Thursday, December 30, 2010

Should Old Acquaintance Be Forgot

Although I started this blog more than eight years ago, it lay largely dormant for most of this period and this has been my first full calendar year of (somewhat) regular posting. The experience has been consistently rewarding but occasionally exhausting. As the year draws to a close I'd like to acknowledge my debt to a few of the individuals whose writing I have enjoyed and learned from over the past twelve months, and to reflect upon some of the main ideas that have been explored in these pages.

Macroeconomic Resilience began the year as an anonymous blog but was subsequently revealed to be the creation of Ashwin Parameswaran, whose ecological perspective on behavior and markets is very close to my own. Every post of his is worth reading in full, but there is one on the trade-off between resilience and stability that remains an absolute favorite of mine.

Steve Randy Waldman's posts on interfluidity are generally so compelling and self-contained that there is usually very little left to add. I have been especially appreciative of a sequence of recent posts in which he argues that technocratic arguments, regardless of their merits, are unlikely to be persuasive if they are not consonant with our moral intuitions. It is the neglect of this important point that has so many commentators wondering why a policy that allegedly saved the financial system from collapse at negligible cost to the taxpayer is so deeply unpopular.

Along similar lines, Yves Smith on naked capitalism has been relentless in her criticism of TARP (and the unseemly self-congratulation of its architects) on the grounds that superior alternatives were available at the time. While there is plenty of room for debate on these points, it's a conversation that must be had, and one that has to consider the impact of the policy on the distribution of financial practices, as well as the outrage generated when moral intuitions are offended. It is essential that Yves (and her guests) continue to challenge the emerging academic consensus on the policy. 

One of the defining events of the year for me was the flash crash of May 6. Contrary to initial media reports, this was not the result of a fat finger or computer glitch -- it was the consequence of interacting trading strategies, most of which involved algorithmically implemented rapid responses to incoming market data for very short holding periods. In understanding the mechanics of the crash I benefited from comments posted by RT Leuchtkafer in response to an SEC concept release. One of these was published three weeks before the crash and turned out to be remarkably prescient. 

Viewed in isolation, the crash might be considered fairly inconsequential, and a recurrence could probably be prevented by implementing rule changes such as trading halts followed by call auctions. But the crash ought not to be viewed in isolation. Like the proverbial canary in a coalmine, it's importance lies in what it reveals about the manner in which trading strategies interact to produce major departures of prices from fundamentals from time to time. These more routine departures take longer to build and correct, are difficult to identify in real time, and leave their mark in the form of value and momentum effects, volatility clustering, and the fat tails of return distributions.

This view of speculative asset markets as a behavioral ecosystem in which the composition of stategies is a key determinant of market stability has also been advanced by David Merkel on The Aleph Blog. David's sequence of posts on what he calls "the rules" is well worth reading, and it was in response to his tenth rule that I wrote my first post on trading strategies and market efficiency. That was just a couple of weeks before the flash crash occurred and brought these ideas suddenly to life.

I am convinced that the non-fundamental volatility induced by the trading process has major effects on portfolio choice, risk-bearing, capital allocation, job creation and economic growth. Some possible mechanisms through which such effects can arise have been explored by David Weild and Edward Kim, and I thank David for bringing this work to my attention. I am also grateful to Terry Flanagan of Markets Media Magazine for an invitation to attend their Global Markets Summit where I witnessed a fascinating and combative debate on the broader economic effects of exchange-traded funds. 

On the issue of market efficiency I have tangled with Scott Sumner on multiple occasions. But his anniversary post on The Money Illusion really struck a chord with me. Scott has a talent for making complex ideas intelligible, and an ability to maintain a clear distinction between a model and the empirical phenomenon that it is designed to explain. His vision of the economy is coherent and he is a formidable intellectual adversary. His post made me even more optimistic about the ability of blogs to shape economic discourse in constructive ways.

My window to the world of economics and finance blogs is Economist's View. Mark Thoma somehow manages to be both comprehensive and highly selective in his choice of links, virtually all of which are worth following. But more importantly, his site is a wonderful clearinghouse for open debate on economic methodology, especially in relation to macroeconomics. His post on the dynamics of learning (featuring a video presentation by George Evans) was especially memorable, as was Brad DeLong's diagrammatic discussion of the topic.

Despite the recent flowering of behavioral and experimental economics, I believe that the level of methodological homogeneity in our profession is stifling. But the time may finally be ripe for the introduction of agent-based computational models into mainstream discourse. A problem with simulation-based approaches is that there are no commonly accepted criteria on the basis of which the robustness of any given set of results may be evaluated. This will change once there is an outstanding article in a leading journal that sets a standard that others can then adopt. Where will it come from? Based on my reading of ongoing work by Geanakoplos and Farmer, I suspect that it may emerge from this recently funded initiative at the Santa Fe Institute. That would be nice to see.

Although my posts here have dealt largely with economics and finance, I also have a deep personal interest in social identity and group inequality, especially in the American context. On this set of issues I have found no voice more incisive than that of Ta-Nehisi Coates, whose freshness of perspective and formidable powers of expression I find breathtaking. His post on Robert E. Lee was one of several spectacular pieces this year, and prompted me to respond with my own thoughts on cultural ancestry. Related themes have been explored in a series of fascinating dialogues between Glenn Loury and John McWhorter.

Finally, I am thankful for the numerous extraordinary comments that have been left here, many by individuals who manage superb blogs of their own. Joao Farinha on economic development, Barkley Rosser on bubbles and agent-based models, Kid Dynamite on the flash crash, Economics of Contempt on TARP, Nick Rowe on learning, Adam P on equilibrium, Andrew Gelman on dynamic graphs, 123 on exchange traded funds, Andrew Oh-Willeke on private equity and cultural founder effects, and JKH on maturity diversification come immediately to mind, but there are many, many others.

I could go on, in a futile attempt to acknowledge all those who have influenced me and taken the time and trouble to  respond either in comments here or on their own blogs. But this post has to end before the calendar year does, and this seems as good a time to stop as any.

A very Happy New Year to you all.


  1. this is a bit off topic, rajiv, but i know you've looked at trading algorithms, so you might be interested in this article:

    Algorithms Take Control of Wall Street

    Last spring, Dow Jones launched a new service called Lexicon, which sends real-time financial news to professional investors. This in itself is not surprising. The company behind The Wall Street Journal and Dow Jones Newswires made its name by publishing the kind of news that moves the stock market. But many of the professional investors subscribing to Lexicon aren’t human — they’re algorithms, the lines of code that govern an increasing amount of global trading activity — and they don’t read news the way humans do. They don’t need their information delivered in the form of a story or even in sentences. They just want data—the hard, actionable information that those words represent. Lexicon packages the news in a way that its robo-clients can understand. It scans every Dow Jones story in real time, looking for textual clues that might indicate how investors should feel about a stock. It then sends that information in machine-readable form to its algorithmic subscribers, which can parse it further, using the resulting data to inform their own investing decisions. Lexicon has helped automate the process of reading the news, drawing insight from it, and using that information to buy or sell a stock. The machines aren’t there just to crunch numbers anymore; they’re now making the decisions.

  2. I haven't read Waldman's posts on interfluidity, but I intend to. I strongly relate to the words "Technocratic arguments, regardless of their merits, are unlikely to be persuasive if they are not consistent with our moral intutitions."

    I share your hope that blogs will be able to shape economic discourse in constructive ways, Rajiv.

    A Happy New Year to you!


  3. Rob, thanks... I should have included your comments on market efficiency in the list at the end of the post; sorry for the omission.

  4. Rajiv - Thank you! The opportunity to converse with you, Steve, David and many others has been far and away the best part of blogging to me.

    Happy New Year.

  5. Ashwin, thanks for all the comments you've left here over the course of the year (dating back to the "macro" days).

    I just realized that less than half the people mentioned in this post are professional economists, which goes to show how much we can all learn by crossing disciplinary boundaries.

    On another note, a reader (rjs) has sent me a link to a recent article on algorithmic trading:

    It's worth a look.

  6. Many thanks for this and all other posts Rajiv.

    While reading many of them I kept promising myself to come back the next day with the structured comments your writing wholly deserves. I’ve repeatedly failed on that “promise”, due to time and travel constraints, but your posts simply lay out so many parallel thought avenues and learning opportunities that I often print out a bunch of them (links included) for hours of in-flight reading. This internet blogging thing is such a game changer in how academic and analytical debate can contribute to our (general public and economists) understanding of how economies work, how they are conceptualized, and how economic policy matters. And your blog Rajiv, is precious in that context. Many, many thanks. Pity that you take so long between posts ;-)

    In any case, I like your reference above to the idea “that technocratic arguments, regardless of their merits, are unlikely to be persuasive if they are not consonant with our moral intuitions”. It’s simply spot on. I’ve been thinking and agonizing about this phenomenon, and how it affects macroeconomic thinking and the national realities of the current global crisis. It’s simply all over the place.

    For example in the current debate about solutions to the “euro crisis”, EU leaders have either (i) been too attached to moralistic views on what the “root problem” is (e.g. to them, PIIGS “lived beyond their means” – presumably, “national income” - so now they have to cut “national spending”), or (ii) simply failed to explain to their national constituents how “macroeconomies” work and macroeconomic policies have to be understood differently from the “household economics” on which our moral intuitions are built. An individual can live beyond its means, but a national economy??!? What does that mean? Do commentators realize that economies with current account deficits (perhaps a measure of “living beyond their means”) have to have a capital account surplus?

    Would commentators interpret that when a country reduces its capital account surplus it is going in the direction of living within its means? You remember that article on “an economy is not a company” by Paul Krugman? I often go back to it, and feel very lonely in that effort. It’s to me incredible that the whole eurozone crisis is understood to be the result of national policy pathologies rather than something that is physiological to a currency area of this sort (i.e. irrevocably-fixed exchange rate regime between countries at very different development stages and misaligned monetary and fiscal institutions – an institutional architecture that is interestingly silent of the fiscal roots of monetary regimes, and the monetary need to address financial panics when they don’t occur in private debt markets). Krugman and others keep posting about this, but institutions at the core of this historical experiment, like the ECB, are irritatingly silent on this problem and surprisingly attached to a strangely-narrow mandate.


  7. Want a better example of how moral intuitions particularly characteristic to one or two nations have actually influenced the design of technocratic constructs like the ECB? Worse, just read Trichet’s speech at Jackson Hole this year. I wonder about the narrow theoretical inclinations (for short, inter-temporally maximizing, single “manager” of a simple economy whose technological features can be represented by a simple production function) of whoever wrote that speech for him, happily reliant on some empirical work made by Alesina and Ardagna indicating that countries in the euro area could all cut their way out at the same time of a crisis of aggregate demand (and unutilized productive capacity).

    So, back to first, how moral intuitions of the general population (e.g. spending is bad, saving is good, which is in fact somehow aligned with the logic of microeconomics) feed into the moral intuitions of policy makers, second, how they undermine macroeconomic understanding of basic national accounting tenets (e.g. that aggregate spending corrected by imports in fact measures national income, and that there is no such meaningful indicator of “aggregate savings” - at least in the way we perceive the idea of “funds set aside” by individuals for future use), and third, how they have actually percolated into the academic research that justifies particular technocratic arguments, I think there is at the root of this problem a fundamental disregard for basic national accounting identities.

    This disregard has only recently been addressed by some commentators, with financial balance analyses (see Gavyn Davies’ blog, as well as Martin Wolf), but many of them keep on analyzing micro and macro issues through the same lens, i.e. led by a moral intuition coincidently justified in microeconomics education. So let me blunt (but not original), most of the “useful macroeconomics” we learned in the last 40 years is simply counterintuitive, especially if moral intuition never felt stifled by the tyranny of national accounting identities, or by the problems of aggregation. But unfortunately, most of the macroeconomics taught in graduate schools in the last 40 years has also repeated the same mistakes.


  8. In other words, many of the technocratic arguments presented in macroeconomic policy debates have also been “facilitated” by a moral intuition developed and justified in micro terms. The resulting confusion in the economics profession and policy debate produces a lot of real-world damage. And surprising reactions too, the other day for example I read a Portuguese newspaper saying something like “as a result of previous budgetary cuts and their effects on aggregate spending and business confidence, fiscal revenues will be hit hard in the next two quarters, which is forcing the authorities to plan and undertake further cuts in order to keep aspirations of fiscal consolidation”. This obvious characterization of a what is a moving target problem was presented in that newspaper article as a “surprising” twist of this crisis. I’ve read the same in the UK media, despite the efforts of Martin Wolf and Samuel Brittan to influence basic economic literacy of FT readers.

    Concepts like the “paradox of thrift” are totally absent in these economic policy debates, precisely when an understanding of it is more urgent. How did this happen? How did macroeconomics education come to this? The same goes for the “paradox of costs”, even though the current crisis is one of Western adjustment in financial leverage and aggregate demand (that just turned into sovereign debt crisis in places without monetary sovereignty). I read high profile professors (like Blanchard about Portugal, and Krugman) writing about the need for internal depreciation in the PIIGS as the only, albeit painful way out of the “competitiveness” problem. These exercises present as justifying arguments a few graphs with unit labor costs rising. But these ULCs are calculated at the aggregate level and thus wrongly interpreted. It’s not only that their interpretation of those indicators disregard that wages are a main source of aggregate expenditure in any economy (the long-forgotten Cambridge equation?), it is that they actually misrepresent the evolution of wages in the economy by the way productivity is plugged in the denominator, i.e. measured in nominal terms, because at the aggregate level it can’t be done in physical terms.

    The only way for this not to be a problem in their interpretation of aggregate ULCs would be for us to live in a World of constant mark-ups and one product economies – the product of course would be called “output”. Rings a bell? I good friend and colleague of mine has written about it less times than I would have preferred him to, given how damaging the whole ULCs arguments currently is. Have a look at this exercise for the Philippines, and let me know if it wouldn’t be interesting to do it for the eurozone countries:

    Again, sorry if this got too long. Now I’ll need to go do some shopping for tonight’s warm climate New Year’s Eve gathering. On the menu we’ll have “arroz de polvo malandrinho” and “vinho verde”. Happy new year Rajiv!! Many thanks for all your work…


  9. Thank you Rajiv for consistent outstanding and important posts, deeply understood and well explained.

    You mention one such post, the one on ETFs of small companies. Very intriguing, and I never had time to really think it through. But I just clicked to it again, and now I'd add this:

    You wrote:

    Bradley and Litan have previously argued their position in a lengthy and data-filled report, and Wield has testified on the issue before the joint CFTC-SEC committee on emerging regulatory issues. Their argument, in a nutshell, is this: The prices of thinly traded stocks can become much more volatile as a result of inclusion in a heavily traded fund as a consequence of the creation and redemption mechanism. For instance, a rise in the price of shares in the fund relative to net asset value induces authorized participants to create new shares while simultaneously buying all underlying securities regardless of the relation between their current prices and any assessment of fundamental value. Similarly a fall in the fund price relative to net asset value can trigger simultaneous sales of a broad range of securities, resulting in significant price declines for relatively illiquid stocks. This process results not only in greater volatility but also in a sharply increased correlation of returns on individual stocks. The scope for risk-reduction through diversification is accordingly reduced, which in turn influences the asset allocation decisions of long term investors. The result is a reduction in the flow of capital to the smaller, more innovative segments of the market, with predictably dire consequences for job creation.

    The sponsors do not deny the possibility of these effects, but argue that any mispricing in the markets for individual stocks represents a profit opportunity for alert fundamental traders, and that this should prevent prolonged or major departures of prices from fundamentals. But this is too sanguine an assessment. Fundamental research is costly and its profitability depends not only on the scale of mispricing that is uncovered but also on the size of the positions that can be taken in order to profit from it. Furthermore, since a significant proportion of trades are driven by the arbitrage activities of authorized participants, mispricing need not be quickly or reliably corrected. Both illiquidity and high volatility serve as a deterrent to fundamental research in such markets.

    The problem, in other words, is real.

    End Quote

    I'll ask, what about the small companies themselves? If a small company's price is getting whipped around predominantly because it's grouped with similar small companies, and not because of its fundamentals, then when it gets unjustifiably whipped down, the CEO, founders etc., will know it, and they can use the company's retained earnings to start buying up the shares heavily. When it gets unjustifiably whipped up, they can start unloading treasury shares heavily. As far as I know it's legal for a corporation to do this, just not any of its individual officers for their personal accounts.

    This could do much to keep prices close to their fundamentals – if the incentives are for those in control to maximize true NPV, and not just game short term incentives. But nonetheless, is this enough that it's still better for society to let these ETFs operate without restriction, than to restrict them in some ways?

    Not clear to me at this point.

  10. Joao, Richard - I'm sorry your comments did not post right away... spam filtering issues. Hopefully fixed now. Thanks to both of you for all your feedback over the past year. I'm on the road today, so I'll respond more fully later.

  11. Rajiv - The pleasure has been all mine.

    It's also interesting that a lot of the economists on the list would not be well-known if they didn't blog - Scott Sumner is a great example of someone I would have never heard of if he didn't blog and I'm glad he does!

    Thanks for the article.

  12. I do know, on the other hand, that one of the well evidenced issues in the finance literature is that CEOs, and other top managers, have relatively short term incentives. Their careers, especially with that particular company, usually won't last nearly as long as the company will. So even if selling treasury shares is good for the company long term, and overall, the CEO may not do it. Because in the short term it can depress the price, especially due to signaling – it lets the market know the CEO, with his vast inside information and analysis, may well think the shares are overpriced.

    So there could be serious agency problems that prevent the CEO from selling treasury shares in his small cap company when it gets overpriced (or issuing and selling new shares). As well as using retained earnings to buy shares when the company gets underpriced.

    Plus, a small cap can easily have strong liquidity constraints, preventing it from doing much buying up of its shares when they get underpriced.

  13. It's interesting to note too that according to one appearantly successful financial blogger:

    "Let me back up a second and explain that insider trading is perfectly legal. All that corporate insiders need to do is declare what trades they make with their own stock, how much and when.
    What’s illegal is when corporate insiders trade on “non-public” info. Let’s say the CEO knows that the earnings report is going to be terrible, so she dumps her shares ahead of time.
    It’s actually a very murky subject."


    So, this would mean that insiders at small caps could push prices to fundamentals (at least through buying; shorting can be a lot harder), at least the publicly known fundamentals, and any non-publicly known usually gets revealed relatively soon anyway. And insiders don't have to invest a lot of additional time and effort. Their job already involves deep knowledge and thought about the company.

    However, insiders are limited by their liquidity and how unbalanced their personal portfolios can become. This is something I wrote about in a letter in The Ecnomist's Voice:

    One reason which was missing, at least explicitly, and which I have not seen yet in the literature, at least explicitly, is that a smart rational investor is limited in how much of a mispriced stock he will purchase or sell by how undiversified his portfolio will become. For example, suppose IBM is currently selling for $100, but its efficient, or rational informed, price is $110. It must be remembered that the rational informed price is what the stock is worth to the investor when added in the appropriate proportion to his properly diversified portfolio of other assets. Such a
    savvy investor will purchase more IBM as it only costs $100, but as soon as he purchases more IBM, IBM becomes worth less to him per share, because it becomes increasingly risky to put so much of his money in the IBM basket. By the time this investor has purchased enough IBM that it constitutes 20 percent of his portfolio, the stock may have become so risky that it’s worth less than $100 to him for an additional share. At that point he may have only purchased enough IBM stock to push the price to $100.02, far short of its efficient market price of $110. Thus, if the rational and informed investors do not hold or control enough—a large enough proportion of the
    wealth invested in the market—they may not be able to come close to pushing prices to the efficient level.


  14. Rajiv,

    You're welcome, and thanks for your high quality commentary here. Have a happy new year!


  15. Joao, lots of food for thought. I don't have much to add at this point but very much appreciate your comments.

    Richard, you introduced a compelling argument and then an even more compelling counterargument. I think that the kind of trading you describe does occur, but not on a scale that can offset the volatility induced by inclusion in an ETF. If the effect were completely offset then I don't think we would see such high and persistent levels of correlation in returns. If you can give me a compelling alternative explanation for the correlation then I might have second thoughts.

    Thank you also for your many interesting comments on other posts throughout the year.

  16. Rajiv, Thank you for the kind comments about my anniversary post. I wish you a Happy New Year, and look forward to future debates on the EMH.

  17. Scott, thanks, and a very happy new year to you too. Your challenging posts on market efficiency have forced me to think through my positions carefully, which is always healthy. I think we agree on many things (for instance on the relative unimportance of minor anomalies, and the high level of trader sophistication). But I hope I can persuade you that non-fundamental volatility induced by the trading process is important both empirically and for policy. I look forward to further discussion of this.

  18. Adam, thanks, and the same to you... I look forward to more interactions over the coming year.

  19. Rajiv,

    How do you think ETFs should be restricted?

  20. Richard, I think that small firms should be allowed to opt out of inclusion in an ETF if they so choose. In other words, the sponsor should be required to get permission from the firm before inclusion. This is the Bradley/Litan proposal.

  21. Rajiv,
    Wonderful year end post! I look forward to and learn something from every one of your blogs and from those you link to. Many thanks for your most excellent blog and Happy New Year!

  22. Thanks Maxine, and a very Happy New Year to you too. I've enjoyed many of your posts over the past few months, and especially admire your breadth of perspective and the manner in which you weave personal narratives into economic arguments. I look forward to reading more from you this year.

  23. This looks like it may be a good idea. Small cap companies where the management has the competence, ability, and willingness to manage their stock price (buy up the stock when it drops clearly below fundamentals, sell shares when it goes clearly above) can opt in, and smartly reap the benefits of the increased liquidity. Others can opt out.

    But management making a good decision on whether to opt in or out depends greatly on good rules and regulation of corporate governance to align shareholder (and societal) and management interests, and to prevent gaming. Corporate governance is greatly in need of improvement, but it's no easy thing getting smart improvements past Republicans, something that's sadly true as a general rule, with few exceptions.