Posts filed under ‘Financial Markets’
Cochrane on Krugman
| Peter Klein |
John Cochrane tackles Paul Krugman’s infamous essay (via Casey Mulligan). My own view of the crisis (and of macroeconomics) is different from Cochrane’s, but his skewering of Krugman is delightful, and there are many nuggets of wisdom. A few snippets:
Crying “bubble” is empty unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row. . . . This difficulty is no surprise. It’s the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what “fundamental” value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism and central planning would have worked. . . .
[T]he economist’s job is not to “explain” market fluctuations after the fact, to give a pleasant story on the evening news about why markets went up or down. Markets up? “A wave of positive sentiment.” Markets went down? “Irrational pessimism.” ( “The risk premium must have increased” is just as empty.) Our ancestors could do that. Really, is that an improvement on “Zeus had a fight with Apollo?” . . . (more…)
Making and Unmaking Economic Orders
| Dick Langlois |
The new issue of the online journal Capitalism and Society has a number of articles that should interest readers of this blog. Each is probably deserving of its own post. (Ah, but time prohibits.)
Jon Elster has a piece called “Excessive Ambitions” that criticizes not only mainstream rational-choice models (as we would expect from Elster) but also modeling in general. Roman Frydman and Michael Goldberg have a piece that applies something like Leijonhufvud’s “corridor” to risk regulation: when swings of asset values are small, government should stay out, since such swings are actually beneficial; but when asset prices get too far from “underlying values,” government regulation is called for.
My favorite paper is by Thorbjørn Knudsen and Richard Swedberg. Here’s the abstract:
This is a theoretical paper in which we attempt to present an economic and sociological theory of entrepreneurship. We start from Schumpeter’s idea in Theory of Economic Development that the economy can be conceptualized as a combination and innovations as new combinations. Schumpeter also spoke of resistance to entrepreneurship. By linking the ideas of combination and resistance, we are in a position to suggest a theory of capitalist entrepreneurship. An existing combination, we propose, can be understood as a social formation with its own cohesion and resistance — what may be called an economic order. Actors know how to act; and profit is low and even in these orders. Entrepreneurship, in contrast, breaks them up by creating new ways of doing things and, in doing so, produces entrepreneurial profit. This profit inspires imitators until a new order for how to do things has been established; and profit has become low and even once more. Entrepreneurship is defined as the act of creating a new combination that ends one economic order and clears the way for a new one. The implications of this approach for a number of topics related to entrepreneurship are also discussed.
This has some affinities to arguments I have made in the past. I am thanked in the acknowledgements, presumably for conversations that Richard and I had at a Schumpeter conference at Harvard last year; but I’m not cited. (Assume sad-faced emoticon here.)
I will talk about the fourth paper in the issue soon in a separate post.
Masters of Finance
| Peter Klein |
The American Finance Association has assembled a terrific set of video interviews and lectures with eminent financial economists including Markowitz, Sharpe, Samuelson, Merton, Scholes, Arrow, Fama, and Myers. (HT: Fama/French.)
John Gray on the Greenspan-Bernanke Economy
| Peter Klein |
From Gray’s April 2009 NYRB review of Margaret Atwood’s Payback: Debt and the Shadow Side of Wealth:
Concepts of debt figure centrally in Western religion, while the notion that debt is something to be avoided, or incurred with caution, has long been important in Western capitalism. Without institutions facilitating borrowing, capitalism would not have developed to the degree that it has; but the belief that debt could be dangerous was until recently also an important part of capitalism. It is only lately, Atwood notes, that debt has been celebrated as positively benign, “a thing we’ve come to feel is indispensable to our collective buoyancy.” From being a necessary tool in productive enterprise, debt came to be viewed as an instrument of wealth creation. Using cheap credit, hedge funds and investment banks were able to multiply their profits, while society at large — including some in its poorest groups — came to see taking on large amounts of debt as a way of building up capital. Now that this structure of debt is unwinding, older ideas may be on their way back: “We seem to be entering a period in which debt has passed through its most recent harmless and fashionable period, and is reverting to being sinful.”
Latest news from Washington: “The Federal Reserve said Wednesday that it would keep short-term interest rates near zero for the foreseeable future, even though the central bank acknowledged that the economy was recovering from its long downturn.”
Scandals and Financial Panics in Historical Perspective
| Peter Klein |
The Spring 2009 issue of Business History Review focuses on scandals and panics. Here’s the TOC. Follow the link for abstracts and ordering information.
A SPECIAL ISSUE ON SCANDALS AND PANICS
With an introduction by guest-editor Per H. HansenNaomi R. Lamoreaux: “Scylla or Charybdis? Historical Reflections on Two Basic Problems of Corporate Governance”
Thomas Max Safley: “Business Failure and Civil Scandal in Early Modern Europe”
Richard Sylla, Robert E. Wright, and David J. Cowen: “Alexander Hamilton, Central Banker: Crisis Management during the U.S. Financial Panic of 1792”
Eric Hilt: “Rogue Finance: The Life and Fire Insurance Company and the Panic of 1826”
Edward J. Balleisen: “Private Cops on the Fraud Beat: The Limits of American Business Self-Regulation, 1895-1932”
Federal Reserve “Independence”
| Peter Klein |
I was invited to sign the Open Letter in support of Fed independence but, like Jerry O’Driscoll, Bob Higgs, and Larry White, I don’t support the cause. Follow the links above for detailed arguments. For my part:
1. The Open Letter focuses exclusively on monetary policy, as if the Fed’s Congressional critics like Ron Paul just want to know how the Federal Funds Rate is set. But the Fed conducts not only monetary policy, but fiscal policy as well, especially during the last 18 months. If the Fed can buy and hold any assets it likes, if it works hand-in-hand with the White House and the Treasury to coordinate trillion-dollar bailouts, isn’t it reasonable to have some oversight? (And don’t forget bank supervision. Even the Fed’s defenders recognize a need to separate its monetary-policy and bank-supervision roles. But as long as the Fed continues as a bank regulator, shouldn’t someone should be watching the watchmen?)
2. The Open Letter itself is poorly crafted, full of unsubstantiated assertions and misleading statements. There’s no argument there, as Higgs emphasizes. Actually, neither the time-series or cross-sectional evidence suggests any correlation between central-bank independence (whatever that means) and economic performance.
3. More generally, the Fed is a central planning agency, and it performs about as well as every central planning agency in history. Have we learned nothing from the huge literature on comparative economic systems? “Independence,” in this context, simply means the absence of external constraint. There are no performance incentives and no monitoring or governance. There is no feedback or selection mechanism. There is no outside evaluation (outside the blogosphere). Why on earth would we expect an organization operating in that environment to improve social welfare? Is this institution run by men, or gods?
Lamoreaux and Sokoloff’s Financing Innovation in the United States
| Peter Klein |
Nice EH.Net review by Charles Calomiris of Naomi Lamoreaux and Sokoloff’s edited volume Financing Innovation in the United States: 1870 to the Present (MIT Press, 2007).
Anyone interested in the organization of innovation, and the nexus between finance and the organization and process of innovation, must read this book. All of the chapters are original, scholarly, and packed with insightful gems (truly a font of inspiration for Ph.D. students), and the analysis manages to be both sophisticated (theoretically and statistically) and accessible to a broad audience. While the volume is too rich to boil down to a single theme, the editors’ introduction does point to a common thread that runs through many of the essays: “… perhaps the most striking aspect of the record of innovation over American economic history is the flexibility that technologically creative entrepreneurs have exhibited in adjusting their business and career plans so as to obtain financing for, and extract returns from, their projects.”
Goldman Sachs, Best in the Business
| Peter Klein |
The business of political capitalism, that is. Like Enron, Goldman operates primarily in the nebulous world of public-private interaction. It is the US’s most politically powerful financial firm, skilled at navigating the byzantine regulations governing the virtually nationalized US financial sector. Goldman’s eye-popping $3.4 billion second-quarter earnings shouldn’t surprise anyone; as Craig Pirrong notes, these earnings reflect good old-fashioned moral hazard, with Goldman exploiting its too-big-to-fail status by taking on huge amounts of risk:
Goldman knows it is too big to fail. How does it know this? Well, the government bailed out AIG not so much for AIG’s sake, but for the sake of big AIG counterparties — most notably Goldman. Moreover, given the conventional wisdom that the government’s primary error in the financial crisis was its failure to bail out Lehman — a piker compared to Goldman — it doesn’t take a rocket scientist to figure out that it won’t repeat that mistake in the future, and let Goldman go down. So Goldman knows it can get bigger, and take more risk. It is the classic heads Goldman wins, tails the sucker taxpayer eats the loss gambit. If nobody steps in to rein in the firm, it will continue to add risk, thereby enhancing the value of the Treasury put hiding in the equity entry on its balance sheet.
Somebody should be stepping in — but nobody is. Why not? Partly, no doubt, it is Goldman’s political heft. It is likely too that important policy makers don’t want to crack down on a major source of risk capital to the markets in the fear that this would impede a recovery. Even though in reality, that risk capital is your money and mine, with the exception that we have no chance of capturing the upside, and are left with a good chunk of the downside. This is a piece with the hair-of-the-dog strategy being pursued by Treasury and the Fed.
Will Macroeconomists Solve the Crisis?
| Benito Arruñada |
One may doubt it after observing that Ben Bernanke was one of those believing in the Great Moderation — the claim that macroeconomic volatility had been reduced. Macroeconomic policymaking seems to be as unsafe as firefighting: extinguishing small fires creates the conditions for hell. Shouldn’t macroeconomists learn something from forest management? (For a start: “Fire Must Be Ally in Forest Management.”) Of course, if coupled with an acid-suppressing pill, they could even dare to read Hayek’s “Pretence of Knowledge.”
Campello and Fluck
| Lasse Lien |
Here is a paper from 2006 by Maurillo Campello and Zsuzsanna Fluck that is even more interesting now than it was in 2006. If you are interested in the micro-implications of the current crisis, you’ll surely like this one.
Abstract: We model the interaction of product market competition and firms’ financing decision when firms face capital market imperfections and consumers face switching costs. In our model, consumers anticipate that capital market frictions may drive their supplier out of business and account for welfare losses that firm bankruptcy imposes upon them. Likewise, managers, when investing in long-term market share building, take into account the possibility of business failure and the residual value they may capture from the firm’s liquidation process. Our theory yields four central implications. In response to a negative shock to demand: (1) more leveraged firms will experience significant market share losses; (2) the market share losses of more leveraged firms will be more pronounced in industries where low debt usage is the norm; (3) the market share losses of more leveraged firms will be more pronounced in industries where consumers face higher switching costs; and (4) the market share losses of more leveraged firms will be magnified in industries where asset liquidation is less efficient. Using detailed firm- and industry-level data from U.S. manufacturers over the 1990-91 recession, we present empirical evidence supporting our model’s predictions. We later expand our empirical analysis, studying a large panel of firms over the various phases of the full business cycles contained in the 1976-96 period. Results from these broader tests provide additional evidence in support of our theory.
Peter L. Bernstein (1919-2009)
| Peter Klein |
I was saddened to learn (from Kenneth Anderson) that Peter L. Bernstein, author of Against the Gods: The Remarkable Story of Risk and other popular works, died June 5. Bernstein was a terrific writer and a clear and provocative thinker with a gift for making difficult concepts accessible. I was greatly influenced by an earlier book, Capital Ideas: The Improbable Origins of Modern Wall Street, which I came across in graduate school while searching for a dissertation topic. Bertstein’s characterization of the brokerage industry in the 1960s and early 1970s, before the deregulation of brokerage fees — an Old Boys Club, lacking competition and innovation — inspired me to examine the role of corporate internal capital markets in replicating the resource-allocation function normally performed by external capital markets, and how the growth and development of financial markets following liberalization contributed to the end of the conglomerate period.
Here are obituaries in the WSJ and NYT and here is Bernstein’s wiki.
Sid Winter and Alice Rivlin on the Current Crisis
| Nicolai Foss |
Sidney G. Winter is a towering figure in management research, essentially being the current thought leader in the strategic management field as it pertains to issues of capabilities, routines, knowledge assets, etc. Most of his work in strategic management is founded on his earlier work in evolutionary economics (notably this seminal volume). Winter is married to Alice Rivlin, a long-time critic of Reagan-era economic policies and a high-ranking bureaucrat under Johnson and Clinton.
Here is Winter and Rivlin on “fixing the global financial system.” Winter thinks that business schools are partly to blame, but is not very concrete in his critique (at least he doesn’t blame agency theory). And here is Winter answering the question, “Is capitalism dead?” Note his comments about “people on the extreme right.” Neither Winter nor Rivlin leave much doubt about where they stand politically.
UPDATE: There is more Winter on YouTube: “Inflation or Deflation,” “Economic Cassandras,” and “The Price of Oil.” They are all very recent and done under the auspices of the Australian School of Business.
The Book (Value) of Revelations
| Dick Langlois |
Here’s the abstract of the day:
Irrational Exuberance in the U.S. Housing Market: Were Evangelicals Left Behind?
Christopher W. Crowe
Summary: The recent housing bust has reignited interest in psychological theories of speculative excess (Shiller, 2007). I investigate this issue by identifying a segment of the U.S. population — evangelical protestants — that may be less prone to speculative motives, and uncover a significant negative relationship between their population share and house price volatility. Evangelicals’ focus on Biblical prophecy could account for this difference, since it may enable them to interpret otherwise negative events as containing positive news, dampening the response of house prices to shocks. I provide evidence for this channel using a popular internet measure of “prophetic activity” and a 9/11 event study. I also analyze survey data covering religious beliefs and asset holding, and find that ‘end times’ beliefs are associated with a one-third decline in net worth, consistent with these beliefs providing a form of psychic insurance (Scheve and Stasavage, 2006a and 2006b) that reduces asset demand.
Interestingly, the author is with the International Monetary Fund. When I googled to find where I had seen this abstract, the search returned several links pointing out that many Evangelicals consider the IMF (and the World Bank) to be the work of the Devil. (Not a few economists feel this way as well, of course, but wouldn’t put it in quite the same terms.) If you believe the end times are imminent, why would you bother to hold assets at all?
Ferguson on Financial History and the Crash
| Dick Langlois |
I too loved the Ferguson piece in the New York Times. More sound bites: “In the months ahead,” he predicts, “the world will reverberate to the sound of stable doors being shut long after the horses have bolted, and history suggests that many of the new measures will do more harm than good. The classic example is the legislation passed during the British South-Sea Bubble to restrict the formation of joint-stock companies. The so-called Bubble Act of 1720 remained a needless handicap on the British economy for more than a century.”
Deregulation and the Financial Crisis
| Peter Klein |
Niall Ferguson joins Charles Calomiris, Jerry O’Driscoll, Arnold Kling, and many others in questioning the supposed link between “deregulation” and the financial crisis. As Ferguson emphasizes, the timing is all wrong; there is no time-series correlation between specific patterns of regulation and deregulation and particular financial or economic outcomes. The relaxation of Glass-Steagall restrictions on universal banking is an oft-cited example, but, as these writers point out, no one has offered any specific mechanism by which universal banking contributed to the problem (indeed, the opposite is likely to be true). The “laissez-faire caused the crisis” meme may be pithy, but is there any systematic theoretical or empirical evidence for it?
Ferguson has the best line (suggested by Luke): “It is indeed impressive how rapidly the economists who failed to predict this crisis . . . have been able to produce such a satisfying story about its origins.”
Sid Winter on the Crisis
| Peter Klein |
From a short piece at Knowledge@Wharton:
As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions, says Wharton management professor Sidney G. Winter. Commonly missing are hard-to-measure factors like human psychology and people’s expectations about the future, he notes.
Among the most damning examples of the blind spot this created, Winter says, was the failure by many economists and business people to acknowledge the common-sense fact that home prices could not continue rising faster than household incomes.
Says Winter: “The most remarkable fact is that serious people were willing to commit, both intellectually and financially, to the idea that housing prices would rise indefinitely, a really bizarre idea.”
Presumably Sid is referring here to some kind of behavioral anomaly, but what I see is the standard malinvestment story from Austrian business-cycle theory. Even investors with rational expectations, who know that a credit-induced artificial boom can’t last forever, won’t know exactly when the bubble will burst, and can profit from taking advantage of artificially low interest rates while they last.
Confidence
| Peter Klein |
Craig Pirrong is concerned about the stress tests:
[Bernanke] emphasized that they were a “confidence-building exercise.” That seems like assuming the conclusion. I would like a fact-finding exercise, with a clear statement of the findings, good or bad. Stating that the objective is to build confidence suggests a pre-ordained result — Kabuki Theater. It’s like saying that something is needed to build “self-esteem.” Success builds self-esteem, not the other way around. Similarly, success builds confidence; confidence-building does not ensure success.
This reminds me of something I read the other day from Isabel Paterson, quoted by Stephen Cox:
[I am] tired of being told that “credit depends on confidence.” Fudge. Credit depends on real assets, sound money and a clean record. . . . When any one asks us to have confidence we are glad to inform him that the request of itself would shatter any remaining confidence in our mind.
Skepticism and Greed
| Dick Langlois |
One of my University colleagues, who works in instructional technology, sent a few of us a post from a mailing list-blog at Stanford called Tomorrow’s Professor. The site has a lot of interesting stuff on teaching and the academy, which O&M readers may find interesting. But this particular post, reprinted from a blog at the Carnegie Foundation for the Advancement of Teaching, prompted me to send in a response. Here is what I said. (Take a look at the original post, but I think you can get the idea from my comment.)
I certainly endorse what I take to be the central idea of post 944 — that students of business and economics would benefit from a liberal education.
Having said that, however, let me also note that I think the post gets things exactly — and perhaps dangerously — backwards in many ways. It is a constant trope in the popular press that the idea of “free markets” is some kind of dogma among economists (and perhaps society more broadly). In fact, economists believe that markets exist only within institutional structures, and economics — even so-called free-market economics — is actually about getting the institutions right, not about letting people do whatever they want.
In my view, moreover, economists are the real skeptics in the academy. Despite his (marketing) claim to being a “rogue” economist, Steve Levitt of Freakonomics fame is actually a better model of what most economists do than is Ben Bernanke or Alan Greenspan. Unlike most other academics, economists are rewarded for taking skeptical and iconoclastic positions, at least when they can back those positions up with hard data and clear analysis.
By contrast, few people outside of economics departments or business schools have any understanding whatever about how and when — or even whether — individual action can lead to beneficial unintended consequences. Economics is actually counter-intuitive in many ways. Humans evolved in small bands of hunter-gatherers, and as a result our intuitions about how a large open society operates are often wrong or backwards.
For all these reasons, it seems to me odd to suggest that economists (and students of economics) are dogmatic and would be made more skeptical and thoughtful about the economy by studying other liberal fields. In my experience, it’s rather the opposite. (Which is not to say, of course, that students won’t benefit in many ways from studying other fields.)
The post itself is a case in point. It starts out in the right direction with a marvelous story from Keynes about the nature of the money supply. But then it goes on to talk about “greed” as the central issue, ending with a quote from Roosevelt that “heedless self-interest” is bad economics. In fact, however, it is pointing to “greed” that is unexamined dogma. Why exactly has the level of greed changed over time? Is that really an explanation of anything? In stark contrast, many professional economists (including such serious scholars of the crisis as John Taylor and Karl Case) would point out that the most fundamental cause of the crisis was the expansive monetary policy of the Fed, which pumped money into the system and caused an asset bubble. Our hunter-gatherer ancestors endowed us with intuitions about greedy individuals; but they didn’t leave us intuitions about how a fiat money system works in a huge economy of non-face-to-face exchange. That we have to learn in an economics course.
Macroeconomic Policy Quote of the Day
| Peter Klein |
Mike Rozeff makes the Hayekian point that is probably obvious to the O&M community, but virtually absent from public debate:
Bernanke is just a man. He is fallible. We learned this week that he pressured Bank of America into absorbing Merrill Lynch. In doing this, he pressured the leader of Bank of America into withholding critical information from his shareholders about Merrill Lynch losses. Technically, he can be charged with conspiracy to defraud. The loans he had the FED make to AIG look far from wise. A number of his other actions are highly questionable in making various kinds of loans to questionable borrowers.
I am saying that Bernanke doesn’t actually know what he’s doing. But I am using him only as an example. He’s not special. The more important point is that no one knows how to do fiscal and monetary policy, and they never have and never will. No one. For that reason alone, which is a narrowly practical one, no one should have those powers.
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