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

Not So Dumb as Economists, Part 1

I was going to point out that finance people are not so dumb as economists,* but Echidne’s takedown of Gary Becker is so divine it deserves your attention more:

This argument was initially made by Gary Becker, an economist, a very long time ago.** It is not an uncommon argument from conservatives (or from certain types of anti-feminist sites.) That does not mean that it shouldn’t be discussed. So let’s do that by looking at what is unrealistic about the specific conclusions….

In [Becker’s] first model only owner/managers have a dislike towards workers from a particular group. That, my friends, is the model from which the above conclusion comes, though even then it would only work to eradicate discrimination from the whole industry if the industry was essentially a competitive one. If the industry is not sufficiently competitive, the bigoted owner/managers can hang on and practice discrimination.

Becker argues that if the only problem we have consists of some bigoted owner/managers, while everyone else is just so sweet, sufficiently well-lubricated markets can get rid of those nasty bigots, always assuming that everybody knows everything relevant about everyone else.

There are no misconceptions in the model. Even the bigoted owner/managers of a pizza parlor, say, know that Joe and Jane are equally good pizza-bakers. They just hate Jane and are willing to hire her only if they can get her for less money.

This cannot last if we can find at least [one] non-bigoted nice owner/manager.

That’s the background of the old chestnut. Becker, having become immersed in the imaginary world of his simple model, concluded that competitive industries would never exhibit any long-run sex or race discrimination. Only oligopolies or monopolies could survive with at least some bigoted owner/managers. [emphases mine; hers varied]

It is a rare and delightful moment when someone looks seriously at an economic model. Strangely, when you examine the social premises of the mathematics—returning economics to its beleaguered claim to being a social science, as it were—it starts to be clearly why people believe economists are the problem, not the solution. It’s progress to see a blogger destroy an economist this thoroughly.***

*And I may still, using this post by Mish as the springboard, but I think the post leads to that as an inevitable conclusion, so for now I’ll just refer people there.

**1971, apparently, though, iirc, several of the papers are from 1965-1966.

***Yes, I know The Snake Woman is, in real life, a qualified economist. But she’s not being asked to play one on television, like Larry Kudlow, whose degree from WooWoo is patently not in economics, or Megan McArdle, who has an Ivy League degree in English Literature and an MBA.

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Name the Year: Declining Home Prices and Equity Removal

UPDATE: In this context, Dr. Black catches Jamie Dimon expressing what is at best ignorance:

However, [Dimon] cautioned, until the market meltdown “you never saw losses in these products, because home prices were going up.”

All that research in 1984 and 1990 was for naught, apparently.

I’m still away (things are better, but still not completely back to normal), but this is too good not to post:

Unfortunately, many default models using original LTV [Loan-to-Value] have underestimated the level of delinquencies in recent years. Measurement of the amount of equity borrowers have in their home is the chief cause. Such mismeasurement is due to two factors: declining home prices and removal of equity via second mortgages or home equity lines of credit.

Is this from:

  1. 2008-2010?
  2. 2004-2006?
  3. 1996?
  4. officially 1996, but other textual evidence indicates it was written between 1989 and 1993?

My answer is (4); the official one is (3), since it’s from the Third Edition of Frank J. Fabozzi’s Bond Markets, Analysis and Strategies (now in its 7th edition).  But if anyone out there has the first or second edition and wants to check the chapter on Mortgage Loans, I’ll give odds the paragraph is virtually identical in the Second Edition.

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Not-So-Select Short Subjects

Now that I know we’re just members of the “Peanut Gallery,”* let this random links post work as a placeholder for longer posts as we prepare for the “holiday”:

Shorter Mark Thoma at Marketwatch: If you can’t build a better model, best to reappoint a man who doesn’t think he has to do half of his job. (UPDATE: Or even less than that. [h/t Linda Beale])

Shorter Mark Thoma at his own blog: All of our current models prefer people to starve and die.

A fun graphic (h/t Abnormal Returns)

Think the Health Insurance “Reform” Bill will “bend the cost curve”? Think again.

*That the “Periodic Table” pretends to be about Finance Bloggers and yet categorizes DeLong, Thoma, and Mankiw, to name three, as “Rocket Scien[tists]” instead of Economists should in no way be seen to impune the quality of the analysis, of course.

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Mundell Fleming Muddle ?

Robert Waldmann

Wow an argument in favor of protection from Paul Krugman. I never expected to read that. Now he’s against protection all the same, but he does admit that there is a good argument that right now a bit of protection would be good for the world.

The argument, basically, is that governments aren’t coordinating macro policy and that, if stimuli spill out, then they won’t stimulate enough so everyone will be better off if every country keeps its stimulus to itself. He concludes however, that protection would be a bad policy, because once countries start they don’t stop so a little bit of protection right now is not an option. Anyway it’s brief so read it.

Nick Rowe has an interesting counter argument. He argues that if all countries are in a liquidity trap, then fiscal stimuli don’t spill over.

According to Krugman “His argument is based on the proposition that since interest rates are fixed under a liquidity trap, capital flows are fixed, and the exchange rate will adjust to offset any change in the trade balance.” I will comment on this alleged argument. Rowe’s post refers to a paper which I haven’t read. Actually the post seems less sophisticated than Krugman’s presentation, as Rowe seems to argue that flexible exchange rates always imply balanced trade. He can’t be arguing that, and I haven’t read the paper.

The argument that this is true specifically if we are in a liquidity trap seems to be specific to Rowe as presented by Krugman.

Rowe’s argument as presented by Krugman seems backward to me (from now on “he” means Rowe as presented by Krugman). Basically he seems to be arguing that demand for say 3 month t-bills is very elastic and so the price of 3 month t-bills won’t change and so the amount of 3 month t-bills in investors’ portfolios won’t change — that is he is going from the assumption people are willing to shift huge amounts of wealth into 3 month t-bills to the conclusion that people won’t shift any wealth into t-bills.

I repeat this argument in various ways after the jump.

The evidence that we are in a liquidity trap is simply that short safe rates are approximately zero. However, the application in macro models is the assumption that, therefore, safe short term interest rates won’t increase if more short term public bonds are issued. That seems to me to be the same as the assumption that people and firms are willing to buy much more of them.

For some reason, Rowe assumes that this applies only to domestic people and firms and that whatever makes investors so eager to buy short term public debt is confined nation by nation. Not to put to fine a point on it, this strikes me as absolutely absurd given, for example the fact that UBS is endangered by the US real estate bubble and that AIG was brought down by its London office.

The argument is interest rates are fixed because a miniscule change in interest rates would cause a huge flow therefore changes in interest rates will be miniscule therefore flows will be miniscule.

I’d say this is a case of the dear old Mundell Fleming model overcoming common sense as if it were an RBC model.

The same goes for the anchoring model.

s = sbar + (i*-i)/k

s is the exchange rate, sbar a steady state exchange rate determined long after the recession and stimulus are over, i domestic interest, i* foreign interest rate and k a constant.

Krugman assumes that k is constant which, for one thing, implies that capital flows are linear in interest rates. Does that assumption seem reasonable right now ? seems to me that an interest rate fluctuating between 0 and 10 basis points is a strong time that k is a bit low right now.

However I guess k doesn’t matter to Krugman. I guess that Krugman’s argument amounts to saying that with constant interest rates, bonds become perfect substitutes so the amounts of different bonds that people will hold (tried to avoid writing “stock of bonds” there) can change a lot and balance large trade deficits at a fixed relative price. That is Krugman is ahead of me as usual always so far.

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Barro on Keynes Barro and Grossman

Robert Waldmann

Robert Barro wrote an op-ed in The Wall Street Journal. The substance of the op-ed is to report an estimate of the Fiscal multiplier 0.8 which is less than one. Thus, according to Barro, a stimulus will partially crowd out of investment, consumption or net exports and not just reduced leisure. Paul Krugman took Barro to task for using the huge WWII stimulus in his estimates, since the economy was at full employment during WWII. So have Matthew Yglesias using his Harvard BA in philosophy from Harvard and Kevin Drum using his BA in Communications from The California State University in Long Beach.

I might want to reassess Long Beach State, but I think the reason that Yglesias and Drum immediately make the same argument is Krugman is that Yglesias and Drum don’t know about modern econometrics. Barro is using an instrumental variables regression in which wartime military spending is considered to be an exogenous variable which is correlated with government consumption. The implicit assumption is that we can safely assume that the fiscal multiplier today is identical to the fiscal multiplier during World War II, because the economy is basically similar. Without training in modern econometrics it is simply impossible to assume something that stupid.

There is also a severe gap in economic theory, at least as remembered by Robert Barro. Wouldn’t one think that there must be some model in which correlations vary depending on the general conditions of the economy — say like whether at current prices there is excess demand for goods or excess supply of goods.

Of course, no one could expect Barro to know that there is a vaguely Keynesian model, which differs from the neoclassical model only because of rigid nominal wages and prices, in which the economy can be in one of three different regimes, Keynsian (with insufficient aggregate demand), Classical (firms can sell as much as they want but real wages are too high so workers are unemployed) and repressed inflation (excess supply of labor and goods).

I’m mean who’s ever heard of the Barro-Grossman model (A General Disequilibrium Model of Income and Employment Barro, Robert J.; Grossman, Herschel I.; American Economic Review, March 1971, v. 61, iss. 1, pp. 82-93 [stable JSTOR link added for those with access])? Certainly not Robert Barro.

The passage quoted by Krugman about what Keynes thought is inconsistent with The General Theory. However, it can be corrected easily. The accurate description of the history of economic thought is “John Maynard Keynes Robert Barro and Herschel Grossman thought that the problem lay with wages and prices … will mean that wages and prices do not have to fall.”

Look I sympathise. Like Barro, when I was young and reckless I did embarrassing things which I have tried to cancel from my memory. I really wish I could do that as well as he has.

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45 trillion credit swap market…how big is that?


The ABX.HE index, which is based on credit default swaps on different tranches of subprime mortgage-backed securities. (Federal Reserve Bank of Cleveland)

Hat tip to Jim Satterfield for this link to Marketplace public radio. Bob Moon is the Senior Business Correspondent.

MOON: OK, I’m about to unload some numbers on you here, so I’ll speak slowly so you can follow this.

The value of the entire U.S. Treasuries market: $4.5 trillion.

The value of the entire mortgage market: $7 trillion.

The size of the U.S. stock market: $22 trillion.

OK, you ready?

The size of the credit default swap market last year: $45 trillion.

RYSSDAL: OK, I’m with you, but let me ask you this. We just had the secretary of the Treasury yesterday with a big policy announcement. If these things are so bad, what’s being done about it?

MOON: The irony here is that the former Fed Chairman Alan Greenspan, a couple of years ago he called credit default swaps “probably the most important instrument in finance,” because they were supposed to spread risk around and stabilize the market. Well, critics now say that they’ve had exactly the opposite effect. One of the leading critics of these things is Christopher Whalen. He’s an expert on financial risk at Institutional Risk Analytics. And he told me that this is nothing more than government-guaranteed gambling:

CHRISTOPHER WHALEN: They are the most hideous kind of speculation. To have a federally insured bank like JPMorgan as the largest dealer in this market, to me says we don’t know what we’re doing anymore, and we don’t understand the difference between real work — real economic activity — and something that’s essentially wasting.

MOON: And Whalen points out that Bear Stearns had more than $2.5 trillion in credit default swaps. He suspects that that’s why JPMorgan came to the rescue, so it didn’t get pulled down.

Update: Do you know what notational means? Comments are a must read.

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Sallie Mae couldn’t have predicted…Model Validation Part 3


Higher Ed Watch reports on Sallie Mae:

Last week, we wrote that Sallie Mae and its promoters on Wall Street claim the company was “blind-sided” by the rising default and delinquency rates on subprime private loans it made to low-income and working class students at poor performing higher education trade schools. It’s a convenient argument considering that the loan giant is facing at least one, and possibly several, class action lawsuits by angry shareholders who accuse the company of deliberately misleading them about the amount of risk it was assuming. But the argument is disingenuous at best.
Financial analysts have long raised red flags about Sallie Mae’s private lending practices. During earnings calls and at shareholder meetings and investment conferences, analysts regularly peppered Sallie Mae officials with questions about whether the company, which is used to having government backing on its loans, had the expertise needed to assess the risks associated with lending unsecured, private loan debt to financially-needy students.
….
In 2005, Fortune Magazine brought attention to the analysts’ worries in an article entitled, “When Sallie Met Wall Street.” That piece specifically raised concerns about the loan company’s dealings with schools owned by Career Education Corporation, which it noted had had been accused “in multiple lawsuits in several states of using hard-sell tactics to recruit students, promising them high-paying jobs that don’t materialize and leaving them with mountains of debt that they can’t pay off.”
The article’s author — Bethany McLean (who, by the way, helped break the Enron scandal) — proved prescient in predicting the predicament in which Sallie Mae now finds itself. McLean wrote:
[A] big question looms in Sallie Mae’s private credit business: How many students who take out these high-interest loans will end up defaulting? After all, private credits are basically unsecured loans to people without jobs. Sallie argues that there won’t be a problem. Each quarter it books a reserve for potential losses; at this time its loss on private credit loans in repayment are running at only 2.4%. Plus, Sallie says, almost half its private credit loans are guaranteed by a parent.
But because private credit is a new business and because students are taking on unprecedented levels of debt, there are no historical measurements by which to gauge potential defaults. As Sallie’s financials note, “the provision for loan losses is inherently subjective as it requires material estimates that may be susceptible to significant changes.” And the current low delinquency rate may be misleading, because as of the end of 2004 nearly half the students to whom Sallie has lent private money hadn’t left school yet.

Lots of financials are changing.

Update: PGL posted on Student loans and default risk in January, 2007.

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Bank risk models and regulation

Here is Avinash Persaud, writing on Willem Buiter’s blog, with his take on the problem:

Why Bank Risk Models Failed and the Implications for what Policy Makers Have to Do Now, by Avinash D. Persaud: Sir Alan Greenspan, and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical. Neither is complex, but many regulators and central bankers chose to ignore them both.

The technical explanation is that market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them. This was not a bad approximation in 1952, when the intellectual underpinnings of these models were being developed … by Harry Markovitz and George Dantzig. …

In today’s flat world, market participants from Argentina to New Zealand have the same data on the risk, returns and correlation of financial instruments and use standard optimization models, which throw up the same portfolios to be favoured and those not to be. Market participants don’t stare helplessly at these results. They move into the favoured markets and out of the unfavoured. Enormous cross-border capital flows are unleashed. But under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. …

When a market participant’s risk model detects a rise in risk in his portfolio, perhaps because of some random rise in volatility, and he tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues of vertical price falls prompting further selling. Liquidity vanishes down a black hole. …

Policy makers cannot claim to be surprised by all of this. The observation that market-sensitive risk models … were going to send the herd off the cliff edge was made soon after the last round of crises*. Many policy officials in charge today, responded then that these warnings were too extreme to be considered realistic.

This brings us to the philosophical problem of the reliance of supervisors on bank risk models. The reason we regulate markets over and above normal corporate law is that from time to time markets fail and these failings have devastating consequences. If the purpose of regulation is to avoid market failures, we cannot use … risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.

In terms of solutions, there is only space to observe that if we rely on market prices in our risk models and in value accounting, we must do so on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets to avoid systemic collapse. This is the approach we have stumbled upon. Central bankers now consider mortgage-backed securities as collateral for their loans to banks. But the asymmetry of being a buyer of last resort without also being a seller of last resort during the unsustainable boom will only condemn us to cycles of instability.

The alternative is to try and avoid booms and crashes through regulatory and fiscal mechanisms designed to work against the incentives … for traders and investors to double up or more into something that the markets currently believe is a sure bet. This sounds fraught and policy makers are not as ambitious as they once were. …

Regulatory ambition should be set now, while the fear of the current crisis is fresh and not when the crisis is over and the seat belts are working again.

Another good angle on models and validation. Incentives count too.

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OldVet: Finding our Way out of the Fog

This one is by OldVet.

Attracted by the pretty lights we wandered into the financial winter and got lost in the fog. The photo is actually Odessa, Ukraine, and seemed apt this morning as we hear plans and counter-plans to deal with financial markets.

I’d like to draw your attention to a most interesting discussion on reforming our American capital markets. The author, Mr. Michael Lewitt, runs the oddly named Hegemony Capital Management LLC, and I have not read anything by him previously. However the discussion he provides is both provocative and salutary in the sense that he starts by trying to discover the root causes for our current financial market troubles. It’s worth reading just for the breadth of the discussion and the bold prescriptions for restructuring American capital markets.

Below are excerpts from the paper, which suggests a much more comprehensive tack than the Paulson plan.

For more than two decades, the United States economy has favored financial speculation over production. Over the past century, our legal system had developed an increasingly outmoded concept of fiduciary duty that privileges short-term, single-firm interests over the kind of long-term, society-wide interests that could lead to prolonged prosperity. The current meltdown in the financial markets is a symptom of a serious disease that is eating away at the stability of our most important institutions.

The Bush Administration, under the intellectual leadership of Treasury Secretary Henry Paulson, has proposed a broad reorganization of financial industry regulation. Unfortunately, this plan merely addresses form over substance and does little or nothing to address the underlying problems that are eating away at the system like a cancer. If reform ultimately follows the path proposed by Mr. Paulson and goes no farther to outlaw the reckless practices that place the system at risk in order to line the pockets of a privileged few, we will have sadly learned nothing from the current crisis. The system is infected by deep, inbred flaws that are rendering it increasingly unstable. Free-market capitalism as practiced on Wall Street and in The City has run amok. If the current crisis, and the recurring crises of the last twenty years, tell us anything, it is that market solutions are insufficient to protect the system from the greed and fear that drive markets. If the deep structural cracks in the system are not addressed and corrected, the markets may not survive the next near-death experience.

This one was by OldVet.

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OCC and Model Validation Part 2

FIRE reports:

“The securities industry is an economic powerhouse that continues to strengthen the U.S. economy,” said Securities Industry Association President Marc Lackritz. “SIA data shows that last year alone, we raised a record $3.2 trillion of capital for American business and nearly $14 trillion over the past five, underscoring our substantial contribution to overall growth in the U.S. economy.”

Also fatbear in comments earlier offers this link by Paul Krugman on the OCC and Office for Thrift Supervision.

Just go read Krugman from right before Xmas last year:
Consider the press conference held on June 3, 2003 — just about the time subprime lending was starting to go wild — to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.
Also in attendance were representatives of financial industry trade associations, which had been lobbying for deregulation. As far as I can tell from press reports, there were no representatives of consumer interests on the scene.
Two months after that event the Office of the Comptroller of the Currency, one of the tree-shears-wielding agencies, moved to exempt national banks from state regulations that protect consumers against predatory lending. If, say, New York State wanted to protect its own residents — well, sorry, that wasn’t allowed.
One thing to remember is the the state subsidiaries of the national banks, many of the them state based mortgage companies, were also exempt from state regulation.

Another thing to remember is the lack of resources to even monitor the new market, as Consumers Union points out.

Even if the OCC had a desire to effectively regulate the consumer practices of national banks, it lacks the resources to do so. According to the OCC’s own statistics, there are about 2,200 nationally chartered banks, with total assets of $3.5 trillion. The entire staff of the OCC is less than 3,000, which is less than one person per $1 billion in bank assets. Even if the OCC did vigorously develop new consumer protection regulations, which it does not, the OCC does not have enough staff to detect and prevent problems for consumers at big and small nationally chartered banks throughout the U.S. is the resources of the agency as they took on added responsibilities…”

The GAO weighed in rather obliquely on the issue.

We shall see how it all shakes out, but remember, do not exclude externalities, which our economic models exclude from serious price adjusting. But that is a different story for 19th century philosophy. It just means we do not even try to validate the model in the 21st century. Whatever happened to innovation in economic philosophy?

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