More on Economists, Black Swans, and Government Regulatory Policies

Responses to Keynes, Krugman, Black Swans et al warrant further comment.

 Richard, a real estate expert, said this:

 …this recent real estate decline was entirely predictable, based upon a study of cycles over the last 200 years.  And I will go further to predict that the next big real estate bust will be in approximately 2026, with a secondary decline in the 2017-2018 period. Unfortunately, we’ve got a long wait to see whether I’m right!

 I agree fully with Richard: Economists have documented that there are real estate cycles. Find me an economist who would disagree with this. Find me an economist who was arguing a real estate downturn was not due at the end of 2008.

 And what usually happens when the real estate market declines? Prices fall; real estate sales decline as sellers mistakenly expect higher prices. And some developers go bankrupt or become wards of their banks. Sooner or later, sellers bite the bullet, accept lower prices, sales pick up, the real estate bottom is reached, and the cycle continues….

 But more happened last October. Details on what caused the credit freeze and consequent global recession can be seen in an earlier posting – http://www.morssglobalfinance.com/the-global-credit-freeze-why-it-happened-and-what-is-next/. But here, let’s focus on the key factors:

• Starting more than a decade ago, the big banks stopped managing their own loans and earning income on the spread between their lending and borrowing rates;
• Instead, the big banks were joined by mortgage companies (who had no money of their own); together, they “commoditized” mortgages, selling them off and taking a commission on the sale; no more worrying about the interest spread or the credit worthiness of borrowers, just sell those loans off for commissions;
• The big banks went further: they bought up mortgages, packaged them, and sold them off again for commissions, sometimes with their own guarantees, or guarantees they got from insurance companies;
• Who knew how safe these packages were? Nobody! Only the collectors of the monthly principal and interest payments had any contact with the mortgagors;
• So when hints of a real estate downturn started in the fall of 2008, banks wondered how safe their mortgage packages were and those they had guaranteed. And they realized they had no way of knowing! Fear spread throughout the banking sector, there was suddenly no market for mortgage-backed securities, and banks stopped lending to one another. 

 Consider now some comments sent to me by Richard, a political scientist:

 The following fascinating tidbits on the current travails of neoclassical economic from the Roubini Global EconoMonitor website relate directly to your analysis.

 Overview: Neoclassical models have dominated the field of macroeconomics since the mid-1970s. The global credit crisis has raised criticism of the neoclassical framework’s blind spots, particularly its inability to predict the current financial crisis because of its unrealistic assumptions that market actors are rational and free markets correct themselves.

 Nobel laureate Paul Krugman: “So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit – and this will be very hard for the people who giggled and whispered over Keynes – that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics”. (NYTimes, September 2, 2009)

 University of Western Sydney professor Steve Keen: “Experts who didn’t see the financial crisis coming were raised solely within the neoclassical approach to economics, which has dominated the academic discipline of economics since the mid-1970s. They have been trained to uncritically believe in models of the economy based on fantasies of hyper-rational individuals (who can predict the future), markets that are always in equilibrium, and a world in which money is simply a veil over barter”. (February 6, 2009)

 LSE professor Willem Buiter: “Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered. They did not allow such questions to be asked”. (Maverecon, March 3, 2009)

 Economist Thomas Palley: “There is a family split among neo-classical economists between those who believe that real-world market economies approximate perfect competition (Chicago School) and those who don’t (MIT School). The Chicago School claims real-world market economies produce roughly efficient (so-called ‘Pareto optimal’) outcomes on which public policy cannot improve. Thus, any state intervention in the economy must make someone worse off. The MIT School, by contrast, argues that real-world economies are afflicted by pervasive market failures, including imperfect competition and monopoly, externalities, and an inability to supply public goods. Consequently, policy interventions that address market failures as well as widespread information imperfections and the non-existence of many needed markets can make everyone better off”. (February 7, 2008)

 Dresdner Bank: “The hypothesis of efficient markets is under scrutiny and the basis for many assumptions and models is looking shaky. It seems curious when theories treat the formation of bubbles in the economic process as irrelevant because free markets would always quickly rebalance themselves”. (March 2009)

 Nobel laureate Paul Krugman: “Friedman-Schwartz argued the Fed could have prevented the Great Depression if only it was more aggressive in countering the fall in the money supply. Today’s Fed has been more aggressive about monetary expansion yet the world economy is still falling off a cliff”. (January 27, 2009)

 My reaction – neoclassical models, Keynesian economics, new classical, the MIT School, the Chicago School, hyper-rational individuals, hypothesis of efficient markets: what in god’s name does any of this have to do with what happened last October? Banks packaged and sold off their mortgages for commissions, lost touch with the mortgagors, and panicked when the real estate market turned down. And this is the fault of the economics profession and their general views of how markets work? This is crazy, irrelevant talk!

 Were economists making important decisions at the big banks? They were not. Instead, individuals making tremendous sums by getting the banks to take tremendous risks were in charge. Senior bank executives cannot justify what they are being paid by just being bankers.

 Another point: Let us suppose an economist was in charge of risk assessment at Bank of America. And let us suppose further that he had the risk models that told him that with the real estate downturn, the market for mortgage backed securities would disappear and banks would stop lending to one another. I ask you two questions:

• Where would he have gotten the empirical data to back up his conclusions? Nowhere because it does not exist.
• What sort of response would he have gotten from the top brass at BofA? They would have thought he was crazy.

 Charles, a medical doctor, sent this:

 I like your article. It is very informative.

It also illustrates the effect of differences in background.

 You, the economist/statistician propose that the Black Swan lesson is that somebody who accurately predicts an unexpected event is not necessarily a person to be revered. The prediction could have been an entirely random event. I agree.

 And so does Taleb, according to my, humanist, reading of his work: namely, that random events, even those not previously known, do happen, and the prudent person never assumes that they cannot. Moreover, when the nature of the event is unknown, it can neither be predicted nor credited.

 Charles: I agree. Taleb is not part of the “can-do” economists and engineers who want to model near random acts.

 Back to Charles:

 This is but a restatement of Murphy’s Law… Murphy was a NASA Director and his meticulous search for and attention to that which might go wrong very likely made our early space efforts successful.  And for me, an aggressive physician involved with development of the laser in surgery in difficult places, attention to potential difficulties (often pointed out to me) kept me out of a lot of the troubles later reported by others.

 Charles: I see your point, but the analogy does not fit. Managing the global economy is a far cry from the near laboratory controls you have in developing a laser for surgery. We simply don’t have the controls you have. We did worry about banks: after many years of study, we developed Basel I & II, regulations that were supposed to keep banks from taking undue risks. They did not work, in part, because they were too complex for bank regulators to understand and use effectively.

 Back to Charles:

 We also have a semantic disagreement: The word humble.

 You write: “Some say that in light of this, we should all be humble: “enjoy living in a world we don’t understand”. I don’t buy it. Since the start of civilization, mankind has progressed (and retrogressed). That progression has not resulted from “being humble”. It is the result of arrogant, energetic people trying new things, failing, and trying again.”

 Again, I agree. Except that your meaning is not my meaning. As I suggest above, I have been, and probably still am among the “arrogant (why else would I argue economics with an economist), energetic people trying new things, failing, and trying again.” But I also know that I can be, have been, and will be wrong. This is humbling. But essential. History is replete (Napoleon, Hitler, etc, and probably some recent economists) with those who unwisely thought other. And Krugman seems to agree. The very title of Krugman’s article, MISTAKING BEAUTY FOR TRUTH, suggests that the current problem has been the result of arrogance unbalanced by humility. Krugman then writes: “..important was the profession’s blindness to the very possibility of catastrophic failures in a market economy.”And: “As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”And: ..”this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong”.

 In short, they forgot Murphy, ignored Taleb, and lacked humility.

 …Yes, I could be wrong….

 Charles: I think that both you and Krugman are wrong. The economists were not in charge. Both of you have an over inflated view of how much influence economists were exerting.

 But let us consider another situation where economists exerted considerable power and were mostly right. Do you remember Long Term Capital Management (LTCM) and John Meriwether, its CEO, the former vice-chairman and head bond trader at Salomon Brothers? And do you remember that its Board of Directors included Scholes and Merton, two economists who shared the 1997 Nobel Economics Prize?

 LTCM’s strategy was to “buy risk”. And they knew that there was a very good chance they would make tremendous money by buying highly leveraged risk. That is what their economists told them, and they were right. It just happened they ran into a “near-perfect storm”. What their economists told them was absolutely correct: there is a large and growing market for groups who will take over other people’s risks, e.g., reduce interest rate and exchange rate spreads for all sorts of clients. And in most cases, risk takers will make a lot of money. And why, in the few cases they lose, do the risk takers care if they using other people’s money? And they will always get other people’s money because the underlying rational for what they are doing makes such good economic sense.

 But we have to get these risk-takers out of banks! I don’t want the money we are paying the FDIC to bail these guys out! Get our banks back to something that only appeals to the green eye-shade types! See my proposal to limit FDIC insurance to banks that manage their own loans and do insignificant amounts of trading – http://www.morssglobalfinance.com/regulatory-reform-of-the-financial-industry-a-proposal/.

 We will never be able to regulate these risk-takers. Let’s stop trying. Just get them out of the banks and caveat emptor.

 Barney Frank: are you listening?