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October 17, 2009

Economist's View - 3 new articles

"Something is Wrong with Wall Street"

One element in the creation of bubble is people's willingness to believe that this time is different. In the present case, this time was different because of financial innovation, better monetary policy, better technology to manage shocks (e.g. digital technology reducing supply bottlenecks), and so on leading to a (supposed) reduction in overall financial risk without a corresponding reduction in returns.

But this time wasn't different, it was in many ways a rerun of the dot.com bubble, and Shane Greenstein says people are finally starting to notice. In fact, according to the argument below, the effort to address problems on Wall Street has passed the "Russ Roberts test":

This just in, something is wrong with Wall Street, by Shane Greenstein [Note: original post replaced with an updated version at the author's request]:

Please forgive the irony in the title. But I just felt like expressing sarcasm because – Ha! — many professional economists have begun to notice something is wrong with Wall Street.

Better late than never, I guess.

This recent essay/podcast from Russell Roberts is a good indication that just about everyone has noticed that Wall Street has a tin ear for its public standing, which has sunk quite low due to self-serving behavior.

In case you have not noticed what Roberts has noticed, then let me remind you. Just recently the management at Goldman Sachs announced that the firm had a very profitable quarter, which, of course, resulted in very high pay for their executives.

That is where it gets interesting. Roberts points out (correctly, IMHO) that had the government not stepped in at AIG, etc., Goldman would have gone down with everyone else. Ergo, their executives should recognize that they have a connection to taxpayer money as much as any other firm, and they should, therefore, eschew blatantly selfish and observable behavior, such as paying themselves high salaries.

Russ Roberts is normally a free market economist, but in his essay he sounds like an old fashioned populist. When a firm does something to turn Russell Roberts into a populist then — perhaps — something is actually amiss with attitudes on Wall Street.

Alright, then, so what? Well, take this observation another step or two…

What Roberts did not say

Here is what Roberts did not say, so I will. Goldman displayed a tin ear by not making any gesture at the same time they announced their profitable earnings.

What do I mean by tin ear? Here is an example. They did not announce the hiring of many (otherwise) laid off workers — as sort of a political gesture to address the need to do something about the high unemployment rate around the country.

Here is another idea. Why stop with hiring a few more employees? How about making an unusually big (I mean VERY BIG) donation to a soup kitchen — once again, as a gesture to suffering of others in these hard time.

Hmmm, here is another idea. How about doing anything mildly publicly-spirited, like buying a new fire truck for the New York city Fire Department, because the whole city is having a bad budget year? Why the New York city Fire Department? Because nobody ever has anything bad to say about firefighters in most cities, and certainly not in New York City after their sacrifice during 9/11.

Heck, once you start thinking this way, it is quite easy to find a way to spend a half billion dollars in unexpectedly large profits. But if you have a tin ear for this sort of non-selfish gesture, then the thought might never have surfaced.

And now to the point of this rant…

For those of us who live in the land of high tech, these type of observations are nothing new. The self-serving and otherwise destructive behavior of some Wall Street managers is well known…

Look, I have been around the block enough to understand that sometimes financial managers have something useful to say to high tech firms. But there is also something wrong. For example, the short-termism of Wall Street managers is legendary among high tech managers who have a long term vision for their firm but are asked to deliver revenue tomorrow. The self-serving decision making of managers who give IPOs to friends is another well known behavior (and most young firms and VCs would love to eliminate it). Another common complaint concerns the unwillingness of IPO managers to change the system if it meant a loss of control. For example, remember this? Wall Street was unwilling to conduct any IPO as an auction until Google insisted — insisted! — that the old system would not apply to them.

Enough is enough. Even guys like Roberts can see that something is amiss.

Remember the dot com madness?

It is really nothing new. Really.

Back in the late 1990s — more than a decade ago — Wall Street cheered on one of the goofiest investment bubbles I have ever seen in my lifetime (and hopefully I ever will see). It was called the dot-com boom, and, frankly, it was nuts from any rational perspective.

Yes, there are lots of explanations for the boom. There was a social dimension: Plenty of observers tried to say it was nuts. They were drowned out by crazy evangelists who ignored basic finance and who argued that price earnings ratios could be way out of whack. And it sold copy: the business media loves of a sensational story, and that did not help.

But that is why adult supervision is required in high tech. The financial professionals and auditors of this country had a professional obligation to say sober things, to ask — perhaps, insist! — that revenues align with expenses, and advise investors when such alignment has little chance of appearing. And in the late 1990s, what did the professionals do? Well, it is complicated, but, suffice to say, few of them said no to the nuttiness.

Why not? Here is a good clue in an essay by Henry Blodget.

You may recall that Blodget was a wunderkindt cheer leader for dot coms. How did he get there? Basically, he made a bold call, got himself some attention, and kept making more bold calls. His bosses saw an opportunity and replaced someone else who had the good sense to point out that the promises had considerably risk. Blodgett instead went full steam ahead because — he fully admits it — he was hired to do just that.

I do not know this fellow, nor have we ever met. I have read some of his writing. As best I can tell, Blodgett actually has a pretty smart head on his shoulders. He writes well and has the capacity to make some intelligent and deep observations.

Anyway, Blodgett eventually got himself into trouble. While I understand how someone with those sort of smarts can delude themselves enough to tempt fate for a short while — he is human, after all — nonetheless, it is beyond my capacity as a psychologist to explain how someone can do it for a long time. And he did. For several years. Until the dot com crashed, and a scandal broke, and he got banned.

There is a deeper question behind that run of several years. How did his bosses allow Blodgett to ply this trade for so long even though the wiser adults among them surely must have suspected/concluded/known that much of it was a financial charade?

The answer, of course is quite simple: they made so much money during that time. Blodgett's bosses had no reason to change anything.

Many years later Blodgett wrote about his time in this essay. He finds many reasons for explaining his own behavior. Blodget says he did it because if he did not others would. He did it because his bosses wanted him to do it. He did because everyone was making huge amounts of money from focusing on the short term benefits to their firm. All in all, he did it because it seemed like a good idea at the time.

In economics-speak, all those explanations add up to the following. Henry and his bosses simply ignored the consequences for the prudent investor or for the country as a whole — even though it had occurred to them that there was a chance that something might have gone wrong.

Let's say this in general terms. Wall Street firms had no reason to internalize the issues with systemic risk — that is, they each ignored the downside to the entire system from all of them taking on too much risk, because each of them only contributed a small amount to it. Instead, each of them pursued their own selfish interests, and made out well in the short run, sacrificing system-wide long run stability.

Summing up

Those of us who live in high tech land noticed the odd behavior of Wall Street a while ago. Finally, it seems, the macroeconomics policy crowd has started to notice the same issues, and has started to argue that — perhaps — it is time to reign this in a bit. When a free market guy like Roberts notices, you know that the sensible people are finally thinking this one through.

Like I said, better late than never.

Now, on to the serious conversation: what to do about it….I am not sure what the right answers are, but limits on executive bonuses seems like a band-aid for a systemic issue. It is too much to ask a manager who makes several million dollars a year to stop gaming the system, but it might be reasonable to ask for better auditing, more transparency for investors, tighter capital requirements for firms taking risky actions, and a few others unpleasant measures that might help us all avoid these system-wide problems.

Oh yes… until then, the executives at Goldman might consider a public spirited gesture or two, such as — I dunno' — donating a fraction of their recent profits to the New York Fire Department.

"Even guys like Roberts can see that something is amiss." So this time is different?

I want to believe that, I really do.


"Superfreakonomics on Climate"

Paul Krugman:

Superfreakonomics on climate, part 1, by Paul Krugman: OK, I'm working my way through the climate chapter — and the first five pages, by themselves, are enough to discredit the whole thing. Why? Because they grossly misrepresent other peoples' research, in both climate science and economics.
The chapter opens with the "global cooling" story — the claim that 30 years ago there was a scientific consensus that the planet was cooling, comparable to the current consensus that it's warming.
Um, no. Real Climate has the takedown. What you had in the 70s was a few scientists advancing the cooling hypothesis, and a few popular media stories hyping their suggestions. To the extent that there was a consensus, it was that there wasn't much evidence for anything, and more research was needed.
What you have today is a massive research program involving thousands of scientists and many peer-reviewed publications, with all major international bodies agreeing that man-made global warming is real. You can, if you insist, dismiss it all as a gigantic hoax or whatever — but it's nothing like the isolated 70s speculations about cooling.
And then we come to a bit of economics. The book asks
Do the future benefits from cutting emissions outweigh the costs of doing so? Or are we better off waiting to cut emissions later — or even, perhaps, polluting at will and just learning to live in a hotter world?
The economist Martin Weitzman analyzed the best available climate models and concluded that the future holds a 5 percent chance of a terrible-case scenario ..
Yikes. I read Weitzman's paper, and have corresponded with him on the subject — and it's making exactly the opposite of the point they're implying it makes. Weitzman's argument is that uncertainty about the extent of global warming makes the case for drastic action stronger, not weaker. And here's what he says about the timing of action:
The conventional economic advice of spending modestly on abatement now but gradually ramping up expenditures over time is an extreme lower bound on what is reasonable rather than a best estimate of what is reasonable.
Again, we're not even getting into substance — just the basic issue of representing correctly what other people said.
Administrative note: I'm going to block comments here, because I know it will be overwhelmed.

Robert Waldmann defends the book (here too).

I haven't read the book, and can't, at least not yet.

Brad DeLong:

Correspondence on Global Warming and Superfreakonomics, by Brad DeLong: Steve Dubner writes:
Brad,
It is amazing to see how quickly and thoroughly Romm's extremely misleading attack has spread, to the point where even independent thinkers like you accept it on face value. His attack is full of deception and outright lies. He makes it sound as if we somehow twisted and abused Caldeira's research; nothing could be further from the truth. We will have to clear this up publicly, although as you suggest it will be hard to put out this fire no matter how wrongfully set. This is politics that's being played now, nothing else. Also: yes, Romm posted a PDF of the chapter on his website, which the publisher, in its routine effort to pull pirated copies of its copyrighted material off the web, asked him to take down. As far as I know, it was never on Amazon; there's been no censoring; we are talking about a book that hasn't yet been published (when it is, I assume Amazon will post the searchable pages, as is typical), but Romm has done a great job of getting people to believe that a book they haven't read is full of errors.
I reply:
Brad DeLong to Stephen
Re: "It is amazing to see how quickly and thoroughly Romm's extremely misleading attack has spread, to the point where even independent thinkers like you accept it on face value..."
As I said, I can't read your chapter--by your publisher's choice.
That's very bad for you: Romm's posting your chapter and a link to it is a way for him to establish credibility--"see for yourself"; your publisher's pulling it down is a way to diminish yours.
Over this weekend, people's views are gelling--Paul Krugman's, for example--while your voice isn't being heard, and once people's views are gelled, it takes a huge amount of evidence and the right kinds of psychological pressure to ungell them.
Thus, for example, I would love to believe in Myrhvold and in cheap geoengineering solutions. But I come from Berkeley, where Richard Muller is the dominant public-intellectual voice on geoengineering, and he is very knowledgeable and very skeptical. My second cousin Tom Kalil does solar panels and so forth for a living at OSTP. The reaction of the climate people I know to Myrhvold on solar panels, whom Romm says you quote:
"A lot of the things that people say would be good things probably aren't," Myrhvold says. As an example he points to solar power. "The problem with solar cells is that they're black, because they are designed to absorb light from the sun. But only about 12% gets turned into electricity, and the rest is reradiated as heat — which contributed to global warming..."
is simply unprintable--that it's like claiming that curve balls curve because of photon pressure from the stadium lights.
So given what is flowing past my computer screen at the moment, it looks very much to me as though you were simply hornswoggled by Myrhvold and company, who have formed their own tight self-reinforcing intellectual community reinforcing each other's beliefs up there in Seattle. There is nothing I can see contradicting that interpretation, and a bunch of things from Romm and others confirming it.
The place where I would concentrate, if I were you, would be Stanford's Ken Caldeira. Romm claims:
"[Caldeira] writes me: 'If you talk all day, and somebody picks a half dozen quotes without providing context because they want to make a provocative and controversial chapter, there is not much you can do.' One sentence about Caldeira in particular is the exact opposite of what he believes (page 184): 'Yet his research tells him that carbon dioxide is not the right villain in this fight.' Levitt and Dubner didn't run this quote by Caldeira, and when he saw a version from Myrhvold, he objected to it. But Levitt and Dubner apparently wanted to keep it very badly — it even makes the SuperFreakonomics Table of Contents in the Chapter Five summary "Is carbon dioxide the wrong villain?..."
If your principal experts truly do repudiate the interpretation you place on their work, that's very bad for you...

Comments are open.

Update: Steven Levitt:

The Rumors of Our Global-Warming Denial Are Greatly Exaggerated, by Steven D. Levitt: SuperFreakonomics isn't even on sale yet, and the attacks on our chapter about global warming are already underway.
A prominent environmental blogger has attacked us. A well-known environmental-advocacy group pressured NPR into reading a statement critical of the book at the end of an interview I had given on Scott Simon's Weekend Edition show. Even Paul Krugman and Brad DeLong got in on the action before they'd even read the book.
We are working on a thorough response to these critics, which we hope to post on the blog in the next day or two. The bottom line is that the foundation of these attacks is essentially fraudulent, as we'll spell out in detail. In the meantime, let us just say the following.
Like those who are criticizing us, we believe that rising global temperatures are a man-made phenomenon and that global warming is an important issue to solve. Where we differ from the critics is in our view of the most effective solutions to this problem. Meaningfully reducing global carbon emissions has proven to be difficult, if not impossible. This isn't likely to change, for the reasons we discuss in the book. Consequently, other approaches represent a more promising path to lowering the Earth's temperature. , so obviously that's not the case.
The statements being circulated create the false impression that our analysis of the global-warming crisis is ideological and unscientific. Nothing could be further from the truth.

I don't get the complaint in the very first sentence. They send the book out early to people hoping for reviews, then complain when people actually review the book? I realize it's not what they hoped for, but what's the complaint here? The people leading the attacks have read the book. If their reviews had been positive, would they still be telling people that the reviewers they chose to send the book to are liars who are not credibly reporting what's in it, and dismissing those who echo what the reviewers wrote? Putting this another way, if they people they chose to send the book to are writing unfavorable things, what would those they suspected would not like the book (and hence were not sent a copy) say?

Finally, it seems to me that they are misstating the objections ("The critics are implying that we dismiss any threats from global warming; but the entire point of our chapter is to discuss global-warming solutions"). The complaint isn't that they are global warming deniers, it's that they misstated the science associated with proposed solutions to the problem.

Update: While they are not global warming deniers, Mathew Yglesias says the book does make the claim that the climate change threat is being overstated by environmentalists, and that the book supports this view by inaccurately representing the views of the scientific community:

...Go here and read for yourself pages 184, 185, and the beginning of page 186 of Suprefreakonomics. The point, quite clearly, is to lead you to believe that "hard-charging environment activist and all-around peacenik" Ken Caldeira share the Levitt/Dubner view that (a) environmentalists are overstating the extent of the climate change problem, (b) curbing carbon dioxide emissions should not be our main tool in combatting climate change, and (c) that it's useful to disparagingly analogize advocates of CO2 emissions curbs to those driven by religious faith rather than scientific expertise. Caldeira is called onto the floor to speak as a voice of sober-minded science against the misguided CO2-limiters. ... Of course it's possible that ... Ken Caldeira is mistaken about some things. But it's not possible that Levitt and Dubner are correctly representing the views of Caldeira or climate scientists in general...

Update: More from Paul Krugman. A snippet:

Levitt now says that the chapter wasn't meant to lend credibility to global warming denial — but when you open your chapter by giving major play to the false claim that scientists used to predict global cooling, you have in effect taken the denier side. The only way I can reconcile what Levitt says now with that reality is that he and Dubner didn't do their homework — not only that they didn't check out the global cooling stuff, the stuff about solar panels, and all the other errors people have been pointing out, but that they didn't even look into the debate sufficiently to realize what company they were placing themselves in.

And that's not acceptable. This is a serious issue. We're not talking about the ethics of sumo wrestling here; we're talking, quite possibly, about the fate of civilization. It's not a place to play snarky, contrarian games.

Update: And more from Brad DeLong: Six Questions for Levitt and Dubner.


links for 2009-10-16

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