Month: September 2009

It is much deserved and here is one press account.  Here are previous MR posts on her work.  Here is an overall list of winners.  I also would draw your attention to winner Elyn Saks, who is a law professor at USC; I recommend her book on fighting schizophrenia.

Can it really be that the G20 is about to adopt elaborate
banker-compensation rules without a single study showing that
compensation incentives contributed to the crisis??

If anyone knows of any such studies, PLEASE CONTACT ME at edcritrev at gmail dot com.

That is Jeffrey Friedman, from the comments.  Please leave your reading suggestions in the comments here.  So far no one in the previous set of comments has come up with anything statistical, not even weak evidence.  Nada.  Please don't let the world violate Cowen's 2nd Law, which promises: "There's a literature on everything."

Some economists are trying to get macroeconomics off the hook by arguing that by their very nature crises are unpredictable.  Thus David Levine aggressively argues that "our models don't just fail to predict the timing of financial crises – they say that we cannot."

There are three problems with this argument.  First, it assumes what is it at question – namely whether what Levine calls "our models" are good models.  Perhaps behavioral models could better predict the timing of financial crises.  I will not push this argument but I do believe that current events call for a greater than normal willingness to think beyond the confines of the models that one defends.

Second, it's not true that "our models" tell us that we can never predict a financial crisis.  In some cases, our models predict the exact moment that a crisis will occur and these models are perfectly consistent with, indeed require, rational expectations.  It is perhaps no accident that Paul Krugman has specialized in these types of models.

Third, the word timing is misleading.  Let's accept that a crisis cannot be predicted to the day or even to the year.  Nevertheless, it is perfectly reasonably and fully consistent with rational expectations to predict an increased probability of a crisis. 

If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can't predict when the crisis will occur.  If you play with 10 bullets, I still can't predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten.  Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis.  Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one.

All of this is true even in the context of stock markets.  Efficient markets theory implies that any two stocks will have similar risk-adjusted returns it does not imply that the risk of bankruptcy is the same for any two firms.  It is perfectly reasonable to say that Google revenues are going to have to increase at a historically unprecedented rate or the stock will plummet.  It is even consistent with efficient markets theory to predict that the probability of Google stock falling is much greater than the probability of it rising (but if it rises it will rise very far, very fast).

Thus the "we could not have predicted the crisis even in theory" argument is a weak defense–even with rational-actor, rational-expectations models there are plenty of senses in which economists could have better predicted the crisis and, although this is yet to be seen, perhaps they could and will do even better with other sorts of models. 

This is an old topic but it is in the headlines again, so I pass this along, from Jeff Friedman:

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 René Stulz and Rüdiger Fahlenbrach[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.

The Stulz and Fahlenbrach abstract reads as follows:

We
investigate whether bank performance during the credit crisis of 2008
is related to CEO incentives and share ownership before the crisis and
whether CEOs reduced their equity stakes in their banks in anticipation
of the crisis. There is no evidence that banks with CEOs whose
incentives were better aligned with the interests of their shareholders
performed better during the crisis and some evidence that these banks
actually performed worse both in terms of stock returns and in terms of
accounting return on equity. Further, option compensation did not have
an adverse impact on bank performance during the crisis. Bank CEOs did
not reduce their holdings of shares in anticipation of the crisis or
during the crisis; further, there is no evidence that they hedged their
equity exposure. Consequently, they suffered extremely large wealth
losses as a result of the crisis.

It's entirely fair to argue that these tests are not decisive.  But still, the evidence isn't there — at least not yet — that executive pay was in fact the big problem.

I thank Jeff Friedman for the pointer.

I've been putting off this topic but reactions to Krugman's essay don't seem to go away.  Mark Thoma links to everyone.  Here is a Krugman post,criticizing Chicago School economists.  Via Greg Mankiw, David Levine offers the latest broadside.  Here is Alexander Rosenberg criticizing John Cochrane.

I would have preferred it if this debate had focused on what real business cycle theory — whatever its limitations — has to offer.  For instance if you are postulating a "jobless recovery," most likely you are invoking ideas from real business cycle theory.  RBC theory has been a major contribution, even if it doesn't explain the core of the recent financial crisis or even if it has some very limited one-person models.  If you think seriously about the persistence of business cycles over time, or the spread of business cycles from one sector to another, probably you are invoking ideas from real business cycle theory.  For all its prominence, Keynesian economics tends to portray states of affairs and it often has difficulty presenting a business cycle per se, such as the time paths of variables across the entire range of the cycle.  RBC theorists have formalized what a cyclical explanation, in the full sense of that term, has to look like and so they have done a big service to Keynesian ideas also.

At this point the debate is more a topic of sociology than substance.  The substantive issues will be better worked through in other forums; this forum has been spoiled.  The remaining lesson — and perhaps the major lesson — is that the Jacksonian mode of discourse does not very well suit a discussion of macroeconomic theory.

In the comments I would say stick to the issues and don't bother criticizing any of the participants in the debate.

Arnold Kling queries what I meant on that point in a recent talk.  I meant the following:

1. There is an entire class of economists — a large class at that — whose choice of problems to work on bears little relation to what they think are important issues in the real world.  I would stress, however, that it is difficult to find such economists (though there are some) at the top tier schools.  This is a bigger problem at lower tier and wanna-be institutions.

2. I commonly meet economists and other social scientists who will tell you about the implications of their latest research, yet if you ask them other questions they will respond in hushed tones of the most severe agnosticism.  For instance they will refuse to answer Robin Hanson's question about identifying large inefficiencies in the contemporary United States.

Now, if such agnosticism truly represents their actual views as human beings, that is a perfectly defensible stance.  Yet I find that many (most?) of these same people will hold very definite political views and act on them in their private lives.  They will support candidates, donate money, condemn colleagues who don't hold similar views, and so on.  In other words, they are not really agnostic on all those other issues, they just don't want their personal views subject to full analytic scrutiny.  They bifurcate the personal and the political.

This is one of my pet peeves.  It is defensible to be truly agnostic.  It is also defensible to believe that general principles of economic theory and empirics and ethics allow us to have "all things considered" policy views on matters we have not studied closely.  It is not defensible to hold such views but, under the cloak of a not-really-meant agnosticism, refuse to put them on the social science table, so to speak.

(I find that bloggers hardly ever suffer from this problem.  In many ways the core of blogging is a willingness to apply what you know to every problem you encounter, and see how good a job you can do of it in a more or less integrated fashion.)

3. Most intelligent people, in their ordinary lives, believe that other people, especially less intelligent ones, make stupid mistakes all the time, including in their decisive choices (not just in their voting).  Yet some of these intelligent people call themselves rational expectations theorists.  I don't get it.