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April 19, 2010

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Paul Krugman: Looters in Loafers

Posted: 19 Apr 2010 12:42 AM PDT

What role did fraud play in the financial crisis?:

Looters in Loafers, by Paul Krugman , Commentary, NY Times: Last October, I saw a cartoon by Mike Peters in which a teacher asks a student to create a sentence that uses the verb "sacks," as in looting and pillaging. The student replies, "Goldman Sachs."
Sure enough, last week the Securities and Exchange Commission accused the Gucci-loafer guys at Goldman of engaging in what amounts to white-collar looting. ...
Most discussion of the role of fraud in the crisis has focused on two forms of deception: predatory lending and misrepresentation of risks. Clearly, some borrowers were lured into taking out complex, expensive loans they didn't understand — a process facilitated by Bush-era federal regulators... And ... subprime lenders ... sold off the loans to investors, in some cases surely knowing that the potential for future losses was greater than the people buying those loans (or securities backed by the loans) realized.
What we're now seeing are accusations of a third form of fraud..., the S.E.C. is charging that Goldman created and marketed securities that were deliberately designed to fail, so that an important client could make money off that failure. That's what I would call looting. And Goldman isn't the only financial firm accused of doing this. ...
So what role did fraud play in the financial crisis? Neither predatory lending nor the selling of mortgages on false pretenses caused the crisis. But they surely made it worse, both by helping to inflate the housing bubble and by creating ... assets guaranteed to turn into toxic waste once the bubble burst.
As for the alleged creation of investments designed to fail, these may have magnified losses at ... banks..., deepening the banking crisis that turned ... into an economy-wide catastrophe.
The obvious question is whether financial reform of the kind now being contemplated would have prevented some or all of the fraud that now seems to have flourished over the past decade. And the answer is yes.
For one thing, an independent consumer protection bureau could have helped limit predatory lending. Another provision in the proposed Senate bill, requiring that lenders retain 5 percent of the value of loans they make, would have limited the practice of making bad loans and quickly selling them off to unwary investors.
It's less clear whether proposals for derivatives reform — which mainly involve requiring that financial instruments like credit default swaps be traded openly and transparently, like ordinary stocks and bonds — would have prevented the alleged abuses by Goldman (although they probably would have prevented the insurer A.I.G. from running wild and requiring a federal bailout). What we can say is that the final draft of financial reform had better include language that would prevent this kind of looting — in particular, it should block the creation of "synthetic C.D.O.'s," cocktails of credit default swaps that let investors take big bets on assets without actually owning them.
The main moral you should draw from the charges against Goldman, though, doesn't involve the fine print of reform; it involves the urgent need to change Wall Street. Listening to financial-industry lobbyists and the Republican politicians who have been huddling with them, you'd think that everything will be fine as long as the federal government promises not to do any more bailouts. But that's totally wrong — and not just because no such promise would be credible.
For the fact is that much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors. And if we don't lower the boom on these practices, the racket will just go on.

Did Goldman Sachs Use "Computational Complexity" to Hide "Lemons"?

Posted: 19 Apr 2010 12:33 AM PDT

The case against Goldman Sachs is not air tight, and law professors have been busy figuring out how the company might defend itself against the charge that it failed to disclose all the relevant information about the CDOs it was selling. One idea noted by Erik Gerding is that so long as investors knew what assets were in the CDOs they purchased (as opposed to who constructed it), they had all the information they needed to make an informed decision.

As he notes, "The question in this case is whether you should be told that that this gambler betting against you selected the cards in the deck." His original answer was that knowing who picked the cards is unimportant so long as you know what cards are in the deck, but he is now reconsidering that conclusion:

Investigating Goldman: How you can hide a lemon in plain sight, by Erik Gerding: In a previous post, I noted that the SEC's case that Goldman failed to disclose the Paulson & Co hedge fund's role in selecting the collateral might be weakened, because the investors themselves likely were told which assets went into the SEC [I think this should be CDO]. To rehash my metaphor, it isn't as critical to know who selected the deck when you know the cards in the deck. Evidently, I was not alone in this conclusion -- see some of the reactions of other law professors in the NY Times.
Offline, a reader pointed me to a paper that convinced me that I might be completely wrong about this. The paper's conclusions may turn out to have pretty significant implications for this case. Here's the insight, an October 2009 paper by a team of computer scientists and an economist at Princeton argues that the parties that structure a CDO may be able to hide lemons -- that is assets that it knows are subpar -- in the collateral of a CDO through carefully structuring the CDO. The investors in the CDO may find it impossible to detect these lemons even when the collateral is fully disclosed and the investors are sophisticated and have significant computing resources.
Why? The paper (Arora et al., "Computational Complexity and Information Asymmetry in Financial Products") argues that the complex structuring of derivatives can create "computational intractability." In layperson terms, finding the "lemons" can become an inordinately difficult mathematical problem. Unless an investor has unlimited computational power, it may not be able to "solve" the problem and detect the lemons. It's the same problem that occurs with trying to decode computer messages protected with a certain level of encryption. The structuring of the deal functions as a kind of encryption to camouflage the bad assets.
This means that the party that both selects the collateral and structures a complex derivative (like a synthetic CDO) has a potentially insurmountable information advantage over its counterparties. ... (In an amusing twist, the paper argues that "even Goldman Sachs" wouldn't be able to detect the lemons).
What could this mean for the Goldman case? Many things. First, we shouldn't assume that when the investors (or ACA, the collateral manager for that matter) knew what the collateral was that they could easily detect any lemons. Arguments that ... investors need to rely on the proper incentives (or at least the disclosure) of both the party that selected the collateral and the party that structured the deal gain a lot more weight.
Second, how the deal was structured (not just how the collateral was selected) may prove to be crucial. From the SEC Complaint, it ... is unclear if Paulson played a role in structuring the deal. Did Goldman structure the deal to "hide" the Paulson-selected assets[?] Unfortunately, based on the conclusions of the Princeton paper, detecting this hiding is subject to the same intractability problem. Unless there is some "smoking gun" evidence -- e.g. loose-lipped e-mail correspondence, testimony from Goldman employees. Even the absence of a smoking gun doesn't detract from the first point -- that the investors wouldn't be able to detect lemons even if the collateral was fully disclosed to them.
Third, this insight means that an already complex case may require even more expert witnesses -- let's see if the Princeton team gets a call. ...

"Life After 'Rational Expectations'?"

Posted: 19 Apr 2010 12:24 AM PDT

Critics of conventional macroeconomic models -- critics of the Rational Expectations and Efficient Markets Hypotheses in particular -- are often accused of simply rehashing old complaints (e.g. see the second paragraph of The Economist article mentioned below). This paper from the INET Conference attempts to depart from "familiar complaints" about REH and EMH. The paper argues that RE requires a mechanistic model of expectations that cannot possibly capture "the diversity of 'reasons' upon which individuals in real-world contexts might base their decisions," and then it offers an alternative approach to modeling expectations:

Life After "Rational Expectations"?, by Roman Frydman and Michael D. Goldberg [presentation slides]: Many people regard the recent financial crisis as a painful addition to an already massive body of evidence that demonstrates the inadequacy of today's economic models of "rational" markets. ...
But very few have interpreted the inability of "rational" market models to account for such swings as a potentially decisive indication that economists' approach to modeling rational decision-making is irreparably flawed. The debate triggered by the crisis, summarized by The Economist in two articles addressing "[w]hat went wrong with economics [a]nd how the discipline should change to avoid the mistakes of the past," has largely overlooked the key problem: the impossibility of establishing a standard approach to modeling how a rational individual makes decisions in every situation.[1]
Precisely the presumption that economists' have found such a standard has come to underpin models of rational decision-making in a wide variety of contexts – diverse economies, markets, and even fields of inquiry, such as political science and law. In order to arrive at such a universal approach, economists' standard of rationality must abstract as much as possible from differences in individuals' interpretations of the social context, including the process driving market outcomes, history, norms and conventions, and public policies and institutions. For the last three decades, the vast majority of economists, including those following the behavioral approach, have considered the "Rational Expectations Hypothesis" (REH) to be the cornerstone of this standard.
In this paper we sketch the emergence of REH and how it evolved to become the centerpiece of contemporary macroeconomics and finance. We focus on major arguments advanced by the promoters of the hypothesis that seemed to have contributed to its rapid and broad acceptance. We argue that REH models are fundamentally flawed on epistemological and empirical grounds and thus cannot serve as a foundation for thinking about markets and public policy.
Consequently, we urge economists to jettison REH. We have recently proposed an alternative approach, called Imperfect Knowledge Economics (IKE)...[2] In contrast to contemporary models, IKE recognizes the inherent limits to economists' knowledge, as well as the imperfection of knowledge on the part of market participants and policy officials.[3] ...[P]sychological findings, as well as observations concerning the context within which participants make decisions – including historical market outcomes, past policies, norms, and conventions – play a key role in formalizing the foundations of IKE models.
Rationality and the Social Context
...For economists, "a decision-maker is rational if [she] makes decisions consistently in pursuit of [her] own objectives" (Myerson, 1991, p. 2). Economists typically suppose that individuals are motivated by self-interest, and thus that in making decisions they attempt to maximize their own well-being. Because selfishness is widely considered to be an innate trait, using self-interest to stand for decision-makers' objectives is compatible with economists' belief that their approach to rational decision-making is universally applicable.
The problem is that what constitutes self-interested decision-making depends on the context within which it occurs.[4] ... As Sen (1993, p. 501) has argued,
"[S]uppose the person faces a choice at a dinner table between having the last remaining apple in the fruit basket (option B) or leaving the apple for someone else to take and forgoing the opportunity of eating the nice-looking apple (option A). She decides to behave decently and picks nothing (option A), rather than one apple (option B). If, instead, the basket had contained two apples, and she had encountered the choice between having nothing (A), having one nice apple (B), [or having two nice apples] (option C), she could reasonably enough choose one (B), without violating any rule of good behavior.[5]
In checking whether these choices are internally consistent, economists would consider them on their own, without any reference to an individual's values or the context within which she makes decisions. To be sure, if her sense of decency or some other reason were not behind her apparent preference for A in the first case and for B in the second, such choices would undeniably be inconsistent on purely logical grounds. But, as Sen (1993, p. 501) emphasizes, although this combination of choices would violate the standard consistency conditions, "[t]he presence of another apple (C) makes one of the two apples decently choosable. [T]here is nothing particularly 'inconsistent' in this pair of choices (given her values and scruples)." Indeed, as this example shows, "There is no such thing as internal consistency of choice" (Sen, 1993, p. 499).
Of course, were an economist to take into account the fact that, beyond the anticipated pleasure from eating an apple, the individual is also concerned about the "decency" of her choice, he could have rationalized her choices as being consistent after all. Consequently, once we enlarge the set of factors that an individual considers important for her well-being to include "decency," her choices can be seen to be consistent with self-interest, broadly understood.
Inventing Rational Expectations
In simple decision problems, as in Sen's apple example, the individual is fairly confident about the consequences of her choices for her own well-being. In such cases, an economist might be able to use his own understanding of the individual's social context to interpret whether she makes consistent choices. However, matters are much more complicated in financial markets, in which the consequences of individuals' choices lie in the future.
Here, an economist must not only model the preferences with which an individual ranks alternative options – for example, in terms of their returns and riskiness – but also how she forecasts these outcomes. Even assuming that all individuals are motivated by self interest, there is simply no general procedure or model that would pick the precise set of reasons – and the forecasting strategy based on those reasons – that would adequately capture how a generic rational individual thinks about the future. But an economist requires precisely such a standard of rational forecasting in order to formulate a set of conditions that would enable him (or anyone else, for that matter) to interpret whether in most situations an individual makes decisions "consistently in pursuit of [her] own objectives." ... Consequently, in modeling "rational" decision-making, economists largely ignore the diversity of "reasons" upon which individuals in real-world contexts might base their decisions.
...
Behavioral economists and non-academic commentators often criticize economists' standard of rationality as implying that rational individuals make decisions as if they had superhuman abilities to understand the future – that they can compute correctly the consequences for their well-being of alternative options available to them. The raison d'ĂȘtre of behavioral economics has been that most people lack these abilities which supposedly explains why they do not make decisions consistent with economists' standard of rationality.
But REH presumes no such thing. ... Instead, REH supposes that individuals adhere steadfastly to a single mechanical forecasting strategy. Indeed, economists' characterizations of rational forecasting would appear to any reasonable person, let alone a profit-seeking participant in financial markets, to be obviously irrational.
After all, a profit-seeking individual understands that the world around her will change in non-routine ways. She simply cannot afford to believe that she has found an overarching forecasting strategy and, thus, she will look for new ways to forecast, which cannot be fully foreseen. Thus, REH imagines a place devoid of the crucial features that characterize, even in the most rudimentary abstract way, how individuals forecast in real-world markets.[7]
Economists, particularly macroeconomists and finance theorists, often view REH as a "useful abstraction." But the necessity to abstract, intrinsic to all science, cannot render coherent, let alone justify, imputing to individuals demonstrably unreasonable beliefs and then claiming that these individuals are rational.
Unsurprisingly, REH models turned out to be woefully inadequate as characterizations of how profit-seeking individuals make decisions, particularly when it comes to selecting and revising forecasting strategies.[8] In real-world markets – in which there is diversity and an ever-present possibility that non-routine change will alter the process driving market outcomes – REH models have no connection to what participants would consider "logical and reasonable." ...

They go on to propose Imperfect Knowledge Economics as an alternative. [...continue reading...]

links for 2010-04-18

Posted: 18 Apr 2010 11:01 PM PDT

Social Mobility and Inequality

Posted: 18 Apr 2010 07:39 PM PDT

"The Case Against Gene Patents"

Posted: 18 Apr 2010 12:06 PM PDT

Joseph Stiglitz and John Sulston argue that "the patenting of human genes is wrong."

[I've been sitting on this post for a couple of days hoping to think of something to say about it, but haven't come up with much. One of the main ideas is that patents are not the only way to solve the market failure associated with innovative activity (the problem is the inability to stop others from taking advantage of your investment in research). An alternative is "government- and foundation-supported research in universities and research laboratories," and they prefer this alternative when "basic knowledge" is involved. I like this idea, but I'm not sure how "basic knowledge" should be defined.]:

The Case Against Gene Patents, by Joseph Stiglitz and John Sulston, Commentary, WSJ: Last month, a federal court in New York ... ruled that patents were improperly granted to Myriad Genetics on two human genes associated with hereditary breast and ovarian cancer. We participated in the case supporting the plaintiffs ... because we believe the patenting of human genes is wrong as a matter of science and as a matter of economics. ...
The court held that genes and human genetic sequences are naturally occurring things, not inventions. They ... contain the most fundamental information about humanity—information that should be available to everyone. The researchers and private companies that applied for these gene patents did not invent the genes; they only identified what was already there.
Proponents of gene patents argue that private companies will not engage in genetic research unless they have the economic incentives created by the patent system. We believe ... exactly the opposite... Patents such as those in this case not only prevent the use of knowledge in ways that would most benefit society, they may even impede scientific progress. ...
As we move into an era where the sequencing of all of an individual's genes is common and necessary for personalized medicine,..., the basic data must be freely available to everyone to interpret and develop. Our genetic makeup is far too complicated for a single entity to hold the keys to any given gene and to be able to choose when, if ever, to share.
Patents are also not necessary for ensuring that genetic tests come to market. Currently, Myriad does not allow any other lab ... to perform full diagnostic testing on patients ... at increased risk of hereditary breast and ovarian cancer. Because of this monopoly, Myriad is able to charge more than $3,000 to perform the test, a prohibitively high amount that keeps some women from being tested...
Other labs have said they would be willing to perform the test for a few hundred dollars,... and could also develop new tests... The information provided by the tests is of enormous importance: The lifetime risk of getting breast cancer is as high as 85% for mutation carriers.
Any marginal social benefits of patenting genes clearly do not measure up to the profound costs of locking down knowledge. ... Like basic mathematical theorems, genes are an example of "basic knowledge"—the kind of knowledge that typically cannot and should not be patented. ... It's true that knowledge cannot be produced without cost, but there is a proven alternative: government- and foundation-supported research in universities and research laboratories. ...
We see this ruling as a turning point in our thinking about our patent system, and more broadly, scientific research.

They say that patenting of human genes is wrong "as a matter of science and as a matter of economics." Economics and science don't deal well with this, but ethics might be involved as well.

One thing I'm confused about in the article is the difference between patenting the genes and patenting the test that looks for them. I understand why genes shouldn't be patented, but what about the test? If a company develops a life-saving test for a genetic disorder, but decides to use a patent to charge monopoly prices that exclude many people from taking the test, how should we respond? Give subsidies to those who can't afford it? Define it as basic research and outlaw the patent? Do nothing and let the market decide? We don't want to discourage the research that produced the test, but we don't want to exclude people either, so a new model is needed for these cases. The question for me is whether "government- and foundation-supported research in universities and research laboratories" provides the correct incentives. It does solve the patent/monopoly prices problem, but will it produce the research we need?

Another alternative is for the government to offer prizes for significant discoveries, e.g. for new, important drugs, but it's not clear to me that government can design the correct incentive system particularly in areas where we know little about which direction to proceed. As Sitglitz notes elsewhere:

Of course, the patent system is itself a prize system, albeit a peculiar one: the prize is temporary monopoly power, implying high prices and restricted access to the benefits that can be derived from the new knowledge. By contrast, the type of prize system I have in mind would rely on competitive markets to lower prices and make the fruits of the knowledge available as widely as possible. With better-directed incentives (more research dollars spent on more important diseases, less money spent on wasteful and distorted marketing), we could have better health at lower cost.

That said, the prize fund would not replace patents. It would be part of the portfolio of methods for encouraging and supporting research. A prize fund would work well in areas in which needs are well known – the case for many diseases afflicting the poor – allowing clear goals to be set in advance. For innovations that solve problems or meet needs that have not previously been widely recognized, the patent system would still play a role.

Continuing:

The market economy and the profit motive have led to extremely high living standards in many places. But the health care market is not an ordinary market. Most people do not pay for what they consume; they rely on others to judge what they should consume, and prices do not influence these judgments as they do with conventional commodities. The market is thus rife with distortions. It is accordingly not surprising that in the area of health, the patent system, with all of its distortions, has failed in so many ways. A medical prize fund would not provide a panacea, but it would be a step in the right direction, redirecting our scarce research resources toward more efficient uses and ensuring that the benefits of that research reach the many people who are currently denied them.

Stiglitz calls for a "portfolio of methods," and perhaps that's the best we can do. But once a portfolio approach including patents is adopted big business, e.g. the pharmaceutical industry, can use its power to distort the portfolio choice in its favor. Thus, the portfolio approach requires countervailing power, power that does not exist in sufficient quantity. Unchecked, the portfolio approach would likely end up looking much like the system we already have, so it's not clear to me that this is the answer.

This Time is Different?

Posted: 18 Apr 2010 09:51 AM PDT

Republicans have always defended business and opposed regulation. It's what they do. I've caught a few glimpses of Republicans making the rounds on the talk shows this morning, and they want you to believe that this time is different, that this time they are the ones defending the nation against the big financial firms that have caused us so much trouble.

During the debate over health care reform, Republicans convinced a lot of people that they are the defenders of Medicare in their effort to stop reform altogether. The media did not seriously challenge this ridiculous claim, and now Republicans think they can keep playing the public (and the media) for fools. Their goal is a simple one, it's to stop meaningful regulation so that their campaign finance buddies can go back to their old, profitable at your expense ways. 

This time is not different.

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