Comments on: The follies of economics?

By: gene berman

gene berman — Sun, 28 Dec 2008 22:05:38 +0000

Mihizon:

Thanks for your comments. Actually, it is precisely due to my appreciation for John's scholarship that I went into such detail with regard to economic science. Few unacquainted with economics (and Austrian School economics in particular) can begin to compehend just how vital such knowledge is to proper understanding of historical events. The decline of ancient civilization is my favorite example and I've mentioned it here before but there are even more recent examples in which commonly-accepted accounts of events are better explained on the basis of economic understanding (WW I and II, for example). Another is the development of local production and trade as the result of foreign trade (rather than t'other way 'round, as is the naive view).

Lest I haven't made myself perfectly clear, I'm pushin' Mises. Verstehen?

By: Roger Bigod

Roger Bigod — Sun, 28 Dec 2008 21:38:47 +0000

Thorfinn

IIRC there was a specific meeting or administrative ruling that increased the permmitted leverage at investment banks to something like 20 or 30. It may not have mattered that much because they could run higher levels during the month and cut back for the one day the leverage was reported. But it did communicate an attitude. The decision wasn't at the Presidential level, so Bush isn't directly responsible.

I've seen multiple accounts of the pressures on Fannie/Freddie and why they wound up with so much bad paper. I'd believe they lowered their standards to maintain market share in the face of reckless competitors. But they used the mission of helping lower-income people as an excuse, rather than acting out of liberal do-gooder idealism.

There have been a lot of stories about hedge funds going under, so I think the jury is out on whether they have fared better than the banks. The simplest view is that it shouldn't matter to the general public welfare if a hedge fund overlevers and goes bust. They're big boys and they are supposed to know their level of risk. Obviously there are secondary effects, as LTCM illustrated.

By: Thorfinn

Thorfinn — Sun, 28 Dec 2008 20:15:58 +0000

Bigod,

The Fed regulates leverage requirements at banks. The problem here was regulatory arbitrage; banks used SIVs and other off-balance accounting to load up on leverage elsewhere. Spain seems to do a better job of keeping track of banks' overall leverage. But it's not as if Bush changed these requirements or even that he kept them the same despite mounting pressure. No one really cared, which is bad since leverage is common to all financial crises.

Spain is still in bad shape. Massive destruction of housing wealth will still lead to huge problems even if you don't lever up.

The tax code may have favored housing before, but if it starts to favor housing by a *greater* amount just at the point when Fannie/Freddie plus low interest rates start sloshing a lot of money into that sector, then it may be a part of the explanation. Housing prices also seem to have taken off much higher in places with more housing regulation, or where buyers are fleeing those places. The CRA point is bogus, but it's clear that housing lenders felt greater pressure to lend to more people at least partially because of Fannie/Freddie.

You should also look at why banks up and decided to take advantage of leverage. Fundamentally, that decision was driven by prevailing low interest rates which encouraged 'doubling up' and more on existing assets to extract every pound of yield. This part is key to Austrian explanations too. Hedge Funds are highly levered as well, and are unregulated, but if anything they have weathered the crisis better than most.

By: mihizon

mihizon — Sun, 28 Dec 2008 19:22:03 +0000

I have to agree with Gene, but go a little bit further … John Emerson’s comments here have been some of the best comments I’ve read on blogs: informative, insightful, links to books/authors I haven’t heard of, and he admits to the limits of his knowledge and opinion (WHO does that on the blogosphere anymore?).

Really great stuff. Gene’s comments are great too.

By: Roger Bigod

Roger Bigod — Sun, 28 Dec 2008 13:15:19 +0000

Thorfinn

I wasn't aware of the 1997 change and confused it with a provision that exempts capital gains on houses if there's a purchase within a year. At least that was the status several years ago, when I looked into it. The point remains that the tax code favored home ownership long before the bubble.

I'm no fan of Fannie/Freddie but I don't buy the right-wing theory that they contributed to the bubble by making unsound loans to the lower classes because of CRA.

If we'd only had a housing bubble, there would be some dud mortgages on the books of some financial institutions. But running them through multiple layers of leverage lad to the destruction of several large financial institutions. And regulation could have prevented this. Deregulation played a role, but Greenspan refused to use regulatory powers he already had.

By: Roger Bigod

Roger Bigod — Sun, 28 Dec 2008 12:55:06 +0000

Can you really find many examples of people being pleased with Citigroup's bailout who oppose the car company bailouts?

How about the Congress of the US, in particular the Republican Senators. I don't recall a lot of complaint about C, but they voted down the bailout. Oh, and the President.

At any rate, there is a substantial qualitative difference in the financial institution bailouts and the auto industry bailouts: if GM goes bust, people won't actually find that their Chevy's were vaporized in their driveways.

Also, it was difficult to get around the fact that some of the auto bailout would go to middle- or worse, lower-middle-class folks, but it was easy to hide the billions in bonuses to the right kind of people.

By: ziel

ziel — Sun, 28 Dec 2008 09:38:12 +0000

This raises questions about the mind-set that finds C a wonderful example of the free market at play while sputtering with outrage over the UAW getting a few extra bucks.

I think you've constructed a bit of a staw man there. Can you really find many examples of people being pleased with Citigroup's bailout who oppose the car company bailouts?

At any rate, there is a substantial qualitative difference in the financial institution bailouts and the auto industry bailouts: if GM goes bust, people won't actually find that their Chevy's were vaporized in their driveways.

By: gene berman

gene berman — Sun, 28 Dec 2008 09:01:50 +0000

John Emerson:

What we call "history' is never pretended, especially by historians, to be either a complete or faithful recapitulation of the past; it is, rather, in all cases, a recapitulation of those events--(including prevalent ideas and opinions) of specific portions of the past--deemed relevant by the practicing historian, whether layman or professional.

There can be no recognition of history or even of the singularity of the phenomena we experience as events (or even, more simply, as stimuli) absent a pre-existing structure for their reception, identification, and categorization and arrangement. Were there not some underlying structure (what we call "mind," or "reason," and whose structure we call "logical") amounting to a biologic characteristic of the species Homo sapiens, no "sense" whatever could be made of such stimuli. Some stimuli evoke responses quite independent of anything we call "mind"; at lower temperatures, many of the animals we call "warm-blooded" begin to shiver, in a manner we call "reflexive." Some also move in a manner, less reflexively, tending to reduce their exposure to the lower temperature. Like some animals, man does both of those things; but he may do more, such as clothing himself, building a shelter, or starting a fire. Even further, the man may even attempt to control the immediate, reflexive behavior in an effort to render the other type successful, or at least, more successful. We call such behavior rational, i.e., guided by the natural, universal characteristic of humankind: reason. Whether some other animals also reason or do so to some lesser degree is unimportant. Reason may well be seen as the characteristically instinctual behavior of Man. To men, mind, logic, consciousnes, thinking, and reason are inseparable; and, to men, the construction (and later "testing" and corrective modfication) of "theory" is inescapable, whether that be according to the original logical pattern (what we refer to as "cause and effect") or as the result of new information (experience, usually) suggesting inadequacy of previous theory. The "takeaway point" is that theory, or at least its indwelling form, is both logically and temporally precedent to experience; it is certainly possible for experience to cast doubt on the validity of a theory and suggest its critical review but where the elements of that theory, on examination, do not admit of any "weak link" in the causal chain, it must be to the experience itself (or, likely, its interpetation) to which we must look for the source of error.

What has all this all to do with the study of history? I could point out that the marginalized and often-ridiculed Austrian School (especially in the person of Mises) rather accurately predicted both world wars and their eventual outcome, the inevitability of recurring "boom and bust" cycles wherever government had appreciable control (especially of quantity) of monetary affairs, and the eventual collapse ("like a house of cards," quoted directly from Mises, 1920!!), while allowing, in the very same passage, that the application of force might mean the elapse of quite some time before that came about. But note that only one U.S. president (Reagan, who read Mises regularly, according to a 1976 interview and his remarks to Mises' widow), to my knowledge, has ever paid the slightest attention to Austrian economic views.

The Mises book to which I would first recommend you is THEORY AND HISTORY; it's relatively modest in size (less than 400 smaller-than-normal pages) and relatively less focused on purely economic relationships. If suitably impressed, you could then "graduate" to the substantially more exhaustive HUMAN ACTION.

One more thing I'd add. LTCM was seen (unanimouly, by Austrians) as a disaster waiting to happen. But, of course, nobody, even Austrians, could predict when. To most, their failure was in having an incorrect or insufficiently comprehensive "formula" or "model." To Austrians, the matter is simpler: there are no such (models or formulas) capable of prediction because, in an environment of data where there are no invariables, no variable may be predicted. The clearly proven (many times over) danger in all mathematical approaches to economics is not to be seen in the faults of equations or computations: it is to be seen, rather, in the power of the symbols to persuade the manipulator or practitioner using those symbols that they represent something closely approaching (or equivalent) to reality. Nobody needs anything more than a rudimentary knowledge of mathematics to comprehend most of the entirety of economic science; conversely, the most exhaustive knowledge of mathematics or skill in its application will suffice in the slightest to convey understanding or predictive power.

I would also remark that men such as Greenspan (and, before him, Friedman) can certainly be considered to have vast economic knowledge. But, once they have taken on the jobs working directly for or advising policymakers in government (anything other than STOP! QUIT! GO BACK THE OTHER WAY BEFORE IT'S TOO LATE!!), they have "sold out" and are, in their own ways, even guiltier and more responsible for havoc than the frankly concupiescent and predatorily deceptive.

By: Roger Bigod

Roger Bigod — Sun, 28 Dec 2008 08:31:12 +0000

TGGP

You appear not to have heard of a company with the pretentiously tarted-up name "Citigroup". Because of the repeal of Glass-Seagal it was able to branch out from the boring business of taking customer deposits to constructing mortgage-backed securities and other derivatives. One result of unleashing the creative powers of the market is that the actual value of the company is considerably less than zero. A few weeks ago, the Federal Government bailed them out with a special ad hoc rescue whose potential price tag is $250 billion or so.

This raises questions about the mind-set that finds C a wonderful example of the free market at play while sputtering with outrage over the UAW getting a few extra bucks.

By: gene berman

gene berman — Sun, 28 Dec 2008 05:32:49 +0000

John Emerson:

Now that you've had a chance to mull the foregoing comments, I'll add a few more, along with a suggestion.

Whether or not various of those prominent in the economics profession are smarter than you or not is pretty much beside the point; being either right or wrong on any given matter is related only indirectly to either intelligence, subject-specific education, or even relevant experience. I am reasonably what is called "smart" and I recognize, in the discussions and considerations of those posting and commenting here at GNXP, a substantial majority quite capable of internalizing a sound understanding of at least broad outlines and basic relationships involved in economic science. What is more (and I here state my opinion but one, nonetheless, based on a long chain of so-far irrefutable reasoning undertaken not originally by myself but by those scholars--known as the "Austrian School"--with whose theories, primarily those of Von Mises, I find no appreciable fault).

But far more weighty (I would judge) than my merely personal recommendation (no matter how well-expressd or not) should be the gist of your own observations and the similar opinions (though differing in prescription) of other commenters here (or in other public fora). You, at least, have the marked advantage of realizing some woeful inadequacy in the totality of your knowledge of the subject. The "experts" in the field are "beyond hope" first, by virtue of lifetimes under the influence of demonstrably faulty theoretical (and epistemological) bases but also by the plain fact of their individual personal investments (termed "rent-seeking" in what passes for new knowledge of phenomena long-known and understood) in the various brands of mumbo-jumbo peddled as authoritatively and fervently as by any (and rightly ridiculed) religious charlatan.

You are an historian. I want to couch my concluding comments (and the suggestion I promised) in terms that should be not only be understandable but welcomed by one such. I'll do so follwing.

By: gene berman

gene berman — Sun, 28 Dec 2008 03:55:16 +0000

John Emerson:

Reread (your most recent comment) the third paragraph; it is exemplary. Above all, it consists of honest (and accurate) general assessments of conditions you observe and a general conclusion (linking the conditions to the theories and practices of leading lights and authorities in the "economics profession"). Though not "scientific" in the ordinary sense, it is, indeed, in its simplicity, not unscientific. Nor even does the characterization of the conditions (as undesirable or "bad") disqualify (any more than would a similar statement about the end result made by a pathologist describing the progression of an untreated case of rabies).

But, best of all, you've started out with a frank recognition that "I'm at the end of what I know," omitting only the inescapable corollaries (which I am sure you will now admit to the body of observation) that "what I think I know may be all wrong" or, what amounts to very much the same thing, that which makes sense (is logical) is vitiated by being built on faulty underlying premises (or theory).

By: Thorfinn

Thorfinn — Sun, 28 Dec 2008 03:02:16 +0000

Bigod,

The capital gains reduction happened in 1997, and is linked to an immediate increase in housing transactions. The scale and scope of Fannie/Freddie's interventions drastically increased as well in response to political pressures. And of course monetary policy deviated from the Taylor rule substantially. Other countries affected by a housing bubble exhibit similar trends.

CDOs are new but it's not at all clear what independent role, if any, they played. Felix Salmon has a lot to say on this topic, but whenever you see trillions of dollars in assets disappear, problems are going to happen, even if banks keep all mortgages on the books rather than parceling them out. Spain does have some nice regulations that limit leverage, saving Banco Santander, as well as downpayment requirements, but many of their other financial institutions are in trouble. Investment Banks have been highly levered for some time now; their big problem was going public which led to their stock price being a barometer for 'trust.' Counterparty concerns seem to play a big role in their downfall.

I wouldn't say this means that *only* the government is responsible; clearly markets failed to price risk and economists failed to point that out. Better banking and housing regulations along Spanish lines are needed as well as stricter leverage controls. Macroeconomics in particular has fared very poorly, and financial models need to incorporate linkages. But as TGGP says, blaming financial deregulation is an unsatisfying story. The best explanations for the housing bubble I can find are economic, rather than psychological or physics-related, in nature and relate government-induced incentives to an unsustainable shock in the housing stock.

By: John Emerson

John Emerson — Sat, 27 Dec 2008 18:08:28 +0000

Iceland as a deregulation success story.

When you go to the doctor, you don't worry that maybe he's on the side of the disease. On the other hand, in any case there will be one lawyer working for you and another one working against you. Economists are more like lawyers. You need economists on your side, because you know that the other side has them.

By: NatteringNabob

NatteringNabob — Sat, 27 Dec 2008 18:05:42 +0000

Nobody knows quite what happened or why, but I think that it will be concluded that aggressive deregulation was a major contributor.

My superficial impression is that the US, GB and Spain all had property valuation bubbles, but the Spanish generated less bad paper and less damage to the banking system. I don't know if this is due to better regulation or failure to takke advantage of the wonderful free market.

The empirical test might be to compare a country which had a housing bubble but didn't lever up bad mortgages and hand the proceeds to executives. I expect you'd find some institutions in deep trouble, but not the wholesale implosion of the financial sector that we've witnessed. An appropriate example might be Spain.

For what it's worth, Australia had/has a housing bubble but is apparently* one of the few OECD nations that's still tracking (barely) to avoid a recession. (As of Dec 15, rates of 1.75% for 2008-9 and 2.5% for 2009-10 were forecast**)

The Labor government is saying that this is due to the relatively stringent regulatory structure here, and I'm not aware of any local commentators trying to argue the contrary.

*www.abc.net.au/news/stories/2008/11/26/2429657.htm
**www.bloomberg.com/apps/news?pid=20601081&sid=aB_M7zBVQDCo

By: TGGP

TGGP — Sat, 27 Dec 2008 17:21:30 +0000

I don't recall anyone pointing to Iceland as a deregulation success story. I do remember this Guardian article where they use Iceland to claim that righties have been proved wrong about the Scandinavian model and welfare state (I would add to the article by pointing out that pretty much all Scandinavian countries have lower corporate tax rates than the U.S though most do indeed have higher personal income taxes or sales taxes).

Roger Bigod, the point of the link is that companies that were both commercial and investment banks (which Gramm-Leach permitted) has not failed at the time but on the contrary were taking over companies about to go under, and that doing so was only possible because of Gramm-Leach (the government actually ran into problems when they tried to do some stuff prohibited by earlier regulations). I agree with you that a lot of companies wouldn't be around without government intervention, but the problem was NOT any more severe due to Gramm-Leach. The problem was among banks not going beyond Glass-Steagal and so we can say that the same thing would have happened if it had not been amended.

I've read too much Robin Hanson to have as high a regard for the medical profession as John!

By: Roger Bigod

Roger Bigod — Sat, 27 Dec 2008 16:56:32 +0000

If Iceland had a property bubble, it may be small in relation the big problem which was that their banks were stuffed with toxic paper and their balance sheets had ballooned to way more than the central bank.

It would be interesting to see a table showing the bubble by country, broken down into property valuation, mortgages, mortgage-backed securities etc. My superficial impression is that the US, GB and Spain all had property valuation bubbles, but the Spanish generated less bad paper and less damage to the banking system. I don't know if this is due to better regulation or failure to takke advantage of the wonderful free market.

I've long been a Poincare fanboi. But I don't see the relevance of the 3-body problem. Yes, there's no closed-form analytic solution. Yes, there's sensitivity to initial conditions. But I don't think economists claim to have solved an analogous system. The problems with their models seem to be simple-minded assumptions necessary to apply the math. E.g. no correlation between mortgage default rates in different states. Duh.

I once took a course in microeconomics by a self-important graduate of the London School of Economics (wooh wooh). The high point of the course (and almost all its substance) was a list of the eight Pareto conditions for an efficient market. But it was almost worth the time and trouble. Going through the list, you realize that there's no perfect market. They could all be improved by some regulation and tweaks. In many cases, the cost of the treatment is greater than the benefit of the cure. But it tends to make one less sympathetic to idiots babbling about "the free market". I can't find the list on wikipedia, but it's worth paying attention if you come across it.

By: John Emerson

John Emerson — Sat, 27 Dec 2008 08:02:59 +0000

I know that Iceland is the European nation worst hit, and they were a deregulation success story only a couple years ago.

Roger, Poincare was a century ago, not recent. The three-body problem was "arcana" because people didn't want to deal with it. (Besides, you talk about subtle quantum effects). It's one of the numerous arguments against the kind of atomistic description of a society of unrelated individuals used by economics.

I'm pretty much at the end of what I know. I'm an outside observer when it comes to economics. My main point is that we seem to have had some sort of culpable system failure, and that the economics profession collectively didn't serve us very well. It seems that when things go well, they take credit, and then when things go badly, they hide. (I include liberal economists like Krugman and DeLong in this). They're really working with a partial and inaccurate model, but that doesn't make them shy or modest when the time comes to make policy prescriptions. And they certainly are smarter than me, but they have to be right too. It's not like power is an end of the year award to be given to the smartest student.

It seems to me, though, that for a variety reasons a comparable medical disaster would have been handled better by the medical profession than this disaster was by the economics profession. I think that economics should have a diinished and more realistic status for that reason.

By: John Emerson

John Emerson — Sat, 27 Dec 2008 08:02:59 +0000

By: Roger Bigod

Roger Bigod — Sat, 27 Dec 2008 04:51:09 +0000

TGGP

You misunderstood my position, if my meanderings can be characterized as a position. I think Taleb and Mandelbrot are interesting but not especially relevant to the situation. I agree with your summary.

I looked at your links and disagree with your position on Gramm-Leach-Bliley. You've set up that straw man argument that it was totally responsible for the debacle. In one link, there's the argument that it paved the way for the formation of AIG, C and Bank of America, which saved the day by taking over Bear, Lehman et al. Huh? It's clear that AIG and C would be defunct without massive government transfusions and BAC is possibly in the same situation.

By: Roger Bigod

Roger Bigod — Sat, 27 Dec 2008 04:19:30 +0000

John Emerson,

Of course I was being sarcastic, or cryptically brief. What I was trying to say is that people were well aware that the models said the 87 Crash and LTCM could occur only over time spans of millenia. Yet they had happened within recent memory. It wasn’t a failure to appreciate subtleties of contemporary physics that led to the disaster. One critique is that the models all contain the assumption of independence. In 1987 it was that multiple actors could “insure” themselves because the other actors would behave as mindless Brownian particles. With LTCM, it was the assumption that dozens of markets would behave independently so that they were placing hundreds of small bets, rather than one huge bet. In both cases, a phenomenon of collective behavior kicked in. Collective behavior is difficult to quantify, but it involves no arcana of recent physics.

I’ve read books by Mandelbrot and by Taleb. I don’t think their ideas are really explanatory. The analogy to the financial crisis views the institutional structure as a vast structure like a particle accelerator tended by disinterested, priestly casts of professors and technicians. But there are subtle quantum effects that lead to episodic failure, effects appreciated only by the cognoscenti. In the real world that wasn’t the problem. If the quants who priced the paper had given greater weight to the tails of the distributions, they’d have set higher prices and done more swaps for protection, which wouldn’t have mattered. Or they would have come up with infinite prices and killed the market for derivatives. Also not a desirable outcome, since derivatives may have social utility in spreading risk. Also a fantasy. Nobody would have listened to quants who came up with that answer. All the PTB wanted out of the quants was the imprimatur of formulas with integral signs on paper they could peddle to justify their bonuses. Quants who went along got their own modest bonuses.