It is a front-page WSJ article, read it here. Excerpt:
In a 2000 academic paper, Mr. Geanakoplos offered a theory. He said that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them "natural buyers."
Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.
I thank Daniel Lippman for the pointer.
And how is this different from the hundreds of similar theories offered before?
I had the privilege to listen to him five a seminar this paper. The one thing he mentioned is that he needed to have empirical studies to prove/disprove his theory. I must say though that the paper in theory seemed valid, but the Professor himself is still waiting for empirical evidence.
I too had the privilege. Both myself and the theorists I spoke to afterward found the talk mostly incomprehensible.
And, understand how fractional reserve is like leverage and your journey to the dark side will be complete. They should of course be called unnatural buyers.
It’s almost shocking that this stuff is not better understood. I feel like Neo who said “either nobody told me, or nobody knows.” But, it’s understandable from a contrarian perspective because some people equate understanding things this way with an attack on their worldview. And you are relying on the altruism of people like me to harangue you while all the while being called names by the people on the government’s payroll. At some point we say, “hell, let’s just go make money off these fallacies.”
ooooooo, “Animal Spirits” did it.
This statement does not prove his genius.
What kind of kookiness is the “efficient Markets” theory that it is violated when individuals make bad investments and then suffer losses on those investments?
Is there some theory that says “Markets” are always allocating resources in their most efficient fashion? Uh, news flash. That theory is
wrong.
And what kind of kook thinks that a change in the
market environment (suddenly folks decide there is
too much investment in housing) leads to an uninterruptable downward spiral?
If Bill is correct, this guy is wrong. Interest rates will reflect an increase/decrease in money supply regardless of source. So interest rates, that the Fed can track is still key.
Sorry, but what happens when the supply of money increases. Interest falls. What happens when financial institutions create additional money in the system by layering collateral on collateral–using CDOs as collateral and then leveraging to make more loans. Doesn’t the money supply increase when non-bank banks increase their lending with excessive leverage on these assets? Since I’m Bill, Bill would say the professor is right, and Bill is not wrong–what the professor is saying is that excessive leverage expanded the money supply, and that is what the professor was saying as well.
I’ll be honest: I am not a monetary theorist, but that seems to me what the professor is saying and what I think probably happened.
Well gee Bill
Non Banks can increase the velocity of money and the money supply.
So the root cause becomes that the Fed kept interests rates too low for too long and Government policy supported excessive risk taking in real estate.
Money aggregates have less meaning in policy, because of non bank banks – but who really tracks that much anymore?
If you take out a blank piece of paper and draw boxes and arrows for lenders, brokers, and appraisers, it seems like the problem would jump out at you.
When your collateral value is based on the appraised value based on the last sale that was paid for by borrowed money based on the value of the collateral, how could the result be any different?
Toss in the Chinese who are repatrioting our dollars as loans to buy more stuff and the question is why it took so long to happen this big and why wasn’t it obvious?
What lies did we tell ourselves to keep the game going? What other forms can those lies take?
(8, nice)
8,
The fact that there are other sources — ancient as they may be — that reference debt and interest, provides little policy insight. Why? Because the implementations that are suggested are unworkable — the bible suggests that we charge no interest at all.
Building a workable theory of collateral and debt provides us with a framework for testing and forecasting, which were not available before. The Lucas critique suggests that model parameters should be invariant to policy changes, so that a workable model can provide reasonable predictions. Most economists would agree this is where Keynes’ work was insufficient.
An example that one can cite here is of option pricing. Sure, options existed before Black-Scholes (people who thought about it for fifteen minutes could come up with the idea), but the advent of a pricing formula made them accessible because it provided a believable quantitative framework.
Economists have struggled with this issue (collateral) for a long time exactly because of this problem, namely, that the framework didn’t exist for proper evaluation of policies, or predictions. Because of this, although cycles related to liquidity and default could be observed, they were difficult to forecast and their welfare effects were difficult to measure.
Current methods exist for a reason, not just for fun. Generally speaking, most economists actually eschew complexity, especially if it is unnecessary. However, putting all of the pieces of this model together in a realistic way creates a huge amount of complexity, and that is where the contribution of Geanakoplos’ work is most apparent.
Most countries that base national policy on religious texts don’t do a very good job on the economy.
“Why are so few economists willing to do the empirical work??”
Division of labor.
“Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets.”
That sounds wrong to me. When we’re talking about a consumption good such as a house, the value depends on people’s tastes and their ability to pay to satisfy their tastes. Thus, efficient market theory would say that if someone stops being able to borrow, the true value of their house falls. The efficient price of an asset depends on the state of the economy, and is always changing.
Comments on this entry are closed.