mousse are few enough that the dead diners immediately know what went wrong when death points at the mousse. That’s not the way MBS work let alone CDOs of MBSs or CDOS of tranches of CDOS.

A better analogy would be making hamburger. Bits from hundreds of steers end up in the same package at the supermarket. If one bit has E. coli on it, you can get sick. If they tried to sell you that bit, you wouldn’t buy it because it would stink. However, mixed in with hundreds of uncontaminated bits of beef, it doesn’t stink.

Is there a hamburger problem? Yes there is. One is much more likely to get food poisoning from hamburger than from unprocessed meat. Is the solution special regulation of hamburger? It sure is.

Today in "Economists Are NOT Totally Clueless" (Part 3 of 4)

Pete Davis:

Treasury Secretary Hank Paulson initially sold Congress in the fall of 2008 on emergency intervention to purchase “toxic assets,” but quickly reversed course in favor of direct capital injections. Those favored financial institutions revived more quickly than most thought possible and most of those injections have already been paid back. However, most of the toxic assets remain on bank balance sheets, impeding new lending. [emphases mine]

At the end of the last post, I was ready to discuss “deadweight loss.” But a brief detour seems in order.

We used to talk a lot at this blog about DSGE models. Economists talk a lot about Equilibrium, even if they don’t fully understand it. At its core, saying “equilibrium” is saying “this is the best of all possible worlds.”  You can’t improve on equilibrium unless you choose a non-Pareto-optimal solution (i.e., a solution in which at least one person is affected negatively).

Equilibrium doesn’t mean you have achieved ideal social welfare. (Anyone who has looked at Game Theory for more than a minute can tell you that.)  But it does mean that things are “hitting on all cylinders.”  Or, more accurately, if the economy is not at equilibrium, the odds are better that people making choices will make mistakes.

Which is why I pointed to Brenda Rosser and especially this

“The way out of this thing is a shift in the way we treat the LDC debt,” Coldwell argued. “The banks would have to take a big hit on their balance sheets, but then it’s over. If you give them a definitive hit, then they could say it’s behind us. If you get down to a crisis stage, the banks would accept that. They would have no choice.” — William Greider. ‘The Secrets of the Temple – How the Federal Reserve Runs the Country’ Touchstone 1989. Page 549

If the banks take that hit, we’re back at equilibrium.  If they don’t, they continue to make suboptimal choices.  Which brings us back to the graphic.

There were several good suggestions for refinement in the comments, none of which can I do at the moment, since I’m working solely from FRED data. (General response: those acquisitions, especially WaMu, were made on terms that were agreeable to all acquiring parties. Which doesn’t mean those acquisitions may not be affecting the flow, but it’s likely more a question of acceleration than velocity, especially given the relative sizes of the institutions.)

But the FRED data is damning enough.  The risk management procedures at larger institutions were significantly worse than they were at smaller ones.  And the bigger they are, the worse they are becoming:

With several waves of doubt still to come, we are (choose one) (a) far from equilibrium or (b) still making suboptimal choices.

So let’s do a finger exercise.

Mortgages Outstanding approx. $11 trillion (Q4 2008)

Amount at risk (SWAG)25%

Expected Losses $2.75T

Fed Holdings (TARP, TALF, CPLF, etc.) approx. $2.2 T

Remaining Balance Sheet Exposuren approx. $550B

25% at risk seems about right.  Slightly over 10% of that $11T was Home Equity Loans, and the outstanding household debt at that time was about 123% of national income while equity was around 40%.

But note that this assumes that all of the special facilities remain in place. For instance, per Hamilton’s graphic, the Fed now owns about $1T worth of MBSes. CR notes that this program “is scheduled to be complete by the end of Q1.”

Of course, there are some cures that would be worse than the disease.  Via alea’s Twitter feed, I see that either the headline writer or the speaker made a slip yesterday:

“There ought to be government-backed ABS,” said Fed economist Wayne Passmore in a presentation to the American Economic Association.

Note that the quote is not (just) MBS but ABS—asset-backed securities, including credit-card receivables, car loans, basically any form of consumer (or other) debt that can be securitized.  The result of this would be that your tax dollars would pay a bank for your default on a credit card that charged you 30% interest, despite the risk-free rate being something near 0%—and almost always in the 5-8% range.

The reason we like equilibrium is that people who make mistakes do so because they are “being irrational.” When we’re not at equilibrium, we realize that they make irrational decisions all the time.  In what I hope will be the last of this series, we’ll look at irrational and rational decisions—and why irrationality may be the best survival strategy.

Today in "Economists Are NOT Totally Clueless" (Part 3 of 3 or 4)

This is taking longer than it should. For now, here is a “teaser” graphic, which I suspect is worth much more than 1,000 words:

Meanwhile, other (mostly related) thing you may want to read:

  1. Brenda Rosser find that everything new is old again.
  2. Steve Randy Waldman tells the truth about banks, and Shames the Devil, not to mention Tim Geithner
  3. Menzie Chinn discusses types of unemployment, and, implicitly, suggests that those who are arguing that structural unemployment (and, therefore, NAIRU) has risen are incorrect.
  4. James Hamilton notes that TARP was not the only program of support for financial institutions, nor will it likely be the last.
  5. Linda Beale finds Amartya Sen discussing “Rational Choice.”
  6. Rick Bookstaber raises a point Brad DeLong made a while back: inflation can be a very good solution to a true macro disaster.
  7. Mark Thoma finds David Cay Johnston’s examination of marginal rate data and economic growth.

How Rational Behavior Leads to Inefficiency if there are Incomplete Markets

Robert Waldmann

My effort immediately below to explain some general equilibrium theory in English didn’t work out so well. Here I will attempt to give simple examples which show how rational individual choice and/or trade between rational consenting adults can make everyone worse off.

Models will all involve strange fruit trees, that is assets which generate goods without labor. There will be only 2 periods. In the first period (period 0) agents plant trees and maybe buy and sell them. It is allowed to short an apple tree (that is to promise to deliver the apples even if you don’t own the tree).

Then in period 1 the trees produce fruit. The amount depends on the state of the world (that is say the weather). People fulfill the terms of their financial agreements. Then people trade fruit on the spot market. Then people eat the fruit giving them their only pleasure in the whole model. Then they die.

If there are so many different kinds of trees that, for each state of the world, one can construct a portfolio which pays a positive amount in that state and only in that state, then markets are complete and the free market outcome is Pareto efficient. Otherwise it is easy to come up with examples in which rational behavior in period 0 makes everyone worse off in expected value.

One Example after the jump (I will add more when my fingers stop aching).

drought resistent apple trees. Here there are only 2 states : in state 1 it rains a lot on the apple orchards, in state 2 it rains little. The only choice in period zero is that people with apple suitable land have to decide wether to grow drought resistant apple trees which get mold if it is wet or drought sensitive apple trees which do great if it is wet. People who grow apples get sick of them and don’t want to eat them. They just eat the other good (oranges). There are always the same number of oranges. Orange growers have utility which is cobb douglas in apples and oranges.

Now if all apple growers plant drought resistent apples they all face no risk. If there are half as many apples, the relative price of apples doubles. They always eat the same number of oranges (and no apples they don’t like apples). If one apple grower plants any drought sensitive apples and their is a drought, he will suffer. If apple growers are risk averse enough, all drought resistant apples will be an equilibrium.

The orange growers face risk. They always eat the same number of oranges but eat different numbers of apples depending on whether there is a drought.

A Pareto improvement is possible. If all the apple growers plant half and half drought resistent and drought sensitive apples, then they are still safe and so are the orange growers. This is a Pareto improvement.

General Equilibrium Theory by Popular Demand

Robert Waldmann

I’m not kidding. Someone in some thread said that he or she thought it would be great if I could give a simple intuitive explanation of Geanakoplos and Polemarchakis (1985). Also I would get an interesting perspective on the crisis if I could fly to the moon.

I will try after the jump. The G&P result is that, if markets are incomplete, unless there is an amazing coincidence, there exists a regulation of financial markets which makes everyone better off than laissez faire.

This does not mean we should decide to regulate. The fact that such a regulation exists, doesn’t mean that it will be implemented if we just convince people that laissez faire is not optimal. It doesn’t even mean that economists can figure out a Pareto improving regulation and the problem is that those rotten politicians won’t implement it. Thus the result has only one practical application. If someone says that econmic theory or common sense tell us that free interactions of rational people must be in the interests of those rational people — that person has just said that he doesn’t know what he is talking about. This is not a judgment call. There is a mathematical proof.

Before the jump, I will just notice that there are many reasons why free market outcomes are presumably not Pareto efficient. The list of sufficient conditions in the most general description of economies with Pareto efficient market outcomes is very long, and for each sufficient condition for optimality it is easy to construct examples where, if the condition doesn’t hold, regulation can be good for everyone.

The requirements are rational expectations, well defined property rights, price taking behavior (which is really stronger than saying no agent has market power), no nonpecuniary externalities which implies, among other things, that people have no sense of pity and don’t mind knowing that others are starving, symmetric information and, finally, complete markets.

After the jump I will consider only the implications of incomplete markets as the assumption of complete markets — that for every distinguishable state of the world there is an asset which pays a positive return in that state and only in that state — is so absurdly false that no one claims it is a good approximation.

OK so the problem is to explain how rational choice by price taking agents with well defined property rights and symmetric information whose happiness depends only on their consumption leisure and whose actions don’t cause externalities except via prices (from now on RCBPTETC)can make all these agents worse off than they would be if the rational choices were constrained by a regulator who knows know more than they do and who can’t introduce new assets (like social insurance) which weren’t available to the private agents (from now on a RWKNETC).

The problem is that the proof really is based on an argument like “we have N inequalities and more than N variables so, generically, we can find variables such that all N inequalities are satisfied.” This is not intuitive. I was asked for examples, but I won’t get to them in this post. I will try to give examples in the next post.

I will define my terms (search for EOD to skip this part)

1. Price Taking: Agents decide what to do given prices, including prices of financial assets and their exactly accurate forecasts of future prices as a function of the state of nature. They assume that they can buy or sell any amount at current prices and ignore any effect that their buying and selling might have on prices. The bolded passage is necessary for Pareto efficiency in a one period model without uncertainty (a model without financial markets). It is also key to proving that equilibrium with financial markets is almost certainly inefficient. Oh note this is describing free markets. If goods are rationed by the regulator, agents know that they are.

2. Symmetric information: agents may not know much but they have the same information. This, along with rationality means that they have the same accurate belief about the probability that something will happen. With asymmetric information, insurance markets which are good for everyone can fail to exist due to the adverse selection death spiral. Forcing all people to participate in such markets can be good for everyone.

3. Well defined property rights: IIRC An assumption in all proofs that the market outcome is inefficient is that agents have an endowment and can choose to consume exactly that endowment neither buying nor selling. This is related to externalities. If anyone is free to pollute the air, then the good “clean air” doesn’t belong to anyone in particular. If fish in the sea belong to no one in particular, there will be overfishing — that is all people including fisherman might be helped by restrictions on catches.

4. Externalities include envy, shame at one’s unearned good fortune and pity. If people mind knowing that other people are starving, a world without starvation is a public good. I help you if I give food to the starving. Even if I care as much about you as I do about the starving person, if I care more about myself, then we can all be made happier by taxing each other to end starvation (and the formerly starving would be much happier). The sort of externality that is assumed not to exist in proofs of the Pareto efficiency of the market outcome is any interest in anything except my own consumption and leisure. Note not that people aren’t selfless but that we are completely totally absolutely selfish.

Becker showed that the results can be generalized if people are divided into non overlapping sets (called “families”) where people only care about other people in their own set and someone in each set cares enough that if you take from someone else in the set and give to them, they will choose to give it back. This is still very strong. He assumed that families don’t overlap (wonder if Becker explained that to his in-laws).

5. The regulator doesn’t know anything that the private agents don’t know. This seems clear. If the regulator knows better, then she can force people to do things which are in their interests but they don’t know it. This result will interest no one who observes the actual senate actually legislating.

6. This corresponds to the “constrained” in Geanokoplos and Polemarchakis title. The point is that, if there are incomplete markets, except for an amazing coincidence, making the markets complete *and* lump sum taxes and transfers can make everyone better off. It makes the challenge of finding a Pareto improvement harder in an important way as one way in which public intervention is widely believed to have made us better off is by introducing new kinds of insurance such as unemployment insurance. That’s too easy for G and P.

7. Pareto efficient: Look this is a very weak claim. It doesn’t mean efficient in any normal sense of the word. A Pareto improvement (making everyone better off) is interesting. The result that no Pareto improvement is possible (Pareto efficiency) isn’t interesting at all.

8: except for amazing coincidences. This is an effort at an Egnlish translation for “generically” which means “for an open and dense set of economies.” The claim is be ” if for some set of tastes technology and endowments the market outcome(s) isn’t (aren’t) constrained Pareto efficient, then there is a change in endowments so tiny that, after the change in endowments, the new economy has a market outcome which isn’t constrained Pareto efficient (or many outcomes which aren’t).” That means the set of economies with constrained Pareto inefficient outcomes is open. Also if there is an economy with a constrained Pareto efficient outcome, there is a tiny change (as tiny as you want) in endowments so that with the new endowments the outcome of the new economy is constrained Pareto inefficient (that’s the dense part).


OK the idea of the G&P result. First the model is a general equilibrium market with financial assets. The idea is that there are 2 periods, period 0 and period 1. IN period 0 agents trade financial assets which are all in zero net supply. The state the world will be in in period 1 is not known but everyone knows the probability of any possible state. Assets have payouts which depend on the state of the world. After the uncertainty is resolved (that is in period 1) agents buy and sell goods on ordinary spot markets, then they consume, then the universe ends. General equilibrium theorists claim that theis simple structure isn’t really as restrictive as it seems.

The point is that trades in the financial assets in period 0 will generally affect the prices in period 1 except in the case of amazing coincidences. One such amazing coincidence if if everyone has identical homothetic preferences so aggregate excess demand is a function of the aggregate endowment and relative prices (so demand can be represented as demand by a representative consumer). In this case only transfering wealth from one person to another (what financial assets do) can have no effect on spot prices in period 1.

So generically decisions made in period 0 will affect spot market prices in period 1. This is a pecuniary externality.

Now if we just look at one state of the world in period 1, there will be no way to make everyone better off by messing around with trade on the spot market in period 1. By then the economy has become a one period Walrasian economy with a Pareto efficient market outcome.

If the regulator messes with trade in financial assets in period 0 then some people iwll be richer and some poorer in some realizations (say one called s) of the state of the world in period 1. If these people have different tastes or if the distribution of wealth affects demand (as in some goods are luxuries) then this will affect spot prices in those states. The change in spot prices will help people who are selling goods whose relative price goes up and hurt people whose are buying those goods. That effect, the change in spot prices due to changes in trade in financial assets in period 1, will move the state s outcome from one Pareto efficient outcome to another. It will help some people and hurt others.

As always, it might increase the happiness of the people it helps by a tiny number of utils and hurt the people it hurts by a huge number of utils. That is Pareto efficient is a very weak result. To be more exact, choose one good and call it the numeraire. the market outcome in state s will maximize the weighted sum of utility of all the agents with weights equal to the inverse of that agents marginal utility of consumption of the numeraire good in state s.

This means in each state a weighted sum of utility will be maximized but the weights will, in general, be different for different states (with low weight in state s on the utility of an agent who is poor in state s)

The key point is that we know that the indirect effects on utility of messing with financial markets through spot prices will be of different signs for different agents in each state, but we don’t know anything about the effect on expected utility. Each agent knows that she will be helped some times and hurt some times, but knows nothing about the probability weighted average effect on utility.

OK so to get to the result that messing with what people buy and sell on the financial market (making them hold different amounts of financial assets than they want to) can make them all better off it is necessary to have 2 things.

1. The relative weights on different agents are different in different states. If there are complete markets, then the relative weights will always be the same (the weights are constants all multiplied by the same state specific factor for each agent). So the market outcome is Pareto efficient.

2. There have to be enough assets that the arbitrary vectors of changes in welfare do to messing around with portfolios are numerous enough that a linear combination of such changes adds up to a vector with all positive elements — that is a Pareto improvement.

The theorem requires an assumption about the number of assets compared to the number of different types of agents. Dimensions of messing with portfolios will be something like number of assets times number of agents minus 1 (because the assets are in zero net supply). There are as many inequalities to satisfy to get a Pareto improvement as there are agents.

Except for amazing coincidences, you can satisfy N inequalities if you have N unknowns so basically it is needed that the numbers of dimensions of meddling with portfolios is greater than the number of different types of agents.