A Simple Theory of the Financial Crisis, link

by on June 8, 2009 at 2:18 pm in Economics | Permalink

A working link to my paper on the financial crisis, discussed below, seems to be here.

1 Michael F. Martin June 8, 2009 at 3:08 pm

Learning of Fischer Black’s objections, I’m beginning to realize that nobody who helped create the models really misunderstood their limits or approximations. It was the slavish imitation that came after those models produced good results.

It’s actually hard to think of a more unrealistic assumption to base a model on than that valuations are independent measurements of the same underlying distribution. Model picking up to now has been driven by tractability. Perhaps the largest social benefit to emerge from this crisis will be the realization that models must be picked (or avoided) on the basis of their possible social consequences, regardless of their tractability.

Shannon and Mandelbrot stocks are up.

2 Will McBride June 8, 2009 at 7:57 pm

“But consumption was highly robust during
the boom, especially in the United States. This fact
implies that the resources behind the real estate and
financial asset boom came from the real economy
and that the Fed is largely not to blame for the
current crisis. The presence of major financial problems in “tight money† Europe is consistent with
this interpretation.”

These are all central bank economies. And just because the ECB brought rates down to 2% rather than 1% doesn’t preclude blaming central banks. Free banks actively suppress bubbles by offsetting increased velocity with a decreased money supply. Central banks did not do this, even while it became, as you say, common knowledge that we were in a housing bubble.

3 Gabe June 8, 2009 at 8:04 pm

Will, you’ll get no where with the Fed worshipping cultist.

4 Doc Merlin June 9, 2009 at 1:36 am

I don’t understand why Neoclassical economists don’t want to use the price mechanism to set prices for interest rates? Its really odd to me, they want to use the price mechanism for everything else. The federal reserve however seems immune to this, they set the rate based on political and economic considerations instead of using the price mechanism.

5 Andrew June 9, 2009 at 6:50 am

Statistical mechanics posits that lakes don’t up and move to the left because the molecules movement averages to zero. Now, drastically reduce the number of decision-making molecules, give them all the same aspirations, and dump a big regulatory whale in the pond and soon enough your beach front will be underwater.

6 Bill Woolsey June 9, 2009 at 7:35 am

“how is that consumption must go down if fed induced investment goes up? Rather, the fed pumps up asset values and thus perceived wealth, and thus investment and consumption can, and do, both go up.”

Scarcity. There are limited resources, which results in limitions on total production. Real consumption and real investment cannot both increase at the same time when confronted by a capacity constraint.

7 Will McBride June 9, 2009 at 5:49 pm

myself, George Selgin is the guy to read on this, especially his book The Theory of Free Banking. In it he describes why the profit motive causes free banks to lend out a high percentage of their deposits. They balance the benefits of more loan interest payments with the costs of insolvency or a liquidity crisis. Historically, they kept 1% to 2% in reserves, so they were very sensitive to changes in net clearings, i.e. velocity. An increase in net clearings raises the risk of a liquidity crisis, and knowledge of this may lead to a run, so to avoid this free banks will reduce their loans to the extent they can, thus reducing the money supply to offset increased velocity. The Fed would love to do this, but lacks the local and timely knowledge, and perhaps the incentive, to do it efficiently.

8 Will McBride June 10, 2009 at 4:55 pm

Bill, I disagree with your statement:

“Credit shifts funds between and among firms and households. It doesn’t create land, labor, or capital out of nothing.”

During a credit boom, employment goes up because wages go up. In this sense it “creates” labor by pulling it off the sidelines. The labor in turn is used to create capital. Labor is not fixed in the short term, and capital is not fixed in the long term. Only land is fixed. I think our disagreement is about dynamics. Technically, you are right that an instantaneous money supply shock has no immediate effect on anything, but go out a few days, weeks, or months and it changes both labor and capital.

And again, here in this statement you are using a static analysis:

“Bob, who borrows to fund consumption, can spend more than his income. That is because someone spends less than their income instead.”

We know banks leveraged up over time, increasing the money supply out of thin air and unrelated to anyone’s income.

9 Will McBride June 11, 2009 at 11:36 pm

Maybe you’re right, but my understanding is that the global savings glut was greatly exacerbated if not primarily caused by foreign central banks defending their currencies and stock piling reserves.

10 家教 August 17, 2009 at 12:50 am

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