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June 3, 2010

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"Bankers Have Been Sold Short"

Posted: 03 Jun 2010 02:43 AM PDT

Raghuram Rajan:

Bankers have been sold short by market distortions, by Raghuram Rajan, Commentary, Financial Times: ...Inquiries under way are bound to unearth more instances of ethically, and even legally, challenged bankers. ... How do we instill more social values in the industry? Or is banker greed mostly good? ...
Take for instance a trader who sells short the stock of a company he feels is being mismanaged. He does not see the workers who lose their jobs or the hardship that unemployment causes their families. But short sellers perform a valuable social function by depriving poorly managed companies of resources they will waste. A company whose stock price tanks will not be able to raise financing easily and could be forced to close down.
The trader does not cause the company to go out of business. ... Mismanagement is the source of the company's troubles; the trader merely holds up a mirror to reflect it. The best measure of the trader's value to society is whether he made money from the trade... This is why free-market capitalism works and why bankers usually do good even as they do very well for themselves.
However, when the discipline of markets breaks down, as it sometimes does, the finely incentivized financial system can derail quickly and cause immense damage. The very anonymity of money then makes it a poor mechanism for guiding financiers' activities toward socially desirable ends. Did the mortgage broker make his fees by offering a variety of sensible options to the professional couple who were looking to upgrade their house, or did he do so by urging an elderly couple to refinance into a mortgage they could not afford? When the broker's loans are scrutinized by sensible banks that refuse to refinance shaky mortgages, there is a market check on his behavior that forces him to focus on persuading the professional couple instead of deluding the elderly one. When the market is willing to buy any loan he makes, however, he leans towards easy pickings.
The key then to understanding the recent crisis is to see why markets offered inordinate rewards for poor and risky decisions. Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets. The tsunami of money directed by a US Congress ... towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans. And the willingness of the Fed to stay on hold until jobs came back, and indeed to infuse plentiful liquidity if ever the system got into trouble, eliminated any perceived cost to having an illiquid balance sheet. Chastise the banker who hankers after his bonus, but also pity him for he is looking for his primary measure of self-worth to be restored. Rather than attempting to instill social purpose in him, however, it is probably more useful for society to target the forces that distorted the market.

I agree that it we should correct bad incentives when we are aware they exist, but as I've argued before, we are never going to be able to ensure that financial markets are perfectly safe. Another meltdown is always possible. So we should also put measures such as strict leverage ratios in place that limit the damage when the next crisis occurs.

Also, in addition to the causes of the crisis that he mentions, I'd add poor risk assessment due to the use of mathematical models that did not properly account for systemic risks, and the reliance on ratings agencies that used the same bad models and had incentives to rubber stamp approvals indicating assets of high quality. I'd also mention deregulation of the financial sector, and an ideology that promoted the idea that greed (maximizing self-interest) is good independent of the conditions that exist in a particular market, i.e. independent of whether the market discipline mentioned above is present.

A change in thinking that recognizes that markets do not necessarily self-correct or lead to optimal societal outcomes on their own, that oversight and regulation is needed to ensure that markets function properly (and safely when a meltdown could threaten the larger economy), is an important part of the solution to the problem. If regulators had taken seriously the possibility that financial markets could meltdown the way that they did and insisted upon the proper safeguards, we might not even be talking about a crisis or what new regulations are needed, the crisis might have been prevented. I think new regulation is needed, as well as a new attitude from those who are charges with enforcing the regulations on the books. But the attitude of regulators can change with the administration in power, and regulators make mistakes in any case, so some part of the new regulation must make discretionary errors by regulators less costly (hence the call for measures such as strict leverage ratios in the previous post).

Let me also add this from Paul Krugman (as noted below, this point has been made repeatedly -- for quite a bit more on the role, or lack thereof, of the CRA, Fannie, and Freddie in the crisis, see here and here.):

Things Everyone In Chicago Knows, by Paul Krugman: Which happen not to be true.

It was deeply depressing to see Raguram Rajan write this:

The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans.

That's a claim that has been refuted over and over again. But what happens, I believe, is that in Chicago they don't listen at all to what the unbelievers say and write; and so the fact that those libruls in Congress caused the bubble is just part of what everyone knows, even though it's not true.

Just to repeat the basic facts here:

1. The Community Reinvestment Act of 1977 was irrelevant to the subprime boom, which was overwhelmingly driven by loan originators not subject to the Act.

2. The housing bubble reached its point of maximum inflation in the middle years of the naughties:

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Robert Shiller

3. During those same years, Fannie and Freddie were sidelined by Congressional pressure, and saw a sharp drop in their share of securitization:

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FCIC

while securitization by private players surged:

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FCIC

Of course, I imagine that this post, like everything else, will fail to penetrate the cone of silence. It's convenient to believe that somehow, this is all Barney Frank's fault; and so that belief will continue.

Risk versus Uncertainty

Posted: 03 Jun 2010 02:04 AM PDT

A refresher on risk versus uncertainty:

Explained: Knightian uncertainty, by Peter Dizikes, MIT News Office: The global economic crisis of the last two years has stemmed, in part, from the inability of financial institutions to effectively judge the riskiness of their investments. For this reason, the crisis has cast new attention on an idea about risk from decades past: "Knightian uncertainty."

Frank Knight was an idiosyncratic economist who formalized a distinction between risk and uncertainty in his 1921 book, Risk, Uncertainty, and Profit. As Knight saw it, an ever-changing world brings new opportunities for businesses to make profits, but also means we have imperfect knowledge of future events. Therefore, according to Knight, risk applies to situations where we do not know the outcome of a given situation, but can accurately measure the odds. Uncertainty, on the other hand, applies to situations where we cannot know all the information we need in order to set accurate odds in the first place.

"There is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known," Knight wrote. A known risk is "easily converted into an effective certainty," while "true uncertainty," as Knight called it, is "not susceptible to measurement." An airline might forecast that the risk of an accident involving one of its planes is exactly one per 20 million takeoffs. But the economic outlook for airlines 30 years from now involves so many unknown factors as to be incalculable.

Some economists have argued that this distinction is overblown. In the real business world, this objection goes, all events are so complex that forecasting is always a matter of grappling with "true uncertainty," not risk; past data used to forecast risk may not reflect current conditions, anyway. In this view, "risk" would be best applied to a highly controlled environment, like a pure game of chance in a casino, and "uncertainty" would apply to nearly everything else.

Even so, Knight's distinction about risk and uncertainty may still help us analyze the recent behavior of, say, financial firms and other investors. Investment banks that in recent years regarded their own apparently precise risk assessments as trustworthy may have thought they were operating in conditions of Knightian risk, where they could judge the odds of future outcomes. Once the banks recognized those assessments were inadequate, however, they understood that they were operating in conditions of Knightian uncertainty — and may have held back from making trades or providing capital, further slowing the economy as a result.

Ricardo Caballero, chair of MIT's Department of Economics, is among those who have recently invoked Knightian uncertainty to explain the behavior of investors in times of financial panic. As Caballero stated in a lecture at the International Monetary Fund's research conference last November: When investors realize that their assumptions about risk are no longer valid and that conditions of Knightian uncertainty apply, markets can witness "destructive flights to quality" in which participants rid their portfolios of everything but the safest of investments, such as U.S. Treasury bonds.

One solution offered by Caballero to stem these moments of panic is government-issued investment insurance for large financial institutions. In this sense, the existence of Knightian uncertainty is not just a quasi-philosophical dispute; the subjective perception of Knightian uncertainty among businesses is a pressing practical problem.
Quickly: Government sponsored insurance for large banks is not the only option available for solving this problem, and other solutions may be more desirable, but if we go this route then the insurance shouldn't be free. Firms should prepay into a fund that will provide the insurance, and then add to it ex-post if the amount proves insufficient.

links for 2010-06-02

Posted: 02 Jun 2010 11:05 PM PDT

"Obama’s Missing Moral Narrative"

Posted: 02 Jun 2010 02:34 PM PDT

I think this makes a good point:

Obama's missing moral narrative and the intimidating right-wing message machine, by George Lakoff, Berkeley Blog: Barack Obama may be one of the best communicators of this generation, but he is not living up to his own talents. ...
Crises are opportunities. He has consistently missed them. This was a grand opportunity to pull together the threads — BP and the spill, Massey and the mine disaster, Wall Street and the economic disaster, Anthem BlueCross and health care, the Arizona Immigration Law, Don't Ask, Don't Tell — even Afghanistan. ...
It's not that he said nothing to tie them together. But there was no home run, no unifying narrative, no patriotic call to the nation on the full gamut of issues. Instead, there were only hints, suggestions, possible implications, notes of concern — as if he had been intimidated by the right-wing message machine.
And yet, Obama of all political leaders, could have done it, because he did before in his campaign.

I fully agree that Obama has not tied this all together into a master narrative. However, the next part of the essay I'm less sure about (there's quite a bit more in the original):

The central idea is Empathy. Democracy is based on empathy, on people caring about one another and acting to the very best of their ability on that care, for their families, their communities, their nation, and the world. Government must also care and act on that care. Government's job is to protect and empower its citizens.
That idea is what draws together all the threads. The bottom line for corporations (whether BP, Massey, Anthem or Goldman Sachs) is money, not empathy. The bottom line for those who hate (whether homophobes, the Arizona Legislature, or al Qaeda) is domination and oppression, not empathy.
Empathy, and acting on it effectively, is the main business of government. And Obama knows it in his heart.
Yet the right-wing has intimidated Obama into dropping not just the word "empathy," but the idea. Empathy is a positive deep connection with other people in general and with all living things, the ability to see and feel as they do. The right-wing, which shows little empathy, has confused empathy with sympathy for individuals, which they see as a weakness. And though Obama has repeatedly made the distinction clear, he has allowed the right wing to intimidate him into abandoning "the most important thing my mother taught me." ...
That should have — and could have — been [a] central narrative drawing all the threads together. ... But .. it ... would be confrontational. It would bring him head-to-head with right-wing ideology — empathy-free, self-interest maximizing, with disdain or even hatred for those seen as lesser beings. It is self-reinforcing: a value-system that above all promotes that value-system itself.
Because that ideology takes precedence over empathy, there will be little or any real bipartisanship with those on the hard-core right. The right is provoking confrontation. It cannot be avoided. The president should be confronting the right-wing on all issues — not issue-by-issue as a policy wonk, but with the master moral narrative that makes sense of our country's values. ...
A great deal follows from a unified moral stance. Empathy and the discipline to act effectively on it, when seen as the basis of democracy and American values, can be powerful. It can unify the major policies of the administration, and unify people of good will — and that is a majority of our citizens. But only if the president communicates the central nature of empathy effectively, and acts on it consistently.

Empathy (e.g. social insurance) would be part of the master narrative I'd tell, for example people who suddenly find themselves jobless through no fault of their own deserve our collective support. But my narrative would also involve economic and political power, the need for government to provide countervailing forces, e.g. antitrust law, campaign finance rules, the decline of unions and the corresponding decline in influence of the working class, and the failure of government to provide countervailing influences in recent decades. That's understandable, it's not in the economic interests of politicians to reform campaign finance, to use antitrust law to break up the source of campaign funds, or to pass new laws to break up big banks, another source of campaign contributions.

But it is in the public's interest, and that's what they were elected to represent. Of course, legislators were never pure in their motives, self-interest always played a role, but it seems to me that the shift toward what's best for individual legislators and away from the public interest has widened in recent decades. Perhaps this is based upon a convenient belief in the metaphor of the invisible hand, that somehow pursuing their own self-interest results in what's best for the public generally even though it's evident that's not the case, But whatever the reason, there does seem to be a shift in emphasis toward the self-interest of individual members of congress and away from the public interest. Perhaps this also explains the lack of concern for the unemployed that we've seen recently in Washington. Without unions to fill campaign coffers, and without a strong sense of any obligation to the unemployed more generally (without empathy?), why should legislators care?

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