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Deja Vu?

| Craig Pirrong |

Writing near to the event, in Capitalism, Socialism, and Democracy, Schumpeter argued that policy shocks, and policy uncertainty generally, lengthened the Great Depression:

The subnormal recovery to 1935, the subnormal prosperity to 1937 and the slump after that are easily accounted for by the difficulties incident to a new fiscal policy, the new labor legislation and a general change in the attitude of government to private enterprise all of which can, in a sense to be defined later, be distinguished from the working of the productive apparatus as such.

Since misunderstandings at this point would be especially undesirable, I wish to emphasize that the last sentence does not in itself imply either an adverse criticism of the New Deal policies or the proposition — which I do believe to be true but which I do not need right now — that policies of that type are in the long run incompatible with the effective working of the system of private enterprise. All I mean to imply is that so extensive and rapid a change in the social scene naturally affects productive performance for a time, and so much the most ardent New Dealer must and also can admit. I for one do not see how it would otherwise be possible for the fact that this country which had the best chance of recovering quickly was precisely the one to experience the most unsatisfactory recovery. [Emphasis in original]

Some of the specifics are different (e.g., health care legislation vs. labor legislation) but the overall thrust of Schumpeter’s analysis of the 1930s is quite applicable today. An “extensive and rapid change in the social scene” is currently in progress, and like Schumpeter, I believe that “policies of [the] type [being considered] are in the long run incompatible with the effective working of the system of private enterprise.” And even if you don’t buy into that, as Schumpeter notes, just the massive rise in uncertainty associated with this policy ferment is sufficient to impede measured economic performance because it is rational for businesses and individuals to delay investment and hiring decisions until the uncertainty is resolved.

10 January 2010 at 9:05 am 4 comments

Socialist Calculation Meets the OTC Markets

| Craig Pirrong |

A new Federal Reserve Bank of NY staff report by Darrell Duffie, Ada Li, and Theo Lubke, “Policy Perspectives on OTC Derivatives Market Infrastructure” has received a lot of attention in the press.

There are some good things in the paper. Notably, it is suitably cautionary about the potential systemic risks posed by central counterparties, and the consequent need for prudential regulation thereof. It also makes a good case for data repositories, and for the role of the Fed and other government agencies in reducing the costs that intermediaries incur to coordinate risk-reducing actions, such as portfolio compression and improvements in the process of confirming deals.

But overall the paper is extremely disappointing. Its tone is Olympian and prescriptive. The word “should” is used 61 times 21 pages of text (that includes several space-eating tables and charts).

This is extremely dangerous because these prescriptions and dictates are not based on a a rigorous analysis of costs and benefits. Most disturbingly, there is virtually no discussion whatsoever of the informational demands inherent in the prescriptions. We’re told that regulators should set the right capital and collateral requirements on non-cleared deals, and that CCPs should maintain “high collateral standards.” (more…)

9 January 2010 at 11:55 am 3 comments

A Tale of Two Papers, or, Humpty Dumpty Writes About Exchanges

| Craig Pirrong |

The American Economic Association/American Finance Association Meetings are just about over. I made a quick trip there to comment on a paper. Upon returning home, I downloaded a couple of the papers presented that seemed of interest. Good call on one, bad call on the other.

The bad one is “Centralized versus Over The Counter Markets” by Viral Acharya of LBS and NYU, and Alberto Bisin of NYU. Although the motivation of the paper is admirable, the execution is execrable, and is representative of a lot of what is wrong in the profession.

The motivation is to compare the efficiencies of alternative ways of organizing derivatives trades: centralized exchanges and over-the-counter (OTC) markets. Great. Big question. I’ve written a lot about it, and would be very interested in seeing other takes thoughtful on the subject.

The paper concludes that organized exchanges are (constrained) first best efficient, and more efficient than OTC markets. A quick review of the paper makes it clear, however, that they’ve rigged the game to produce that result. (more…)

5 January 2010 at 3:09 pm 6 comments

Happy Keynesian New Year

| Craig Pirrong |

Keynes and Hayek were major adversaries in the 1930s, but it is interesting to note that they shared some important ideas in common, but drew diametrically opposed conclusions from them.

In particular, Hayek, and the Austrians generally, believed in radical uncertainty, in the sense that individual economic agents had too little information about the world to assess probabilities of states of the world, or even to identify the possible states. Keynes similarly believed in the inability of individuals to evaluate investments in a rigorous quantitative way. Keynes concluded that this made investors subject to radical shifts in sentiment and “animal spirits” that could cause an autonomous collapse in investment. (more…)

29 December 2009 at 2:22 pm 6 comments

The Age of Constructivism

| Craig Pirrong |

I am reading Vernon Smith’s Rationality in Economics. I highly, highly recommend it. Largely a homage to Hayek, it explores the implications of Hayek’s distinction between constructivist rationality and what Smith relabels ecological rationality. It contains a wealth of methodological and substantive insights. Smith is knowledgeable and thoughtful. He is almost John Stuart Mill-like in his even handed and fair characterizations of competing views, even those he disagrees with. He integrates experimental economics, game theory, institutional economics, neoclassical economics, neurology, and much, much more.

What fascinates Smith is the ineffable process by which an ecologically rational order emerges from the actions of myriad imperfectly informed and incompletely rational (in the constructivist sense) individuals. This process — a sort of economic transubstantiation — is the most fascinating economic mystery. It is also, alas, one that has received far too little attention from economists whose formal tools permit them to analyze (constructively) equilibrium, but which are virtually powerless to analyze the process of getting there; the proverbial drunks looking for their keys under the lamppost.

We live in an era of constructivism regnant. In health care and finance, especially, constructivist schemes will reshape for better or worse — and almost certainly worse — vast swathes of the American economy. What’s more troubling still, this is constructivism refracted through the flawed lens of politics and public choice. Appreciation of the emergent order, the ecologically rational, is sadly rare. Vernon Smith appreciates it, deeply, with an almost religious sense of awe. Read his book and you will appreciate it too.

20 December 2009 at 10:25 pm 5 comments

A Piece on Financial Derivatives Regulation in FT Alphaville

| Craig Pirrong |

FT Alphaville, one of the Financial Times’ blogs, kindly asked me to contribute a guest post on the financial-markets regulation legislation currently working it’s way through Congress. (Thanks, Stacy-Marie.) Here’s what I wrote:

Lawmakers in DC are due to resume debate on major financial-reform legislation currently working its way through the US House of Representatives. One closely watched aspect of that debate is sweeping overhaul of over-the-counter derivatives markets. Lawmakers are pushing to mandate that most derivatives be centrally cleared and traded either on exchanges or swap execution facilities. Professor Craig Pirrong of the University of Houston discusses some of the proposals.

In attempting to impose standardization on the ways that derivatives are traded, and derivatives counterparty risks are managed and shared, the legislation reflects a one-size-fits-all mentality (not to say fetish) that is sadly typical of most legislative attempts to construct markets. These standardization directives fail to recognize that market participants are diverse, with diverse needs and preferences, and that as a consequence, it is desirable to have diverse trading mechanisms to accommodate them. (more…)

11 December 2009 at 11:04 am 1 comment

Lynch ‘Em

| Craig Pirrong |

I’ve had several calls from reporters asking my opinion on the Lynch Amendment to Barney Frank’s derivatives-regulation bill. For some reason, Forrest Gump pops into my head every time that question is asked. You know, the part where he says “stupid is as stupid does.”

As I am sure you all know, the amendment, introduced by New Jersey representative Stephen Lynch, imposes restrictions on the ownership and control of the clearinghouses that the Frank bill will require the vast bulk of derivatives to be traded through. The amendment imposes similar restrictions on ownership of exchanges and swap execution facilities.

Specifically, the amendment defines a class of “restricted owners” that includes swap dealers and major swap participants, and limits the amount of a clearinghouse (or execution facility or exchange) that these restricted owners can own or control collectively to 20 percent. The justification for this limitation is to reduce conflicts of interest, the specific nature of which are not identified.

This represents yet another example of Congressional micromanagement of the organization and governance of financial institutions. In my view, it is incredibly wrong-headed. (more…)

2 December 2009 at 3:47 pm 1 comment

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