Causes of the Crisis

commentary on the book

2011-10-30T16:47:00.006-05:00

From the New York Times Sunday Magazine, Marginal Revolution, CNBC, Econlog, the Financial Review of Books, CNBC again, CNBC again, RealClearMarkets, CNBC again, Wall St. Journal.

So far, all praise--where is the pushback? Surely we must have made at least one big mistake!

New Data on Bankers' Risk Aversion

2011-10-15T11:40:00.022-05:00

Probably the most controversial claim of the book will prove to be our suggestion that the behavior of bankers before the crisis was actually risk averse, at least in the aggregate. (A key point of Chapter 4, however, is that there was considerable heterogeneity underneath these aggregates.)

The risk-aversion claim rests on two facts: the much-higher-than-legally required capital ratios of commercial banks and savings and loans before the crisis; and the fact that commercial banks and S&Ls overwhelmingly bought the least lucrative and supposedly “safest” mortgage-backed securities: those implicitly guaranteed by the federal government through Fannie and Freddie’s congressional charters; and those rated AAA vs. those rated AA or lower.

Lower-paying bonds pay higher yields than higher-rated bonds, which in turn pay higher yields than “agency” (Fannie/Freddie) bonds. Reckless, greedy bankers should not have bought agencies or AAA bonds; they should have bought BB or BBB bonds.

In Table 2.2 of the book, we claim that banks bought more than twice the quantity of agency bonds as AAA mortgage bonds, and four times the quantity of AAA mortgage bonds as AAA CDOs. CDOs usually tranched mezzanine (sub-AAA) tranches of “regular” mortgage bonds, i.e., private-label mortgage-backed securities (PLMBS), so AAA CDOs were objectively riskier than AAA PLMBS. Thus, one way to view the collective risk profile of U.S. banks and savings and loans is to recognize that the following list shows the least risky and least lucrative of their mortgage bond holdings first, with the riskiest and most lucrative last:

$852 billion in agency bonds

$383 billion in AAA private-label mortgage-backed securities

$90 billion in AAA CDOs

Those are the figures on which row 1 of our Table 2.2 are based. However, none of our tables show bank holdings of actual AA, A, BBB, or BB tranches of PLMBS. This is because our data on the distribution of the various types of mortgage bond in banks’ portfolios came from a famous Lehman Brothers study dated April 11, 2008: “Residential Credit Losses—Going into Extra Innings?” (We discuss this study in end note 1 to the conclusion of the book.) The Lehman figures assign PLMBS and CDO holdings by various types of investor (commercial banks and S&Ls, investment banks, hedge funds, etc.) by billions of dollars. But the 2008 Lehman table says that commercial banks held no PLMBS or CDOs rated lower than AAA. That seems implausible, unless the authors of the report could not find holdings totaling more than $500 million, so the figure got rounded down to zero billions of dollars. (We attempted to contact the authors of the report, but they all now work for hedge funds and are barred from communicating with members of the public.)

The Lehman figures have been widely cited by others (e.g., Arvind Krishnamurthy, “The Financial Meltdown: Data and Diagnoses”--download PDF--Table 1 [November 2008]; Viral Acharya and Matthew Richardson, Restoring Financial Stability: How to Repair a Failed System [2008], Table 5). They are more comprehensive and newer than the only comparable data source, a 2007 Lehman Brothers report entitled “Who Owns Residential Credit Risk” (cited by the Financial Crisis Inquiry Commission, “Preliminary Staff Report: Securitization and the Mortgage Crisis” [April 2010], Table 1). However, we wish there were a better source. Unfortunately, as of November 2010, when our book was completed, we knew of no other data. Now (ht Viral Acharya) we do—although this source, too, has limitations.

In August 2011, Isil Erel, Taylor D. Nadauld, and René M. Stulz released an NBER working paper, “Why Did U.S. Banks Invest in Highly Rated Securitization Tranches?” Erel et. al found a way to use regulatory filings from bank holding companies to “back out” their mortgage-bond holdings.

The key data source, Schedule HC-R of form FR Y-9C, groups assets by risk bucket: 0%, 20%, 50%, 100%. This means that AAA and AA PLMBS, which were both risk weighted at 20%, are grouped together. And the 100% category contains so many different types of securities, such as corporate bonds and equities, that we cannot back out mortgage bonds in that category, namely those rated BBB or BB. Using Erel et al.’s method, however, we are able to provide the following results for the four biggest bank holding companies as of the end of 2006:

Citigroup:

$70 billion in agency bonds

$28 billion in AAA/AA mortgage bonds

$10 billion in A-rated mortgage bonds

Bank of America:

$157 billion in agency bonds

$4 billion in AAA/AA mortgage bonds

$2 billion in A-rated mortgage bonds

JPMorganChase:

$75 billion in agency bonds

$1 billion in AAA/AA mortgage bonds

$0 billion ($351 million) in A-rated mortgage bonds

Wells Fargo:

$27 billion in agency bonds

$27 billion in AAA/AA mortgage bonds

$1 billion in A-rated mortgage bonds

Aggregate:

$329 billion in agency bonds

$60 billion in AAA/AA mortgage bonds

$14 billion in A-rated mortgage bonds

In short, the Big Four invested in the safest two classes of mortgage securities, agencies and AAA/AA, at a ratio of 28:1 compared to the riskiest, most lucrative category for which we have figures: A-rated bonds. One should keep in mind that, for example, in mid-2006, agencies paid a 9-bps spread over Treasuries, AAAs paid 18 bps, AAs paid 32 bps, and As paid 54 bps. Reckless, greedy bankers should have bought As--or lower-rated mortgage bonds (BBBs paid 154 bps, and BBB- paid 267 bps) every time--never agencies, AAAs, or AAs.

However, do the new data mean that the Lehman figures on which we relied are wrong, for showing zero (or less than $500 million) in sub-AAA mortgage-bond holdings among commercial banks and savings and loans? Not necessarily. The figures above are from the consolidated regulatory filings of bank holding companies, which include investment-banking arms. The Lehman figures do show $24 billion in sub-AAA bonds among investment banks.

As for the data, then, we conclude that the full story remains to be told, but that our basic point stands: the bankers—even at Citigroup, which had the riskiest portfolio—were not behaving in patterns we would expect from reckless greedheads.

Corrections to "Engineering the Crisis"

2011-10-15T09:06:00.008-05:00

We note in the introduction to the book Max Weber's rueful acknowledgement (in "Science as a Vocation") that empirical claims are bound to be superseded over time. We hope it takes more than a day or two for our claims to be superseded, but we are happy to contribute to the process and we invite others to help. Today is October 15, the release date of the book. Let's see how long any of our claims remain standing!

Juliusz Jablecki, formerly an economist at the central bank of Poland, points out an error in our discussion of AIG. AIG's inability to cover its CDS contracts was, as far as we know, the one case in which the CDS "insurance" system failed to work during the crisis. However, it was a major case. We contend on p. 33 that once AIG was bailed out on September 16, 2008, its CDS "were a nonissue in the interbank panic that was underway." Juliusz points out, first of all, that the AIG "bailout" was actually a collateralized line of credit from the Fed. More important, however, CDS on AIG (i.e., not CDS to which AIG was a counterparty, but CDS insuring against AIG's default), after falling precipitously after September 16, spiked again in November 2008 and even higher in April 2009. So concerns about AIG's ability to make good to its counterparties may well have been an ongoing contributor to the financial crisis, contrary to our claim. Thank you, Juliusz.

Here is an important typo on p. 76, 2/3 down page: should read "the spread for agency bonds was 0.04 percent," i.e., 4 bps, not "0.4 percent," or 40 bps.

Blog Transition Announcement

2011-10-11T12:41:00.004-05:00

This blog was initially established by the Critical Review Foundation as a forum for contributors to What Caused the Financial Crisis, published by the University of Pennsylvania Press in 2010. That, in turn, was the book version of a special issue of Critical Review devoted to the causes of the financial crisis, published in 2009.

However, it's been a long time since there was activity on the site. (For a while, it seemed that the financial crisis might be fading away like a bad dream.) And now Penn has published a new book, Engineering the Financial Crisis, coauthored by Wladimir Kraus of the University of Aix-en-Provence (an Associate Editor of Critical Review) and myself. Since the new book is also about the causes of the financial crisis, and in the hope that nobody will object, I believe it's time to turn this into a blog about the new book.

And so we have done....

Jeffrey Friedman
Editor, Critical Review
Coauthor, Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

"What Caused the Financial Crisis" availability

2011-01-04T11:51:00.003-06:00

Update on availability: the first shipment to Amazon sold out within a week of the December 15 release. As of today there are four copies of the second shipment left at Amazon, and they have reduced the original $10 discount to $1. However, copies are still available at BarnesandNoble.com, which has reduced its discount from $10 to $2.

This doesn't mean the book has sold out yet, just that it is hard to buy at discount. The University of Pennsylvania Press still has copies. Unfortunately, the Critical Review Foundation is out of extras.

JF

"What Caused the Financial Crisis" is in print

2010-12-23T09:21:00.000-06:00

"What Caused the Financial Crisis," edited by Jeffrey Friedman, is now available from the University of Pennsylvania Press and from Amazon. It contains Critical Review's special issue on the financial crisis, along with a completely revised introduction by the editor and an Afterword by Judge Richard Posner.

Review copy requests and suggestions should be sent to the Critical Review Foundation.

"Capitalism and the Crisis" to Be Published by Penn

2010-12-23T09:19:00.000-06:00

The University of Pennsylvania Press has concluded the peer review of "Capitalism and the Crisis: Regulation, Competition, and Systemic Risk," by Jeffrey Friedman and Wladimir Kraus. The book will be published on September 1, 2011.

This book takes up the "Basel thesis" laid out in Critical Review's special issue on the crisis by Viral Acharya and Matthew Richardson ("Causes of the Financial Crisis") and by Juliusz Jablecki and Mateusz Machaj ("The Regulated Meltdown of 2008"): capital-adequacy regulations promulgated in the Basel I accords (1988), the U.S. financial regulators' Recourse Rule (2001), and Basel II (2004) significantly contributed to the financial crisis by inadvertently encouraging banks to purchase triple-A-rated mortgage-backed securities.

Chapter 1 rebuts various myths about the crisis, including the notion that the "too big to fail doctrine" and the performance incentives used by banks encouraged deliberately reckless risk-taking; that the crisis was caused by "irrational exuberance"; and that it was caused by deregulation.

Chapter 2 briefly reviews the rationale for capital-adequacy regulation and the provisions of Basel I, the Recourse Rule, and Basel II. The chapter also shows that U.S. commercial banks invested three times the proportion of their portfolios in mortgage bonds as did other U.S. investors, yet that banks preferred the safest mortgage bonds, those issued by GSEs, at a 2:1 ratio to privately issued mortgage bonds; and that all of the privately issued mortgage bonds bought by banks appear to have been relatively low-yielding, less-risky triple-A bonds. These facts suggest that capital arbitrage was a major motive. Yet under the Recourse Rule and Basel II, the same capital relief could have been achieved by buying higher-yielding, riskier double-A bonds, suggesting that banks were being prudent while operating within the Basel/Recourse Rule framework. Finally, the chapter discusses the paradox that capital arbitrage did not--contrary to the conventional wisdom--increase banks' leverage overall. Why, then, did banks want capital relief? The chapter answers by distinguishing between regulatory capital cushions and actual capital cushions. Regulatory capital cushions entail legal penalties if they are used, and thus are as good as worthless to banks. Real capital cushions, in contrast, offer security against future losses. By purchasing assets such as triple-A and GSE mortgage bonds that required less regulatory capital, banks were able to increase their real capital cushions.

Chapter 3 discusses the interaction of the Basel rules with fair-value (mark-to-market) accounting regulations that translated market unease (and eventually panic) about the value of mortgage-backed bonds into dollar-for-dollar subtractions from banks' regulatory (and real) capital cushions, dramatically reducing banks' lending capacity from the summer of 2007 through 2008. It also discusses the interaction of the Basel rules with the SEC's regulatory protection of the incumbent rating agencies--Moody's, S&P, and Fitch--whose ratings were given legal status by capital-adequacy regulations.

Chapter 4 considers the reasons for these regulatory errors and the implications for capitalism and regulation. The basic conclusion is that the regulators, like the bankers, were ignorant of the unintended consequences of their actions, but that the regulations had the inadvertent effect of making the entire economic system more fragile by homogenizing banks' asset purchases in pursuit of regulatory capital relief.

This book was written and edited for adoption in courses on the financial crisis, modern government, and related subjects in courses offered by American Studies, economics, history, political science, and sociology departments. It is accessible to educated laymen and nonspecialists.

--Jeffrey Friedman and Wladimir Kraus

Amar Bhide's New Book

2010-12-16T10:22:00.004-06:00

Critical Review contributor Amar Bhide's "A Call for Judgment" is now available from Oxford University Press. Bhide presents a meticulous history and critique of economic doctrines that implied market omniscience and that may have contributed to the financial crisis.

It's a Banking Crisis

2010-05-18T10:29:00.001-05:00

From the New York Times:

"seemingly safe institutions in more solid economies like France and Germany hold vast amounts of bonds from their more shaky neighbors, like Spain, Portugal and Greece....For example, Portuguese banks owe $86 billion to their counterparts in Spain, which in turn owe German institutions $238 billion and French banks $220 billion. American banks are also big owners of Spanish bank debt, holding nearly $200 billion, according to the Bank for International Settlements, a global organization serving central bankers."

European Bank Bailout

2010-05-10T10:05:00.006-05:00

The NY Times reports what may be the key part of the rescue package that is now rallying the markets: a bank bailout. "The European Central Bank reversed its position of just a few days ago and began buying government and corporate debt."

Why did the prospect of defaulting Greek government bonds--like the prospect in 2007-8 of underperforming AAA-rated mortgage-backed securities--cause a *banking* crisis? Because banks held so many of these securities. Why did they do that? In part, at least, because of banking regulations.

Under Basel I, banks received 100 percent capital relief for off-balance-sheet holdings of bonds purchased in short-term commercial paper markets with funds borrowed from money market funds, which are required by law to invest in AAA bonds.

Under the Recourse amendment to Basel I, enacted in the U.S. only in 2001 and implemented 1/1/2002, AA or AAA rated asset-backed securities received a 20 percent risk weight, meaning that $100 in ABS, such as MBS, could be bought using only $1.60 of capital: 8 percent regulatory capital minimum x .20 = 1.60. In comparison, whole (individual) mortgages were risk weighted at .50, requiring 60 percent more capital: $4 in capital to lend $100 in mortgages. And business loans and commercial bonds were risk weighted 100 percent, requiring $8 in capital per $100 in business loans.

Could that be why economic growth was comparatively slow in the 2000s, outside the housing sector?

Under Basel II, implemented outside the United States in 2006-7, the regulators favored highly rated sovereign debt. For the exact risk weights of Greek, Portugese, Spanish, and Italian government bonds, see yesterday's post here.

However, yesterday's reporting probably underestimated the amount of Greek sovereign debt in European banks' hands--$140 billion in sovereign plus private debt, according to today's WSJ, which has a good analysis of the role of the Basel rules in encouraging these bank holdings.

One might argue that banks would have bought sovereign debt anyway, for all the usual reasons one might buy any bonds. Yep, and the same is true of mortgage-backed securities, which were bought by many institutional investors that weren't covered by the Basel or Recourse rules. However, it would be ludicrous to think that the regulations therefore had no effect. The effect was to *magnify the quantity* of these particular assets that were purchased by commercial banks.

The purpose of regulation is to push behavior in the direction desired by the regulators. Purchases of AAA-rated MBS and of variously rated sovereign debt were *not* just governed by the usual considerations. Also weighing heavily on the scale were the financial inducements that the Basel rules provided for leveraging into "safe" assets, as defined by the Basel Committee on Banking Supervision. This is presumably why only banks, as a class of institutional investor, were nearly wiped out by their MBS holdings in 2008, and why banks needed to be bailed out last night.

It is thus misleading to argue, as do Johnson & Kwak and the few other economists who have discussed the Basel rules, that banks "exploited a loophole" by buying assets with low risk weights. Banks that did this were doing *exactly* what regulators wanted them to do: they were leveraging into securities that the regulators judged safe. Unfortunately, in both cases, the regulators' judgments were wrong.

Greek Panic Update

2010-05-09T08:35:00.007-05:00

It appears that, as hypothesized here three months ago, the Greek debt crisis may actually be another Basel-induced banking crisis.

Basel II (adopted outside the United States in 2007, but not yet adopted here, where Basel I (1991) and the Recourse Rule (2001) are still in effect) gave a zero risk weight to government bonds rated AAA to AA-; a 20 percent risk weight to government bonds rated A+ to A-; and a 50 percent risk weight to government bonds rated BBB+ to BBB-.

On April 21, Moody’s downgraded Greek debt to BBB+, suddenly requiring banks holding A- Greek government bonds to raise 60 percent more capital for these securities. Portugal’s AA rating is under pressure (according to Moody’s), as is Spain’s (according to S&P), although Italy's Aa2 (AA) Moody's rating, and S&P's rating of A+, seem stable. According to yesterday's New York Times, "French and German banks...have $1.16 trillion at risk in Spain and Italy, including government and private debt."

The downgrade pressures on banks are in addition to the default threat from Greece. Yesterday's Financial Times reports that "French and German banks and insurance groups...hold just under 80 billion euros in Greek sovereign debt," and that banks are afraid to lend to each other for fear of counterparty insolvency. According to Bloomberg, "The cost of insuring against losses on European bank bonds soared to a record, surpassing levels triggered by the collapse of Lehman Brothers." Another FT story reports that "worried bankers from 47 European groups urged the ECB to become a 'buyer of last resort' of eurozone government bonds to steady markets. There was speculation that the central bank could be preparing a $762 billion loan facility for one-year loans at 1 percent to help more than 1000 banks in their funding."

And from today's NYT: "United States banks have $3.6 trillion in exposure to European banks."

Why the Greek Debt Panic?

2010-02-16T09:36:00.010-06:00

The key to understanding the "Basel thesis" about the cause of the crisis, advanced in Critical Review's special issue on the crisis by coauthors Viral Acharya & Matthew Richardson, and by coauthors Juliusz Jablecki & Mateusz Machaj, as well as by Wladimir Kraus and me in our forthcoming Engineering the Perfect Storm: Banking Regulation, Capitalism, and Systemic Risk (University of Pennsylvania Press, 2010), is to understand one thing: The bursting of the housing asset bubble would not, alone, have caused (1) a financial crisis, and thus probably would not have caused (2) a worldwide recession of such depth.

This is also a point made by the other coauthor team in Critical Review's special issue, Steven Gjerstad and Nobel laureate Vernon L. Smith. Asset bubbles pop all the time, but worldwide financial crises are rare.

A financial crisis is a banking crisis. So why did the bursting of the asset bubble in housing cause a banking crisis, freezing interbank lending and then bank lending into the "real" economy?

Because, according to the Basel thesis, Basel I bank-capital regulations, enhanced in 2001 in the United States by the Recourse Rule, encouraged banks worldwide and especially in the United States to leverage into asset-backed securities, including mortgage-backed securities, that were either government guaranteed (by Fan or Fred) or were privately issued but had an AA or AAA rating. How did the Basel rules encourage this? By giving such securities a 20 percent risk weight.

Translation: An AAA-rated mortgage backed security worth $100 required only $2 in bank capital at the 8 percent Basel rate for adequately capitalized banks. $100 x .08 x .20 (the 20 percent risk weight assigned to asset-backed securities by the Recourse Rule) = $2. By contrast, a commercial loan of $100 required $8 of bank capital, because Basel gave such loans a 100 percent risk weight. $100 x 8 percent x 1.00 = $8. Similarly, a $100 whole mortgage retained by the bank required $4 of capital, because the Basel risk weight for unsecuritized mortgages was 50 percent. With these risk weightings, securitized mortgage-backed debt offered significant capital relief.

Today's FT brings the news that "European financial institutions have $235 billion worth of claims on Greek debt, most of which is thought to be in government bonds." Why do they hold so much Greek government debt? Because under Basel II, implemented (outside the United States) in 2007, Greek government bonds, rated A-, had the same 20 percent risk weight as AA/AAA asset-backed securities in the United States. That is, until S&P downgraded Greek debt from A- to BBB+. That raised the risk weight to 50 percent, suddenly requiring 60 percent more capital from banks holding Greek bonds.

This appears to be the reason that the possibility of Greek default has led to fears of another banking crisis.

Too Big to Fail: The Evidence

2010-02-13T08:49:00.013-06:00

Ironically, Cafe Hayek takes issue with my Austrian claim that bankers were (in general) ignorant of the risks they were taking, hence could not have been taking these risks due to their knowledge that they were "too big to fail" and thus would be bailed out. Or at least I think that's what Russ Roberts is suggesting, because he is disputing what I said, and what I said is that TBTF did not cause the crisis--not that the thought of a bailout never crossed any bankers' minds. (If I were one of them and it crossed my mind, however, I would have said to myself: "Maybe. But I'm not going to count on it.")

Roberts cites a speech by Andrew Haldane,an official of the Bank of England, who claims that at an undated meeting of unnamed bankers, an unnamed individual said that bankers had no incentive to run severe stress tests because in a severe event, they would lose their jobs and then "the authorities would have to step in."

Props to Russ for this interesting evidence, which I hadn't seen before. But it's not exactly unambiguous.

Consider a banker who, as posited in the anonymous scenario, thinks that a disastrous financial situation would get him fired. What difference would it make to this allegedly self-interested banker that the bank would subsequently be bailed out?

Of course, as the bailouts actually unfolded, the bankers did not get fired in many cases--but according to Haldane's anecdote, the bankers did not know that in advance.

So, as I said, when it comes to the TBTF, corporate-compensation, and ABCT theories of the crisis, we're in a high-conviction, low-evidence zone. However, we are not in an evidence-free zone. Consider, on TBTF:

1. Many banks that were too small to be bailed out (except by the FDIC, in which case the bankers would definitely be fired) invested in the same AAA-rated MBS as the big banks that got bailed out.

2. Commercial bankers like Sandy Weill and investment bankers (e.g., Jimmy Cayne, Ralph Cioffi, and Matthew Tannin at Bear Stearns) lost many millions--in Weill and Cayne's case, $1 billion each--because they were fully invested in their banks' stock right up to the end.

Cafe Hayek quotes Cayne: "The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?" What is the point of this quotation: That Cayne didn't care about his heirs, so he didn't care about losing $1 billion, so that's why he knowingly allowed Bear Stearns to take risks that led to its collapse?

That is certainly not the implication of the passage when it is read in context.

3. If one reads the rest of the book from which the quotation is drawn, one finds that Cayne was consumed by the construction of a new skyscraper headquarters for Bear Stearns that would symbolize the permanence of the success of this once-underdog, scrappy, Jewish firm. Is it really plausible that Cayne would risk that success, his life's legacy, because, in the event that the risk brought down Bear Stearns, the firm might get bailed out (by being absorbed, in the event, into arch-rival JP Morgan)?

Similarly, as I document in my introduction to the Critical Review financial-crisis issue, Cioffi and Tannin, who were the only ones at Bear Stearns who actually knew what was going on, revealed in secret emails to each other (discovered by the FBI) that they were true believers in the accuracy of the triple-A ratings. They were mistaken.

Again, as the crisis unfolded, all the books on the crisis show that the principals were shocked, frantic, and bewildered. If they had deliberately taken risks because they had a bailout in the back of their minds, would they not have have reacted with knowing cynicism and serenity?

(More documentation will appear in the revised introduction to the book version of Critical Review's financial-crisis issue, The Causes of the Financial Crisis, forthcoming from the University of Pennsylvania Press.)

4. I'm still waiting for somebody to explain why these bankers who were supposedly insensitive to risk--due to being TBTF, or due to their compensation incentives--bought government-guaranteed or AAA-rated MBS 93 percent of the time.

AA-rated MBS were riskier, paid higher returns, and got exactly the same capital relief as AAAs. They would have been the MBS of choice if both the capital-relief theory of the crisis, which I favor, and the TBTF or corporate-compensation theories of the crisis were true. Subtract the capital-relief motive, though, and BBB or lower-rated securities would have been the choice. But never, ever, AAAs.

I submit that the bankers--like the regulators--simply did not realize that this was the first-ever significant nationwide housing bubble. And they did not realize how fragile the bubble was, due to subprime lending. Meanwhile, the Basel regulators encouraged them to leverage into the bubble by buying AA- or AAA-rated MBS. That is the crisis in three easy sentences.

The crisis has ideological ramifications. So economists of libertarian bent want to blame it on TBTF. Those of leftist bent want to blame it on bankers greedy for bonuses. Is it so difficult to imagine, though, that both the regulators and the bankers, being human, were ignorant of what was to come?

That, I think, is what Hayek might have said.

Another Good Thing about Austrian Economics

2010-02-11T17:51:00.003-06:00

Bill Woolsey draws attention in the comments to the Austrian emphasis on malinvestment, as opposed to the mainstream preoccupation with aggregate investment levels.

That certainly does seem like an important theoretical contribution (but I am a mere political scientist).

But is it a contribution to understanding the causes of the 2008 financial crisis? I thought the mechanism of malinvestment is supposed to be the low interest rates themselves, not laws that encouraged housing investment, such as those pointed to by Gjerstad and Smith and Wallison.

I'd love to be corrected if I am wrong about that, and also about whether any empirical work has been done to test the ABCT hypothesis regarding what caused the financial crisis.

Against the New Consensus

2010-02-11T11:44:00.005-06:00

For what it is worth, here is Wladimir's and my response to the new consensus: "A Silver Lining to the Financial Crisis: A More Realistic Understanding of Capitalism." In it, we move from a rebuttal of the Corporate Compensation Myth to an explanation of the homogenizing effect of capital regulations that privileged Fannie, Freddie, or AAA/AA-rated private-issue mortgage-backed securities; and we contrast regulatory homogenization against the normal situation in markets, namely competition among businesses with heterogeneous interpretations of what they should do to make profits and avoid losses. That heterogeneity, we maintain, is the chief justification of capitalism, and the best insurance against systemic risk.

From Diversity to Consensus, and Austrian Economics

2010-02-11T10:53:00.020-06:00

The most shocking result of having researched the causes of the financial crisis for the last year and a half is this discovery: economists have no compunctions about answering empirical questions, such as what caused the specific crisis of 2008, with general theoretical models, whether macro- or micro- in nature, that may or may not have any applicability to the actual historical event at hand. The possibility that a good model may not be applicable in a specific circumstance never seems to cross their minds.

Or, to put it differently (since we all use models): economists seem particularly uninterested in testing their hypotheses against evidence. Why do that, if all economic models express "universal laws"?

During the first year after the peak of the crisis in September 2008, however, a positive side effect of the economists' apriorism was that it produced several different hypotheses that, in this case, were relatively easy to test against evidence.

For instance, there was the Austrian business-cycle theory. But it runs up against two (not necessarily fatal) questions when it is applied to the specific crisis at hand: "Why housing?" and "Why a banking crisis?"

I.e., if low interest rates were the cause of the crisis, why wasn't there a general overinvestment in capital goods, as the Austrian theory predicts? In fact, there was an overinvestment in housing, a labor-intensive good with a short production period (roughly 3 months). Why not, instead, an overproduction of jet airplanes or skyscrapers?

One may supplement the Austrian theory with explanations such as Stephen Gjerstad and Vernon Smith's Critical Review focus on the favorable tax treatment given to home-equity capital gains, or Peter Wallison's Critical Review focus on federal housing policy, which, via Fannie Mae and Freddie Mac, added to low interest rates even more favorable terms for home buyers (e.g., no down payments).

But then we aren't really talking about a specifically Austrian theory any more: nearly everyone, of every theoretical stripe, blames low interest rates as a facilitating condition of the crisis. And while low interest rates may (perhaps) have been necessary, they were not sufficient, to cause the crisis. And they did not operate in the specifically Austrian fashion of boosting spending on more "roundabout" methods of production.

Moreover--why should a housing crisis have turned into a banking crisis?

Brian S. Wesbury's new book, It's Not as Bad as You Think (Wiley 2010), demonstrates that the collapse of housing did not cause the recession. It was the banks' overinvestment in mortgage-backed bonds, whose value was called into question during the panic of September 2008, that caused the recession--by freezing bank lending. There is no known macroeconomic explanation for the banks' purchases of these bonds; so it must have been caused by institutional or microeconomic factors.

Nonetheless, some "Austrians" continue to push "the Austrian" theory, even though that theory is but a minor aspect of the rich Austrian legacy.

Back when I received an informal education in Austrian economics in New York City in the mid-1980s (via Israel Kirzner and Don Lavoie), and then, more intensively, through editing them and virtually every other Austrian economist in Critical Review in the early 1990s, Austrian business-cycle theory was seen by Austrians as an embarrassment. The distinctive thing about "Austrian" economics, it was thought, was not business-cycle theory but the Austrian focus on human ignorance.

This focus is evident in the best explicitly Austrian books ever written: Lavoie's Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered (CUP 1985) and Mario Rizzo and Gerald P. O'Driscoll's The Economics of Time and Ignorance (2nd ed. Routledge 1996). This tradition continues with Amar Bhide's forthcoming masterpiece, A Call to Judgment: Sensible Finance for a Dynamic World (OUP 2010), which attributes the crisis to the spread of mistaken theories of finance, such as the Capital Asset Pricing Model.

Karen Vaughn's Austrian Economics in America (CUP 1998) is a challenging, exciting history of this epistemically oriented Austrian economics, now largely abandoned. Most Austrians have now, sadly, adopted (perhaps due to the influence of Public Choice theory) the mainstream economists' obsession with rational-choice game theory (the strategic interaction of knowledgeable self-interested agents), which tends to reduce error to perverse incentives rather than genuine ignorance. So all that Austrians have left to distinguish themselves from the mainstream is Hayek's old business-cycle theory, which may or may not explain some business cycles but does not seem sufficient to explain this one.

Meanwhile, non-Austrian economists have gravitated toward two game-theoretic "moral hazard" stories that fit with their predisposition to reduce human error to misaligned incentives.

First, the moral hazard of "too big to fail" (TBTF). Empirical problem: Before the bailouts, nothing of this scale had ever happened, so no bank could have been sure they would be bailed out. And if one actually reads accounts of the decision making in the years leading up to the crisis, such as Gillian Tett's Fool's Gold and William D. Cohan's House of Cards, no decision makers factored bailouts into their calculations. Why? Because they didn't think they were doing anything particularly risky (an ignorance-based human error), so they didn't even consider the chances of being bailed out.

Second, the moral hazard of "corporate compensation systems," i.e., bonuses.

Empirical problem #1: When this theory took hold, there was virtually no evidence for it (whereas now there is one study for it and one against it)--see Wladimir's and my post on the topic (below).

Empirical problem #2: There was, and remains, the following overwhelming evidence against the theory: 93% of the banks' mortgage-backed securities were either guaranteed by the U.S. government (i.e., Fannie and Freddie) or were rated AAA--the "safest" and lowest-yielding securities available. Triple-A bonds are the last thing revenue-seeking, bonus-hungry, risk-indifferent (i.e., risk-knowledgeable, rather than risk-ignorant) bankers would have bought.

Yet now the Corporate Compensation Myth is the hegemonic story of the crisis, all but universally accepted by financial journalists, politicians, regulators--and scholars.

Why? Because it fits the scholars' rationalistic predilection for incentives stories that reduce an apparently widespread error to the knowing, deliberate actions of selfish actors--i.e., "greedy bankers." And guess what? That is exactly the simplistic model that journalists, politicians, and the general public are inclined to believe, evidence or not.

The Critical Review Book(s)

2010-02-11T10:44:00.008-06:00

It has been a long while since anyone has posted here. One reason is that the creative frenzy of last year, in which many different ideas about the financial crisis were debated, has lapsed into a hegemonic consensus about the causes of the crisis (see next post), so there hasn't been much for us to link to.

But the other reason is that the University of Pennsylvania Press is republishing Critical Review's special issue on the crisis in book form, under the title The Causes of the Financial Crisis, and Shterna Friedman (the managing editor) and I (the editor) have had our hands full preparing the volume for republication, including a complete revision of my introduction to the issue in light of more recent developments and research.

The new book should be on sale by September and is available for discounted group purchase and, of course, classroom use. Contact me about this at edcritrev@gmail.com

Making matters worse (or better, depending on your perspective), the University of Pennsylvania Press has also commissioned Causes of the Crisis Blog editor Wladimir Kraus and me to coauthor a second book, Engineering the Perfect Storm: How Reasonable Regulations Caused the Financial Crisis, and we have been hard at work on it. Our target completion date is September 1, which would allow the book to be available for course adoption for Spring 2011.

Sorry that we have therefore been out of touch.

Jeffrey Friedman

The Myths of Financial Deregulation

2009-11-16T10:41:00.002-06:00

An exhaustive compendium by Critical Review author Peter Wallison.

Regulation, Not Markets, Let Us Down

2009-11-04T14:27:00.005-06:00

by Viral V. Acharya

In the aftermath of the crisis, it is customary to fault the markets: Markets missed the crisis; markets are euphoric in good times; markets suffer from mob mania; markets reflect animal spirits, and so on. It is tempting to ring the death knell of “efficient markets”: How could creditors get it so wrong? Why did bank shareholders not react sooner? Can we rely on markets any longer?

I contend that markets have been reasonably efficient, but only within poor regulatory constraints. Markets slept in the buildup to this crisis when regulation was supposed to be on the watch. It was lax regulation – not markets – that let us down. And until we improve the regulatory perimeter within which markets operate, we will not be able to generate stable economic growth.

Let me elaborate.

Most of the leverage built by financial firms between 2004 and 2007 was either done through regulatory arbitrage or was the result of lax regulation. Commercial banks added over $700bln to their off-balance sheet leverage by providing under-capitalized guarantees to structured purpose vehicles (“conduits”) that themselves had hardly any capital. Regulators allowed this, even though a similar leverage game brought down Enron. Once the Securities Exchange Commission (SEC) lifted their “net capitalization rule” in 2004, investment banks ramped up their exposure to sub-prime mortgages. In no time, these banks drove up their debt-to-equity ratios from 22:1 to 33:1. A.I.G. was the mother of all jurisdictional arbitrages. It bought a small thrift in order to get its several hundred billion dollars of credit default swaps weakly capitalized, avoiding the New York State Insurance Department, its natural but tougher regulator. Banks buying protection from A.I.G. could not care less as they too got a regulatory capital relief in the process. And regulators allowed Fannie and Freddie – set up by the government to securitize prime mortgages – to bet in sub-prime assets that eventually ruined them.

Markets could be deemed inefficient in all this if they had the relevant information, but made a mistake in not using it. But many activities through which the financial sector built up leverage, such as conduits and over-the-counter exposures, were not visible to investors. In contrast, these activities were – or should have been – visible to regulators. Elsewhere, it was simply not in the interest of investors to be bothered. For instance, Fannie and Freddie’s debt was understood by all to be government-backed, so their sub-prime bets were a pure gambling option for the shareholders. And except for a few cases, even uninsured creditors and counterparties of failed financial institutions have walked away without taking substantial haircuts.

The low price of credit risk of financials until 2007, coinciding with a rising path of their leverage, implied that the hidden trajectory of expected taxpayer losses was exploding. Put simply, profits were being privatized and risks socialized. It was regulation, not markets, that allowed this to happen.

Regulation is supposed to fix market failures. But regulation also reduces market discipline. For instance, insured depositors are unlikely to “run” but they also freely deposit at the highest-yielding bank, not worrying about its credit risk. Thus, when regulators deem a bank as well-capitalized, the onus is on regulators that this be right. Markets may not have the incentive to gather this information nor possess the details of regulatory supervision that led to such an assessment. Conversely, when regulation allows itself to be arbitraged, the financial sector becomes more opaque exposing markets to unexpected outcomes.

When such adverse outcomes materialized in the first eight months of 2007, market learned fairly quickly. By then, Countrywide had fallen, Bear Stearns had to bail out hedge funds invested in the US subprime assets, and indices tracking such assets were declining day by day. When BNP Paribas declared on August 8th that there was no market for subprime assets in its hedge funds, it became clear to investors that the entire financial sector had made a one-way bet on the economy. Investors realized that the seemingly well-capitalized financial institutions were in fact significantly more levered, no matter what their regulatory capitals looked like.

Since that day of rude awakening, markets have given hell to the weak players and rewarded the strong ones. Financials with the worst balance sheets have fallen, and the next in line have been punished severely. Bear Stearns failed in March 2008 even as its regulatory capital level exceeded 10%, well above the required minimum. It was clear to markets that Bear’s regulatory capitalization had little information content about its solvency. In fact, only the relatively stringent “stress tests” conducted earlier this year have restored markets’ confidence in regulatory endorsements of financial stability.

Alan Greenspan, the former Federal Reserve Chairman, acknowledged that he “made a mistake” in trusting that free markets could regulate themselves. The underlying assumption is itself questionable. The financial sector – so heavily regulated and partly guaranteed since 1930’s – is not exactly a free market, is it?

Recently, the G20 also accused the “reckless excesses” of the banking sector for the mess we are in. While there might be a grain of truth to this, there is also a sense in which these excesses are consistent with the efficiency of markets. If government guarantees are offered gratis to the private sector, competition leads to their fullest exploitation. If regulators legitimize the shadow banking world, then profit-maximizing bankers avoid capital requirements through off-balance sheet transactions. If money is being thrown at insolvent firms without any strings attached, these firms procrastinate on capital issuances and continue paying bonuses and dividends.

Hence, compared to 1930’s, the current job of rewriting regulation is tougher. We need to address regulatory failures in addition to market failures. Will we restrict the scope of government sponsored enterprises? Will we stop rebating deposit insurance premiums to banks in good times? Will we bring capital requirements of off-balance sheet activities in line with on-balance sheet ones? Will central bank lines of credit be made contingent on solvency criteria, like the private lines of credit? And will regulatory supervision be held accountable by requiring that they produce public reports on strengths and weaknesses of banks they invigilate?

To attribute this crisis to a failure of efficient markets is to miss its most important lesson: That poor regulation, with its incentive and information distortions, can also destabilize markets.

The author is a professor of finance at New York University Stern School of Business and co-editor of the book “Restoring Financial Stability: How to Repair a Failed System.” With Matthew Richardson, he coauthored "Causes of the Financial Crisis" in the special issue of Critical Review devoted to that topic.

Terrific Article by Edmund Phelps

2009-11-04T12:03:00.004-06:00

Nobel laureate Ned Phelps writes : "The lesson the crisis teaches, though it is not yet grasped, is that there is no magic in the market: the expectations underlying asset prices cannot be 'rational' relative to some known and agreed model since there is no such model."

The Real Bank Pay Scandal

2009-10-31T10:14:00.004-05:00

Federal Reserve chairman Ben Bernanke announced last week that all federally regulated banks will be subject to regulatory scrutiny of compensation practices “to ensure that they do not encourage excessive risk-taking.” Bernanke justified this plan by asserting that “flawed compensation practices at financial institutions” helped cause the financial crisis.

It would be an understatement to say that this assertion has not been proven. Bernanke’s heavily footnoted speech provides dozens of statements from various regulatory bodies that simply assert the Bernanke thesis as if it were self-evidently true. The real scandal of bankers’ pay contributing to the financial crisis is that nobody, literally nobody, has offered a shred of evidence that it did contribute to the crisis. Yet public opinion, the financial press, and the regulators have decided that it did, and drastic new regulatory policies are being constructed on that basis.
Moreover, when we consult what evidence is known, it seems that bankers, far from deliberately courting disaster so as to boost their pay, unintentionally took risks that jeopardized their own wealth.

We can see some of the results in the huge hits taken by key bank executives, such as Richard Fuld of Lehman Brothers, who lost $1 billion by retaining his Lehman holdings until the bitter end. Sanford Weill of Citigroup lost half that amount. Ohio State economists Rüdiger Fahlenbrach and René Stulz have shown that banks whose CEOs held a lot of their banks’ stock fared worse in the crisis than banks with CEOs who held less stock. The CEOs who held stock in the riskier banks must have been ignorant of the risk, or they would have sold their shares.

Ignorance, not a perverse pay structure, also seems to have been at work at Bear Stearns. William D. Cohan’s "House of Cards" suggests that before losing about $900 million in stock when the bank imploded, Bear Stearns CEO James Cayne had no idea that anything was amiss. In fact, he was obsessed with the construction of a huge new headquarters building that would testify to the permanence of Bear Stearns, formerly the upstart of investment banks. It isn’t plausible that he would have let anything jeopardize this legacy—if he knew about the risk. All the while, two Bear Stearns hedge funds were buying billions of dollars worth of mortgage-backed securities that ended up sinking the parent bank. Did the employees who ran these funds, Ralph Cioffi and Matthew Tannin, understand the risks they were taking? That is part of what’s at issue in their trial for securities fraud. But we already know that they had millions of dollars of their own invested in their hedge funds, and emails between them suggest that until nearly the end, they felt secure in the knowledge that the funds’ holdings were rated AAA.

Indeed, 93 percent of the mortgage-backed securities purchased by banks either were rated AAA or—better yet—were insured by Fannie Mae or Freddie Mac, with implicit federal guarantees. It turned out to be a mistake to trust the AAA ratings, but in making this mistake, bankers again demonstrated that they were not seeking short-term profits to boost their annual bonuses. Had that been the bankers’ aim, they would not have bought AAA-rated mortgage-backed bonds, which, being “safe,” paid a lower interest rate than AA- and lower-rated bonds. Bankers who were indifferent to risk because they were seeking higher return should have bought the more-lucrative, riskier bonds, but they did so only 7 percent of the time.

The theory that the financial crisis was caused by pay incentives that encouraged risk-taking simply does not fit the facts. Moreover, if we ask why bankers invested so heavily in mortgage-backed bonds instead of other securities, the answer seems to be a previous regulatory attempt to steer banks away from risk. In 2001, the Fed, the FDIC, the Comptroller of the Currency, and the Office of Thrift Supervision promulgated the Recourse Rule, which encouraged commercial banks to trade individual mortgages, which the regulators deemed risky, for mortgage-backed securities, which the regulators deemed safe—as long as they were guaranteed by Fannie or Freddie, or were rated AA or AAA. The bankers’ repudiation of the higher-yielding AA bonds shows that they were not deliberately courting risk. But the regulators’ judgment about the risklessness of AAA mortgage-backed bonds proved to be disastrously wrong—and this judgment, in the form of the Recourse Rule, made those bonds much more profitable for banks than they otherwise would have been. As a result, banks ended up buying about half of the world’s entire supply of mortgage-backed securities, and when housing prices began to drop, the uncertain value of these securities caused the financial panic of September 2008.

One lesson of the financial crisis, then, is that regulators, like bankers, are human. Nobody can flawlessly predict the future, but regulators—like bankers and other businesspeople—have no choice but to try.

There is a difference, however. Competing businesses may pursue a variety of strategies based on divergent risk/reward assessments. Citigroup jumped into mortgage-backed bonds with both feet, even opening its own securitizing unit to transform mortgages into mortgage-backed securities. J. P. Morgan thought the risk was too great and went in the opposite direction, even though that meant passing up the extra rewards offered by the Recourse Rule. Such heterogeneous behavior is perhaps the one saving grace of capitalism. By behaving heterogeneously in order to compete with each other, capitalists spread society’s bets among a variety of ideas about the location of risk and reward.

Capitalists as a group aren’t smarter or better at predicting the future than regulators are, and when capitalists fall victim to the herd mentality, they may homogeneously converge on a mistaken prediction. This is a danger, but regulations aggravate it. Of necessity, a regulation homogenizes capitalists’ behavior. Prudential bank regulation, for instance, imposes one idea about risk on the whole banking system, skewing the various risk/reward calculations of all bankers in a direction the regulators deem safe. If the regulators turn out to be mistaken, as they were in 2001, they put the whole system at risk.

The Bernanke plan is intended to reduce the risk taken by banks, but by homogenizing all banks’ compensation practices, it may actually aggravate systemic risk. To take such an action with no evidentiary basis flies in the face of reason.

--Jeffrey Friedman and Wladimir Kraus

Katarina Juselius on Is Beauty Mistaken For Truth? A Marchallian Versus a Walrasian Approach to Economics

2009-10-01T10:52:00.004-05:00

In his New York Sunday column Paul Krugman launches a blistering attack on mainframe macro (mostly based on representative agents with rational expectations who maximize over an infinite future). John Cochrane launches an equally blistering response rhetorically beginning with:
“Krugman, says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong.”
No doubt, there are quite a number of economists, not to mention non-economists, that would nod at least in partial agreement with the above. As a result of the crisis, such views have manifested themselves in numerous critical articles in the press and in a chorus of critical voices (including the English queen!) demanding that standard textbooks in economics should be re-written. Also, a number of economists have triumphantly declared ‘I told you so, Keynes is right after all!’ But isn’t the latter just a foreseeable reaction by those whose papers were previously rejected by editors of top economic journals and whose proposals were largely ignored by policy makers? Loosely interpreted this seems more or less what Cochrane says in his response to Krugman’s critique. So, has Cochrane a valid point in saying that Krugman has misled New York Times readers with his outdated Keynesian insights?

I believe this is a question of considerable interest both among economists and the general public and have tried to address it based on my experience as an empirical econometrician over a period over roughly 25 years. Let me say it right from the beginning: when we let the data speak freely (in the sense of not constraining the data according to one’s economic prior without first testing such restrictions) they mostly tell a very different story than the one found in standard textbooks. No doubt, our fast changing reality is infinitely more rich and complicated than the models which are discussed there. This does not necessarily mean that these models are irrelevant; it only means that abstract theory models and the empirical reality are two very different entities. Therefore, it did not come as a big surprise that very few observers came close to predicting the scale of the global financial and economics crisis that erupted in August 2007, and that those who did predict a massive correction in financial markets, with the associated impact on the real economy, typically relied on anecdotal evidence and rule-of-thumb indicators that are far less sophisticated than the models employed by central banks and leading academics (Colander et al. 2009).

What lessons can we draw from the widespread failure of central bank modelling and forecasting prior to the crisis? Which considerations need to be built into future models to improve their predictive power? Cochrane essentially argues that the efficient market hypothesis tells us that there is no need to do anything. This is just what one should expect to happen in a market economy every now and then: “it is fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences.”

But is this really so? The efficient market hypothesis says that nobody should be able to systematically make money by predicting future outcomes. This has generally been interpreted to mean that financial prices should behave like a random walk and this hypothesis has certainly been tested many times. The problem is that the univariate random walk hypothesis is all too simple as a test of the EMH. For example, if we assume for a moment that stock prices in general should be affected by the level of savings and investments in the economy, it would be reasonable to assume that stock prices would have a common component. In that case some linear combination would very likely be cointegrated and, hence, testing the random walk hypotheses in a multivariate setting would reject the hypothesis (which is what we find). This, however, does not as such imply a rejection of the EMH. If everybody reacts on the common information (though not according to the Rational Expectations Hypothesis) the market may not be able to systematically make money. Over the long run prices would converge to a level that could, for example, be consistent with a Tobin’s q level or a constant price/earnings ratio, and would therefore in a broad sense be predictable. But, even though the EMH might be right over the very long run, over the medium run of say 5-10 years, unregulated financial markets are likely to produce persistent swings in asset prices (Frydman and Goldberg, 2009) which are basically inconsistent with the following two interrelated assumptions:

1. Financial markets tend to drive prices towards their fundamental equilibrium values
2. Financial markets pricing behaviour is influenced by fundamentals in the real economy, but it does not change the fundamentals.

While most rational expectations models are implicitly or explicitly based on the above assumptions, empirical evidence (when letting data speak freely) suggest that financial markets drive prices away from fundamentals for extended periods of time with strong effect on the real economy. This is what George Soros has named reflexivity between the financial and real sector of the economy. Since it undermines the idea of unregulated financial markets as a guarantee for efficient capital allocation, reflexivity is an important feature of free financial markets that need to be included in our economic models.

Could empirical analysis have signalled the looming crisis? Already many years before the bubble burst, the relative house-consumption price index exhibited very pronounced nonstationary behaviour. Such movements of house prices away from ordinary consumer prices was (primarily) facilitated by low price inflation and interest rates. Prior to the bursting of the bubble, the house – consumption price ratio increased almost exponentially signalling that house prices were moving far away from their sustainable level, given by the level of inflation and interest rates. This, in my view, would have been the absolutely last moment for the authorities to react to prevent the subsequent disaster. But, the empirical result that the extraordinary high level of house prices were sustainable only by the extraordinary low levels of nominal interest rates and inflation rates should have been a reason for concern much earlier.

Has beauty been mistaken for truth? Assume for a moment that economists would agree that a minimum requirement for a theory model to be called empirically relevant is that it would be able to explain basic empirical facts as formulated in terms of the pulling and pushing forces estimated from a correctly specified and adequately structured VAR model. In such a case I would not hesitate to answer the above question in the affirmative. Economic data, when allowed to speak freely, often tell a very different story than being told by most Walrasian type of models. If anything, the stories data tell have much more a flavour of Keynesianism (though not New Keynesianism!) than Neoclassicism (or other recent isms). But when this is said, I doubt whether it is a good idea to ask which school is right and which is wrong. In some periods, one school seems more relevant, in other periods, it is another one. Quite often data suggest mechanisms which do not fit into any school. But, I am convinced that relying on beautiful but grossly oversimplified models as a description of our economic reality may easily prevent us from seeing what we really need to see. For example, I believe information about looming crisis was there in sufficiently good time to have helped us see the coming disaster, had we chosen to look carefully.

To conclude: I believe many economists were indeed blinded by the beauty of their theory models and in my view Krugman was right to point this out to the readers of NY Times.

Katarina Juselius

The full article can be downloaded here.

Alan Kirman on What's Wrong with Economics

2009-09-29T10:48:00.004-05:00

Alan Kirman, one of our contributors, was unable to post this himself for technical reasons:

The first thing that comes to mind, as one reads through the various postings about the crisis, is that economic theory was locked into a bubble which has now burst--and that the reactions have either to ignore this (John Cochrane) or to herald the return of one of our old heroes, Keynes (Paul Krugman). Economists seem to have been victims of extremely short memories and an incapacity to anticipate what the next theoretical developments will be. We periodically come to believe that we have hit upon the "right model" and that all previous efforts can be consigned to the waste basket of history. When the current model turns out to be completely at odds with reality, the reflex reaction seems to go back to the previous model and to chide the modernists for having lost sight of it. Dave Colander has tried to add a little historical perspective, but the debate remains very short sighted and ideologically motivated.

All of this seems to be misplaced. Supposing that we accept that economic theory, like the economy, is a complex adaptive system. Then we should expect to see it continually evolving and being modified to take into account both new theoretical insights and the evolution of the economy itself. We will not see theory evolving toward a given model which more closely represents the economy, since the economy itself is changing.

However, we might expect theory to evolve to at least be able to envisage the occurrence of the major crises that periodically shake the economy. We might then avoid the usual habit of falling back on the standard equilibrium notions and claiming that some major exogenous shock has hit the system. The latter sort of claim rarely identifies the shoc,k and as Bouchaud has shown, almost every significant turning point in all of the major stock price indices was accompanied by no notable news, and hence shock, at all.

Thus these large and abrupt movements must be due to the endogenous dynamics of the system. What has become the standard macroeconomic model--Dynamic General Stochastic Equilibrium (DGSE), for insiders--is justified by its proponents on the grounds that it has more "scientific" foundations than its predeceesors. By this is meant that it is based on rational maximising individuals. But there are two problems with this. First, we have known since the mid-70s that aggregating the behaviour of lots of rational individuals will not necessarily lead to behaviour consistent with that of some "representative agent." Second, the axioms that are used to define "rationality" are based on the introspection of economists and not on the observed behaviour of individuals. Thus, we have wound up in the weird position of developing models which unjustifiably claim to be scientific because they are based on the idea that the economy behaves like a rational individual, when there is a wealth of evidence to show that the rationality in question has little or nothing to do with how people behave.

Why do I say we do not look back far enough? Consider the Efficient Markets Hypothesis which has ruled the roost for some years in finance. Its originator was, by common accord, Bachelier, who developed the notion of Brownian motion at the turn of the twentieth century. His argument that stock prices should follow this sort of stochastic process, after years of being ignored, was acclaimed by economists both for analytic and ideological reasons. Yet, shortly after having written his report on Bachelier’s thesis, the great French mathematician Henri Poincaré observed that it would not be sensible to take this model as a basis for analysing what happens on financial markets. As he said, individuals who are close to each other, as they are in a market, do not take independent decisions, they watch each other and it is always herd behaviour that persists. Thus Poincaré clearly envisaged one of the most prevalent features of financial markets long before modern economists took this theme up to explain "excess volatility."

With regard to modern macro models, the same Poincaré wrote to Walras and chided him for his assumptions of infinite farsightedness and infinite selfishness. The latter he could believe at a pinch, but the former he found dubious, to say the least. Yet, while in other areas of economics we have moved on from these assumtptions,we are still faced today with macro models in which these two assumptions are central.

This brings me to my second point. Why are we so reluctant to envisage different models and different tools? As somebody said, we went through the twentieth century developing and perfecting a model based on nineteenth century physics; perhaps in the twenty first century we could move on to a model based on twentieth century physics. But as Paul Krugman has pointed out, the vested interests are strong and to ask economists to take up a new set of tools is probably asking too much. To discard equilibrium in the standard sense and to move on to study out of equilibrium dynamics is perhaps too big a step. To place externalities, the influence of one person’s actions on another, at the centre of the action rather than to regard them as "imperfections" in our equilibrium model is a necessary step. But if we argue that the interaction between individuals is important, then we have to specify the structure of that interaction. This means that we have to study the structure and fragility of the networks which govern the interaction between individuals and again to make this central in our analysis and not just a peripheral, albeit fascinating, topic.

Such changes are essential if we are to progress, but the inertia in the economics profession is strong and whilst the economy has shown that it is capable of sliding rapidly into a new phase, economists may well self organise to prevent this from happening to them in the immediate future. But in the end we will move on, for as Max Planck said, "A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it."

--Alan Kirman

The Basel Rules & the Crisis

2009-09-24T16:20:00.006-05:00

Here is (believe it or not!) a very illuminating blog discussion (illuminating blog discussions are a bit like black swans) regarding whether bank-capital regulations, even if they did help cause the crisis, can justly be blamed on the regulations themselves or on the bankers who took advantage of them to "leverage up." The discussion was prompted by my post here last week and was begun by Mike Konczal of the Atlantic business blog. All credit to him for pushing me on whether a regulatory inducement (as opposed to a command) constitutes a form of deregulation, not regulation.

Also relevant: an article on bank capital from today's Financial Times.

Frydman and Goldberg on "Rationality"

2009-09-24T10:13:00.004-05:00

A very important piece on the impossible standards of economic rationality that lead, in reaction, to claims of "irrationality"; coauthored by Roman Frydman of NYU and Critical Review contributor Michael Goldberg of the U. of New Hampshire.

John Taylor's new blog

2009-09-23T09:35:00.001-05:00

http://www.johnbtaylor.com/

Posner on Friedman on Posner on the Crisis

2009-09-20T12:54:00.008-05:00

I invited Judge Richard Posner--who will be contributing a postscript to the book version of Critical Review's special issue on the causes of the crisis--to post a reply to my review in The Weekly Standard of his book, A Failure of Capitalism (Harvard, 2009). And here it is:

I fear that my book may not have conveyed with adequate clarity my views about the economic crisis. The depiction of those views in Jeffrey Friedman’s review does not correspond to what I thought I was saying. He says that the “heart of Posner’s case against ‘capitalism’ is the…theory…[that] perverse incentives, created by banks’ executive-compensation systems, caused the crisis.” That is not my position at all. For one thing, I do not mount a “case against ‘capitalism.’” I believe in capitalism. I merely argued that capitalism is apt to run off the rails without (and here I am quoting from Friedman’s review) “active and intelligent government.” I attribute the financial collapse of last September that deepened a recession into something grave enough to warrant the name of “depression” to unsound monetary policy by the Federal Reserve and to excessive deregulation, coupled with lax regulation, of the financial services industry. Friedman I think agrees, at least about regulation (he doesn’t mention monetary policy at all), as when he remarks that banks’ leverage ratios are regulated by law and “this law, unmentioned by Posner, was probably the main cause of the crisis.” The decision by the SEC in 2004 to allow broker-dealers (Merrill Lynch, Goldman Sachs, Lehman Brothers, etc.—major components of the “shadow banking” system, which played a bigger role in the financial collapse than the commercial banks) to increase their leverage is an example of excessive deregulation, which was indeed, as I emphasize throughout the book, a main cause of the crisis.

Friedman appears to agree that regulatory ineptitude created an environment in which rational self-interest drove bankers to take risks that were excessive from a macroeconomic standpoint. That and unsound monetary policy were the main causes of the crisis—as I argued, I thought clearly and indeed emphatically, in the book (as in my subsequent blogging on the crisis in my Atlantic blog, which is also called “A Failure of Capitalism”).

I never said, by the way, as Friedman thinks I did, that the banks were “heedless of the risk” of risky lending. I said they took risks that seemed appropriate in the environment in which they found themselves. They probably were heedless of macroeconomic risk, but as I explain in the book it is not the business of private business to avoid actions that create external costs, such as the costs borne throughout the economy when the financial system collapses. The responsibility for controlling those costs are the government’s, and it was discharged poorly.

I do think executive-compensation practices played a role in the crisis, and Friedman does me the courtesy of describing my theory of how the practices affected the behavior of banks “logical.” But he is incorrect to suggest that I think the practices “caused” the crisis. They were a causal factor, but not a principal one; the main ones, as I thought I had made clear in my book, were as noted above.

He does make the good point that to test the theory would require correlating different banks’ compensation schemes with different banks’ losses; I don’t believe that that’s been done.

He points out correctly that banks structured as partnerships would be more risk averse than banks that are structured as corporations (because of the limited liability of shareholders), but it is unrealistic to suppose that banks of the scale of the major modern banks could attract sufficient equity capital as partnerships—precisely because of the greater financial risk borne by a partner than by a shareholder. Friedman’s example of a financial company organized as a partnership—Brown Brothers Harriman—has partnership capital of only about $500 million. Goldman Sachs’s market capitalization of almost $100 billion is 200 times greater.

But I agree that the tax laws are among the deep underlying causes of the economic crisis, in particular the deductibility of mortgage and home-equity interest (but not other interest) from personal income tax, which encourages risky investment in housing, and the favorable treatment by the tax code of debt versus equity, which encourages leverage. I do not dwell on these causes of the crisis in my book because they will not be changed. In contrast, improvements in monetary policy and in regulation are at least within the realm of the possible, though perhaps unlikely.

--Richard A. Posner

Has the Recovery Been "Unstimulated"?

2009-09-20T09:03:00.007-05:00

In James Hamilton's reply to the Scott Sumner article linked below, Hamilton raises a separate issue in pointing out that in October 2008, "the Fed began paying interest on reserves, in effect borrowing directly from banks, and creating an incentive for banks to hold the newly created deposits as a staggering burgeoning of excess reserves . . . preventing its actions from increasing the value of M1." Hamilton is suggesting that the monetary stimulus could not have worked, since the huge wave of liquidity created by the Fed was sequestered inside the banks.

In conjunction with the John Taylor article posted below, which argues that the fiscal stimulus did not work, the implication of Hamilton's point would seem to be that the current economic recovery has occurred as a "natural" process, unstimulated either by fiscal or monetary policy.

Was It Actually a Monetary Crisis?

2009-09-20T08:49:00.004-05:00

In the first post in a debate on Cato Unbound, Scott Sumner argues that contrary to the general consensus of the papers in Critical Review, the crisis was indeed "macro"--caused by contractionary monetary policy in the summer and fall of 2008--rather than being a "financial" crisis caused by banks' misinvestments in mortgage-backed securities.

"Why Austrians, Keynesians, Monetarists, and Other Economists Are Wrong about the Crisis"

2009-09-19T13:28:00.004-05:00

From Scott Sumner, ht David Levey.

"The Stimulus Didn't Work"

2009-09-18T10:31:00.002-05:00

The latest from contributor John Taylor.

Three Myths about the Crisis: Bonuses, Irrationality, and Capitalism

2009-09-14T12:25:00.030-05:00

With a year having passed since the start of the greatest economic crisis in our lifetimes, you’d think we would know a lot more now than we did then about what caused it. Yet by the spring of 2008, a three-part conventional wisdom about the crisis had taken hold that still governs mainstream thinking about what happened and why—even though there was never any evidence in favor of the conventional wisdom, and there is now much evidence against it.

The Myth of Irrational Exuberance

The first part of the conventional wisdom began to make its way into public consciousness soon after September 15, 2008, when most people thought of the crisis as a burst housing bubble. Bubble talk naturally leads to visions of “irrational exuberance,” and the notion that home buyers, bankers, and investors had irrationally thought that house prices would keep rising forever quickly took hold.

But in reality, very sober housing experts and economists (including Ben Bernanke) agreed that there was no bubble, and there was nothing “irrational” about this consensus. After all, housing prices had risen steadily since the Depression as the U.S. population grew and its affluence increased. Why shouldn’t people keep buying bigger, more expensive homes? There had never been a significant nationwide housing bubble, and housing speculation in “hot” markets such as Miami and Las Vegas could be quite rationally dismissed as localized. Those who dismissed the bubble may have been wrong--but they had good reasons for their error; there was nothing irrational about it. Likewise for those who participated in the bubble. For instance, Peter Wallison points out that in most states, “no-recourse” laws effectively removed penalties from home buyers and house flippers who walked away from their mortgages if their investments went sour.[1] So there was a legally sanctioned incentive to gamble on rising prices, and it was hardly irrational for people to take advantage of this incentive by buying into the bubble.

Although careful scholars have grouped psychologically established behavioral biases under the term "irrationality," in the present context the term can easily become an emotionally satisfying but non-explanatory explanation for people’s mistakes. In retrospect, housing investments premised on ever-rising prices can be labeled “irrational,” but the label explains nothing about why people actually made their mistakes.

The Myth of Bankers’ Bonuses

Eventually scholars and pundits began to realize that even a burst housing bubble was not enough to have caused the crisis,[2] since what we were experiencing was a banking crisis (albeit one that was triggered by a burst housing bubble). Many banks had invested heavily in triple-A rated tranches of subprime mortgage-backed securities, and when delinquencies and defaults on subprime mortgages began to spike, the price of these tranches began to fall, calling into question the solvency of banks that had invested in them. But since nobody knew which banks had the biggest subprime investments, or how far the value of these investments would eventually fall, the effect of the sudden re-evaluation of their soundness was to trigger interbank panic, a lending freeze, and the recession; or so most scholars now believe.

How can the banks’ investments in subprime mortgage-backed securities be explained? Here, too, "irrationality" could be invoked, since it can be used as an all-purpose tool to "explain" any error. But self-interest, i.e., "greed," is always the most popular explanation among economists—and the general public. So a new idea took root: Far from being irrational, bankers knew how risky these investments were, but made them anyway because they were paid big bonuses for short-term profits.

This “executive compensation” theory of the crisis is now the keystone of the conventional wisdom, having been embraced by President Obama, the leaders of France and Germany, and virtually the entire financial press. But if anyone has evidence for the executive-compensation thesis, they have yet to produce it. It’s a great theory. It “makes sense”—we all know how greedy bankers are! But is it true?

The evidence that has been produced suggests that it is false.

For one thing, bankers were often compensated in stock as well as with bonuses, and the value of this stock was wiped out because of the investments in question. Richard Fuld of Lehman Brothers lost $1 billion this way; Sanford Weill of Citigroup lost half that amount. A study by Rüdiger Fahlenbrach and René Stulz [3] showed that banks with CEOs who held a lot of stock in the bank did worse than banks with CEOs who held less stock, suggesting that the bankers were simply ignorant of the risks their institutions were taking. Journalists’ and insiders’ books about individual banks[4] bear out this hypothesis: At Bear Stearns and Lehman Brothers, for example, the decision makers did not recognize the risks until it was too late, despite their personal investments in the banks’ stock.

Perhaps the most powerful evidence against the executive-compensation thesis, however, is that 81 percent of the mortgage-backed tranches purchased by banks were rated AAA[5], and thus produced lower returns than the double-A and lower-rated tranches of the same mortgage-backed securities that were available. Bankers who were indifferent to risk because they were seeking higher return, hence higher bonuses, should have bought the lower-rated tranches universally, but they did so only 19 percent of the time. And most of those purchases were of double-A rather than A, BBB, or lower-rated, more-lucrative tranches.

The Myth that Capitalism Caused the Crisis

Both the myth of irrational exuberance and the myth of bankers’ bonuses have contributed to the notion that the excesses of capitalists—whether irrational excesses or self-interested ones—were the root cause of the crisis. Without the first two myths, however, the “Capitalism Did It” thesis itself begins to look more like a myth than a reality. Obviously capitalists were involved in the crisis—bankers were not government officials. But with irrationality and bonuses out of the way, the question is why bankers bought those triple-A mortgage-backed securities, and the answer may well lie in the regulations promulgated by government officials.[6]

Had bankers been looking for the safety connoted by triple-A ratings, they could have bought Treasurys, which were even safer. If they were looking for yield, they could have bought double-A or lower-rated bonds. And why mortgage-backed bonds? The answer seems to be an obscure rule enacted by the Fed, the FDIC, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision in 2001: the Recourse Rule, an amendment to the Basel I accord that governed banks' capital minima.

Under the Recourse Rule, an AA- or AAA-rated asset-backed security, such as a mortgage-backed bond, received a 20-percent risk weight, compared to a zero risk weight for cash and a 50-percent risk weight for an individual (unsecuritized) mortgage. This meant that commercial banks could issue mortgages—regardless of how sound the borrowers were—sell them to investment banks to be securitized, and buy them back as part of a mortgage-backed security, in the process freeing up 60 percent of the capital they would have had to hold against individual mortgages. Capital held by a bank is capital not lent out at interest; by reducing their capital holdings, banks could increase their profitability.

To be sure, banks that bought mortgage-backed securities to reduce their capital cushions were, indeed, knowingly increasing their vulnerability if the investments turned out badly. But absent the Recourse Rule, there is no reason that banks seeking a safe way to increase their profitability would have converged on asset-backed securities (rather than Treasurys or triple-A corporate bonds); thus, they would not have been so vulnerable to a burst housing bubble. The Recourse Rule artificially boosted the profitability of a certain type of investment that the Fed, the FDIC, and the other regulators thought was safe.

We know in retrospect that the capitalists who took advantage of the Recourse Rule, such as those at Citibank, were making a mistake. But not all capitalists made this mistake, even though it was costly for them to turn down the higher profits offered by the Recourse Rule. JPMorgan, for instance, recognized the danger and escaped destruction. None of these capitalists were irrational; all were self-interested; yet they had different perceptions of how to pursue their self-interest, based on different perceptions of risk.

In relatively unregulated markets, this diversity of viewpoints is precisely what makes capitalism work. One capitalist thinks that profit can be made, and loss avoided, by pursuing strategy A; another, by pursuing strategy B. These heterogeneous strategies compete with each other, and the better ideas produce profits rather than losses. In a complex world where nobody really knows what will work until it is tried, competition is the only way that people’s endless capacity for error can be checked, and loss is the regrettable but inescapable result.

In the banking industry, however, bankers’ heterogeneous strategies were homogenized (although not entirely) by the Recourse Rule, which loaded the dice in favor of the regulators’ ideas of where risk did and did not lie.

The regulators thought that AA or AAA tranches of asset-backed securities were 60-percent safer than individual mortgages. To be sure, this was not an “irrational” theory, either: The tranching structure created by Moody’s, Standard and Poor, and Fitch had a lot to be said for it, and even the little-known fact that the SEC had effectively conferred oligopoly status on these three rating companies[7] did not guarantee that disaster would follow from placing further official weight on their ratings. But the crucial fact is that however reasonable it seemed at the time, the Recourse Rule imposed a new profitability gradient over the bankers’ calculations, producing the same effect that is intended by all regulations: The regulatory carrot altered the behavior of those being regulated, the better to align it with the regulators’ ideas about what would make for prudent banking. By thus homogenizing the heterogeneous competitive process, the regulators inadvertently made the banking system more vulnerable--if, in fact, the regulators’ theory turned out to be wrong.

If we seek the sources of a systemic failure, a logical place to look is among the legal rules that govern the system as a whole. Unfortunately, being legal mandates, these rules--unlike the different strategies pursued by competing capitalists--aren't subjected to a competitive process. So if they are based on mistaken ideas, we all suffer the consequences. That turned out to be the case with the Recourse Rule.

Contrary to popular belief, then, the crisis of 2008 is best described as a crisis of regulation—not a crisis of capitalism.

--Jeffrey Friedman, Editor, Critical Review

NOTES

[1] Peter J. Wallison, “Cause and Effect: Government Policies and the Housing Crisis,” Critical Review 21(2-3), 372. See http://www.criticalreview.com/crf/special_issue.html

[2] Although judging from his recent New York Times Magazine article, Paul Krugman has not yet realized this. See my earlier post on this blog, "Is Macroeconomics Relevant?"

[3] "Bank CEO Incentives and the Credit Crisis." Social Science Research Network.

[4] The best of these is William D. Cohan’s House of Cards, which shows that the chief executives and subordinate players at Bear Stearns had full faith in the triple-A ratings of the subprime securities in which they had invested. Lawrence G. McDonald and Patrick Robinson’s A Colossal Failure of Common Sense, about Lehman Brothers, inadvertently makes the same point, despite the authors’ conviction that “common sense” should have revealed to the decision makers that they were mistaken. Gillian Tett’s Fools’ Gold, conversely, shows that at JPMorganChase, Jamie Dimon and his subordinates saw great risk in mortgage-backed securities and largely avoided them.

Evidence from the Cohan and Tett books is assembled in my “A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure,” Critical Review 21(2-3): 127-84, available online.

[5] Viral V. Acharya and Matthew Richardson, "Causes of the Financial Crisis." Critical Review 21(2-3): Table 1. (See http://www.criticalreview.com/crf/current_issue.html.)

[6] We won't know with any certainty, however, that bankers did buy these securities because of the Recourse Rule until somebody actually asks them, in confidence. This research is being undertaken by Wladimir Kraus of the University of Turin.

[7] Lawrence J. White, "The Credit-Rating Agencies and the Subprime Debacle." Critical Review 21(2-3): 389-99. (See http://www.criticalreview.com/crf/current_issue.html.)

Pretence and Economic Knowledge

2009-09-12T17:33:00.001-05:00

Paul Krugman critiques the economics profession for widely shared views that failed to anticipate and ill prepared us for an economic crisis that promises to be the worst since WWII.

Hayek made a similar charge in his Nobel Lecture of December 11, 1974, The Pretence of Knowledge: “… the economists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.” Although Hayek saw the problem as stemming from an inappropriate "scientistic" attitude, he explicitly wanted “…to avoid giving the impression that I generally reject the mathematical method in economics.” Rather, his main message was that “If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible…The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society - a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.”

Economic scientists have precious little understanding of this rule governed complex order, and how to keep it on its demonstrated long term path of growth and human betterment without suffering too irreparably from the kind of unpredictable reverses that we are now mired in. Less pretence and a commitment to learn from the new data being generated as I write, will be both humbling and informative, after the inevitable human political impulse to blame one’s long standing political adversaries has run its course.

What is most impressive in the current crisis is that even those who find bubbles unsurprising, and who had warned of the housing bubble debacle, did not anticipate its ability to undermine the financial system so decisively and thereby to devastate a good performing economy. This is revealed in a fairly crisp timeline: residential home prices started their decline in 2006; mortgage market collapse in July-August, 2007 (which kick-started the Fed into taking “enhanced liquidity” measures); the fourth quarter 2008 events—the Treasury, Fed, FDIC joint announcement of crisis action, unprecedented extensions of FRB credit to holders of all varieties of underwater assets in implicit recognition that the financial system was under reserved and insolvent, not just illiquid.

Economists and policy makers have been learning as we go, and no one can be sure how long that process has yet to go.

The Failure of Economists to Account for Complexity

2009-09-12T10:32:00.008-05:00

Testimony of David Colander submitted to the Congress of the United States, House Science and Technology Committee, for the Hearing on “The Risks of Financial Modeling: VaR and the Economic Meltdown,” September 10, 2009

Mr. Chairman and members of the committee: I thank you for the opportunity to testify. My name is David Colander. I am the Christian A Johnson Distinguished Professor of Economics at Middlebury College. I have written or edited over forty books, including a top-selling principles of economics textbook, and 150 articles on various aspects of economics. I was invited to speak because I was one of the authors of the Dahlem Report [revised and republished in Critical Review vol. 21, nos. 2-3, Spring-Summer 2009] in which we chided the economics profession for its failure to warn society about the impending financial crisis, and I have been asked to expand on some of the themes that we discussed in that report. (I attach that report as an appendix to this testimony.)
Introduction

One year ago, almost to the day, the U.S. economy had a financial heart attack, from which it is still recovering. That heart attack, like all heart attacks, was a shock, and it has caused much discussion about who is to blame, and how can we avoid such heart attacks in the future. In my view much of that discussion has been off point. To make an analogy to a physical heart attack, the US had a heart attack because it is the equivalent of a 450-pound man with serious ailments too numerous to list, who is trying to live as if he were still a 20 year old who can party 24-7. It doesn’t take a rocket economist to know that that will likely lead to trouble. The questions I address in my testimony are: Why didn’t rocket economists recognize that, and warn society about it? And: What changes can be made to see that it doesn’t happen in the future?

Some non-economists have blamed the financial heart attack on economist’s highly technical models. In my view the problem is not the models; the problem is the way economic models are used. All too often models are used in lieu of educated common sense, when in fact models should be used as an aid to educated common sense. When models replace common sense, they are a hindrance rather than a help.

Modeling the Economy as a Complex System
Using models within economics or within any other social science, is especially treacherous. That’s because social science involves a higher degree of complexity than the natural sciences. The reason why social science is so complex is that the basic unit in social science, which economists call agents, are strategic, whereas the basic unit of the natural sciences are not. Economics can be thought of the physics with strategic atoms, who keep trying to foil any efforts to understand them and bring them under control. Strategic agents complicate modeling enormously; they make it impossible to have a perfect model since they increase the number of calculations one would have to make in order to solve the model beyond the calculations the fastest computer one can hypothesize could process in a finite amount of time.
Put simply, the formal study of complex systems is really, really, hard. Inevitably, complex systems exhibit path dependence, nested systems, multiple speed variables, sensitive dependence on initial conditions, and other non-linear dynamical properties. This means that at any moment in time, right when you thought you had a result, all hell can break loose. Formally studying complex systems requires rigorous training in the cutting edge of mathematics and statistics. It’s not for neophytes.

This recognition that the economy is complex is not a new discovery. Earlier economists, such as John Stuart Mill, recognized the economy’s complexity and were very modest in their claims about the usefulness of their models. They carefully presented their models as aids to a broader informed common sense. They built this modesty into their policy advice and told policy makers that the most we can expect from models is half-truths. To make sure that they did not claim too much for their scientific models, they divided the field of economics into two branches—one a scientific branch, which worked on formal models, and the other political economy, which was the branch of economics that addressed policy. Political economy was seen as an art which did not have the backing of science, but instead relied on the insights from models developed in the scientific branch supplemented by educated common sense to guide policy prescriptions.

In the early 1900s that two-part division broke down, and economists became a bit less modest in their claims for models, and more aggressive in their application of models directly to policy questions. The two branches were merged, and the result was a tragedy for both the science of economics and for the applied policy branch of economics.

It was a tragedy for the science of economics because it led economists away from developing a wide variety of models that would creatively explore the extraordinarily difficult questions that the complexity of the economy raised, questions for which new analytic and computational technology opened up new avenues of investigation.[1] Instead, the economics profession spent much of its time dotting i’s and crossing t’s on what was called a Walrasian general equilibrium model which was more analytically tractable. As opposed to viewing the supply/demand model and its macroeconomic counterpart, the Walrasian general equilibrium model, as interesting models relevant for a few limited phenomena, but at best a stepping stone for a formal understanding of the economy, it enshrined both models, and acted as if it explained everything. Complexities were just assumed away not because it made sense to assume them away, but for tractability reasons. The result was a set of models that would not even pass a perfunctory common sense smell test being studied ad nauseam.

Initially macroeconomics stayed separate from this broader unitary approach, and relied on a set of rough and ready models that had little scientific foundation. But in the 1980s, macroeconomics and finance fell into this “single model” approach. As that happened it caused economists to lose sight of the larger lesson that complexity conveys —that models in a complex system can be expected to continually break down. This adoption by macroeconomists of a single-model approach is one of the reasons why the economics profession failed to warn society about the financial crisis, and some parts of the profession assured society that such a crisis could not happen. Because they focused on that single model, economists simply did not study and plan for the inevitable breakdown of systems that one would expect in a complex system, because they had become so enamored with their model that they forgot to use it with common sense judgment.

Models and Macroeconomics
Let me be a bit more specific. The dominant model in macroeconomics is the dynamic stochastic general equilibrium (DSGE) model. This is a model that assumes there is a single globally rational representative agent with complete knowledge who is maximizing over the infinite future. In this model, by definition, there can be no strategic coordination problem—the most likely cause of the recent crisis—such problems are simply assumed away. Yet, this model has been the central focus of macro economists’ research for the last thirty years.

Had the DSGE model been seen as an aid to common sense, it could have been a useful model. When early versions of this model first developed back in the early 1980s, it served the useful purpose of getting some intertemporal issues straight that earlier macroeconomic models had screwed up. But then, for a variety of sociological reasons that I don’t have time to go into here, a majority of macroeconomists started believing that the DSGE model was useful not just as an aid to our understanding, but as the model of the macroeconomy. That doesn’t say much for the common sense of rocket economists. As the DSGE model became dominant, important research on broader non-linear dynamic models of the economy that would have been more helpful in understanding how an economy would be likely to crash, and what government might do when faced with a crash, was not done.[2]

Similar developments occurred with efficient market finance models, which make similar assumptions to DSGE models. When efficient market models first developed, they were useful; they led to technological advances in risk management and financial markets. But, as happened with macro, the users of these financial models forgot that models provide at best half truths; they stopped using models with common sense and judgment. The modelers knew that there was uncertainty and risk in these markets that when far beyond the risk assumed in the models. Simplification is the nature of modeling. But simplification means the models cannot be used directly, but must be used judgment and common sense, with a knowledge of the limitations of use that the simplifications require. Unfortunately, the warning labels on the models that should have been there in bold print—these models are based on assumptions that do not fit the real world, and thus the models should not be relied on too heavily—were not there. They should have been, which is why in the Dahlem Report we suggested that economic researchers who develop these models be subject to a code of ethics that requires them to warn society when economic models are being used for purposes for which they were not designed.

How did something so stupid happen in economics? It did not happen because economists are stupid; they are very bright. It happened because of incentives in the academic profession to advance lead researchers to dot i’s and cross t’s of existing models, rather than to explore a wide range of alternative models, or to focus their research on interpreting and seeing that models are used in policy with common sense. Common sense does not advance one very far within the economics profession. The over-reliance on a single model used without judgment is a serious problem that is built into the institutional structure of academia that produces economic researchers. That system trains show dogs, when what we need are hunting dogs.

The incorrect training starts in graduate school, where in their core courses students are primarily trained in analytic techniques useful for developing models, but not in how to use models creatively, or in how to use models with judgment to arrive at policy conclusions. For the most part policy issues are not even discussed in the entire core macroeconomics course. As students at a top graduate school said, “Monetary and fiscal policy are not abstract enough to be a question that would be answered in a macro course” and “We never talked about monetary or fiscal policy, although it might have been slipped in as a variable in one particular model.” (Colander, 2007, pg 169).

Suggestions
Let me conclude with a brief discussion of two suggestions, which relate to issues under the jurisdiction of this committee, that might decrease the probability of such events happening in the future.

* Include a wider range of peers in peer review
The first is a proposal that might help add a common sense check on models. Such a check is needed because, currently, the nature of internal-to-the-subfield peer review allows for an almost incestuous mutual reinforcement of researcher’s views with no common sense filter on those views. The proposal is to include a wider range of peers in the reviewing process of NSF grants in the social sciences. For example, physicists, mathematician, statisticians, and even business and governmental representatives, could serve, along with economists, on reviewing committees for economics proposals. Such a broader peer review process would likely both encourage research on much wider range of models and would also encourage more creative work.

* Increase the number of researchers trained to interpret models
The second is a proposal to increase the number of researchers trained in interpreting models rather than developing models by providing research grants to do that. In a sense, what I am suggesting is an applied science division of the National Science Foundation’s social science component. This division would fund work on the usefulness of models, and would be responsible for adding the warning labels that should have been attached to the models.

This applied research would not be highly technical and would involve a quite different set of skills than the standard scientific research would require. It would require researchers who had an intricate consumer’s knowledge of theory but not a producer’s knowledge. In addition it would require a knowledge of institutions, methodology, previous literature, and a sensibility about how the system works. These are all skills that are currently not taught in graduate economics programs, but they are the skills that underlie judgment and common sense. By providing NSF grants for this work, the NSF would encourage the development of a group of economists who specialized in interpreting models and applying models to the real world. The development of such a group would go a long way toward placing the necessary warning labels on models, and make it less likely that fiascos like a financial crisis would happen again.

BIBLIOGRAPHY
Colander, David. 2006. (ed.) Post Walrasian Macroeconomics: Beyond the Dynamic Stochastic General Equilibrium Model. Cambridge, UK. Cambridge University Press.

Colander, David. 2007. The Making of an Economist Redux. Princeton, New Jersey: Princeton
University Press.

Solow, Robert. 2007. “Reflections on the Survey” in Colander 2007.

NOTES
[1] Some approaches working outside this Walrasian general equilibrium framework that I see as promising includes approaches using adaptive network analysis, agent based modeling, random graph theory, ultrametrics, combinatorial stochastic processes, cointegrated vector autoregression, and the general study of non-linear dynamic models.

[2] Among well known economists, Robert Solow stands out in having warned about the use of DSGE models for policy. (See Solow, in Colander, 2007, pg 235.) He called them “rhetorical swindles.” Other economists, such as Post Keynesians, and economic methodologists also warned about the use of these models. For a discussion of alternative approaches, see Colander, ed. (2007). So alternative approaches were being considered, and concern about the model was aired, but those voices were lost in the enthusiasm most of the macroeconomics community showed for these models.

Beyond Krugman's Morality Tale

2009-09-12T10:30:00.004-05:00

Paul Krugman has become the voice of economists for many businessmen, politicians, and lay people. Thus, when he writes an article entitled “How did Economists Get It So Wrong?” (The New York Times Magazine, September 6), it’s big news. Over the past week I’ve been continually asked by acquaintances what my view is of what he had to say. It’s difficult to respond; he’s a wonderful writer, and there’s some parts of the story he tells that are nicely expressed. But there are other parts that, from my viewpoint as an historian of economic thought and an economist watcher, he got quite wrong—sufficiently wrong to warrant a response.

The biggest general problem with the story Krugman tells is that it’s so black and white. There’s the good guys—the Keynesian gang, and bad guys—the Classical/Chicago gang. That, in my view, is seriously wrong. The real story is one of shades of grey, and full of nuances; it is a story in which it is hard to tell who are the good guys and who are the bad guys. The real story is one of systemic failure of the large part of the academic economics profession which led them to pretend, and some of them to actually believe, that they understood a complex system that they did not, and still do not, understand. It’s a story of the economics profession’s failure to express their ideas and arguments with the humility with which they deserve to be told. It’s a story of a profession that has lost the enormous insights of past economists—both Keynesian and Classical.

There are three places where I'd say Krugman gets it wrong. The first is that he does a hatchet job on Classical economics. He misses the depth of Classical understanding. The second is that he doesn't make clear what Keynesian economics he is talking about when he says that Keynesian economics is the future of macro. If he is saying that the Keynesian economics of the discredited IS/LM variety is the future of macro--I think he is quite wrong. The third place where he gets it wrong is where he seems to claim that mathematics is to blame for the crisis. It isn't the mathematics; it's the use of the mathematics. See the Dahlem's group's response to Tony Lawson which can be found at: http://www.paecon.net/PAEReview/issue50/DahlemGroup50.pdf

--David Colander

Is Macroeconomics Relevant?

2009-09-07T14:18:00.017-05:00

Paul Krugman's New York Times Magazine article argues for the superiority of Keynesian rather than efficient-markets explanations of...what, exactly? Sometimes his dependent variable seems to be bubbles, other times recessions/depressions. But the topic is supposed to be the financial crisis of 2008. How does Keynesianism explain that?

As near as I can tell, here is Krugman's answer, in the fourth paragraph from the end of the article: "...prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole." Is that really what brought the world economy to its knees--the unemployment of construction workers in California, Nevada, and Florida?

There is no place in Krugman's scenario for banks; Krugman is describing what we have just endured as if it were a standard-issue recession, or depression (as understood by a Keynesian), but as a practical matter, this seems to require assuming that what we just suffered was *not* a "financial" crisis.

I am a mere political scientist. But to judge from most of the economists' research published in the (widely acclaimed!) issue of CRITICAL REVIEW that gave rise to this blog, Krugman's story is, at best, incomplete. If I'm not mistaken, every one of our contributors argues (or assumes?) that this was a banking crisis--albeit one triggered by the popping of the housing bubble. According to them, the sources of the housing bubble and of its deflation are important, but these factors did not directly cause an economic calamity of worldwide scope. Instead, the popped housing bubble caused a sharp drop in the perceived value of mortgage-backed securities held by banks, leading to a severe credit crunch--and *that* is what led to the recession.

So I wonder if Krugman has managed to escape the abstraction from reality that he criticizes as typical of economics. Perhaps part of the urge to abstraction is the tendency to assume that all recessions are alike, and so can be subsumed under one or another macro theory--in turn, perhaps, part of the economists' conviction that they are only "scientists" if they discover economic "laws."

By contrast, our contributors suggest (in my reading of them anyway) that even if a decline in aggregate demand was an end result, the cause of the crisis was a series of "micro" factors that contributed to the concentration of toxic housing debt in the banks. These factors, according to our authors, ranged from bank-capital regulations (see the papers by Viral Acharya and Matthew Richardson and by Juliusz Jablecki and Mateusz Machaj) to the rating of mortgage-backed securities as AA or AAA (Lawrence J. White) to financial deregulation (Daron Acemoglu, Amar Bhide, and Joseph Stiglitz). Even the federal and state housing policies discussed by Peter Wallison, and the monetary factors emphasized by Steven Gjerstad and Vernon Smith, Joseph Stiglitz, and John Taylor are seen by the authors as having had their effect at the micro level--by making mortgages more affordable to subprime borrowers.

Maybe macroeconomics is useful in explaining "normal business cycles" or the Great Depression, but was the Crisis of 2008 in one of these two categories?

Jeffrey Friedman
Editor, Critical Review

The "Causes of the Crisis" blog

2009-09-07T12:26:00.013-05:00

Welcome to "Causes of the Crisis." It is an experiment in scholarly discourse using what is usually the worst venue for careful discussion--the blog.

The Critical Review Foundation, the nonprofit foundation that is the blog's sponsor, hopes to encourage reflection on what caused the financial crisis, and on what the implications are for the financial system, the economy, the study of economics, the polity, and the study of politics. We hope to discourage polemics and ideological posturing, so these will be ruthlessly hunted down if they appear in the Comments section.

The distinguished contributors to this blog published articles in CRITICAL REVIEW vol. 21, nos. 2-3 (Spring-Summer 2009), a special issue on the causes of the crisis. Consistent with an ancient editorial policy of CRITICAL REVIEW, the special issue focused only on the past--what caused the crisis?--not on the future--what should be done about it? This self-imposed constraint is consistent with Max Weber's view of the proper role of social science, which is to understand, not to advise.

That will be the aim here, too. There is all too much policy advocacy in the world today, and it tends to engage emotions and "priors"--pre-existing beliefs about what has caused major social problems. So we shall confine ourselves to addressing the basis of future "priors" about the crisis by asking what did, in fact, cause it. We will leave the policy recommendations to the pundits.

This does not mean that our focus will be narrow or inaccessible, however. Factors that have been identified as possible causes of the crisis range from glitches in financial technology to normal business-cycle movements to major problems in financial capitalism and/or in attempts to regulate it. Big factors as well as small ones will be our concern.

The authors of articles in the special issue of Critical Review, all of whom have been given authorization to post blogs, are:

Daron Acemoglu (MIT)
Viral V. Acharya (NYU)
Amar Bhide (Columbia Univ.)
David Colander (Middlebury Coll.)
Michael Goldberg (Univ. of New Hampshire)
Steven Gjerstad (Chapman U.)
Michael Goldberg (U. of New Hampshire)
Armin Haas (Postdam Inst.)
Juliusz Jablecki (Polish Central Bank)
Katerina Juselius (U. of Copenhagen)
Alan Kirman (Univ. d'Aix Marseille III)
Thomas Lux (U. of Kiel)
Mateusz Machaj (U. of Wroclaw)
Matthew Richardson (NYU)
Brigitte Sloth (U. of Southern Denmark)
Vernon L. Smith (Chapman U.)*
Joseph E. Stiglitz (Columbia U.)*
John B. Taylor (Stanford U.)
Peter J. Wallison (American Enterprise Inst.)
Lawrence J. White (NYU)

* = Nobel laureate in economics

--Jeffrey Friedman (U. of Texas, Austin)
Editor, Critical Review