Month: October 2008

Anna Schwartz on the crisis

She offers a clear statement of the previous default point of view:

…this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

This is almost certainly true if the number of "problem banks" is sufficiently small.  It works less well if the number of problem banks is very large.  And why might you believe the number of problem banks is large?:

1. The very actions of Bernanke and Paulson — both smart and competent people and in the case of Bernanke with libertarian sympathies — are signaling that the number of problem banks is large.

2. The credit freeze signals that the number of problem banks is large.

3. We cannot afford to take the chance that the number of problem banks is large.

4. Direct knowledge that the number of problem banks is large.

#1-3 seemed increasingly persuasive to me as the crisis went on, but it would be nice to shore up #4, which to this day remains weak.  Of course since #4 is not independent of what government is doing at any point in time, the signal extraction problem is significant.  If we see banks doing poorly, it could simply be that markets do not like the chosen remedy.  Furthermore share prices reflect what the market thinks banks are worth, but only conditional on what policies the market expects.

What econ majors think of their major

David Colander and co. give us a whole paper on this topic:

This data suggests that the presence of an unrestricted-entry business program has a positive impact on the satisfaction levels of economics majors. When such programs exist, the economics major is not forced to balance both the goals of students who would rather be in business programs with the goals of students who would study economics either way; therefore the economics major can more easily suit all of its students’ demands.

There are many more tidbits, including the following:

Students generally considered the majors more difficult at liberal arts schools than at state schools. The difference is most pronounced in economics, considered hard by 25.4% of state school students compared to 40.2% of students at liberal arts schools. At research liberal arts school, the major was considered even harder; 44.2% of students considered the economics major hard.

p.7 warmed my heart and p.11 gives the main reason for becoming an economics major: "I did well in early courses, and found it interesting."  That Smithian explanation is more important than the quest for job opportunities.  The paper is here.  Hat tip to Pluralist Economics Review.

Will the price of risk be too high or too low?

From the comments at MR:

…we had all better hope that there will be some stupid groups in the
future, because if not, then our society will be poorer due to a
societywide excessively high price of risk. an excessively high price
of risk isn’t as spectacularly catastrophic as the excessively low
price of risk of the last 10 years, but compounded over time it can do
just as much damage…

I hold a few beliefs:

1. For a while the price of risk had been too low.

2. Currently the price of risk is too high.

3. In response to the crisis, we will regulate to prevent the particular previous manifestations of #1.  The bad news is this will be an overreaction; the good news is that because of #2 the regulatory overreaction won’t matter for some while.

4. We do not know how to regulate to prevent other, future, hitherto unexperienced manifestations of an excessively low price of risk.

5. Maybe #4 is wrong, but beware of any huff-and-puff polemic discussion that is not at least considering these points.

What caused the financial crisis?

The column is titled "Three Trends and a Train Wreck."  I attempt to explain the financial crisis in as simple and general terms as possible.  Here is one paragraph:

Over all, then, the three fundamental factors behind the crisis have
been new wealth, an added willingness to take risk and a blindness to
new forms of systematic risk. All three were needed to bring about the
scope of the current mess – so that means we’ve had some very bad luck
on top of everything else.

I have about nine hundred words to flesh this out and to discuss Fischer Black as well; Black is a neglected but insightful macroeconomic theorist who starts with ideas from finance.  Here is another paragraph:

Subprime loans collapsed first because those were the investments most
dependent on relatively poor borrowers who were the most likely to
fail. Since then, we’ve seen asset values fall throughout the economy.
Subprime borrowing was the canary in the coal mine, but it was hardly
the only problem. It now seems that a wide range of asset prices were
artificially inflated. The market for contemporary art, which depends
almost exclusively on very wealthy buyers, will probably be the last
market to plummet but that development is almost certainly on its way.

One thing to keep in mind is how international the crisis has been; any explanation should start there.  I wish in the column I had had space to discuss Spain, which has had relatively prudent banking regulation but still will have one of the biggest downturns in Europe.  It is also worth considering Norway, Canada, and some of the other countries which limited their risk exposure all along.  I mention Japan, but Brazil and Mexico also already have their banking crises behind them in the former decade and they too form other valuable points of comparison.

I am not sure I understand this Daniel Davies post, but it may have some overlap with my arguments.

Addendum: You might want to read this Jacob Weisberg column saying that the financial crisis refutes libertarianism.  His paragraph starting with "There’s enough blame to go around…" is exactly the foil I had in mind.  His overall thesis is worth pondering but he doesn’t once consider any cross-sectional variation across nations; such consideration wouldn’t help his thesis.  Am I allowed to say that the experience of Iceland refutes the small nation, social democratic model?  Probably not, nor should I be.

Second addendum: Tim Harford has a humorous piece comparing the crisis to Monopoly the board game.

Markets in everything?: Mexico edition

Tens of thousands of teachers are blocking highways and seizing
government buildings across Mexico to protest a federal education
reform ending their longtime practice of selling their jobs or giving
them to their children.

…At the heart of the conflict is the "Alliance for Quality Education," a
national plan to professionalize teachers and hold them accountable for
their students’ performances. The plan was ratified in May by Mexican
President Felipe Calderon and Elba Esther Gordillo, the leader of the
country’s 1.6 million-member National Education Workers Union, and sent
to Mexico’s 31 state governments and Federal District for approval.

To buy a good teaching job costs at least $6,000.  Here is the article.  This issue is very important for the future of Mexico.  I thank John Thacker for the pointer.

Manipulation of Prediction Markets

As many people suspected someone was manipulating Intrade to boost John McCain’s stock price:

An internal investigation by the popular online market Intrade has revealed that an investor’s purchases prompted “unusual” price swings that boosted the prediction that Sen. John McCain will become president.

Over the past several weeks, the investor has pushed hundreds of thousands of dollars into one of Intrade’s predictive markets for the presidential election, the company said.

This is big news but not for the reasons that most people think.  Although some manipulation is clearly possible in the short run, the manipulation was already suspected due to differences between Intrade and other prediction markets.  As a result,

According to Intrade bulletin boards and market histories, smaller investors swept in to take advantage of what they saw as price discrepancies caused by the market shifts – quickly returning the Obama and McCain futures prices to their previous value.

This resulted in losses for the investor and profits for the small investors who followed the patterns to take maximum advantage.

This supports Robin Hanson’s and Ryan Oprea’s finding that manipulation can improve (!) prediction markets – the reason is that manipulation offers informed investors a free lunch.  In a stock market, for example, when you buy (thinking the price will rise) someone else is selling (presumably thinking the price will fall) so if you do not have inside information you should not expect an above normal profit from your trade.  But a manipulator sells and buys based on reasons other than expectations and so offers other investors a greater than normal return.  The more manipulation, therefore, the greater the expected profit from betting according to rational expectations.

An even more important lesson is that prediction markets have truly arrived when people think they are worth manipulating.  Notice that the manipulator probably doesn’t care about changing the market prediction per se.  Instead, a manipulator willing to bet hundreds of thousands to change the prediction of a McCain win must think that the prediction will actually affect the outcome.  And if people think prediction markets are this important then can decision markets be far behind?

Hat tip to Paul Krugman.

USA regulates USA — whoops!

Government regulations — numerous ones I might add — are standing in the way of the Treasury plan to recapitalize U.S. banks:

The problem is this: Under existing rules, banks cannot count the
Treasury Department’s investment as part of their core capital, the
foundation of money that supports a bank’s operations. The very goal of
the plan was to buttress those foundations, which have been eroded by
recent losses, undermining the stability of the banks.

The Fed has changed its rule to accommodate Treasury policy and so has the OCC.  But will the Office of Thrift Supervision, the Federal Deposit Insurance Corp. and state banking regulators follow suit?  Sooner or later, yes.  Get this: "All have their own capital standards and it remained unclear early this
afternoon how many of those standards might need to be adjusted."  I vote on the state authorities to come in last.

Jokes about the financial crisis

The most popular game for Icelandic families in 2009?

Go Fish!

What’s the capital of Iceland?

About $20

Iceland was a currency posing as a bank.

I went to an ATM today, and it asked to borrow a twenty till next week.

Quote of the day (from a trader): "This is worse than a divorce. I’ve lost half my net worth and I still have a wife."

In Soviet America, banks rob people because that is where the money is!

Those are from this comments section.  Do you know any such jokes?

Questions that are no longer rarely asked

Why would you leave your money in UBS?

I’m not a close observer of the company, but I have to wonder how they would now describe their business model to a new and eager customer.  Bernard Bauhofer had a funny way of putting it:

The big question is whether high net worth individuals are
willing to stay with an institution incapable of surviving on its

Meanwhile, over at the state-owned bank:      

Clients seeking to open an account last week at ZKB’s
central branch on Bahnhofstrasse in Zurich, a block from UBS’s
headquarters, had to wait as long as an hour. "We don’t know what to do with all the money right now,”
ZKB spokesman Urs Ackermann said.    

My dream

I just had a dream about economics (NB: the word "dream" means that what follows is not real).  It turned out that Fischer Black wrote a short, secret manuscript shortly before his death and that manuscript was just dug up and published in an obscure portfolio journal.  In the piece Black expresses new yet serious reservations about the idea of arbitrage.  He built a simple model in which there are four kinds of arbitrage but each serves as a substitute for investment in human capital.  The more arbitrage an economy engages in, the worse off it is in the long run.  For various second best reasons, most of all related to the concept of superfluous assets and "spanning," the arbitrage did not bring the usual welfare gains from equalizing prices across different markets.

It is rare that my dreams are so detailed or for that matter so analytical.