Wednesday, March 31, 2010

Norms as a Substitute for Laws

In a fascinating post on joke-theft in the world of stand-up comedy, Kal Raustiala and Chris Sprigman describe the manner in which social norms backed by informal sanctions can accomplish what copyright laws cannot:
Late one Saturday night in February 2007, a stand-up comic named Joe Rogan decided to take the law into his own hands... For weeks, Rogan had been furious over reports from fellow comedians that an even more famous stand-up, Carlos Mencia, had stolen a joke from one of Rogan’s friends... Rogan spotted Mencia in the audience, and he blew up. Slamming Mencia as “Carlos Menstealia,” Rogan accused his rival of joke thievery. Mencia rushed the stage to defend himself, and there began a long, loud, and profane confrontation...

Rogan’s decision to confront Mencia is an example of what stand-up comedians do all the time. Comedians have rules of their own about joke-stealing. And they impose their own punishments on thieves... Why do comedians do this? In part, because they live in a world where intellectual property law – in particular, copyright – does not help them much when a rival comedian steals a joke... lawsuits are simply too expensive and uncertain to work as an effective response... Today’s comics are intent on enforcing ownership rights. Yet they do so via social norms – informal but nonetheless powerful rules enforced by comedians on their peers... Comedians maintain a small list of commandments that every comic must follow – or risk being ostracized, boycotted, and sometimes worse. These norms track copyright law at times... More often than not, however, the norms deviate from copyright: for example, copyright protects expression but not ideas, but comedians’ norms protect expression as well as ideas...

Importantly, comedians’ norms... include informal but powerful punishments. These start with simple badmouthing and ostracism. If that doesn’t work, punishments may escalate to a refusal to work with the offending comedian – which can keep the accused joke-thief off of comedy club rosters. Occasionally, punishments turn violent. None of these sanctions depend on the law – indeed, when comedians resort to threatening or beating up joke thieves, that’s against the law. That said, although both the rules and the punishments are informal, they are effective. Within the community of comedians, it hurts to be accused of stealing a joke. In some cases, repeat accusations may destroy a showbiz career.
Raustiala and Sprigman recognize that the prevalence of such phenomena undermines one of the standard arguments for copyright protection:
What does this all mean? The story of stand-up tells us that... the law is not always necessary to foster creativity. Using informal group norms and sanctions, comedians are able to control joke-stealing. Without the intervention of copyright law, comedians are able to assert ownership of jokes, regulate their use and transfer, impose sanctions on joke-thieves, and maintain substantial incentives to invest in new material.
This presents a challenge to the conventional economic rationale for intellectual property rights. Absent legal protection, the usual theory goes, there will be too few creative works produced — authors and inventors would be unlikely to recoup their cost of creation, so they won’t bother creating in the first place. As we have described, there is no effective legal protection against joke theft. Yet thousands of stand-ups keep cranking out new material night after night. In the absence of law, we find anti-theft norms providing comedians with a substantial incentive to innovate. Which leads to an important and fascinating question: Where else might creativity norms effectively stand in for legal rules?
In fact, one could ask an even broader question: in which other areas of economic and social life might norms (backed by decentralized sanctions) operate as effective substitutes for legal institutions?
This question lies at the heart of the lifelong work of Elinor Ostrom, co-recipient of the 2009 Nobel Memorial Prize in Economics, whose contributions I discussed in in a couple of earlier posts. Using an eclectic mix of methodological approaches, including case studies, laboratory experiments, and game theoretic models, Ostrom managed to overturn conventional wisdom regarding the "tragedy of the commons." She demonstrated the possibility of self-governance when a well-defined group of users with collective rights to an economically valuable resource were at liberty to develop their own rules, and to ostracize, expel, or otherwise sanction each other for violations. 
While Ostrom's focus was on natural resources such as forests, fisheries, and pastures, her basic insights have more general relevance. For instance, institutions of self-governance are critically important in the case of urban communities that lie largely outside the reach of the formal legal system in the United States. There are parts of the country where residents do not have recourse to the courts to adjudicate contractual and other disputes. Given the very high costs of violence as an enforcement mechanism, norms backed by limited community sanctions can therefore play a crucial role.
Sudhir Venkatesh provides a number of vivid examples of this phenomenon in Off the Books, his first-hand account of a Chicago community that functions with limited direct reliance on the police, courts, banks or government agencies. In order to do so, it must draw upon on its own informal substitutes for formal institutions. There is extensive use of barter and in-kind payments for wages and debt settlement, reciprocal lending agreements for insurance, and informal mechanisms for the resolution of disputes and the assignment of property rights. As in the local commons studied by Ostrom, norms sustained by the threat of sanctions allow a broad range of mutually beneficial transactions to occur without formal contracts backed by the power of the state.
The kinds of norms and enforcement mechanisms identified by Ruastiala and Sprigman (and Ostrom and Venkatesh) are pervasive. Many more examples may be found in an extraordinary volume edited by Daniel Bromley. Included among these is a study of sea tenure in Bahia by Cordell and McKean in which the authors describe a system of ethical codes "far more binding on individual conscience than government regulations could ever be." Such codes also crop up in James Acheson's work on the lobster gangs of Maine, E. Somanathan's account of forest resource management in Central Himalaya, and literally hundreds of other studies, enough to fill a two volume bibliography and more.
Norms not only accomplish the goals of laws, they can often do so more efficiently. The erosion of norms (or the prohibition of the sanctions that stabilize them) can therefore be costly, even if formal laws are enacted to take their place. Since laws can sometimes undermine and sometimes reinforce informal codes of conduct, finding the right balance between norms and laws is not an easy task. I suspect that legal scholars are acutely aware of such tensions, but (to my knowledge) these trade-offs have received limited attention in economics.

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Update (4/1). In response to a lively discussion of these issues on Mark Thoma's blog, I have posted a few clarifications. Here's a slightly edited version of my comment:
In hierarchical contexts there can be oppressive norms that serve to reinforce and entrench status. Axelrod has a 1986 paper in the APSR with some examples from the Jim Crow period, and many vivid cases can be found in rural parts of South Asia even today, related both to gender and caste. The fact that oppressive norms can be more effective than oppressive laws makes them less rather than more desirable. I should have been more careful on this point.

For norms backed by sanctions to work, group boundaries have to be well-defined, although communities need not be close knit... For example, norms against plagiarism are pretty effective deterrence mechanisms in academic circles.
This is why the distinction between common property and open access is so critical in resource economics. Open access resources would be depleted in no time without laws backed by state power. But a huge number of people living in rural areas of developing countries own little more than the rights to use common pool resources. Privatization or nationalization of these can have massive welfare consequences. So it's important to know whether or not these resources can be managed sustainably by the populations whose livelihood depends on them.
To me, this is the main message emerging from Ostrom's work.

Friday, March 26, 2010

The Future of Academic Publishing

Theoretical Economics is among the most prestigious journals specializing in economic theory, with a stellar editorial board and high quality submissions. It is also an open access journal: every published article may be viewed, downloaded and printed freely worldwide without subscription. And authors release their work under a creative commons license that allows users to "copy, distribute and transmit" the work provided that this is done with proper attribution, in the "manner specified by the author."
The founders of the journal clearly see this as a template for academic publishing more generally:
The advent of the web has made free dissemination of research feasible and financially viable. Because existing specialty journals obtain revenues from selling subscriptions, primarily to libraries, access to the research they publish is limited. The attractive revenue stream that such subscriptions provide makes it unlikely that these journals will convert to Open Access. Thus a need exists for new refereed Open Access journals to replace existing journals. We believe that the establishment of a major Open Access journal in economic theory will lead others to establish Open Access journals for other fields of economics, reclaiming full control for the profession of its research output. We hope that this will lead the profession to a new norm in which all research is freely available.
Under the open access format the size of the user pool (and the aggregate consumers' surplus) is maximized, but none of the benefits that accrue to readers can be appropriated by publishers. This would ordinarily make financial viability difficult. But in the case of journal articles there is very little value added by the publisher in any case: from the point of view of most readers, a working paper is usually a near perfect substitute for the typeset article. Hence the lion's share of the product's value is created by authors, referees and editors for little or no direct financial compensation. As a result, relatively modest fees for submission or  the processing of accepted papers can be enough to cover the costs of production and online dissemination.
The attractiveness of this business model has not escaped the attention of commercial publishers. Bentham Science, for instance, is already publishing more than 200 open access journals, including one in economics. The Hindawi Publishing Corporation (in collaboration with Sage Publications) also has a portfolio of comparable size, and has just launched Economics Research International. And such initiatives exist side by side with non-commercial ventures such as the e-journal Economics, which operates not only under open access but also uses an innovative public review process involving a large community of registered readers.
So far, the major academic publishers have managed to maintain their lucrative subscription based model, although they now allow articles to be accessed free of charge if the author pays an additional fee (the publisher typically retains copyright and imposes restrictions on redistribution). It is doubtful that this hybrid model can be sustained. For one thing, libraries will be increasingly reluctant to pay for bundled journal subscriptions when much of the content could be accessed freely in any case. More importantly, when given a choice, authors will surely prefer retention of copyright, avoidance of exorbitant fees, and the broadest possible dissemination of their work.
Accordingly, if some of the major economic societies and associations make the transition to open access, the floodgates will open. Traditional publishers will find themselves in a pincer like grip, with highly prestigious society journals weighing down upon them and new entrants nipping at their heels. The giants who currently dominate academic publishing and own vast numbers of important titles will then be faced with a choice. They could themselves fully adopt the open access format and continue to compete effectively (but with diminished profit margins), or watch the value of their holdings gradually decline. Either way, open access seems destined to be the future of academic publishing.
This would be a welcome development. In an earlier post, I claimed that the proliferation of blogs is leading to a democratization of discourse in economics, as non-specialists and autodidacts bring fresh perspectives to bear on theoretical disputes and policy questions. This process depends critically on the ability of outsiders to eavesdrop easily on conversations among economists. Unfettered access to academic research not only increases the visibility of ideas, it also increases the scrutiny to which they are subjected. And this should result in the development of better, more interesting, and more robust ideas in the long run.

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Update (3/29).  Theoretical Economics is now an Econometric Society journal, so its status and survival are both secure. The Society has also launched a more empirically oriented counterpart, Quantitative Economics, that also has a first rate editorial board. I find it puzzling that the American Economic Association did not choose the open access format for its four new journals; this was a wonderful opportunity missed.

For anyone interested in the economics of academic publishing, Ted Bergstom's journal pricing page is a comprehensive source, featuring links to articles, news, comments and data. In an email to me, Ted points out that open access is not without its own problems:
Your mention of Bentham publishing reminds me that there is a "dark side" to open access publishing as well.  There are some slimy types who are trying to profit from open access publishing by spamming for authors and editors and publishing without any form of quality control. Bentham seems to be one of them. 
In support of his claims, Ted points to a couple of revealing interviews by the British journalist Richard Poynder (also discussed here) and an extraordinary post on the acceptance of a meaningless computer generated article by a Bentham journal. Separating the scam from the genuine article is clearly going to be a challenge in the early stages of this transition.

Friday, March 19, 2010

On Hedging, Speculation and Financial Instability

Over on the Aleph Blog, David Merkel has promised a "long set of irregular posts" about what he calls "the rules." Here's an extract from the second in this series:
On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.
This rule is pretty simple.  There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.  In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.  There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.
The trouble occurs when the speculator can’t make good on his obligations.  As with many speculators, he overcommits.  He is short of funds because many trades are going against him at the same time.  It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.
That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.  The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.
There are really two separate points here: (i) hedging is generally possible only if speculation also occurs, and (ii) if speculators do not have adequate capital reserves, then the stability of the system is at risk.
The first point is worth keeping in mind when thinking about the regulation of derivatives. For every bondholder who purchased credit default swaps as protection, there was a counterparty betting against default. Hedging by the former would not have been possible without speculation by the latter. This kind of transaction involves the transfer of credit risk from one party to another at a price that is agreeable to both. If such transactions were not possible, then those who have the capital to buy the underlying bonds would be forced also to bear the credit risk, possibly resulting in a thinner market and increased costs of borrowing. This is the usual economic argument against curtailing the use of such instruments.
In thinking about the costs and benefits of speculation, however, it is equally important to keep in mind that the converse of David's rule does not hold: it is clearly not the case that someone must hedge in order to allow you to speculate. Two parties can enter a contract in which they are both making directional bets. Naked credit default swaps (where the buyer does not hold the underlying bond) are contracts with this character, as are put options purchased (or call options written) without ownership of the underlying stock. 
Hence, while some degree of speculation is necessary to make hedging possible, there is essentially no limit on the volume of purely speculative transactions that can be sustained by any given quantity of underlying assets. The fact that the sum total of such side bets must net to zero does not mean that the scale of this activity has no effect on prices, volatility, or financial instability. Richard Portes (via Mark Thoma) explains why:
Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations, as Daniel Cohen and I have argued.
In addition to the multiple equilibrium issue (previously discussed on this blog here and here), there is the problem of counterparty risk:
The mechanism of CDS is like that of reinsurance. The fees are received up front, the risks are long-term, with fat tails. There are chains of risk transfer – a CDS seller will then hedge its position by buying CDS. So the net is much less than the gross, but the chain is based on the view that each party can and will make good on its contract. If there is a failure, the rest of the chain is exposed, and fears of counterparty risk can cause a drying up of liquidity. The long chains may create large and obscure concentration risks as well as volatility, since uncertainty about any firm echoes through the system.
Naked CDS increase leverage to the default of the reference entity. They can thereby substantially increase the losses that come from defaults. And the leverage comes at low cost – nothing equivalent to capital requirements, no reserve requirement of the kind insurers must satisfy.
This brings us full circle to the second part of David's rule: the dangers of undercapitalized speculation. AIG was able to sell credit default swaps without posting collateral as long as it maintained its AAA credit rating. When the Lehman bankruptcy simultaneously triggered both higher CDS spreads and a downgrade of AIGs rating, the company faced major collateral calls that it could not meet. Had it not been for an $85 billion line of credit from the Federal Reserve (acting in concert with the Treasury) AIG would have entered bankruptcy and its counterparties, despite having correctly predicted the movement in CDS spreads, would themselves have taken major losses. They either failed to fully appreciate this risk, or anticipated (correctly as it turned out) that the government would not allow a failure on this scale.
That $85 billion investment has now swollen to more than $180 billion and there is a great deal of public outrage and incomprehension concerning the need for taxpayer funded payouts on privately negotiated speculative bets. William Dudley, in a speech at Columbia University last December, defended the actions taken by his employer but acknowledged that the situation was "unfair on its face... galling in an environment in which the unemployment rate is 10 percent and many people are struggling to make ends meet... deeply offensive to Americans" and "counter to basic notions of justice and fairness."
These decisions were made under enormous pressure with little time for reflection, and mistakes made in such circumstances would ordinarily be forgivable. But Dudley, as well as Bernanke and Geithner in their congressional testimony, continue to insist that the best available course of action was taken, and that any alternative would have had devastating economic costs. Even if they are correct on this point (and I have my doubts), the fact that it came to this surely reflects one of the most staggering failures of regulatory oversight in recent history.

Thursday, March 18, 2010

Selection into and within Occupations

A recent report by Max Abelson contains some choice statements by a couple of former Lehman executives:
There are two ways to react to the biblically proportioned report that Lehman Brothers’ bankruptcy examiner released last Friday... The first is to lose faith in man...
The second reaction is to shrug... Two former senior Lehman executives did just that this week, telling The Observer that the examiner’s autopsy... was simply not a big deal... “It’s just not that big of an event... They just want to be mad and don’t know what they’re talking about and want to be outraged...”

“When I read this, I giggle a little bit. Because $50 billion is a shitload of money, but in the grand scheme of things... $50 billion is a drop in the ocean.”

The former managing director in London said that Repo 105 was an open secret there, if it was a secret at all. “Yeah, yeah, yeah. In Europe, people just generically talk about it. It’s funny, for nonprofessionals, you can try to make it a smoking gun,” the source said, “I’m like, whatever.”
The only people who would worry about using an old trick to reduce leverage from 13.9 to 12.1, the second executive said, are “yappers who don’t know anything.”
Stacy-Marie Ishmael at FT Alphaville is rendered speechless by this. Felix Salmon, however, is not lost for words:
[It’s] important not to lose sight of the fact that what we’re seeing here is a corporate failing to an even greater degree than it is an individual one, and that it infects investment banks generally, not just Lehman Brothers. These shops deliberately go out to hire psychopaths, and then they fire the ones who go soft, while promoting the most aggressive assholes, keeping a few smooth-talking client-relationship types on hand to preserve some semblance of a respectable public face.
I prefer to think in terms of preferences over risk and reward rather than psychological pathologies, but behind the strong language his point still stands: human behavior differs substantially across career paths because of selection both into and within occupations. This is what I was trying to get at in an earlier post in which I argued that behavioral economics, despite its many successes, was going to be of limited use in understanding the determinants of financial instability:
[Regularities] identified in controlled laboratory experiments with standard subject pools have limited application to environments in which the distribution of behavioral propensities is both endogenous and psychologically rare. This is the case in financial markets, which are subject to selection at a number of levels. Those who enter the profession are unlikely to be psychologically typical, and market conditions determine which behavioral propensities survive and thrive at any point in historical time.
This calls for an ecological approach to understanding financial market behavior, focused on behavioral heterogeneity and selection pressures. The argument is not by any means new; it is a critical component of Minsky's financial instability hypothesis, and has been articulated recently in the following terms by Macroeconomic Resilience:
If we assume that there is a sufficient diversity of balance-sheet strategies being followed by various bank CEOs, those... who follow the... strategy of high leverage and assets with severely negatively skewed payoffs will be “selected” by their shareholders over other competing CEOs... cheap leverage afforded by the creditor guarantee means that this strategy can be levered up to achieve extremely high rates of return. Even better, the assets will most likely not suffer any loss in the extended stable period before a financial crisis. The principal, in this case the bank shareholder, will most likely mistake the returns to be genuine alpha rather than the severe blowup risk trade it truly represents.
Selection of strategies necessarily implies selection of people, since individuals are not infinitely flexible with respect to the range of behavior that they can exhibit. Hence any incentive structure will elevate certain types of individuals at the expense of others. As Felix notes, this is "something that regulatory reform can’t even come close to addressing, unless it deals head-on with the question of compensation."

Sunday, March 14, 2010

An Ecological Perspective on Financial Market Reform

Financial practices such as leverage and maturity transformation have been getting a lot of attention in the aftermath of the recent crisis. Consider, for instance, the following comments by William Dudley from a speech he gave in November:
Turning [to] inherent sources of instability, there are at least two that are worthy of mention. The first instability stems from the fact that most financial firms engage in maturity transformation — the maturity of their assets is longer than the maturity of their liabilities. The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation — borrowing shorter-term in order to finance longer-term lending.

If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.

The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent... But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line... because the liquidation value is lower than the firm’s value as a going concern...

These sources of instability create the risk of a cascade... Once the firm’s viability is in question and it is does not have access to an insured deposit funding base, the next stop is often a full-scale liquidity crisis that often cannot be stopped without massive government intervention.
More recently, David Merkel has discussed the issue as follows:
If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.  It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.  CIT did die.  Mexico in 1994.  When you can’t roll over your short term debts, it gets really ugly, and fast... The phrase, “You can always refinance,” is a lie... Long-dated assets should be financed by non-putable long-dated liabilities or equity.  Don’t cheat and finance shorter than the life of the assets involved.  There is never an assurance that you will be able to get financing on terms that you will like later.
In his report on the Lehman bankruptcy, the court-appointed examiner Anton Valukas observed that "demands for collateral by [its] lenders had direct impact on Lehman’s liquidity" and that the resulting inability to obtain short-term financing "is central to the question of why Lehman failed." As Barry Ritholtz points out, however, this was a proximate rather than ultimate cause of the bankruptcy:
So what actually kills the patient — the disease that ravages the body, destroys its naturally ability to fight off invaders, and leaves it totally vulnerable? Or whichever random infection finally does them in?

In the case of Lehman Brothers, the disease that left them vulnerable was a mad embracing of risk, the excess use of leverage, an extensive exposure to mortgage and real estate, and the enormous usage of derivatives — concurrent with a lack of intelligent risk management.

Citi and JPM were merely the opportunistic infections that came along at when Lehman’s immune system was compromised. That is why you never want to allow yourself to become that vulnerable on Wall Street.
Note that if Lehman were the only firm engaged in such practices, we would probably have had a contained bankruptcy rather than a full-fledged financial crisis:
On Monday September 15, Lehman Brothers... was allowed to go into bankruptcy... It was a game-changing event with catastrophic consequences... the price of credit default swaps... went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to “break the buck” – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.
None of this would have been possible without extensive maturity transformation and high levels of leverage across a broad range of financial institutions, making them all simultaneously vulnerable to a liquidity shock. But how did this level of fragility arise in the first place?
As far as I am aware, there are few economists who have attempted to shed light on the process that gives rise to changes over time in systemic financial fragility. An important exception is the late Hyman Minsky, who developed what might be interpreted as an ecological theory of financial practices. I have discussed his ideas at length in a previous post, but they are worth revisiting in light of the Lehman report. 
Central to Minsky's theory is the idea that at any point in time there is a distribution of financial practices in the economy, ranging from prudent debt structures with ample margins of safely to highly aggressive positions involving significant leverage and maturity transformation. In particular, Minsky draws a distinction between hedge financing and speculative financing. The former refers to a debt structure in which expected cash flows in all future periods are large enough to meet contractual debt commitments. Unless revenues are unexpectedly low, therefore, there will be no need for such a firm to roll over its debt. Speculative financing refers to a debt structure in which cash flows are expected to lie below debt commitments in some periods. In this case the firm anticipates that it will need to refinance, and is therefore vulnerable to changes in interest rates and the availability of credit.
Minsky is interested in the manner in which the distribution of financial practices -- the extent of hedge relative to speculative financing in the economy --  changes over time. The proximate determinants of such changes are differential rewards: those practices associated with the highest realized returns will tend to proliferate through reinforcement, imitation, and flows of capital to successful firms. As long as a liquidity crisis is averted, the prevalence of speculative financing will therefore increase. This effect is amplified by the fact that speculative financing results in faster economic expansion and asset appreciation:
The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety, so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments. As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price for capital assets and increases investment. As this continues, the economy is transformed into a boom economy." (Minsky, 1982)
The inevitable result of a progressive shift towards increasingly aggressive financial practices is a rise in system fragility. When a liquidity crisis eventually arrives, it is the most highly leveraged firms that face bankruptcy. I summarized this process in a 2002 review as follows:
During stable expansions, profits accrue disproportionately to firms with the most aggressive financial practices, resulting in an erosion of margins of safety. This raises the probability that a major default will trigger a widespread crisis. When a crisis does eventually occur, its most devastating impact is on the highly indebted firms that prospered during the expansion. Balance sheets are purged of debt, margins of safety rise, and the stage is set for the process to begin anew. From this perspective, expectations of financial tranquility are self-falsifying. Stability, as Minsky liked to put it, is itself destabilizing.
Those who recognize that such a process is underway can make a killing when the crisis eventually erupts, but will make steady losses in the interim and must have deep enough pockets to hold on. If they are managing other people's money, they may face major withdrawals of cash precisely when their expected returns are highest (this is the central insight in Shleifer and Vishny's analysis of the limits of arbitrage).
One cannot, therefore, simply rely on self-correcting market mechanisms to keep such crises at bay. What should one do instead? The ecological perspective suggests that static approaches to financial sector reform (such as curtailing the use of certain types of contracts or shifting over-the-counter transactions to exchanges) may not be enough. What is required is a more dynamic policy response that makes aggressive financial practices more costly at precisely those points in time when fragility is greatest. As long as prudence doesn't pay, the injunction that "long-dated assets should be financed by non-putable long-dated liabilities or equity" will surely continue to fall on deaf ears.

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Update (3/18). For anyone interested in reading more about the ecological approach to financial market behavior, Macroeconomic Resilience has a number of posts on the topic; see especially this one on parallels and complementarities between Minsky's ideas and those of the Canadian ecologist Buzz Holling.

Wednesday, March 10, 2010

On Asymmetry, Reflexivity and Sovereign Default

One of the most rewarding aspects of blogging is that it gives me the opportunity learn from those who read and comment on the ideas expressed here. I have had the good fortune of being visited by a number of informed and thoughtful readers, whose remarks have often been of greater quality than the posts to which they were responding. Among those for whom I have developed the greatest respect is the anonymous author of Macroeconomic Resilience, who left a couple of very helpful comments in response to my recent post on credit default swaps.
MR pointed out that the idea of multiple self-fulfilling default probabilities plays a key role in George Soros' theory of reflexivity, and linked to an article in which Soros interpreted the Lehman bankruptcy in precisely these terms. In fact, it is a combination of reflexivity and a particular kind of risk/reward asymmetry that gives rise to what Soros calls self-validating bear raids:
First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market... Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract...

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.
Soros' point about risk/reward asymmetry directly answers one objection to curtailing purchases of naked credit default swaps, namely that such contracts "provide identical leverage both to the optimistic and the pessimistic side of the transaction." Leverage may be considerable on both sides of the contract but this does not mean that market clearing prices reflect optimistic and pessimistic beliefs in equal measure, because the spreads at which sellers are willing to enter the contract must offer them adequate compensation for the significant downside risk that they face.
MR does not consider reflexivity to be a routine problem in credit markets, arguing that "only when the entity is in a state of low resilience that markets are sufficiently reflexive to push it over the edge." This is also David Merkel's view of the matter:
... if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.  You have the upper hand.  But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.  Even without derivatives, that is a tough place to be.
But what causes a balance sheet to become weak? In the case of sovereign states, it could be widespread tax avoidance and excessive spending relative to revenues, as has been alleged in the case of Greece. But it could also be a significant decline in economic activity that reduces the tax base and triggers automatic stabilizers. This is how Paul Krugman interprets the experience of Spain, which had a budget surplus three years ago, but "is running huge deficits now [as] a consequence, not a cause, of the crisis: revenue has plunged, and the government has spent some money trying to alleviate unemployment."
Any attempt to raise taxes or cut spending in this environment could make it even harder for the country to meet its near term debt obligations. For this reason, Felix Salmon's claim that countries "have essentially no limit on how much they can tax or cut spending in order to make their debt repayments" cannot possibly be correct as a general principle. A government can change expenditure policies and tax rates, but has no direct control over realized revenues and outlays. As a result, raising tax rates or trimming expenditures (such as unemployment benefits) in the face of severe deficiencies in aggregate demand can worsen rather than improve its balance sheet position.
Under such circumstances, it is terribly important to determine whether the looming threat of default is simply one of several possible equilibrium paths. As Felix acknowledged in his response to my post, it is true in principle that "a company or country can find it easy to repay debt when spreads are low, thereby justifying the low spreads, while finding it hard to repay debt when spreads are high, justifying the high spreads." Default under these conditions would be terribly wasteful, and I can see no reason why attempts to avoid it should not be pursued vigorously.

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Update (3/11). Paul Krugman also seems to think that it's worth considering the possibility of multiple self-fulfilling default probabilities in the context of sovereign defaults (h/t Mark Thoma):
Markets are getting slightly more bullish on Greek debt — and Peter Boone and Simon Johnson are crying bubble. I’m not so sure, but I think their argument highlights something else: the possibility of multiple equilibria in sovereign solvency...
Suppose that Greece had as much credibility as Germany, and could borrow at a real interest rate of 2 percent. Then stabilizing the real value of its debt, even with a debt ratio of 150 percent, would require a primary surplus of only 3 percent of GDP. That’s certainly possible for some countries, although maybe not for Greece.
Boone and Johnson assume, however, that Greece would have to pay 10 percent nominal, say 8 percent real. Servicing that would require a primary surplus of 12 percent of GDP, probably impossible for almost anyone.
So this suggests that optimism or pessimism about future default can, to at least some degree, be a self-fulfilling prophecy. Not a new insight, I know, but it looks increasingly important for thinking about where we are now.
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Update (3/19). And here's Richard Portes arguing for the importance and empirical relevance of multiple self-fulfilling default probabilities, based on his work with Daniel Cohen (h/t Mark Thoma):
Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations, as Daniel Cohen and I have argued.

Saturday, March 06, 2010

Defenders and Demonizers of Credit Default Swaps

The recent difficulties faced by Greece (and some other eurozone states) in rolling over their national debt has let some to blame hedge fund involvement in the market for credit default swaps. These contracts can be used to insure bondholders against the risk of default, but when purchased naked (without holding the underlying bonds), they can serve as highly leveraged speculative bets on a rise in the cost of borrowing faced by the sovereign states.
A cogent case for prohibiting the use of credit default swaps to make directional bets has been made recently by Wolfgang Münchau in the Financial Times:
I generally do not like to propose bans. But I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer...
A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point...
Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss...
I do not want to exaggerate the case for a ban. This speculation is neither the underlying cause of the global financial crisis, nor of the eurozone’s underlying economic tensions. But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.
Felix Salmon objects to this reasoning, arguing that trade in naked credit default swaps adds liquidity to the market, which in turn makes borrowing easier in times of stress:
One of the big problems with debt markets is that, especially during times of stress, they become very illiquid. Many bankers have spent many hours trying to explain to emerging-market finance ministers that just because their bonds are trading at a certain level in the secondary market, that doesn’t mean they can issue new bonds at that level, or even at all.
But it turns out that a liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil. Which is yet another reason to laud the notorious buyers of naked CDS protection, rather than demonizing them.
Sam Jones also rises in defense of naked CDS contracts, though for somewhat different reasons:
Here’s the rub: there is a palpable social and economic benefit to naked CDS positions. And what’s more, that benefit has perhaps never been more strongly borne out than as in the recent case of Greece.
First, some context via a trip back in time: back to 2004, when the Euro was a more lustrous specie than it is today, and when credit default swaps were breaking into the mainstream... some hedge funds in those more moderate times spotted an opportunity for a trade... buy default protection against the eurozone’s weakest member states, the bonds of which had no place trading so close to German bonds. Buy Italy, buy Spain, buy Greece. And do so, naturellement, au naturale...
What they saw happening was an inevitable re-risking of the eurozone. Italy could not possibly be priced so close to Germany indefinitely, and at some point, during the lifetime of their ten year CDS contract, spreads on Italian bonds would widen... The result would be –- if done well — a perfect sovereign basis trade. And because the CDS contracts required so little initial outlay, it could be done on a huge scale, to significant profit...
In 2008 and 2009... the logic of the trade returned with more heft... Last year, big hedge funds were significant buyers of CDS protection on risky EU states: in particular, they bought CDS against Greece in anticipation of a budget blowup that would send the yields on Greek bonds soaring at some point in the next few months...
What, though, to return to the point of this post, of the broader economic and social benefit beyond well-heeled Mayfair and leafy Connecticut? 
Firstly, any naked CDS buying... occurred, by hedge funds at least, well before the current crisis. Hedge funds have not been the most significant buyers of CDS in recent weeks... Ergo, there is no speculative, opportunistic “attack” underway to try and push Greece further into catastrophe...
Secondly... hedge funds, completing their clever trade, have been buyers of Greek government debt, or else insurers of other holders as CDS writers.
In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.
And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago.
So the argument here is that while hedge funds may have raised the cost of borrowing for Greece in 2008-09, their current actions are making borrowing easier and less costly. 
Leaving aside the question of whether naked CDS trading has been good or bad for Greece, it is worth asking whether there exist mechanisms through which such contracts can ever have destabilizing effects. I believe that they can, for reasons that Salmon and Jones would do well to consider. 
Any entity (private or public) that faces a maturity mismatch between its expected revenues and debt obligations anticipates having to to roll over its debt periodically. Such an entity could be solvent (in the sense that the present value of its revenue stream exceeds that of its liabilities) and yet face a run on its liquid assets if investors are sufficiently pessimistic about its ability to refinance its debt. More importantly, it may face a present value reversal if the rate of interest that it must pay to borrow rises too much. In this case expectations of default can become self-fulfilling. 
This is the central insight in Diamond and Dybvig's classic paper on bank runs, and is a key rationale for deposit insurance. William Dudley highlighted the importance of such effects in a speech last November:
If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.
Dudley is speaking here of financial firms, but his arguments hold also for governments that do not have the capacity to issue fiat money. This is the case for state and local governments in the US, as well as individual countries in the eurozone. The main "assets" held by such entities are claims on future tax revenues, which are obviously not marketable. In this case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic.
What does this have to do with naked credit default swaps? As John Geanakoplos notes in his paper on The Leverage Cycle, such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation.
Whether or not these considerations are relevant in accounting for the troubles faced by Greece is an empirical question. But it does seem to be within the realm of possibility. At least the Chairman of the Federal Reserve appears to think so
Addressing concerns that financial firms have been engaging in trades to bet on a Greek default, Bernanke said that "using these instruments in a way that intentionally destabilizes a company or a country is counterproductive, and I'm sure the SEC will be looking into that."
Felix Salmon hopes that Bernanke "was just being polite to his Congressional overlords, rather than buying in to this theory." I hope, instead, that he is taking the theory seriously.

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Update (3/7). Felix Salmon has another post dismantling a New York Times report on the issue. The Times is an easy target, and it is true that their reporting has been riddled with errors and inconsistencies, including a bizarre failure to distinguish between the systemic effects of selling credit default swaps without adequate capital reserves (as AIG did), and those of large scale naked CDS purchases (as hedge funds are alleged to have made).

But what I would like to see from Salmon is a clearer distinction between the use of CDS contracts for hedging (which even Münchau would probably agree has beneficial effects on the ease and cost of borrowing) and their use for speculation (which need not). The Sam Jones post does this, and makes clear that if current hedge fund activity is holding down CDS spreads, then prior activity must have had the opposite effect. One may then ask whether Greece (and its fellow PIGS) would be in such a precarious position without this prior activity: this is an empirical question that has yet to be convincingly answered.

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Update (3/8). The comment thread following Mark Thoma's post on this is excellent. Leigh Caldwell questions the feasibility of banning naked credit default swaps and links to this post. Robert Waldmann argues that it is trivially easy to do so, and links to his September 2008 post making the case. Paine wonders whether the bank run model is adequate (and seems to be the only one taking the multiple equilibrium problem seriously). Bruce Wilder is concerned that insuring bonds against default destroys incentives for supervision and control. Gump explains the structure and incentive effects of CDS contracts with greater clarity than I've seen anywhere else. And mrrunangun makes an interesting proposal. There's plenty of criticism of my post, but I very much enjoyed reading the entire thread.

Also, I have edited the Münchau quote to remove his quip about banning bank robberies (this was a rhetorical excess, and unhelpful in advancing debate on the topic).

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Update (3/8). Felix responds on empirical grounds, and he may well be right about Greece. But the following claim is clearly incorrect:
Countries have essentially no limit on how much they can tax or cut spending in order to make their debt repayments: just look at Latvia right now. I’m not saying they should always raise taxes and cut spending rather than default, of course — I’m just saying they can. Companies are in a very different boat, and if they can’t find the money to make a payment then they default: it’s as simple as that.
The problem with this is that while governments can change expenditure policies and tax rates, they do not have direct control over revenues or actual expenditures, which depend on the level of economic activity. If attempts to raise revenues are too contractionary, the deficit may increase rather than decrease. As Paul Krugman points out in this post, Spain had a budget surplus just three years ago, but "is running huge deficits now... a consequence, not a cause, of the crisis: revenue has plunged, and the government has spent some money trying to alleviate unemployment." Any attempt to raise taxes or cut spending in this environment could make it even harder for the country to meet its near term debt obligations. There is also political viability to consider: a government has to stay in power if it is to do anything at all.

Wednesday, March 03, 2010

Public Outrage and Criminal Justice

Today's New York Times reports on the case of Ruchika Girotra, who at the age of 14 was molested by a senior police officer in Haryana, India, and committed suicide three years later after an intense campaign of harassment against her family, including the false arrest and torture in custody of her brother. The family of a witness maintained pressure on the judicial system, backed by considerable attention from the media. The officer was eventually charged in 2000, ten years after the original crime. It took another nine years to win a conviction and a sentence (currently under appeal) of six months in prison and a trivial fine. 
This case is not in the least bit unusual, and illustrates the manner in which a reasonably free press interacts with a sluggish and often corrupt legal system to determine judicial outcomes in India. There have been numerous instances in which serious crimes have been committed by highly placed individuals against whom the evidence is overwhelming. But through extensive witness tampering and intimidation, enough doubt and confusion is sown that no case against the accused can be sustained. The subsequent media attention is then critical in bringing the perpetrators to justice, often after a lag of several years and multiple judicial twists and turns.
Five such cases were discussed in some detail in a paper on "Public Outrage and Criminal Justice: Lessons from the Jessica Lal Case" that I wrote recently with Dan O'Flaherty. (The paper was published last year in a conference volume edited by Bhaskar Dutta, Tridip Ray and E. Somanathan.) These cases all illustrate the importance of public outrage, channeled through a free and competitive press, in securing justice against powerful defendants. And they reveal the importance of what Albert Hirschman called "voice" in his extraordinary book on the variety of mechanisms that can serve to maintain effiiciency in organizations. 
The first of the cases we considered in the paper was that of Jessica Lal:
During the early hours of April 30, 1999, a thirty-four year old model named Jessica Lal was shot and killed at a private party in a South Delhi restaurant, allegedly for refusing to serve liquor to a guest after the bar had closed. The man in question was identified by three eye witnesses as Manu Sharma, the son of a senior Congress Party politician and former Union minister. After several days in hiding, Sharma surrendered to authorities in Chandigarh. In an interview with police that was subsequently broadcast on national television, Sharma confessed to the murder. This confession was later retracted, and a plea of non-guilty entered at trial. During the trial the three critical eye witnesses recanted earlier statements made to the police, and twenty-nine witnesses of lesser importance did the same. One of the eye witnesses, Shyan Munshi, changed his testimony so completely that his revised statement was used as exculpatory evidence by the defence.
Sharma and eight other codefendants were acquitted of all charges in February 2006, resulting in a public outcry against what was perceived to be a gross miscarriage of justice. During the weeks that followed the verdict, petitions were circulated, protest marches organized, and candlelight vigils held. Prime Minister Mammohan Singh publicly expressed concern at the general phenomenon of witnesses changing their testimony, in an oblique reference to the Jessica Lal case. President Abdul Kalam received a petition of 200,000 names collected by journalists at NDTV, and promised action. The decision was appealed to the Delhi High Court by the prosecution in March, and in December the lower court ruling was reversed with respect to three of the defendants. Manu Sharma was convicted of murder and sentenced to life in prison, and two other defendants were convicted for conspiracy and destruction of evidence.
While this case is perhaps the most widely known, there are others that followed a similar course:
Priyadarshini Mattoo was a twenty-five year old law student when she was raped, brutally beaten and strangled to death at her New Delhi residence on January 23, 1996. Although there was no eye witness to the murder, physical and circumstantial evidence pointed immediately to Santosh Kumar Singh, the son of a senior police officer then posted in Pondicherry. Singh had been stalking Mattoo for over a year at the time of the murder, with multiple instances of harassment having been reported to the police. He was seen outside her residence by a neighbor immediately prior to the attack, and blood stained pieces of his motorcycle helmet vizor were found beside the body. DNA tests confirmed the presence of his semen on her clothes and her blood on his helmet.
What seemed like an open and shut case, however, ended in an acquittal in 1999. Defence claims that the physical evidence had been tampered with while in police custody were given enough credence by trial judge to allow for reasonable doubt. Suspicions were raised by the judge regarding deliberate police misconduct, including false depositions, traced to the influence of the father of the accused: by the time of the trial Singh's father was among the most senior police officers in Delhi.
The acquittal triggered massive public outrage, and the case was appealed to the Delhi High Court in 2000. Little action was taken for several years, until the 2006 acquittal of Manu Sharma for the Jessica Lal murder led to renewed scrutiny and a sense of urgency in the part of the Court. The verdict of the lower court was reversed in October 2006, with the High Court finding that the "circumstantial evidence in the case is absolutely inconsistent... with the innocence of the respondent." Justices RS Sodhi and PK Bhasin observed that the acquittal by the trial judge had "shocked the judicial conscience" of their Court. Singh was sentenced a few days later to death by hanging.
The third case we considered was that of Nitish Katara:
While a studying at the Institute of Management Technology in Ghaziabad in 1998, Nitish Katara became romantically involved with a classmate, Bharti Yadav. Bharti was the daughter of D.P. Yadav, a major force in U.P. politics, and the sister of Vikas Yadav, who was subsequently convicted for destruction of evidence in the Jessica Lal case. Her family disapproved of the relationship and Katara received multiple threats over the course of their relationship.
On the night of February 2, 2002, Katara attended a wedding at which several members of Bharti's family were present. Four witnesses observed him leaving in the company of three men, including Vikas Yadav and a cousin, Vishal Yadav. Katara's remains, charred and battered beyond recognition, were found on a roadside the next morning. Vikas Yadav and a cousin, Vishal Yadav, went into hiding but were arrested a few days later. A detailed confession, admitting to the abduction and murder, was recorded by UP police and aired on national television. Vikas admitted to having killed Nistish with a hammer blow to the head and setting his lifeless body on fire. He subsequently led police to the spot where the body had been dumped and the murder weapon concealed.
Once the trail began, however, one witness after another "turned hostile", including all four witnesses who had earlier reported having seen Katara depart with Vikas and Vishal Yadav. In testimony before the court, Bharti Yadav denied a romantic relationship with Katara, admitting only to a vague friendship. There remains a single witness, a passer-by whose scooter broke down on the road taken by the accused, and who has testified to seeing Katara in the vehicle. This witness has reported having received threats against his life, and is currently under police protection. The case remains unresolved, and under intense public scrutiny.
Fourth we looked at what has come to be called the "BMW hit-and-run case":
At around 4am on January 10, 1999, a speeding black BMW crashed through a police checkpoint in Delhi, killing four people on the spot. Two others subsequently succumbed to injuries, leaving just one survivor, Manoj Malik. Three of the dead were police constables. A passer by who witnessed the crash, Sunil Kulkarni, came forward a few days later. According to his initial report to police, three individuals stepped out of the car, briefly inspected the damage, then fled from the scene. The damage was so extreme that the speed of the vehicle upon impact was estimated to be 140 kmph (about 90 mph).
The car was alleged to have been driven by Sanjeev Nanda, son of businessman and arms dealer Suresh Nanda, and grandson of Navy Admiral S.M. Nanda. Also present in the vehicle were his friends Siddharth Gupta and Manik Kapoor. They were returning to Delhi from a party in Gurgaon, and Sanjeev was found to have elevated levels of alcohol in his blood several hours after the incident. The BMW was traced by police following oil leaks from the scene of the crash to the Gupta residence, where it was determined to have been cleaned of blood and human remains. All three were charged with culpable homicide and destruction of evidence.
The trial is still in progress, but there have already been extraordinary changes in witness testimony. Claiming that his initial statement was made under police pressure, Kulkarni testified in October 1999 that it had been a truck rather than a BMW that had ploughed through the police checkpoint. The prosecution dropped him as a witness, considering him to be unreliable, but he was subsequently reinstated. In May 2007, Kulkarni identified Nanda as one of the three occupants of the vehicle, but then retracted this testimony two months later, saying that he had been unable to see any of them clearly.
Nanda now maintains that he was not in the vehicle at the time and had nothing to do with the accident. A sting operation by NDTV turned up evidence of attempted bribery, and it now appears that the witness spent eighteen months residing at a farmhouse owned by the lead lawyer for the defence. Nanda is free on bail while the proceedings continue.
Finally, we examined the so-called Best Bakery case:
The Best Bakery was a Muslim owned and operated business in Vadodara, Gujarat that was set on fire by a Hindu mob during communal riots on March 1, 2002. Fourteen people were killed in the attack, including the owner Habibullah Shaikh and eight other members of his family. Among the witnesses was Zahira Shaikh, the owner's eighteen year old daughter, who identified several individuals in the mob in a March 2 statement to police. The accused were also identified by Zahira in a statement before the National Human Rights Commission (NHRC) of India three weeks later. Twenty-one individuals were charged in the murder.
During the trial in May 2003, Zahira and other surviving members of her family retracted earlier statements made to the police, resulting in the acquittal of all the accused on June 27. Shortly thereafter, on July 11, Zahira claimed in a sworn statement before the NHRC that she and other family members had been threatened and forced to retract their statement. In doing this, she was assisted by Teesta Setalvad, secretary of the NGO Citizens for Justice and Peace. The NHRC petitioned the Supreme Court of India to order a retrial in a state other than Gujarat, and the Court did so on April 12, 2004. The retrial began in October 2004, before a Special Court of Sessions in Mumbai.
At a dramatic November 3 press conference one day before she was due in court, Zahira changed her testimony yet again, claiming that she had been abducted by Setalvad and her organization, threatened and confined for months, and forced to file false statements against the accused. A sting operation by Tehelka magazine in December revealed that a substantial bribe of 1.8 million rupees (about $40,000) was paid to Zahira and her family in order to retract her testimony against the accused. On February 24 2006, nine of the original accused were convicted and eight acquitted by the Court. In separate proceedings, Zahira was convicted of perjury and contempt of court.
In the absence of a vigilant and competitive media, it is unlikely that any of these cases would have resulted in convictions. 
It has been four decades since Albert Hirschman published his classic Exit, Voice and Loyalty. In it, he argued that market competition is just one of several mechanisms through which efficient functioning of organizations can be sustained. Firms in competitive markets are forced to function well for fear of exit: low quality or high prices will induce their customers to look elsewhere. But there are many organizations in which exit is not a realistic option, either because no competitors exist, or because individuals have a sense of loyalty to the group with which they are affiliated. This applies to ethnic groups, nation states, and (most relevant to the examples considered here) judicial systems. In this case, voice remains the only mechanism available for inducing good performance. And without a free and competitive press, the voice of public outrage will often remain muted.
This is how Dan and I conclude our article:
The central message of this paper is that legal institutions alone are not enough to produce justice. In terms of Albert Hirschman’s memorable formulation, effective judicial systems require a balance of exit and voice. Open competition in politics and the media facilitates and amplifies the expression of voice, keeping blatant miscarriages of justice at least occasionally in check.
Albert Hirschman will be 95 years old next month, and is in poor health. He is seldom mentioned as a serious contender for the the Nobel Memorial Prize in Economics. But when I look at the list of those who are considered to be likely recipients, I can't escape the feeling that something is not quite right with our profession.

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Update (3/4). I just came across two wonderful posts on Hirschman by Dani Rodrick. From the first of these:
Reading this work, I am awed once again by a mind which was as much at ease with the technical arcana of irrigation projects as it was with the rarified world of political philosophy. Yet I can also see why he must have been such a source of frustration for his contemporaries.  He was in many ways the ultimate contrarian--always looking for the unique and the exceptional, while not shying from building general theories from those cases.  He was a critic of the reigning development theories of his time (the big push and balanced growth), arguing, quite correctly in my view, that the under-developed societies who had the capacity to implement these comprehensive programs would not have been under-developed in the first place.  He argued instead for a strategic, opportunistic approach, based on making the best of what you have.
And from the second:
Which brings me to the question of the Nobel Prize for Hirschman. I think Hirschman's contributions have been greatly under-appreciated within economics, and that goes a long way to explain why he has not won a Nobel. If the Nobel was given for impact on social sciences more broadly, Hirschman would have clearly won a long time ago. But who knows, there is still some time...   
Rodrick was the first recipient of the Albert O. Hirschman Prize, awarded since 2007 by the Social Science Research Council.