Economists begin to wonder -- are financial markets inherently unstable?

Justin Fox has a nice piece in the Harvard Business Review looking at how economics and finance have changed in the years since the onset of the crisis. He offers several conclusions, but one is that financial economists are now, much more than before, coming to accept the notion that financial markets are by their nature inherently unstable. Can you imagine that? From the article:

Before the late 1950s, research on finance at business schools was practical, anecdotal, and not all that influential. Then a few economists began trying to impose order on the field, and in the early 1960s computers arrived on college campuses, enabling an explosion of quantitative, systematic research. The efficient market hypothesis (EMH) was finance’s equivalent of rational expectations; it grew out of the commonsense observation that if you figured out how to reliably beat the market, eventually enough people would imitate you so as to change the market’s behavior and render your predictions invalid. This soon evolved into a conviction that financial market prices were in some fundamental sense correct. Coupled with the capital asset pricing model, which linked the riskiness of investments to their return, the EMH became a unified and quite powerful theory of how financial markets work.

From these origins sprang useful if imperfect tools, ranging from cost-of-capital formulas for businesses to the options-pricing models that came to dominate financial risk management. Finance scholars also helped spread the idea (initially unpopular but widely accepted by the 1990s) that more power for financial markets had to be good for the economy.

By the late 1970s, though, scholars began collecting evidence that didn’t fit this framework. Financial markets were far more volatile than economic events seemed to justify. The link between “beta”—the risk measure at the heart of the capital asset pricing model—and stock returns proved tenuous. Some reliable patterns in market behavior (the value stock effect and the momentum effect) did not disappear even after finance journals published paper after paper about them. After the stock market crash of 1987, serious questions were raised about both the information content of prices and the stability of the risk measures used in finance. Researchers studying individual investing behavior found systematic violations of the premise that humans make decisions in a rational, forward-looking way. Those studying professional investors found that incentives cause them to court tail risks (that is, to follow strategies that are likely to generate positive returns most years but occasionally blow up) and to herd with other professionals (because their performance is judged against the same benchmarks). Those looking at banks found that even well-run institutions could be wiped out by panics.

But all this ferment failed to produce a coherent new story about how financial markets work and how they affect the economy. In 2005 Raghuram Rajan came close, in a now-famous presentation at the Federal Reserve Bank of Kansas City’s annual Jackson Hole conference. Rajan, a longtime University of Chicago finance professor who was then serving a stint as director of research at the International Monetary Fund (he is now the head of India’s central bank), brought together several of the strands above in a warning that the world’s vastly expanded financial markets, though they brought many benefits, might be bringing huge risks as well.

Since the crisis, research has exploded along the lines Rajan tentatively explored. The dynamics of liquidity crises and “fire sales” of financial assets have been examined in depth, as have the links between such financial phenomena and economic trouble. In contrast to the situation in macroeconomics, where it’s mostly younger scholars pushing ahead, some of the most interesting work being published in finance journals is by well-established professors out to connect the dots they didn’t connect before the crisis. The most impressive example is probably Gary Gorton, of Yale, who used to have a sideline building risk models for AIG Financial Products, one of the institutions at the heart of the financial crisis, and has since 2009 written two acclaimed books and two dozen academic papers exploring financial crises. But he’s far from alone.

What is all this research teaching us? Mainly that financial markets are prone to instability. This instability is inherent in assessing an uncertain future, and isn’t necessarily a bad thing in itself. But when paired with lots of debt, it can lead to grave economic pain. That realization has generated many calls to reduce the amount of debt in the financial system. If financial institutions funded themselves with more equity and less debt, instead of the 30-to-1 debt-to-equity ratio that prevailed on Wall Street before the crisis and still does at some European banks, they would be far less sensitive to declines in asset values. For a variety of reasons, bank executives don’t like issuing stock; when faced with higher capital requirements, they tend to reduce debt, not increase equity. Therefore, to make banks safer without shrinking financial activity overall, regulators must force them to sell more shares. Anat Admati, of Stanford, and Martin Hellwig, of the Max Planck Institute for Research on Collective Goods, have made this case most publicly, with their book The Bankers’ New Clothes, but their views are widely shared among those who study finance. (Not unanimously, though: The Brunnermeier-Sannikov paper mentioned above concludes that leverage restrictions “may do more harm than good.”)

This is an example of what’s been called macroprudential regulation. Before the crisis, both Bernanke and his immediate predecessor, Alan Greenspan, argued that although financial bubbles can wreak economic havoc, reliably identifying them ahead of time is impossible—so the Fed shouldn’t try to prick them with monetary policy. The new reasoning, most closely identified with Jeremy Stein, a Harvard economist who joined the Federal Reserve Board last year, is that even without perfect foresight the Fed and other banking agencies can use their regulatory powers to restrain bubbles and mitigate their consequences. Other macroprudential policies include requiring banks to issue debt that automatically converts to equity in times of crisis; adjusting capital requirements to the credit cycle (demanding more capital when times are good and less when they’re tough); and subjecting highly leveraged nonbanks to the sort of scrutiny that banks receive. Also, when viewed through a macroprudential lens, past regulatory pressure on banks to reduce their exposure to local, idiosyncratic risks turns out to have increased systemic risk by causing banks all over the country and even the world to stock up on the same securities and enter into similar derivatives contracts.

A few finance scholars, most persistently Thomas Philippon, of New York University, have also been looking into whether there’s a point at which the financial sector is simply too big and too rich—when it stops fueling economic growth and starts weighing on it. Others are beginning to consider whether some limits on financial innovation might not actually leave markets healthier. New kinds of securities sometimes “owe their very existence to neglected risks,” Nicola Gennaioli, of Universitat Pompeu Fabra; Andrei Shleifer, of Harvard; and Robert Vishny, of the University of Chicago, concluded in one 2012 paper. Such “false substitutes...lead to financial instability and could reduce welfare, even without the effects of excessive leverage.”

I shouldn’t overstate the intellectual shift here. Most day-to-day work in academic finance continues to involve solving small puzzles and documenting small anomalies. And some finance scholars would put far more emphasis than I do on the role that government has played in unbalancing the financial sector with guarantees and bailouts through the years. But it is nonetheless striking how widely accepted in the field is the idea that financial markets have a tendency to become unhinged, and that this tendency has economic consequences. One simple indicator: The word “bubble” appeared in 33 articles in the flagship Journal of Finance from its founding, in 1946, through the end of 1987. It has made 36 appearances in the journal just since November 2012.

Too bad this shift didn't take place 20 years ago, or maybe 40 years ago.

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Shiller, Fama and all that...

I couldn't help but write a little in my latest Bloomberg column on the strange choice for this year's Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. For readers of the column I wanted to give a few more links here to some stuff I've written before on the Efficient Markets Hypothesis, an idea that I think has been cause for an enormous waste of intellectual energy over 40 years or so. It has many versions. They are either 1) clearly false and so uninteresting or 2) clearly and unsurprisingly true, and hence uninteresting. That's my opinion in short; links to more extended discussions below.

The aforementioned Prize certainly involves a weird juxtaposition of two names -- Robert Shiller and Eugene Fama -- that you wouldn't normally think of seeing together. The one, Shiller, is a great enthusiast for markets, but also a staunch realist who thinks markets can and do go awry in lots of ways, creating bubbles, wasting resources, etc. The other, Fama, is a great enthusiast for markets who thinks they never go wrong, ever, and have an almost magical capacity to steer investments wisely (I think, but it's pretty hard to know exactly what he believes). So wait -- I guess they are clearly linked after all by the label "market enthusiast." There the similarity ends.

I've written previously on a number of occasions about the dreadfully long and confused arguments over the Efficient Markets Hypothesis. See here for a general introduction, here for some very recent evidence that pretty much kills the idea in one swoop, and here for a discussion of the perversions of normal logic often used by defenders of the EMH to prop the idea up in the face of all evidence. If writing papers about the EMH was banned I think finance would immediately take a step in the right direction. I just don't think it is interesting. Saying that the "market is hard to beat" and is therefore "efficient" in some peculiar sense isn't saying much at all.

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Playing dice with our future

I have a new column out in Bloomberg. Touch on politics, I've learned, and you get an order of magnitude more comments than you do otherwise, and this is proof again (not that I choose my topics this way). Many of the comments seem particularly vicious, but I did venture to wade into the Tea Party/Government Shut Down saga, so there's no surprise.

The article is motivated by my perception -- right or wrong? -- that many people in the Tea Party movement (and many Republicans in general, perhaps) have a naively safe view of the world. They seem to believe in the inherent superiority of America and the American System -- in American Exceptionalism, if you want -- and find it hard to imagine that we could easily slip way down in the world relative to other nations. This belief persists despite all kinds of statistics showing that our standing in things like education, public health, life expectancy, quality of life, etc. has indeed dropped way down in recent decades.

This kind of naive belief in a guaranteed good future breeds, I think, dangerous complacency regarding current policy. We can reduce taxes, disregard investment in infrastructure, not worry about trying to improve the healthcare system, etc., because we are, after all, NUMBER 1, aren't we! Well no, and keeping standards high in anything from education to communications infrastructure demands investment and hard work, not just slogans and tax breaks. And defaulting on the debt might actually be quite a good way to screw up our economy quite quickly.

Anyway, my article may tries to make this point in an unusual way -- with reference to evolution, adaptation and extinction -- but that's how my brain works. The 239 comments so far make it clear that quite a few people think I'm pretty daft, although roughly half seem to agree.

BTW, for interesting perspective on what lies behind the Tea Party furor, I highly recommend this fascinating article by Thomas Edsall in the New York Times.  The word cloud at the top of this post shows the words used most frequently by people in Tea Party focus groups when talking about the country and Obama. They really seem deeply frightened that Obama is trying to turn the US into a Soviet state where old style (white) Americans won't be welcome and a majority gay/black/hispanic/other immigrant population of slackers will live entirely off government programs. As Edsall notes:

Among Greenberg’s other findings from his focus groups:

• The participants “are very conscious of being white in a country that is increasingly minority.”
• Republican voters are threatened by Obama and the Democratic Party, but they are angry at their own party leaders. “The problem in D.C. is not gridlock; Obama has won; the problem is Republicans failing to stop him.”
• Together, evangelicals and Tea Party supporters comprise more than half the party. Moderates, about a quarter of Republicans, “are very conscious of being illegitimate within their own party.”

 I find all of this quite disconcerting. Fear + ignorance generally spells trouble.

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Republicans: destroy planet if need be to stop OBAMACARE

A gem from the Borowitz Report:

WASHINGTON (The Borowitz Report)—Senator Ted Cruz (R-Texas) raised the ante in the battle over the Affordable Care Act on Sunday, telling CNN’s Candy Crowley that “destroying the entire planet is really the best and only way to stop Obamacare.”

“Look, I’m in favor of shutting down the government and not raising the debt ceiling, but let’s not kid ourselves. Those are only half measures,” he told Crowley. “If we are really serious about stopping Obamacare, we’ll destroy the entire planet.”

Explaining his proposal to a visibly alarmed Crowley, Senator Cruz said, “Obamacare is like a parasite that needs a host to feed on. If you want to kill the parasite you kill the host, and in this case that means killing this planet. As long as there’s a planet Earth, the nightmare of Obamacare could always come screaming back to life.”

While he was not specific about how he would go about destroying the planet, Cruz said, “This is something that my colleagues and I have been working on for some time.”

The Texas senator refused to speculate on whether there were enough votes in Congress to support his proposal of obliterating Earth, but he ended his interview on a personal note: “Candy, I don’t want my children and my children’s children to live in a world with Obamacare. And the best way to guarantee that is by destroying the world.”

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Ross Douthat explains the conservative movement

Today's column by Ross Douthat in the New York Times is a must read, as it is a kind of confession of what the Conservative Movement really wants, according to Douthat. What really has them so angry, he says, is the history of the last 40 years or so during which, even when the Republicans were in power, they were unable to roll back the various programs they hate so much that were established from the 1930s to the 1960s. Mostly because they discovered, quite inconveniently, that most people in America want those programs. He quotes Conservative Dave Frum from the early 1990s:

However heady the 1980s may have looked to everyone else, they were for conservatives a testing and disillusioning time. Conservatives owned the executive branch for eight years and had great influence over it for four more; they dominated the Senate for six years; and by the end of the decade they exercised near complete control over the federal judiciary. And yet, every time they reached to undo the work of Franklin Roosevelt, Lyndon Johnson and Richard Nixon — the work they had damned for nearly half a century — they felt the public’s wary eyes upon them. They didn’t dare, and they realized that they didn’t dare. Their moment came and flickered. And as the power of the conservative movement slowly ebbed after 1986, and then roared away in 1992, the conservatives who had lived through that attack of faintheartedness shamefacedly felt that they had better hurry up and find something else to talk about …

The Conservative Movement is really upset, it turns out, because the policies they long for are more or less completely out of tune with what most Americans want. Or, as Douthat prefers to rather crazily phrase it , "American political reality really does seem to have a liberal bias." (Isn't reality, by definition, unbiased??) In other words, if most people don't agree with me, they must be biased.

I recommend reading some of the comments, where NYT readers chop Douthat into little pieces. Here are a few of my favorites for amusement:

• Don Duval, North Carolina

What Mr. Douthat apparently fails to grasp is in democracies, majorities matter, and Americans have repeatedly--in both elections and opinion polls--indicated that there isn't just majority support--but super-majority support for maintaining and even strengthening the programs that formed the heart of the New Deal (Social Security) and the Great Society (Medicare)"

The right's passionate hatred for both programs--and for the true believers' obsession with dismantling both--is not shared by anyone outsider their base.

Equally bogus is their belief that conservative ideas and ideals have never Ben given a chance--if you look at Romney's--and the right's economic policy--compared the economic, tax and governance policies of Coolidge and Hoover, in the 12 years that Mellon served as Treasury Secretary--one could be forgiven for wondering why Mellon's heirs are not suing the right for plagiarism.

An America without Social Security?

That's not a new idea--we tried that for two centuries.

Ditto for a society where seniors were forced to depend upon charity for healthcare at the time in their lives where there was a high need for medical care and virtually no chance for employment that offered health benefits.

The right fights because they are convinced that a bygone era was a golden time in this nation--when all was right in America.

Far right.

• Jeff G, Atlanta

If these foolishly romantic right wingers actually got a truly smaller government, what do they imagine would fill the vacuum? Do they expect an 18th century agrarian society to spring up spontaneously? This small government fantasy might have made sense in the early twentieth century, when they were opposing FDR. It was even a silly but excusable delusion through the late twentieth century. But now it's clear that the era of the rugged individual, small town values, and decentralized authority is long gone. In its place we have an interdependent worldwide economy, multinational corporations with revenues larger than the gdp of most nations, global terror networks capable of engaging in effective asymmetrical warfare, and a rising foreign middle class competing with us for jobs and resources while our own middle class is shrinking.
There's certainly a case to be made for limiting government's growth, and for continuing to seek greater efficiencies in its dealings, and keeping markets reasonably unfettered, and protecting individual liberties. But government actually gets smaller (enough to drown it in Grover Norquist's bathtub for instance) whatever accretion of power takes it place will certainly be much less humane, enlightened, or accountable to the masses than what we have now. Some fighting for this small government fantasy are well aware that they are really fighting for corporate plutocracy (such as the Kochs) but most have just been duped.

• RDG,  Cincinnati

"But to many conservatives, the right has never come remotely close to getting what it actually wants, whether in the Reagan era or the Gingrich years or now the age of the Tea Party."

Maybe because that is because the "right", meaning the far-right of the GOP, wants a national government that resembles 1912. And that far-right are in the driver's seat.

Meantime,"American political reality really does seem to have a liberal bias." True enough. The American people don;t want Wall Street brokers handling their Social Security or vouchers for their Medicare and seem to like what the ACA (as opposed to "Obamacare") has to offer so far.

They want clean water, safe food, drugs and bridges. Leaving those and other issues to the mercies of the private sector is not always the answer.

Cut spending? How about no tanks for an Army that doesn't want them, streamlined but still effective regulation, tax loopholes that don't only benefit the very well off, the end of fee-for-service medical practices, farm subsidies to folks averaging $250 in annual income and some tightening up of welfare outlays without hurting those who really need the help.

Acting as wreckers rather than governing to make what is in place better and more cost efficient in serving the people is why the GOP enjoys the reputation it enjoys today...outside its gerrymandered districts, that is.

 Read more here.

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Some conspiracies are real...

I wrote a while back in Bloomberg about the mystery of how so little has changed in economics and finance, despite the crisis. I mentioned there the great new book, “Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown,” by economic historian Philip Mirowski. It reads a little like a conspiracy theory, as he argues that defense of the academic status quo in economics and finance also serves an array of interests in business and finance for whom the “markets always work best” mantra paves the way to profit. Hence, the profession’s claim that nothing is seriously wrong with economic thinking has found ready allies, especially in conservative and libertarian-leaning think tanks and foundations.

 The picture above is of Polish economist Michael Kalecki, who died in 1970. Lars Syll points out that Kalecki had some very wise things to say -- and not all that different from Mirowski -- about the convenience of many "principles" of economics for industrial interests:

Every widening of state activity is looked upon by business with suspicion, but the creation of employment by government spending has a special aspect which makes the opposition particularly intense. Under a laissez-faire system the level of employment depends to a great extent on the so-called state of confidence. If this deteriorates, private investment declines, which results in a fall of output and employment (both directly and through the secondary effect of the fall in incomes upon consumption and investment). This gives the capitalists a powerful indirect control over government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis. But once the government learns the trick of increasing employment by its own purchases, this powerful controlling device loses its effectiveness. Hence budget deficits necessary to carry out government intervention must be regarded as perilous. The social function of the doctrine of ‘sound finance’ is to make the level of employment dependent on the state of confidence.

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What do we know about climate?

Sad to say this is only my second post of September. I have been busy with other things... extensive travel.... re-roofing a barn... the usual. Anyway, just a couple of links I'd like to mention in connection to my most recent Bloomberg column, which appeared yesterday.

The point of my column was to emphasize just how complex the science of the Earth's climate really is. I was struck by two recent articles in Nature, both of which are worth reading. One, an excellent feature by Nicola Jones, describes a few of the counter-intuitive effects of climate, for example, how the sea can rise (or fall) in different ways in different places. Water doesn't just spread out, as you might intuitively think. It has mass, and inertia, gets blown by winds, etc., and can pile up. A short taste:

When Jeff Freymueller, a geophysicist at the University of Alaska Fairbanks, visited Alaska's Graves Harbor more than a decade ago, his marine charts showed three isolated little islands; what he saw, instead, were three grassy peninsulas connected to the mainland. That was because water levels in some parts of Alaska are dropping — by up to 3 centimetres per year.

The ground there is lifting upwards, in a slow-motion rebound that has been going on for 10,000 years, since the glacial ice sheet that once weighed down the continent receded at the end of the last ice age. Gravitational influences on the oceans are also at work: as local glaciers recede and the Greenland ice sheet melts, their gravitational pull is subtly reduced, allowing more ocean water to slop southwards.

Trends in local sea level can differ strongly from the global average, which is increasing by around 3.2 millimetres per year. “Some places, sea-level rise is ten times faster than the average,” says Jerry Mitrovica, a geophysicist at Harvard University in Cambridge, Massachusetts.

One side of this equation is the movement of the land. Canada's Hudson Bay, for example, was once buried under more than 3 kilometres of ice, and the release from that load is now causing the land to rise at about 1 centimetre per year. As that part of North America moves upwards, land to the south is being levered down: the US east coast is dropping by millimetres per year.

Subsidence can cause some areas to sink much faster. Compaction of river sediments and hollowing out of the earth by groundwater extraction, for example, are causing parts of China's Yellow River delta to sink at up to 25 centimetres per year⁴.

Adding to the complexity, the oceans do not rise evenly all over the world as water is poured in. Air pressure, winds and currents can shove water in a given ocean to one side: since 1950, for example, a 1,000-kilometre stretch of the US Atlantic coast north of Cape Hatteras in North Carolina has seen the sea rise at 3–4 times the global average rate⁵. In large part, this is because the Gulf Stream and the North Atlantic current, which normally push waters away from that coast, have been weakening, allowing water to slop back onto US shores.

Finally, waters near big chunks of land and ice are literally pulled up onto shores by gravity. As ice sheets melt, the gravitational field weakens and alters the sea level. If Greenland melted enough to raise global seas by an average of 1 metre, for example, the gravitational effect would lower water levels near Greenland by 2.5 metres and raise them by as much as 1.3 metres far away.

Scientists and engineers are only just starting to wrangle all these effects into local projections. In June, the New York City Panel on Climate Change updated its estimates of sea-level rise by including the local effects of gravitational shifts⁶. Panel members concluded that they expect to see 30–60 centimetres of rise by 2050. Finding and combining the right data sets took about six months; the exercise should pave the way for other cities to do the same, says Cynthia Rosenzweig, a climate-impact researcher at NASA's Goddard Institute for Space Studies in New York City. “We really are working to get the best science.”

Equally interesting and informative, in a very different way, is a commentary piece in the same issue by K. John Holmes. This looks at the history of the use and management of the arid lands in the central and western US. Sounds a little boring, but Holmes argues that the process then was just as messy, just as fraught with hysteria and massive disinformation, as is the current debate over climate change and what to do about it:

When nineteenth-century explorer William Gilpin travelled across the Great Plains, the expanse that covers much of the central and western United States, he marvelled at the “great pastoral region”, the dry climate of which was “favorable to health, longevity, intellectual and physical development”¹. Great cities could be built there, he imagined, taking advantage of the wealth of local resources — rivers, forests and even gold.

Geologist John Wesley Powell saw things differently. Moving from the humid east to the arid west would affect agricultural practices, occupations, social interactions and political customs, he contended^{2, 3}. Dry-land agriculture could not support a large population; any towns built in the west would need appropriate designs, irrigation and resource management. A controversy erupted.

The ensuing debates about how the arid lands should be settled hold lessons for us today on adapting to a changing climate. At their heart was a development plan for the region that Powell published in 1878 (ref. 2). It called for detailed scientific and engineering surveys, and analysis to inform land-use plans and laws. Although it addressed a spatial change in conditions caused by westward population expansion, Powell's coupling of physical and human dimensions was a forerunner to the assessment approach used today by the Intergovernmental Panel on Climate Change (IPCC).

Powell's plan was never implemented in its entirety, but it began an era in which large-scale environmental and natural-resources assessments became central to the policy process in the United States⁴. Stalled by misinformation, political controversy and recessions, legislation for allocating resources in the arid lands took decades to enact. Then, as now, the assessments and their validity became part of the debate. Eventually, extreme weather, including long droughts, pushed policy-makers to act.

Read the whole thing here. 

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