Rajiv Sethi

Returns to Information and Returns to Capital

2012-01-29T14:08:00.002-05:00

One of the benefits of maintaining this blog is that it gives me the opportunity to think aloud, expressing half-formed ideas in the hope that the feedback will help me sort through some interesting questions. My last post on double taxation attracted a number of thoughtful (and in some cases skeptical) comments for which I am grateful.

What I was trying to do in that post was to evaluate two incompatible statements: Warren Buffet's declaration that he pays a substantially lower tax rate at 18% than any of his office staff, and Mitt Romney's conflicting claim that his effective tax rate is close to 50%, the sum of the corporate tax rate and the rate on long-term capital gains. I argued that since the corporate tax is capitalized into prices at both the time of purchase and the time of sale, it ought not to be simply added to the capital gains tax to determine an effective rate.

The point may be expressed as follows. Over the past couple of years Romney seems to have paid about 3 million dollars in taxes on income of about 20 million annually, a rate of about 15%. If his effective tax rate is 50% then his "effective" gross income is about twice his current after-tax income, or approximately 34 million. What he is claiming, in effect, is that in the absence of the corporate tax, and with no change in the nature of his economic activities, he would have been able to secure a capital gain of 34 million annually. This does not seem plausible to me. Elimination of the corporate tax would certainly result in a one-time gain to any currently held long positions, but I don't see how it could allow him to generate an extra 14 million, which is 70% greater than his current gross income, on an ongoing basis every year.

Whatever the merits of this argument, I think that most commenters on my earlier post agree with me on two things:

The adding-up approach to effective tax rates does not work for short sales and related derivative positions, since it would lead to the absurd conclusion that short sellers were paying a negative effective tax rate on capital gains.
Elimination of the corporate tax would result in a sharp rise in equity prices and a windfall gain to current long investors, but would have more modest and uncertain effects on the returns to future investors who enter positions after the lower rate has been capitalized into prices.

In particular, the following comment from Richard Serlin got me thinking about the nature of capital gains:

With regard to short selling, when the corporate tax first hits (or becomes known to hit), they'll get a windfall, but then their expected returns (of the short sales people actually choose to take) will adjust to the new norm for their risk. It's not like short selling opportunities that pay a fair market risk adjusted return always exist, anyway. When they do, it's largely not a reward for the capital, but for the information that the stock is an overpriced bad deal.

It is certainly true, as Richard points out, that profits to short positions are rewards for information, broadly interpreted to include the processing and analysis of information. They are not returns to capital in any meaningful sense, although one requires capital to enter a short position. But the same is true for at least some portion of the profits to long positions. In fact, the essence of Buffet's investment strategy is to identify underpriced companies in which to take long (and long-term) positions on which capital gains are then realized.

If capital gains are viewed largely as a return to capital, then the double taxation argument makes some sense. But viewed as a return to information and analysis, it is not clear why capital gains should be given preferential tax treatment relative to the income generated, for instance, by doctors or teachers.

I suspect that Warren Buffet views his income as being generated largely by information and judgment, and does not believe that his opportunities for ongoing capital gain would be substantially increased if the corporate tax were eliminated. He does not therefore see the tax as a significant burden, and does not consider his effective gross income to be substantially greater than that which he declares on his tax returns. Whether Romney himself feels the same way is impossible to know, since political expediency currently compels him to take a very different position.

Double Taxation

2012-01-28T16:01:00.006-05:00

The release of Mitt Romney's tax returns has drawn attention yet again to the disparity between the rates paid on ordinary income and those paid on capital gains. It is being argued in some quarters that the 15% rate on capital gains vastly underestimates the effective tax rate paid by those whose income comes largely from financial investments, on the grounds that corporations pay a rate of 35% on profits. Were it not for this tax, it is argued, dividends and capital gains would be higher, and so would the after-tax receipts of those who derive the bulk of their income from such sources.

Romney himself has made this argument recently, claiming that his effective tax rate is closer to 50%:

One of the reasons why we have a lower tax rate on capital gains is because capital gains are also being taxed at the corporate level. So as businesses earn profits, that's taxed at 35 percent. Then as they distribute those profits in dividends, that's taxed at 15 percent more. So all total, the tax rate is really closer to 45 or 50 percent.

The absurdity of this claim is clearly revealed if one considers capital gains that accrue to short sellers, who pay rather than receive dividends while their positions are open. Following the logic of the argument, one would be forced to conclude that short sellers are taxed at an effective rate of negative 20%, thereby receiving a significant subsidy due to the existence of the corporate tax. The flaw in this reasoning is apparent when one recognizes that asset prices are lower (relative to the zero corporate tax benchmark) not only when a short position is covered, but also when it is entered.

There is no doubt that the presence of the corporate tax depresses the price of equities, but it does so both at the time of purchase and at the time of sale. If there were no corporate tax, dividends and capital gains per share would certainly be higher, but an investor would have paid substantially more per share to acquire his assets in the first place. As a result he would be holding fewer shares for any given initial outlay, and his after-tax income (holding constant the rate paid on capital gains) would not be substantially different.

To see why, it is useful to think about what determines the price of equities. Three factors are especially important: the current earnings of a firm (after payment of interest and taxes), the rate at which these earnings are expected to grow, and the riskiness of the security, which itself is linked to the degree to which the firm's earnings are correlated with broader market movements. Securities that are riskier in this latter sense tend to appreciate faster on average because investors would otherwise avoid them, depressing their prices and raising their expected returns until such returns are viewed as adequate compensation for the greater risk of holding them. This risk is routinely expressed as a market capitalization rate, interpreted as the expected return that investors require in order to hold the security. Airline and automobile stocks, for instance, have higher market capitalization rates than do shares in utilities.

The manner in which these factors interact to influence prices may be illustrated by considering the simplest possible case of a firm with constant expected earnings growth and a fixed dividend payout ratio. In this case, for reasons discussed in any introductory finance textbook, the fundamental value of the security is given by the simple formula D/(k-g), where D is the current dividend forecast (a constant share of the earnings forecast), g is its expected rate of growth, and k is the market capitalization rate. Shares in a debt-free firm that pays 20% of its earnings as dividends, is currently earning $10 per share annually, is expected to grow at 10%, and has a market capitalization rate of 12% would then have a share price of $100. After a year (assuming no change in these parameters) the share price would be $110 and the dividend payout $2. An investor would have made $12 on a $100 investment, a percentage return precisely equal to the market capitalization rate. All this is with no corporate tax.

Now suppose that a 35% corporate tax is in place, so after-tax earnings per share are $6.50 instead, with no change in other specifications. Dividends are then $1.30 per share and the initial share price is $65. After a year this rises to $71.50. Adding dividends and capital gains, an investor makes $7.80 for each share purchased at $65, again earning precisely 12%. Each share results in lower revenues to the investor, but since more shares can be purchased at the outset, aggregate income is no different.

None of this should be in the least bit surprising. Note, however, that if the corporate tax were to be eliminated today, there would be a sharp rise in the price of equities and current asset holders would enjoy a windfall gain. Similar issues arise with respect to the mortgage interest deduction: eliminating this would result in an immediate decline in home values, severely punishing those who purchased recently at prices that reflected the anticipated tax savings over the duration of the mortgage.

This does not necessarily mean that eliminating the corporate tax while simultaneously raising the rate on capital gains is necessarily a bad idea, or that elimination of the mortgage interest deduction is necessarily bad policy. A case could be made for both initiatives. The corporate tax is not uniformly applied due to the broad range of loopholes and exemptions, and the mortgage deduction is regressive and inhibits both neighborhood integration and labor mobility. But any such changes will have major distributional effects that must be taken into account in any comprehensive evaluation of the policy. Doing so properly requires a clear distinction between stocks and flows, and an analysis that goes a little deeper than simple arithmetic.

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Update: Follow-up post here.

Self-Fulfilling Prophecies and the Iowa Caucus

2012-01-01T14:03:00.006-05:00

A few days ago Nate Silver made the following intriguing comments on the Iowa Caucus (emphasis added):

There are extremely strong incentives for supporters of Mrs. Bachmann, Mr. Santorum and Mr. Perry to behave tactically, throwing their weight behind whichever one appears to have the best chance of finishing in the top two. What that means is that if any of these candidates appear to have any momentum at all during the final week of the campaign, their support could grow quite quickly as other voters jump on the bandwagon.

This is also a case in which the polling may actually influence voter behavior. In particular, if one of these candidates does well in the highly influential Des Moines Register poll that should be published on New Year’s Eve or thereabouts, that candidate might be a pretty good bet to overperform polling as voters use that as a cue on caucus night to determine which one is most viable...

I’m not sure that this theory actually makes any sense... But it may not matter if the theory is true. If voters are looking for anything to break the logjam between these candidates, mere speculation that one of them has momentum could prove to be a self-fulfilling prophecy.

What's most interesting about this is the possibility that even a methodologically flawed or misleading poll, provided that it is given credence, could coordinate expectations on one of these three candidates and result in a surge of support.

In fact, this seems to be precisely what has happened. A CNN/Time poll covering the period December 21-27 revealed Santorum to be in third place with 16% of the vote. This was an outlier at the time, and was sharply criticized by Tom Jensen of PPP and by Nate himself for surveying only registered Republicans:

What’s wrong with using a list of Republican voters for a Republican caucus poll? The answer is that it’s extremely easy for independent and Democratic voters to register or re-register as Republicans at the caucus site. Historically, a fair number of independent voters do this.

According to entrance polls in Iowa in 2008, for instance, about 15 percent of participants in the Republican caucus identified themselves as independents or Democrats on the way into the caucus site... Most other pollsters are making some attempt to account for these voters. They are anticipating that the fraction of independents and Democrats will be at least as high as it was in 2008 if not a little higher, which would make sense since Republicans do not have a competitive Democratic caucus to compete with this year.

The recent Public Policy Polling survey, for instance, estimated that 24 percent of Iowa caucus participants are currently registered as independents or Democrats and will re-register as Republicans at the caucuses. This month’s Washington Post/ABC News poll put the fraction at 18 percent. There is room to debate what the right number is but it will certainly not be zero, as the CNN poll assumes.

Since few independents and Democrats are inclined to vote for Santorum, the CNN/Time poll very likely exaggerated the level of support he enjoyed at the time. But despite this, it contributed to expectations of a surge which seem to have become self-fulfilling. The Des Moines Register poll released last night confirms this, with Santorum rising sharply from 10% on the 27th all the way to 22% four days later. This survey, conducted by the highly regarded Ann Selzer, has historically been among the most reliable of Iowa polls.

Did a misleading poll based on an unsound sample shift expectations in such a manner as to fulfill it's own flawed forecast? Tom Jensen certainly appears to think so:

Selzer had Santorum at 9% Tu-W. We had him at 10% M-Tu. Surge quite possibly generated by CNN poll that was quite possibly wrong... If CNN had shown Perry at 15% and he got all the momentum stories, the buzz in Iowa might be all about him this weekend.

The CNN/Time poll may also have given Romney an expectational boost at the expense of Paul by excluding independents from the survey. As Tom Jensen noted in his response, Romney was ahead of Paul in the restricted sample of the PPP poll, but quite clearly behind overall on December 27. It's an interesting example of how a seemingly innocuous methodological decision on a single primary poll could end up having major ramifications for the direction of the country.

The mechanisms at work here have some broader implications. They reveal the potential value to candidates (or their supporters) of manipulating prices in prediction markets such as Intrade, which have come to be closely monitored indicators of candidate viability. And they appear in all sorts of other contexts, from sovereign debt crises to speculative currency attacks.

In fact, any borrower who has financed long-dated assets with short term liabilities needs to periodically roll over debt, and the willingness of investors to facilitate this depends on their beliefs about whether other investors will continue to facilitate it in the future. These expectations are subject to capricious change, often as a result of small and seemingly unimportant triggers. The Iowa caucus illustrates the phenomenon, and the Eurozone debt crisis demonstrates its broader relevance.

Price Coherence on Intrade

2011-12-01T16:29:00.002-05:00

A couple of days ago, Richard Thaler tweeted this:

Intrade prices seem incoherent. How can Newt nomination price soar but Obama win stay at 50%?

Here's what Thaler is talking about. Over the past couple of weeks, the price of a contract that pays $10 in the event that Gingrich is nominated has risen sharply from about a dollar to above $3.50:

Over the same period a contract that pays $10 if Obama is reelected has remained within a narrow window, trading within a ten cent band a shade above $5:

Thaler considers this pattern to be incoherent because Gingrich is widely believed to be a weaker general election candidate than Romney. For instance, in head-to-head poll averages Obama currently leads Gingrich by 5.7%, but leads Romney by the much smaller margin of 1.5%.

But even if Gingrich really is the weaker candidate against Obama under any set of conditions that might prevail on election day, it does not follow (as a point of logic) that a rise in the Gingrich nomination price must be associated with a rise in the Obama reelection price. For instance, a belief among voters that Obama is more vulnerable would ordinarily result in a decline in his likelihood of reelection, but this could be offset if the same belief also leads to the nomination by the GOP of a more conservative but less electable candidate.

This reasoning is consistent with the so-called Buckley Rule, which urges a vote for the most conservative candidate who is also electable. As perceptions about the electability of the incumbent shift, so does the perceived viability of more ideologically extreme members of the opposition. These countervailing effects can dampen fluctuations in the electability of the incumbent. Hence the market data alone cannot decisively settle the question of price coherence.

Notes on a Worldly Philosopher

2011-10-07T04:24:00.001-04:00

The very first book on economics that I remember reading was Robert Heilbroner's majesterial history of thought The Worldly Philosophers. I'm sure that I'm not the only person who was drawn to the study of economics by that wonderfully lucid work. Heilbroner managed to convey the complexity of the subject matter, the depth of the great ideas, and the enormous social value that the discipline at its best is capable of generating.

I was reminded of Heilbroner's book by Robert Solow's review of Sylvia Nasar's Grand Pursuit: The Story of Economic Genius. Solow begins by arguing that the book does not quite deliver on the promise of its subtitle, and then goes on to fill the gap by providing his own encapsulated history of ideas. Like Heilbroner before him, he manages to convey with great lucidity the essence of some pathbreaking contributions. I was especially struck by the following passages on Keynes:

He was not without antecedents, of course, but he provided the first workable intellectual apparatus for thinking about what determines the level of “output as a whole.” A generation of economists found his ideas the only available handle with which to grasp the events of the Great Depression of the time... Back then, serious thinking about the general state of the economy was dominated by the notion that prices moved, market by market, to make supply equal to demand. Every act of production, anywhere, generates income and potential demand somewhere, and the price system would sort it all out so that supply and demand for every good would balance. Make no mistake: this is a very deep and valuable idea. Many excellent minds have worked to refine it. Much of the time it gives a good account of economic life. But Keynes saw that there would be occasions, in a complicated industrial capitalist economy, when this account of how things work would break down.

The breakdown might come merely because prices in some important markets are too inflexible to do their job adequately; that thought had already occurred to others. It seemed a little implausible that the Great Depression of the 1930s should be explicable along those lines. Or the reason might be more fundamental, and apparently less fixable. To take the most important example: we all know that families (and other institutions) set aside part of their incomes as saving. They do not buy any currently produced goods or services with that part. Something, then, has to replace that missing demand. There is in fact a natural counterpart: saving today presumably implies some intention to spend in the future, so the “missing” demand should come from real capital investment, the building of new productive capacity to satisfy that future spending. But Keynes pointed out that there is no market or other mechanism to express when that future spending will come or what form it will take... The prospect of uncertain demand at some unknown time may not be an adequately powerful incentive for businesses to make risky investments today. It is asking too much of the skittery capital market. Keynes was quite aware that occasionally a wave of unbridled optimism might actually be too powerful an incentive, but anyone in 1936 would take the opposite case to be more likely.

So a modern economy can find itself in a situation in which it is held back from full employment and prosperity not by its limited capacity to produce, but by a lack of willing buyers for what it could in fact produce. The result is unemployment and idle factories. Falling prices may not help, because falling prices mean falling incomes and still weaker demand, which is not an atmosphere likely to revive private investment. There are some forces tending to push the economy back to full utilization, but they may sometimes be too weak to do the job in a tolerable interval of time. But if the shortfall of aggregate private demand persists, the government can replace it through direct public spending, or can try to stimulate additional private spending through tax reduction or lower interest rates. (The recipe can be reversed if private demand is excessive, as in wartime.) This was Keynes’s case for conscious corrective fiscal and monetary policy. Its relevance for today should be obvious. It is a vulgar error to characterize Keynes as an advocate of “big government” and a chronic budget deficit. His goal was to stabilize the private economy at a generally prosperous level of activity.

This is as clear and concise a description of the fundamental contribution of the General Theory that I have ever read. And it reveals just how far from the original vision of Keynes the so-called Keynesian economics of our textbooks has come. The downward inflexibility of wages and prices is viewed in many quarters today to be the hallmark of the Keynesian theory, and yet the opposite is closer to the truth. The key problem for Keynes is the mutual inconsistency of individual plans: the inability of those who defer consumption to communicate their demand for future goods and services to those who would invest in the means to produce them.

The place where this idea gets buried in modern models is in the hypothesis of "rational expectations." A generation of graduate students has come to equate this hypothesis with the much more innocent claim that individual behavior is "forward looking." But the rational expectations hypothesis is considerably more stringent than that: it requires that the subjective probability distributions on the basis of which individual decisions are made correspond to the objective distributions that these decisions then give rise to. It is an equilibrium hypothesis, and not a behavioral one. And it amounts to assuming that the plans made by millions of individuals in a decentralized economy are mutually consistent. As Duncan Foley recognized a long time ago, this is nothing more than "a disguised form of the assumption of the existence of complete futures and contingencies markets."

It is gratifying, therefore, to see increasing attention being focused on developing models that take expectation revision and calculation seriously. A conference at Columbia earlier this year was devoted entirely to such lines of work. And here is Mike Woodford on the INET blog, making a case for this research agenda:

This postulate of “rational expectations,” as it is commonly though rather misleadingly known... is often presented as if it were a simple consequence of an aspiration to internal consistency in one’s model and/or explanation of people’s choices in terms of individual rationality, but in fact it is not a necessary implication of these methodological commitments. It does not follow from the fact that one believes in the validity of one’s own model and that one believes that people can be assumed to make rational choices that they must be assumed to make the choices that would be seen to be correct by someone who (like the economist) believes in the validity of the predictions of that model. Still less would it follow, if the economist herself accepts the necessity of entertaining the possibility of a variety of possible models, that the only models that she should consider are ones in each of which everyone in the economy is assumed to understand the correctness of that particular model, rather than entertaining beliefs that might (for example) be consistent with one of the other models in the set that she herself regards as possibly correct...

The macroeconomics of the future, I believe, will still make use of general-equilibrium models in which the behavior of households and firms is derived from considerations of intertemporal optimality, but in which the optimization is relative to the evolving beliefs of those actors about the future, which need not perfectly coincide with the predictions of the economist’s model. It will therefore build upon the modeling advances of the past several decades, rather than declaring them to have been a mistaken detour. But it will have to go beyond conventional late-twentieth-century methodology as well, by making the formation and revision of expectations an object of analysis in its own right, rather than treating this as something that should already be uniquely determined once the other elements of an economic model (specifications of preferences, technology, market structure, and government policies) have been settled.

I think that the vigorous pursuit of this research agenda could lead to a revival of interest in theories of economic fluctuations that have long been neglected because they could not be reformulated in ways that were methodologically acceptable to the professional mainstream. I am thinking, in particular, of nonlinear models of business cycles such as those of Kaldor, Goodwin, Tobin and Foley, which do not depend on exogenous shocks to account for departures from steady growth. This would be an interesting, ironic, and welcome twist in the tangled history of the worldly philosophy.

David Levey on the Ratings Downgrade

2011-08-08T00:01:00.006-04:00

David Levey (Managing Director, Sovereign Ratings, Moody's Investors Service, 1985-2004) sent out the following statement yesterday to a number of publications, including the New York Times, Wall Street Journal, Financial Times, and Bloomberg. Since I haven't seen it published anywhere and he has granted permission to freely reproduce it, I'm posting it here (I thank Sam Bowles for forwarding the statement to me):

The recent S&P downgrade of the credit rating of US Treasury bonds is unwarranted for the following reasons:

The US dollar remains the dominant global currency and no viable competitor is on the horizon. The euro is heading into dangerous and uncharted waters while deep and difficult political, economic and financial reforms will be required before the renminbi could become fully convertible for capital flows and Chinese government bonds a safe reserve asset.

US Treasury bills and bonds, along with government-guaranteed bonds and highly-rated corporates, will for the foreseeable future remain the assets of choice for global investors seeking a "safe haven", due to the unparalleled institutional strength, depth and liquidity of the market. Although there are several advanced Aaa-rated OECD countries with lower debt ratios and better fiscal outlooks than the US, their markets are generally too small to play that role. Since ratings are intended to function as a market signal, it makes little sense to implicitly suggest to investors seeking "risk-free" reserve assets that they reallocate their portfolios toward these relatively illiquid markets.

Despite the above positive factors for the US, it is certainly the case that the US long-term debt outlook is deteriorating under the pressure of rising entitlement costs and an inefficient, distortionary tax system. Failure to reverse that trajectory would eventually make a downgrade unavoidable. But the recent discussions signal to me that -- finally -- public awareness of the fiscal crisis is growing and beginning to influence Washington. There is still a window of time -- perhaps as much as a decade -- within which structural reforms to spending programs and the tax system could reverse the negative debt trajectory.

The bottom line is that the global role of the dollar and the central position of US bond markets make somewhat elevated debt ratios more compatible with a Aaa rating than is the case for other countries, another version of the US's "exorbitant privilege". But that extra leeway is finite and serious reforms to entitlement programs, particularly Medicare, must be made in a reasonable time horizon. If not, global investors will eventually conclude that our political system is incapable of making the needed changes and turn away from US assets, regardless of the institutional strengths of US markets.

This is consistent with Warren Buffet's view of the downgrade.

Even more interesting than Levey's statement was his preamble, in which he states that he has "no connection with Moody's nor any non-public knowledge of what its analysts think about the rating or what they intend to do" and then adds the following:

As I see our current situation, the Federal Reserve, with its too-tight monetary stance since the summer of 2008, has allowed nominal GDP to fall far below trend, causing a collapse of output and employment -- as described by the monetary bloggers Scott Sumner, David Beckworth, Bill Woolsey, and David Glasner. Had the Fed acted properly (by, for example, setting a nominal GDP level target) the recession would have been much shallower and fiscal stimulus might not have been undertaken. As it was, the collapse of nominal GDP drove the "fiscal multiplier" to zero, leaving us with more debt and nothing to show for it.

Whether or not the Fed had the capacity and the commitment to have substantially mitigated the recession in the absence of fiscal policy, I'm not qualified to judge. But I remain skeptical that the rating agencies have the ability to evaluate credit risk with greater accuracy than the market itself would do in their absence. Were it not for the fact that capital requirements for financial institutions are set on the basis of their ratings, I doubt that there would be much of a market for their services, or that they would have such visibility and influence. And as far as sovereign debt is concerned, I'm not sure that they provide us with any useful information or guidance.

Rating the Agencies

2011-08-06T13:13:00.001-04:00

It's being argued that yesterday's downgrade of the credit rating of the United States government by Standard and Poor's could increase borrowing costs throughout the economy, worsen the burden of debt, retard a recovery that already appears to be faltering, affect political brinkmanship in future negotiations, and further tarnish our national reputation.

Unless, of course, we chose to collectively ignore it, as Dan Alpert recommends:

Effectively – the S&P pronouncement last evening amounted to not much more than a guest in your house telling your children to clean up their rooms “or else.” I don’t know about you, but in my case, at least, I would ask such a guest to apologize or leave.

But it's difficult to ignore events on which everyone else is lavishing such great attention, and this seems like an appropriate time to examine how these agencies managed to gain such visibility and influence. As Ross Levine notes in his recent autopsy of the financial crisis, this is where we stood forty years ago:

Until the 1970s, credit rating agencies were comparatively insignificant, moribund institutions that sold their assessments of credit risk to subscribers. Given the poor predictive performance of these agencies, the demand for their services was limited for much of the twentieth century (Partnoy, 1999). Indeed, academic researchers found that credit rating agencies produce little additional information about the firms they rate; rather, their ratings lag stock price movements by about 18 months (Pinches and Singleton, 1978).

But then a policy shift occurred that continues to have major ramifications to this day. The SEC provided a special designation to a class of rating agencies and then proceeded to use their opinions as a basis for setting capital requirements. The selected agencies suddenly found themselves endowed with vastly increased market power and a very lucrative business model:

In 1975, the SEC created the Nationally Recognized Statistical Rating Organization (NRSRO) designation, which it granted to the largest credit rating agencies. The SEC then relied on the NRSRO's credit risk assessment in establishing capital requirements on SEC-regulated financial institutions.

The creation of – and reliance on – NRSROs by the SEC triggered a cascade of regulatory decisions that increased the demand for their credit ratings. Bank regulators, insurance regulators, federal, state, and local agencies, foundations, endowments, and numerous entities around the world all started using NRSRO ratings to establish capital adequacy and portfolio guidelines. Furthermore, given the reliance by prominent regulatory agencies on NRSRO ratings, private endowments, foundations, and mutual funds also used their ratings in setting asset allocation guidelines for their investment managers. NRSRO ratings shaped the investment opportunities, capital requirements, and hence the profits of insurance companies, mutual funds, pension funds, and a dizzying array of other financial institutions.

Unsurprisingly, NRSROs shifted from selling their credit ratings to subscribers to selling their ratings to the issuers of securities. Since regulators, official agencies, and private institutions around the world relied on NRSRO ratings, virtually every issuer of securities was compelled to purchase an NRSRO rating if it wanted a large market for its securities. Indeed, Partnoy (1999) argues that NRSROs essentially sell licenses to issue securities; they do not primarily provide assessments of credit risk.

This shift in business model by the selected agencies raised some rather obvious conflicts of interest, since their customers were now issuers of debt who stood to gain from overly optimistic assessments of their credit risk. As is common in such cases, the counterargument was made that the need to preserve one's reputation for accuracy would provide adequate incentives for objective ratings:

There are clear conflicts of interest associated with credit rating agencies selling their ratings to the issuers of securities. Issuers have an interest in paying rating agencies more for higher ratings since those ratings influence the demand for and hence the pricing of securities. And, rating agencies can promote repeat business by providing high ratings...

Nevertheless, credit rating agencies convinced regulators that reputational capital reduces the pernicious incentive to sell better ratings. If a rating agency does not provide sound, objective assessments of a security, the agency will experience damage to its reputation with consequential ramifications on its long-run profits. Purchasers of securities will reduce their reliance on this agency, which will reduce demand for all securities rated by the agency. As a result, issuers will reduce their demand for the services provide by that agency, reducing the agency's future profits. From this perspective, reputational capital is vital for the long-run profitability of credit rating agencies and will therefore contain any short-run conflicts of interest associated with “selling” a superior rating on any particular security.

I have previously discussed some of the limitations of this argument in a different context, and such limitations were clearly evident in the case of the agencies:

Reputational capital will reduce conflicts of interest, however, only under particular conditions. First, the demand for securities must respond to poor rating agency performance, so that decision makers at rating agencies are punished for issuing bloated ratings on even a few securities. Second, decision makers at rating agencies must have a sufficiently long-run profit horizon, so that the long-run costs to the decision maker from harming the agencies reputation outweigh the short-run benefits from selling a bloated rating.

These conditions do not hold, however... regulations weaken the degree to which a decline in the reputation of a credit rating agency reduces demand for its services. Specifically, regulations induce the vast majority of the buyers of securities to use NRSRO rating in selecting assets. These regulations hold regardless of NRSRO performance, which moderates the degree to which poor ratings performance reduces the demand for NRSRO services. Such regulations mitigate the positive relation between rating agency performance and profitability.

This brings us to the role of the agencies in the financial crisis. The rapid growth of structured products provided the agencies with a substantial new source of demand, as well as the problem of assessing credit risk for securities of much greater complexity. Minor changes in modeling assumptions could lead to significantly different ratings for such assets. Nevertheless, there were strong incentives in place for the agencies to act as if they could make competent assessments of credit risk:

The explosive growth of securitized and structured financial products from the late 1990s onward materially intensified the conflicts of interest problem. Securitization and structuring involved the packaging and rating of trillions of dollars worth of new financial instruments. Huge fees associated with processing these securities flowed to banks and NRSROs. Impediments to this securitization and structuring process, such as the issuance of low credit rating on the securities, would gum-up the system, reducing rating agency profits.

In fact, the NRSROs started selling ancillary consulting services to facilitate the processing of securitized instruments, increasing NRSRO incentives to exaggerate ratings on structured products. Besides purchasing ratings from the NRSROs, the banks associated with creating structured financial products would first pay the rating agencies for guidance on how to package the securities to get high ratings and then pay the rating agencies to rate the resultant products.

Other evidence also indicates that rating agencies adjusted their behavior to capture the profits made available by securitization and the design of new structured financial products. Lowenstein's (2008) excellent description of the rating of a MBS by Moody's demonstrates the speed with which complex products had to be rated, the poor assumptions on which these ratings were based, and the profits generated by rating structured products... Indeed, internal e-mails indicate that the rating agencies lowered their rating standards to expand the business and boost revenues... A collection of documents released by the US Senate suggests that NRSROs consciously adjusted their ratings to maintain clients and attract new ones.

The short-run profits from these activities were mind bogglingly large and made the future losses from the inevitable loss of reputational capital irrelevant. For example, the operating margin at Moody's between 2000 and 2007 averaged 53 percent. This compares to operating margins of 36 and 30 percent at Microsoft and Google, or 17 percent at Exxon... Thus, rating agencies faced little market discipline, had no significant regulatory oversight, were protected from competition by regulators and legislators, and enjoyed a burgeoning market for their services... It was good to be an NRSRO.

Levine's bottom line is this:

While the crisis does not have a single cause, the behavior of the credit rating agencies is a defining characteristic. It is impossible to imagine the current crisis without the activities of the NRSROs. And, it is difficult to imagine the behavior of the NRSROs without the regulations that permitted, protected, and encouraged their activities.

Perhaps the time has come to consider a complete overhaul of this dysfunctional system. Withdraw the special designation accorded to the major agencies, so that they compete on a level playing field with new entrants. If they really do have the expertise to make assessments of credit risk that are more accurate than the market, let them build reputation and find clients willing to pay for their pronouncements. Make capital requirements for financial institutions independent of ratings, thus stripping the agencies of their monopoly power and guaranteed sources of income. And in the meantime, greet their pronouncements on sovereign debt not with an anxious wringing of hands, but with a collective yawn.

---

Update (8/10). Andrew Gelman follows up:

Another way to look at this is: Given all the above, those S&P dudes must really really think the U.S. is at risk of defaulting. Keeping the AAA rating would’ve been the safe default choice. Deciding to downgrade—that’s political dynamite, with a risk of losing their lucrative quasimonopoly. That’s a decision you’d only make for a really good reason. Or maybe they’re just overcompensating for all those bad AAA ratings they gave out a few years ago?

I certainly see his point. But I don't think that the agencies are in much danger of losing their quasimonopoly, which makes the decision a bit harder to interpret as a bold act driven by conviction.

Greek Games

2011-07-24T11:09:00.002-04:00

I haven't made up my mind yet about the wisdom of the latest plan to secure the financial viability of Greece within the eurozone, but as a piece of financial engineering it has some very intriguing features.

Current bondholders have the option of exchanging their assets for new issues that promise less and deliver later, but are considerably more secure. There are four new issues to choose from, varying with respect to maturity, interest rate, and the proportion of principal that is guaranteed (by highly rated zero coupon bonds or funds held in an escrow account). But these options are designed to be roughly equivalent in present value terms, and it is expected that they will be selected in approximately equal measure by those who choose to participate in the exchange.

Participation is voluntary, so current bondholders can simply choose to do nothing. For this reason, the financing offer does not trigger payouts on credit default swaps.

What makes the mechanism strategically interesting is that the payoffs from participation are highly sensitive to the overall participation rate. The higher the participation rate, the greater will be the ability of Greece to meet its financial obligations not only on the new issues but also on the outstanding ones. Participation by some raises the value of the assets held by the remainder. If the target participation rate of 90% is met, then those who decline to participate will find themselves holding bonds that are much less likely to default than is currently the case. In anticipation of this effect, yields on Greek bonds (and the cost of insuring them with credit derivatives) fell sharply following the announcement.

It's interesting to think about who gains and who loses from this. Contrary to most accounts in the media, current bondholders benefit from the existence of the financing offer, regardless of whether or not they choose to participate. Those who decline to participate experience a capital gain on their assets (relative to the status quo without the offer). And those who participate are choosing to forgo this capital gain and must therefore be even better off. Of course, there will be many bondholders who purchased their assets at times when Greek default was considered highly unlikely, and they will experience a loss on their original investment. But this loss has already been inflicted on them: the financing offer just gives them an opportunity to capitalize it in a manner that eases Greece's debt burden, as an alternative to selling their bonds in the open market.

The fact that credit default swaps are not triggered by the offer, coupled with the lowered likelihood of default on current bonds, benefits sellers of protection on Greek debt. In fact, such sellers have strong incentives to buy up Greek bonds and participate in the exchange, thus lowering the probability that a credit event will arise in the near future. I would not be surprised if some of the buying that raised prices on the heels of the announcement came from such sources.

So who loses as a result of the financing offer? First and foremost, those who bought naked credit default swaps, thus making a directional bet on a credit event that is now less likely to occur. It is quite conceivable that the plan was designed to have precisely this effect. Speculators betting on sovereign default have come in for a fair amount of public criticism by political leaders in Europe, and stand accused of raising the cost of borrowing and the likelihood of default. (I have argued in joint work with Yeon-Koo Che that there is some theoretical basis for this claim.)

Costs will also be imposed on the countries of the eurozone core, who are providing the collateral to guarantee principal on the new issues (Greece remains solely responsible for all interest payments). But these countries are motivated by the belief that a formal default by Greece would have contagion effects across the periphery, leading to a chaotic collapse of the currency union. The biggest risk entailed in the current initiative is that it may not, in the end, be enough to prevent this.

Some Thoughts on the Unthinkable

2011-07-18T09:46:00.003-04:00

In his April 4 letter to Congress on the urgent need to raise the debt limit, the Secretary of the Treasury made the following claims:

As the leaders of both parties in both houses of Congress have recognized, increasing the limit is necessary to allow the United States to meet obligations that have been previously authorized and appropriated by Congress. Increasing the limit does not increase the obligations we have as a Nation; it simply permits the Treasury to fund those obligations that Congress has already established.

If Congress failed to increase the debt limit, a broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on the debt, unemployment benefits and tax refunds. This would cause severe hardship to American families and raise questions about our ability to defend our national security interests. In addition, defaulting on legal obligations of the United States would lead to sharply higher interest rates and borrowing costs, declining home values and reduced retirement savings for Americans. Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover.

For these reasons, default by the United States is unthinkable.

Unthinkable as it may be, it's worth giving this a little thought.

Strictly speaking, the Treasury could continue to make payments on all obligations authorized by Congress, simply by sending out checks as they come due. Commercial banks would undoubtedly accept these from depositors, confident in the knowledge that the Fed would create the reserves necessary to credit their accounts. If the Fed were concerned about the resulting expansion of the monetary base, it could neutralize this by selling bonds on the open market. The result would be an increase in the debt held by the public, with no change in the monetary base, which is exactly what would transpire if the deficit were financed by the issue of new bonds.

The problem, of course, is that the Treasury's account at the Fed would then be vastly overdrawn and the debt limit thereby exceeded. Instead of borrowing from bondholders, the Treasury would be borrowing, so to speak, from the Federal Reserve. I'm quite certain that in the current political climate this would be treated by Congress as a usurpation of its power, resulting in a constitutional crisis and possible impeachment. Not surprisingly, the Treasury Secretary is reluctant to go down this road.

The only alternative is for the Treasury to meet some of the obligations authorized by Congress while failing to meet others. For this to happen, someone in the executive branch would have to decide which prior appropriations made by Congress to respect, and which to ignore. Interest and principal on the debt would probably receive the highest priority, given constitutional imperatives. But everything beyond that, it seems, would be fair game. By respecting one law -- the debt ceiling -- the Treasury would be forced to disregard others. Payments to contractors, congressional and agency staff, state and local governments, social security recipients, and health care providers would all need to be prioritized. This is a bizarre and highly undemocratic manner of repealing legislation.

I doubt very much that it will come to this. If the Treasury were able to communicate its priorities credibly to the public, making clear exactly who would get paid and who would not, I suspect that we would have an agreement in short order. But even if we get past the current crisis unscathed, the same scenario is likely to be repeated whenever government is acrimoniously divided in the future. Accordingly, it's worth thinking about the kind of structural changes that could help us avoid a periodic repetition of this farce.

One possibility is to absorb an increase in the debt ceiling into any legislation that has budget implications, and to do so in a manner that allows for all the implied borrowing needs to be met. Any tax cuts or increases in appropriations should be accompanied by an authorization of borrowing so that all anticipated shortfalls in revenues relative to expenditures could be accommodated.

This would be very imperfect solution, because severe shortfalls in revenues relative to expenditures are often unanticipated. Unusual economic conditions (such as those we are currently navigating) can devastate revenues just as expenditures are rising sharply, thus pushing the deficit outside bounds that were forecast when the legislation was enacted.

The only sure way to eliminate the contradictions implicit in current laws would be to repeal the debt ceiling itself. This is what common sense would dictate. But expecting common sense to guide the legislative process in the present climate... now that is truly unthinkable.

Commodity Corrections

2011-05-05T21:37:00.002-04:00

As we close in on the one year anniversary of the flash crash, there are some fireworks on display in the commodities markets:

Commodities plunged the most since 2009, led by oil and silver... The Standard & Poor’s GSCI index of 24 commodities sank 6.5 percent... and has lost 9.9 percent this week. Oil tumbled 8.6 percent, the most in two years, to $99.80 a barrel. Silver dropped 8 percent, extending the biggest four-day slump since 1983 to 25 percent...

Selling swept commodities markets as investors sold positions following gains of more than 23 percent in 2011 through April 29 by silver, oil, gasoline, coffee and cotton... Futures on Brent crude, crude oil, gas oil, heating oil, gasoline and natural gas plunged more than 6.9 percent today. Crude oil dropped below $100 a barrel for the first time since March 17. Copper futures slumped 3.3 percent, falling below $4 a pound for the first time in five months. Among agricultural commodities, cocoa, cotton, corn and weak retreated more than 2.3 percent in futures trading.

Adherents of the efficient markets hypothesis will look for fundamental explanations for the sell-off, and will doubtless come up with some plausible triggers. But as John Kemp observes in an excellent post, it's impossible to understand the plunge without first recognizing that prices in speculative asset markets can become disconnected from fundamental values from time to time:

It will be entertaining to read the thousands of gallons of ink spilled over the next couple of days as journalists and analysts try to rationalise the sudden turn around and identify that one or few factors that were the “tipping point.”

In reality, commodity prices and other assets rise because investors and hedgers anticipate further gains. The market needs a steady stream of net buying orders to keep rising. But at some point the risk of a setback outweighs the prospect of further gains. Long liquidation offsets fresh buying orders, and the process heads into reverse as the length cascades out of the market.

Given the powerful role of expectations and sentiment in building and sustaining coalitions of long (or on occasion short) investors and hedgers, there does not really have to be a rational cause for the market to turn on its tail, if by rational we are looking for a trigger that seems proportionate to the effect caused.

Even in retrospect, and after thousands of hours of econometric analysis, it has proved impossible to identify rational triggers for big market movements ranging from the stock market crashes of 1907, 1929 and 1987, to the flash crash of May 2010, the implosion of the technology bubble in 2000 or the sudden collapse of the subprime madness in 2007-2008.

None of the prior market movements was in any rational sense sustainable. But when it comes to identifying a specific trigger that caused the market to peak and then head into sudden reverse, it has proved impossible in every case to find the rational cause.

I have little to add to this, except to suggest a more disaggregated view of speculative behavior and an explicit recognition of belief heterogeneity. At any point in time there are a variety of price views within the population of speculators, and trading based on this distribution of beliefs causes prices to move. Prices rise if those expecting appreciation are more confident or better capitalized than those expecting depreciation. The rise then reinforces the price views of buyers and further increases their capitalization advantage relative to sellers. This propels further appreciation.

The main check on the process, as Kemp says, is the increasing perception among some investors that "the risk of a setback outweighs the prospect of further gains." When such fears become sufficiently widespread, further price appreciation is arrested. But the crash does not follow until selling is synchronized, an event whose precise timing is essentially impossible to predict.

There is some evidence that bubbles can be identified in real time by examining the prices of securities that provide crash insurance. But regardless of whether or not this can be done, the presence of non-fundamental volatility in speculative asset prices is important to consider in the execution of monetary policy. Headline inflation has recently exceeded core inflation largely due to pressures from commodity prices. This has put Fed officials in a bind, uncertain of the relative weights to place on the two measures. If there's a lesson in today's events, it is that the speculative components of inflation measures should not have first order effects on monetary policy, at least until the economy is operating closer to its capacity.

The Self-Subversion of Albert Hirschman

2011-04-07T00:01:00.002-04:00

Albert Hirschman is 96 years old today.

A year ago I marked the occasion with a post on Exit, Voice and Loyalty, a masterpiece full of deep and original insights into the mechanisms that can restore performance in failing organizations and states. This work continues to shed light on events of enormous contemporary importance, from the effects of forced migration to the maintenance of good governance.

This year, I'd like to focus instead on a little-known interview that Hirschman gave to a trio of Italian writers in 1993. The interview was translated into English by Hirschman himself a few years later and published (with minor revisions) in a slim volume called Crossing Boundaries. It covers his early life in a turbulent Europe, his escape to the United States, his work on the economic development of Latin America, and his thoughts on methodology and language.

Interesting lives make for interesting ideas, and Hirschman's is a case in point. Born to a German family of Jewish origin in 1915, he was baptized (but never confirmed) as a Protestant. His education was in French and German, though he would later become fluent in Italian, and eventually in Spanish and English. By the age of sixteen he had joined the youth movement of the Social Democratic Party. Through his sister Ursula (who was a major influence on his life and thought) he met Eugenio Colorni, whose Berlin hotel room was used for the production of anti-fascist pamphlets and fliers. Ursula would later marry Colorni, and one of their daughters, Eva, would go on to become an economist in her own right and marry Amartya Sen. (Eva's untimely death and her influence on Sen's thought is acknowledged in the touching leading footnote of this paper.)

Hirschman watched the rise of Hitler with increasing alarm, and fled Berlin for Paris alone at the age of 18 just a couple of months after the Reichstag fire. Over the course of the next few years he would live in France, England, Spain, and Italy. He spent a year at the London School of Economics in 1935-36, taking courses with Robbins and Hayek, but finding greater intellectual affinity with a younger group of economists among whom was Abba Lerner.

When war broke out in 1939 he joined the French Army and, for fear of being shot as a traitor by approaching German forces, was compelled to adopt a new identity as a Frenchman, Albert Hermant. By 1941 he had migrated to the United States, where he met and married Sarah Hirschman. (They have now been married for seventy years.) He joined the US Army in 1943, and found himself back in Italy as part of the war effort soon thereafter.

At the end of the war Hirschman returned to the US and was involved with the development of the Marshall plan. He subsequently spent four years in Bogota, first as an adviser to the government on development policy, and then as a private economic consultant. After a sequence of appointments at Yale, Stanford, Columbia and Harvard, he moved to the Institute for Advanced Study in Princeton where he and Sarah remain.

As far as methodology is concerned, Hirschman expresses "a dislike for too unilateral and uniform diagnoses," preferring instead to imagine the unexpected:

I have always had a certain dislike for general principles and abstract prescriptions. I think it is necessary to have an "empirical lantern" or a "visit with the patient" before being able to understand what is wrong with him. It is crucial to understand the peculiarity, the specificity, and also the unusual aspects of the case.

I know well that the social world is most variable, in continuous change, that there are no permanent laws. Unexpected events constantly happen, new causality relations are being installed... with age one's new ideas are predominantly those that contradict the old.

Self-subversion has been a permanent trait of my intellectual personality...

I also feel the need to engage from time to time in abstract theory. This means that I am not totally "anti-theoretical," that I am not totally opposed to parsimony, nor totally in favor of complexity. Some of my ideas are essentially theories of economic development, on the importance of unbalanced growth, for example; the "exit/voice" schema may also derive from a new way of looking at social reality... The success of a theory consists precisely in that suddenly everyone begins to reason according to the new categories.

The idea of trespassing is basic to my thinking... Attempts to confine me to a specific area make me unhappy. When it seems that an idea can be verified in another field, then I am happy to venture in this direction...

I have always been against that methodology of certain social scientists... who study what has happened in some fifty or so countries and then proceed to draw deductions from there on what is likely to happen in the future. Of course, they find themselves without instruments in the face of "important exceptions," such as the case of Hitler in Germany. This is the reason that I have always disliked certain types of social research. I am always more interested in widening the area of the possible, of what may happen, rather than in prediction, on the basis of statistical reasoning, of what will actually happen. The inquiry into the statistical probability that certain social events will actually take place interests me little... I have always found that when something good happens, it occurs as a result of a conjunction of extraordinary circumstances... I am simply not much interested in forecasts; they are not part of my theoretical impulses.

Hirschman has always enjoyed playing with language, taking words with negative connotations and endowing them with fresh and positive meanings. Trespassing, subversion, bias, and doubt all start to carry strangely bright associations in his writing. But for Hirschman this act of appropriation is not simply a source of joy; it can also generate genuine insight:

I enjoy playing with words, inventing new expressions. I believe there is much more wisdom in words than we normally assume.... Here is an example. One of my recent antagonists, Mancur Olson, uses the expression "logic of collective action" in order to demonstrate the illogic of collective action, that is, the virtual unlikelihood that collective action can ever happen. At some point I was thinking about the fundamental rights enumerated in the Declaration of Independence and that beautiful expression of American freedom as "the right to life, liberty, and the pursuit of happiness.'' I noted how, in addition to the pursuit of happiness, one might also underline the importance of the happiness of pursuit, which is precisely the felicity of taking part in collective action. I simply was happy when that play on words occurred to me.

Hirschman's love of words led him to invent a number of palindromes over the course of his life. Some of these he collected together under the title Senile Lines, signed by Dr. Awkward, for his daughter Katya upon her graduation (both title and author are, of course, palindromes).

Reading this interview made me wonder whether graduate programs in economics place enough emphasis on facility of expression when screening students for admission. A high level of mathematical preparation can certainly ease one's passage through the required coursework. But it does not seem too far-fetched to conjecture that an appreciation for language and a gift for expression might be valuable inputs in the generation of interesting new ideas.

From Order Books to Belief Distributions

2011-03-14T11:11:00.004-04:00

In my last post I argued that the price at last trade in a prediction market doesn't generally correspond to the belief of an average or representative trader in any meaningful sense, and ought not to be interpreted loosely as the "perceived likelihood according to the market" that the underlying event will occur.

In contrast, the order book, which is the collection of all unexpired bids and offers that cannot currently be matched against each other, contains a wealth of information about the distribution of trader beliefs. Under certain assumptions about the risk preferences of market participants, one can deduce a distribution of trader beliefs from this collection of standing orders. The imputed distribution may then be used to infer what the average trader (in a well-defined sense) perceives the likelihood of the underlying event to be. Furthermore, it can be used to gauge the extent of disagreement about this likelihood within the trading population.

To illustrate, consider the order book for the contract PRESIDENT.DEM.2012, which pays $10 if the official nominee of the Democratic Party wins the next presidential election. At the time of writing my last post, the collection of unexpired and unfilled orders looked like this:

BID

Qty	Price
18	62.5
441	62.1
500	62.0
4	61.1
79	61.0
86	60.0
1	59.9
173	59.0
1	58.4
1	57.7
67	57.4
1	56.8
200	56.6
5	56.3
100	56.1

ASK

Price	Qty
62.9	1
63.1	30
63.4	1
63.5	2
63.6	1
63.7	10
63.8	6
63.9	1
64.0	111
64.1	2
64.2	1
64.5	100
64.6	101
64.8	10
65.0	200

Prices are expressed as percentages of face value, so the highest bidder was willing to pay $6.25 per contract, while the lowest offer was at $6.29 per contract. The frequency distributions of orders on the two sides of the market were as follows:

These distributions necessarily have disjoint supports, otherwise some orders would be matched and exit the book. The median bid was 62.0 per contract, while the median offer was 64.6.

How might one deduce a belief distribution from this data?

The first point to note is that anyone placing an order that cannot immediately be filled (and does not immediately expire) faces two kinds of risk. There is the obvious risk that the event may or may not occur; even those whose orders trade immediately are exposed to this. But for an order that remains in the book for some time there is a second source of risk: new information might arrive that substantially alters the likelihood that the event will occur, and results in the order being matched before it can be removed. Given these two sources of risk, traders will post bids at prices that are below their subjective estimates of the likelihood that the event in question will occur. Similarly, those who post offers to sell will do so at prices that lie above their subjective estimates of this likelihood.

A simple way to take these effects into account is to assume that the risk preferences of traders are given by a linear mean-variance objective function of the kind that may be found in any standard text on Investments, with risk aversion parameter A. As an example to illustrate the procedure, suppose that all traders have the same degree of risk-aversion given by A = 0.15, and that buyers post the highest price that they are willing to pay for the asset, while sellers post the lowest price that they are willing to accept. Then the order distribution implies the following distributions of beliefs on the two sides of the market:

Note first that buyers on the whole assign greater likelihood to the occurrence of the underlying event than sellers do, even though all bid prices lie strictly below the lowest of the offer prices. This is a direct consequence of risk-aversion, which induces buyers to post prices below their subjective beliefs and sellers to offer at prices above theirs. The median buyer belief is 0.65 while the median seller belief is 0.59.

Second, buyer beliefs are spread across a wider range than are the beliefs of sellers. This simply replicates a pattern in the order book, which is characterized by many large bids at varying prices but a concentration of offers in a narrower price range.

Third, the belief supports are not disjoint: there is a range of beliefs that is represented on both sides of the market. These beliefs probably correspond to orders placed by market makers who simultaneously place bids and offers with the aim of profiting from the spread. For instance, the bid for 200 contracts at 56.6 and the offer of 200 at 65.0 both imply an imputed belief of about 0.60 under the assumed value for the risk-aversion parameter. It is quite conceivable, indeed very likely, that these orders were placed by the same individual.

Aggregating the buyer and seller belief distributions yields the belief distribution for the market as a whole:

Since bids are more numerous than offers, this aggregate belief distribution lies closer to that for buyers. The median belief in this case is 0.63, which happens to be slightly above the price at last trade.

This is one way of making precise the idea of "the perceived likelihood according to the market." Under the specifications adopted here, this perception is close to the equilibrium price. But it need not be in general. Higher values of the risk-aversion parameter would generate belief distributions for buyers and sellers that are further apart. While the theoretical effect of this on the median belief is ambiguous, for the particular example considered here, a risk-aversion parameter of A = 0.25 would generate a median belief of 0.65.

Furthermore, changes in beliefs within the population of traders could make their presence known through changes in bids and offers without any change in the equilibrium price. That was essentially the point of my last post: any given equilibrium price is consistent with a broad range of belief distributions. By focusing on the complete distribution (rather than just a point estimate) one can get a better sense of where market perceptions really lie.

One interesting question that follows from the arguments advanced here is this: could one use an imputed belief distribution to predict short-term movements in the equilibrium price?

Not necessarily. Even if one felt that the belief corresponding to the median order was in some sense the best forecast regarding the likelihood of the underlying event, one would not be induced to place an order that moves the equilibrium price. This is simply due to the fact that bids lie below subjective beliefs while offer prices lie above them. If large numbers of individuals simply adopted the imputed median belief as their own forecast, they would be induced to enter bids and offers around this belief, affecting the variance of the belief distribution but not necessarily its median. Nevertheless, it is worth noting that high-frequency trading outfits in US equity markets do manage to use proprietary data feeds to make effective short-run price forecasts.

As Andrew Gelman put it in his (very kind) response to my earlier post:

Markets are impressive mechanisms for information aggregation but they're not magic. The information has to come from somewhere, and markets are inherently always living in the phase transition between stability and instability... This is not to say that prediction markets are useless, just that they are worth studying seriously in their own right, not to be treated as oracles.

Prediction markets are indeed worth studying seriously not only because they are complex and interesting mechanisms for information aggregation, but also because the simplicity of the contracts traded can allow strong inferences to be made about the behavior of market participants. And some of these insights could be generalized to apply to speculative asset markets with much greater volume, liquidity, and economic importance.

On the Interpretation of Prediction Market Data

2011-03-06T00:21:00.004-05:00

As the election season draws closer, considerable attention will be paid to prices in prediction markets such as Intrade. Contracts for potential presidential nominees are already being scrutinized for early signs of candidate strength. In a recent post on the 2012 Republican field, Nate Silver used prediction market data (among other sources of information) to generate the following very interesting chart:

Source: FiveThirtyEight: Nate Silver's Political Calculus

While Nate's post was concerned primarily with the positioning of candidates along two-dimensions of the political spectrum, he used market prices as a proxy for the probabilities of eventual nomination:

[The] area of each candidate’s circle is proportional to their perceived likelihood of winning the nomination, according to the Intrade betting market. Mitt Romney’s circle is drawn many times the size of the one for the relatively obscure talk-radio host Herman Cain because Intrade rates Mr. Romney many times as likely to be nominated.

This interpretation of prices as probabilities is common and will be repeated frequently over the coming months. But what could the "perceived likelihood according to the market" possibly mean?

Markets don't have perceptions. Traders do, but there is considerable heterogeneity in trader beliefs at any point in time. Prediction market prices contain valuable information about this distribution of beliefs, but there is no basis for the common presumption that the price at last trade represents the beliefs of a hypothetical average trader in any meaningful sense. In fact, to make full use of market data to make inferences about the distribution of beliefs, one needs to look beyond the price at last trade and examine the entire order book.

As an example, consider Intrade's market for the presidential election winner by party. This market consists of three contracts comprising a mutually exclusive and exhaustive set of outcomes. One contract pays out if the winner is a Democrat, a second if the winner is a Republican, and the third if the winner is not the official nominee of either party. The current prices of these contracts are as follows:

Contract	Bid	Ask	Last
PRESIDENT.DEM.2012	62.5	62.9	62.5
PRESIDENT.REP.2012	35.1	35.5	35.0
PRESIDENT.OTHER.2012	2.2	2.3	2.2

These prices are expressed as percentages of contract face value, which in each case is $10. That is, the price at last trade of the DEM contract was $6.25. The buyer risks this amount (per contract purchased) and stands to receive $10 if (and only if) the specified event occurs. The seller risks $3.75 to take the opposite side of the bet.

It's tempting to interpret the price at last trade as a probability because the sum of these prices adds up to approximately 100% of the contract face value. The reason for this is that the sum of the ask prices must be no less than 100, otherwise an arbitrage opportunity would exist: one could buy all contracts and be sure that one will expire at face value, thus generating in a risk-free profit. Similarly, the sum of bid prices must be no greater than 100. If the market is liquid, so that bid-ask spreads are small, then all prices (bid, ask, and last) will sum to approximately 100. This is the basis for the claim that, at current prices, the "market" is predicting that the Democratic nominee will win the White House with probability 62.5%.

But is this interpretation reasonable? All that the price at last trade can tell us about is the beliefs of the two parties to this transaction. If both are risk-averse or risk-neutral, they each must believe that entering their respective positions will yield a positive expected return. Hence the buyer must assign probability at least 62.5% to the event that the Democrat is elected, while the seller assigns a likelihood of at most 62.5% to this event.

This tells us nothing about the beliefs of traders who are not party to this transaction. However, additional information about the distribution of beliefs in the trader population can be obtained by looking at the order book, which at present looks like this:

BID

Qty	Price
18	62.5
441	62.1
500	62.0
4	61.1
79	61.0
86	60.0
1	59.9
173	59.0
1	58.4
1	57.7
67	57.4
1	56.8
200	56.6
5	56.3
100	56.1

ASK

Price	Qty
62.9	1
63.1	30
63.4	1
63.5	2
63.6	1
63.7	10
63.8	6
63.9	1
64.0	111
64.1	2
64.2	1
64.5	100
64.6	101
64.8	10
65.0	200

Note that there are several large orders (in excess of 100 contracts) but these are unevenly distributed on the two sides of the market. Consider, for instance, the bid for 500 contracts at 62. Whenever such an order is placed, Intrade freezes funds in the trader's account equal to the worst case loss, which in this case is $3,100. Upon expiration, these contracts will be worth either $5,000 (if the event occurs) or they will be worthless. Again, assuming risk-aversion or risk-neutrality, one can impute to the potential buyer a belief that the event will occur with probability at least 62%.

But this imputation will be an underestimate for at least two reasons. First, the greater the degree of risk-aversion, the more compensation a trader will demand to enter a risky position. Since these positions are indeed very risky, it is likely that many of those placing large standing bids have significantly positive expected returns, and hence believe that the probability of the event occurring exceeds by some measure the imputed value.

Second, traders placing large bids are aware that conditional on their order being met, it is likely that some news will have emerged that makes the event less likely to occur. That is, they understand that a trade against their order is more likely to occur in the event of bad news (from their perspective) than good news. Taken together, these factors imply that traders placing large bids must be considerably more optimistic about the occurrence of the event than the naive imputation of 62% would suggest.

The same reasoning applies to those taking positions on the sell side: traders placing large limit orders must believe that the event is considerably less likely to occur than a naive reading of their posted price would suggest.

What, then, can one say about the distribution of beliefs in the market? To begin with, there is considerable disagreement about the outcome. Second, this disagreement itself is public information: it persists despite the fact that it is commonly known to exist. That is, traders don't attribute differences in beliefs simply to differences in information applied rationally to a common prior. (This follows from Aumann's famous theorem which states that individuals who have common priors and are commonly known to be rational cannot agree to disagree no matter how different their private information may be.) As a result, the fact of disagreement is not itself considered to be informative, and does not lead to further belief revision. The most likely explanation for this is that traders harbor doubts about the rationality or objectivity of other market participants.

Third, there is a cluster of large buy orders at around 62, and a cluster of large sell orders in the 64-65 range. Hence there are some traders who believe quite confidently that Democrats will hold the White House with probability considerably greater than 62%. And there is another group who believe, also confidently, that the chances of this occurring are quite a bit below 64%. As things stand, the former group appear to be either more numerous or more confident in their judgments.

More generally, it is entirely possible that beliefs are distributed in a manner that is highly skewed around the price at last trade. That is, it could be the case that most traders (or the most confident traders) all fall on one side of the order book. In this case the arrival of seemingly minor pieces of information can cause a large swing in the market price. Of course, such swings may draw into the market other participants whose beliefs are not currently represented in the order book. But the bottom line is this: there is no meaningful sense in which one can interpret the price at last trade as an average or representative belief among the trading population.

Market Ecology

2011-02-20T16:21:00.006-05:00

The erudite and very readable RT Leuchtkafer has posted yet another comment for the Securities and Exchange Commission to digest. This one was prompted by a paper by Andrei Kirilenko, Albert Kyle, Mehrdad Samadi and Tugkan Tuzun that provides a fascinating glimpse into the kinds of trading strategies that are common in asset markets today and the manner in which they interact to determine the dynamics of asset prices.

As I have argued on a couple of earlier occasions, the stability of a market depends on the composition of trading strategies, which in turn evolves over time under pressure of differential performance. Since performance itself depends on market stability, and destabilizing strategies prosper most when they are rare, this process can give rise to switching regimes: the market alternates between periods of stability and instability, giving rise to empirical patterns such as fat tails and clustered volatility in asset returns.

But the underlying strategies that are at the heart of this evolutionary process are generally unobservable. Since traders have no incentive to reveal successful strategies, these can only be inferred if individual orders can be traced to specific accounts.

This is what Kirilenko and his co-authors have been able to do, on the basis of "audit-trail, transaction-level data for all regular transactions in the June 2010 E-mini S&P 500 futures contract (E-mini) during May 3-6, 2010 between 8:30 a.m. CT and 3:15 p.m. CT." While their primary concern is with the flash crash that materialized on the afternoon of the 6th, their analysis also sheds light on the composition and behavior of strategies over the period that led up to this event. Their analysis accordingly provides broader insight into the ecology of financial markets.

The authors classify accounts into six categories based on patterns exhibited in their trading behavior, such as horizon length, order size, and the willingness to accumulate significant net positions. The categories are High Frequency Traders (HFTs), Intermediaries, Fundamental Buyers, Fundamental Sellers, Opportunistic Traders and Small Traders:

[Different] categories of traders occupy quite distinct, albeit overlapping, positions in the “ecosystem” of a liquid, fully electronic market. HFTs, while very small in number, account for a large share of total transactions and trading volume. Intermediaries leave a market footprint qualitatively similar, but smaller to that of HFTs. Opportunistic Traders at times act like Intermediaries (buying a selling around a given inventory target) and at other times act like Fundamental Traders (accumulating a directional position). Some Fundamental Traders accumulate directional positions by executing many small-size orders, while others execute a few larger-size orders. Fundamental Traders which accumulate net positions by executing just a few orders look like Small Traders, while Fundamental Traders who trade a lot resemble Opportunistic Traders. In fact, it is quite possible that in order not to be taken advantage of by the market, some Fundamental Traders deliberately pursue execution strategies that make them appear as though they are Small or Opportunistic Traders. In contrast, HFTs appear to play a very distinct role in the market and do not disguise their market activity.

Based on this taxonomy, the authors examine the manner in which the strategies vary with respect to trading volume, liquidity provision, directional exposure, and profitability. Although high-frequency traders constitute a minuscule proportion (about one-tenth of one percent) of total accounts, they are responsible for more than a third of aggregate trading volume in this market. They have extremely short trading horizons and maintain low levels of directional exposure. Under normal market conditions they are net providers of liquidity but their desire to avoid significant exposure means that they can become liquidity takers very quickly and on a large scale.

The extent to which different trading strategies provide liquidity to the market is assessed by the authors on the basis of a measure of order aggression. An order is said to be aggressive if it is marketable against a resting order in the limit order book (and is therefore executed immediately.) The resting order with which it is matched is said to be passive:

From a liquidity standpoint, a passive order (either to buy or to sell) has provided visible liquidity to the market and an aggressive order has taken liquidity from the market. Aggressiveness ratio is the ratio of aggressive trade executions to total trade executions... weighted either by the number of transactions or trading volume... HFTs and Intermediaries have aggressiveness ratios of 45.68% and 41.62%, respectively. In contrast, Fundamental Buyers and Sellers have aggressiveness ratios of 64.09% and 61.13%, respectively.

This is consistent with a view that HFTs and Intermediaries generally provide liquidity while Fundamental Traders generally take liquidity. The aggressiveness ratio of High Frequency Traders, however, is higher than what a conventional definition of passive liquidity provision would predict.

Moreover, the aggressiveness ratio of HFTs is not stable over time and can spike in times of market stress as they compete for liquidity with other market participants:

During the Flash Crash, the trading behavior of HFTs, appears to have exacerbated the downward move in prices. High Frequency Traders who initially bought contracts from Fundamental Sellers, proceeded to sell contracts and compete for liquidity with Fundamental Sellers. In addition, HFTs appeared to rapidly buy and [sell] contracts from one another many times, generating a “hot potato” effect before Opportunistic or Fundamental Buyers were attracted by the rapidly falling prices to step in and take these contracts off the market.

To my mind, the most revealing findings in the paper pertain to the profitability of the various strategies, and the ability of some traders to anticipate price movements over very short horizons (emphasis added):

High Frequency Traders effectively predict and react to price changes... [they] are consistently profitable although they never accumulate a large net position. This does not change on May 6 as they appear to have been even more successful despite the market volatility observed on that day... Intermediaries appear to be relatively less profitable than HFTs. During the Flash Crash, Intermediaries also appeared to have incurred significant losses... consistent with the notion that the relatively slower Intermediaries were unable to liquidate their position immediately, and were subsequently run over by the decrease in price...

HFTs appear to trade in the same direction as the contemporaneous price and prices of the past five seconds. In other words, they buy... if the immediate prices are rising. However, after about ten seconds, they appear to reverse the direction of their trading... possibly due to their speed advantage or superior ability to predict price changes, HFTs are able to buy right as the prices are about to increase... In marked contrast... Intermediaries buy when the prices are already falling and sell when the prices are already rising...

We consider Intermediaries and HFTs to be very short term investors. They do not hold positions over long periods of time and revert to their target inventory level quickly... HFTs very quickly reduce their inventories by submitting marketable orders. They also aggressively trade when prices are about to change. Over slightly longer time horizons, however, HFTs sometimes act as providers of liquidity. In contrast... unlike HFTs, Intermediaries provide liquidity over very short horizons and rebalance their portfolios over longer horizons.

What appears to have happened during the crash is that the fastest moving market makers with the most effective algorithms for short run price prediction were able to trade ahead of their slower and less effective brethren, imposing significant losses on the latter. In Leuchtkafer's colorful language, this was a case of interdealer panic and market maker fratricide.

But regardless of how the gains or losses were distributed in this instance, the fact remains that an overwhelming share of trading activity is based short-run price forecasts rather than fundamental research. Under these conditions, how can one expect prices to track changes in the fundamental values of the income streams to which the assets give title?

Markets have always been based on a shifting balance between information augmenting and information extracting strategies, but a computational arms race coupled with changes in institutions and regulation seem to have shifted the balance markedly towards the latter. Unless the structure of incentives is altered to favor longer holding periods, I suspect that we shall continue to see major market disruptions and spikes in volatility.

This is not just a matter of academic interest. To the extent that changes in the perceived volatility of stocks gives rise to changes in asset allocations by institutional and retail investors, there will be consequences for the extent and distribution of risk-bearing, and ultimately for rates of job creation and economic growth.

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Update (2/21). Yves Smith has generously allowed me to crosspost freely on naked capitalism, where this entry has attracted a couple of interesting comments. Here is Peripheral Visionary:

With respect to May 6... the faster algorithms may have caused the damage, but I think they also suffered from it. From the data I reviewed, the traditional market makers had huge numbers of buys at the bottom and huge numbers of sells through the recovery, and so may have come out net positive on the day, while the faster algorithms panicked when the market moved outside the range of expected behavior, and many were shut down, effectively locking in losses. In fact, I suspect that losses for HFT algorithms would have been much larger had not the exchanges canceled so many trades, with many, even most, of the sells at the bottom being algorithm trades.

This was also my initial reaction to the crash, which is why I argued against the cancellation of trades on grounds of stability. The Kirilenko paper does not really settle the question because it focuses only on the E-mini futures market where no trades were broken.

The comment by financial matters is also worth a look; this one links to a CNBC interview with Jim McCaughan in which the exit of institutional and retail investors from the market is documented.

Belief Heterogeneity

2011-02-12T21:41:00.005-05:00

There was an interesting conference at Columbia yesterday (though not nearly as interesting as the momentous events unfolding elsewhere at the time). The theme was "Heterogeneous Expectations and Economic Stability" and this is how the organizers (Ricardo Reis and Mike Woodford) described the goal of the meeting:

Conventional models in both macroeconomics and finance are based on the hypothesis of rational expectations, under which all agents are assumed to have common expectations, corresponding to the probabilities implied by the economist’s model. The adequacy of this familiar hypothesis has been called into question by recent events, however, notably the instability resulting from the boom and bust in real estate prices. The purpose of this conference is to bring together researchers exploring alternative approaches to modeling the dynamics of expectations, with particular attention to applications in macroeconomics and finance. We have sought to bring together proponents of a variety of approaches, who may not frequently engage one another, in the hope of reaching conclusions about which directions are most promising at this time.

And, indeed, the collection of papers presented were methodologically diverse. Although any such classification is bound to be coarse and imperfect, there seem to be four different directions in which research on expectations is proceeding. First, there is the approach of near-rational expectations, in which intertemporal optimization and Bayesian rationality are maintained but allowance is made for heterogeneous prior beliefs. Then there is the behavioral approach, which endows agents with heuristics based on regularities identified in laboratory experiments. Third, there is the evolutionary approach, which allows for a broad range of competing forecasting rules with the population composition shifting over time under pressure of performance differentials. And finally, the empirical approach, which treats expectations as a state variable to be measured using survey or market data and explained just as one would explain output or inflation. Each of these perspectives was on prominent display at the conference.

Regular readers of this blog (if there are any left, given the recent decline in my rate of posting) will know that I am deeply skeptical of the behavioral approach to trading strategies, for the simple reason that behavior in high stakes environments with strong selection pressures driving entry and exit is unlikely to be psychologically typical in the sense of reflecting outcomes of lab experiments with standard subject pools. What might be a common behavioral trait in the population at large could be extremely rare among traders, especially if such traits can be exploited with ease by other market participants. By the same token, behavior that is pathological in the lab could well become widespread in financial markets from time to time. As a result my favored approach to trading strategies in general and forecasting rules in particular is ecological.

Not surprisingly, then, the presentation I found most appealing was that of Blake LeBaron. Blake is a pioneer in the development of agent-based computational models of financial markets, and the paper he presented belonged to this class. A large number of different forecasting strategies, some based on fundamental information and others on technical data analysis, compete with each other and with a traditional buy-and-hold strategy in his model. The resulting trading dynamics give rise to asset price returns that exhibit both moderate levels of short-run momentum as well as mean reversion over longer horizons. Moreover, the long run population of forecasting rules is ecologically diverse, with both passive and active strategies well represented.

During the panel discussion at the end of the conference, Albert Marcet observed that the conference itself was symptomatic of a revolution in economic thought that is currently underway, prompted in large measure by the global financial crisis. If methodologies such as agent-based computational economics start to be published in major journals and attract attention from the most promising graduate students, then there really will be a revolution underway. But I'm not convinced that we're there yet.

One final thought. The conference organizers described the rational expectations hypothesis as one "under which all agents are assumed to have common expectations, corresponding to the probabilities implied by the economist’s model." This is an accurate characterization as far as the contemporary implementation of the hypothesis is concerned, but it is important to note that this is not the hypothesis originally advanced by John Muth in his classic paper. In fact, Muth cited survey data exhibiting "considerable cross-sectional differences of opinion" and was quite explicit in stating that his hypothesis "does not assert... that predictions of entrepreneurs are perfect or that their expectations are all the same.'' In Muth's version of rational expectations, each individual holds beliefs that are model inconsistent, although the distribution of these diverse beliefs is unbiased relative to the data generated by the actions resulting from these expectations. It is a wisdom of crowds argument, rather than one based on individual rationality.

Viewed in this manner, there a sense in which the heterogeneous prior models (with diverse beliefs centered on a model consistent mean) represent both a departure from the rational expectations hypothesis as currently understood, as well as a return to the original rational expectations hypothesis as formulated by Muth. The history of economic thought is full of such rather strange twists and turns.

Alison Snow Jones (fine economist)

2011-01-26T08:48:00.005-05:00

The world of economics blogs lost a wise and original voice when Alison Snow Jones, better known to her audience as Maxine Udall (girl economist), died suddenly on Monday.

Through her blog, Maxine (as I will always remember her) gave us a glimpse of a personality that was both deeply serious about the thorny issues confronting us as a society and wonderfully playful in the manner in which she addressed them. She managed to weave personal narratives into economic arguments without ever appearing to be self-absorbed. I never met her but we exchanged occasional comments on posts and linked to each others' writing from time to time. Sometimes one sees more at a distance than is visible at close range.

Steve Waldman has done us all a great service by collecting together in a single moving post a series of excerpts from her most thoughtful writing.

She will be missed by many.

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Update (1/30). Will Kranz writes in (posted with permission):

Thanks for your post. I knew Alison through a family association. We ate, drank, and laughed together for close to 30 years. I know nothing about econometrics, but enjoyed her company. In addition to economics, she was interested in horses... and kayaking.

Will also sent me a link to a photograph with the following explanation:

Alison is probably taking the picture, so not in the image. This is from a trip to the Middle Fork of the Salmon in Idaho she went at least 10 years ago. Its typical of the sort of thing she did. Normally closer to home on the east coast, but a couple major trips to special places.

The Original Mandate of the Federal Reserve

2011-01-15T19:41:00.000-05:00

Writing on his recently launched blog, my colleague Perry Mehrling traces the evolving mandate of the Federal Reserve from its founding to the present day:

From a longer historical perspective, populist targeting of the Fed, both from the right and from the left, is nothing new. Big Finance and Big Government are perennial bogeymen in American political discourse. Coupling the two in the institution of a central bank is at the heart of current debate about the role of the Fed during the crisis.

In 1913, at the founding of the Fed, legislators directly confronted both bogeymen. The whole idea of the Federal Reserve System, so the language of the Act made clear, was to channel credit preferentially to productive uses. Section 13(2) makes clear who was supposed to get the credit: “Discount of Commercial, Agricultural and Industrial Paper”, not speculative financial paper and not Treasury paper. The new Fed was about reversing the upper hand enjoyed by Big Finance, and without replacing it with the hand of Big Government.

Exigencies of war finance soon shifted the focus of the newborn Fed, and the Act was accordingly amended. During both World War I and World War II, the Fed pegged the price of Treasury debt, and expanded its balance sheet as necessary to absorb any excess supply that was not taken up by private buyers.

Does that kind of emergency intervention sound familiar? It should.

So-called QE1, back in early 2009, involved the Fed pegging the price of mortgage-backed securities by taking $1.25 trillion worth onto its own balance sheet. This is war finance. Actually it started even earlier, back in September 2008, with the collapse of Lehman and AIG. The initial balance sheet expansion occurred as, in addition to its domestic lending, the Fed lent $600 billion to foreign central banks, as well as other billions directly to foreign private banks, financing the loans simply by expanding its own monetary liabilities. This again is war finance, but without the war.

What troubles critics of the Fed is the use of the powerful tools of war finance to support private capital markets, and to support foreign bankers. For some, a similar unease arises from the latest QE2 twist, which has the Fed buying $600 billion of Treasury debt. There is no doubt in my mind that the Fed’s actions were legal under the “unusual and exigent circumstances” provision of the Act. But what everyone wants to know is whether the Fed did the right thing, and what the transformation of the Fed over the last few years portends for the future.

As it happens, one of the many responses of the Fed to the financial crisis was a return to its original mandate as an active participant in the commercial paper market: "funding purchases of commercial paper... to improve liquidity in short-term funding markets and thereby increase the availability of credit for businesses and households." But this was done in late October 2008, after a massive expansion of its balance sheet in support of failing financial intermediaries, and after TARP had been signed into law.

The main justification for these extraordinary measures in support of the financial sector was that perfectly solvent firms in the non-financial sector would have been crippled by the freezing of the commercial paper market. But as Dean Baker has consistently argued, had the Fed's intervention in the commercial paper market been more timely and vigorous, it might been unnecessary to provide unconditional transfers to insolvent financial intermediaries. While I do not subscribe to Baker's view that Ben Bernanke "deliberately misled" Congress in order to gain approval for TARP, his main point still stands: if the Fed can increase credit availability to non-financial businesses and households by direct purchases of commercial paper, than why is any financial institution too big to fail?

It's a question that the most ardent defenders of the bailouts would do well to address. The impressive numerical estimates of the effects of these policies on output and employment rely on a comparison with a "scenario based on no financial policy responses." But this is obviously not the proper benchmark. If output and employment could have been stabilized by direct support of the non-financial sector, then we would currently be faced with a different distribution of claims to this output, as well as a different distribution of financial practices.

Among supporters of the government's financial market policies, Bill Dudley has been especially forthright in acknowledging their flaws:

[It] is deeply offensive to Americans, including me, and runs counter to basic notions of justice and fairness, that some of the very same individuals and financial firms that precipitated this crisis have also benefited so directly from the response to the crisis. This has occurred at the same time that many Americans have lost their jobs and hard-earned savings. The public outrage this situation has produced is understandable. In the context of actions taken to support the financial system, the Federal Reserve and other government agencies have provided considerable support to banking organizations and other large systemically important financial institutions. The employees and executives of those institutions have benefited from our intervention. In a perfect world we would be able to prevent those individuals and institutions from benefiting; we would have a better way to penalize those who acted recklessly. But once the crisis was underway, one goal took precedence: keeping the financial system from collapsing in order to protect the nation from an even deeper and more protracted downturn that would have been more damaging to everyone.

In a perfect world, according to Dudley, we could have done much better. But even in our very imperfect world, might we not have been able to stabilize output and employment by returning quickly and forcefully to the original mandate of the Federal Reserve, to channel credit preferentially to productive uses?

Should Old Acquaintance Be Forgot

2010-12-30T09:47:00.002-05:00

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.

Perspectives on Exchange-Traded Funds

2010-12-11T14:58:00.012-05:00

Are exchange-traded funds good or bad for the market?

That was the title of a lively and interesting session at Markets Media's third annual Global Markets Summit last Thursday. The session was organized as an old-fashioned debate between two teams. On one side were David Weild and Harold Bradley (joined later by Robert Litan on video), who argued that heavily traded funds composed of relatively illiquid small-cap stocks were responsible, in part, for the sharp decline in initial public offerings over the past decade, with devastating consequences for capital formation and job creation.

Responding to these claims were Bruce Lavine, Adam Patti and Robert Holderith, all representing major sponsors of funds (WisdomTree, IndexIQ and EGShares respectively). The sponsors argued that they are marketing a product that is vastly superior to the traditional open-end fund, provides investors with significant liquidity, transparency and tax advantages, and is rapidly gaining market share precisely because of these benefits. From their perspective, it makes as little sense to blame exchange-traded funds for declining initial public offerings and the sluggish rate of job creation as it does to blame them for hurricanes or influenza epidemics.

So who is right?

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. But what I find puzzling about Bradley's position on this issue is that he seems unable (or unwilling) to recognize that precisely the same effects can be generated by high-frequency trading. As was apparent in an earlier session at the conference, he remains among the most vocal and fervent defenders of the new market makers. His justification for this is that spreads have declined dramatically, lowering the costs of trading for all market participants, including long term investors.

There is no doubt the costs of trading are a fraction of what they used to be, but a single-minded focus on spreads misses the big picture. It is worth bringing to mind John Bogle's wise words:

It is the iron law of the markets, the undefiable rules of arithmetic: Gross return in the market, less the costs of financial intermediation, equals the net return actually delivered to market participants.

If spreads and costs per trade decline, but holding periods shrink to such a degree that overall trading expenditures rise (due to significantly increased volume), the net return to long term investors as a group must fall. Furthermore, if increases in volatility and correlation induce shifts in asset allocation that have the effect of reducing financing for small companies with high growth potential, then even gross returns could decline.

I have been arguing for a while now that the stability of an asset market depends on the composition of trading strategies and, in particular, that one needs a large enough share of information trading to ensure that prices track fundamentals reasonably well. But changes in technology and regulation have allowed technical strategies to proliferate, and high frequency trading is a significant part of this phenomenon. The predictable result is a secular increase in asset price volatity and an increased frequency of bubbles and crashes.

The flash crash of May 6 was just a symptom of this. Viewed in isolation, it was a minor event: prices fell (or rose, in some cases) to patently absurd levels, then snapped back within a matter of minutes. But the crash was the canary in the proverbial coal mine -- it was important precisely because it made visible what is ordinarily concealed from view. Departures of prices from fundamentals are routine events that, especially on the upside, are not quickly corrected. Some of the proposed responses to the crash that were favored at the conference -- such as trading halts followed by call auctions -- are cosmetic changes. They will have the effect of silencing the canary while doing nothing to lower toxicity in the mine.

It is the unremarkable, invisible, gradually accumulating departures of prices from fundamentals that are the real problem. These show up in the magnitude and clustering of asset price volatility and, through their effects on the composition of portfolios, leave their mark on the path of capital allocation, employment, and economic growth.

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I am grateful to Terry Flanagan of Markets Media Magazine for the invitation to attend the summit.

I would also like to mention that the Kauffman report contains a number of assertions with which I disagree. For instance, Bradley and Litan endorse the claims of Bogan, Connor and Bogan that an exchange-traded fund with significant short interest could collapse with some investors unable to redeem their shares. This has been refuted very effectively by Steve Waldman in his comments on the Bogan post, and by Kid Dynamite. It is unfortunate that most responses to the report have focused on this dubious claim, rather than the more legitimate arguments that are advanced there.

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Update (12/11). David Weild writes in to say:

I think we are seeing capital leave the microcap markets for a variety of reasons including:

Loss of liquidity providers
Emergence of ETFs (they don't buy IPOs and most don't buy follow-on offerings)
Indexing displacing fundamental investing (again, when this occurs, the funds stop investing in IPOs)
Loss of the retail broker as a stock seller.
If you don't have access to sufficient capital then capital formation, innovation and economic growth will suffer. That is clearly where we are.

I have also heard from someone who was once active in convincing the SEC to expand approval of ETF applications (and prefers to remain anonymous). He asserts that "the effects now being debated were certainly not an anticipated consequence. I can't remember a single conversation externally or internally at the SEC about whether the creation and redemption mechanism would increase correlations."

In hindsight it seems obvious that returns would become more highly correlated, but the fact that it was completely unanticipated at the time illustrates the enormous challenge of regulatory adaptation to financial innovation.

Building a Computational Model of the Crisis

2010-12-08T11:46:00.001-05:00

A team of four researchers affiliated with the Santa Fe Institute has secured a grant from the Institute for New Economic Thinking to fund the development of an agent-based computational model of the financial crisis. The model will explicitly consider "housing and mortgage markets, banks and other financial institutions, securitization processes and hedge fund investors, manufacturing and service firms, and regulatory agencies," with the goal of discovering "the essential elements needed to reproduce the crisis, while investigating alternative policies that may have reduced its intensity and strategies for recovery."

It's an interesting and multidisciplinary group, composed of Doyne Farmer, John Geanakoplos, Peter Howitt and Robert Axtell. Genakoplos and Howitt are two of the most creative economists around, and I have discussed the work of the former on leverage and the latter on learning in earlier posts. Axtell is the co-author (with Joshua Epstein) of a fascinating book called Growing Artificial Societies, in which they develop an elaborate computational model of the interaction between a renewable resource base and the human population that depends on it. The model reproduces spatial patterns of resource depletion and recovery as well as population growth, migration and decline. Farmer is a physicist by training but has been working on finance for as long as I can remember. I discussed some of his work in an earlier post making a case for greater methodological pluralism in economics in general, and agent-based modeling in particular.

The team is looking for a graduate student or postdoctoral fellow to join them for a couple of years. For a young researcher interested in finance, the microfoundations of macroeconomics, and the agent-based computational methodology, this could be a fantastic opportunity.

Global Health and Wealth over Two Centuries

2010-12-02T11:49:00.009-05:00

Here is a story in four minutes of remarkable divergence followed by rapid convergence in health and wealth across nations over the past two centuries (h/t David Kurtz)

Where the entire world was clustered in 1810 only sub-Saharan Africa remains. But even here there are profound stirrings of change.

I suspect that someday soon animations such as this will replace the soporific tables and charts than now appear as motivating evidence in economic papers.

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Update (12/6). Pinkovskiy and Sala-i-Martin argue that over the past decade and a half, the nations of sub-Saharan Africa have experienced a dramatic and broad-based decline in poverty and inequality (h/t Mark Thoma):

African poverty reduction has been extremely general. Poverty fell for both landlocked and coastal countries, for mineral-rich and mineral-poor countries, for countries with favourable and unfavourable agriculture, for countries with different colonisers, and for countries with varying degrees of exposure to the African slave trade. The benefits of growth were so widely distributed that African inequality actually fell substantially...

It has often been suggested that geography and history matter significantly for the ability of Third World, and especially African, countries to grow and reduce poverty... Since these factors are permanent (and cannot be changed with good policy), they imply that some parts of Africa may be at a persistent growth disadvantage relative to others.

Yet... the African poverty decline has taken place ubiquitously, in countries that were slighted as well as in those that were favoured by geography and history. For every breakdown... the poverty rates for countries on either side of the breakdown tend to converge, with the disadvantaged countries reducing poverty significantly to catch up to the advantaged ones. Neither geographical nor historical disadvantages seem to be insurmountable obstacles to poverty reduction... even the most blighted parts of the poorest continent can set themselves firmly on the trend of limiting and even eradicating poverty within the space of a decade.

This is consistent with recent observations by Shanta Devarajan, Ngozi Okonjo-Iweala, and even the much-maligned Gordon Brown.

I have argued in a couple of earlier posts that sub-Saharan Africa may have entered what might be called a zone of uncertainty in which optimistic growth expectations can become self-fulfilling:

History can matter for long periods of time (for instance in occupational inheritance or the patrilineal descent of surnames) and then cease to constrain our choices in any significant way. Once reliable correlations can break down suddenly and completely; history is full of such twists and turns. As far as African prosperity is concerned, I believe that a discontinuity of this kind is inevitable if not imminent.

Foley, Sidrauski, and the Microfoundations Project

2010-11-19T22:08:00.007-05:00

In a previous post I mentioned an autobiographical essay by Duncan Foley in which he describes in vivid detail his attempts to "alter and generalize competitive equilibrium microeconomic theory" so as to make its predictions more consonant with macroeconomic reality. Much of this work was done in collaboration with Miguel Sidrauski while the two were members of the MIT faculty some forty years ago. Both men were troubled by the "classical scientific dilemma" facing economics at the time: the discipline had "two theories, the microeconomic general equilibrium theory, and the macroeconomic Keynesian theory, each of which seemed to have considerable explanatory power in its own domain, but which were incompatible." This led them to embark on a "search for a synthesis" that would bridge the gap.

This is how Duncan describes the basic theoretical problem they faced, the strategies they adopted in trying to solve it, the importance of the distinction between stock and flow equilibrium, and the desirability of a theory that allows for intertemporal plans to be mutually inconsistent in the aggregate (links added):

My intellectual preoccupation at M.I.T. was what has come to be called the "microeconomic foundations of macroeconomics." The general equilibrium theory forged by Walras and elaborated by Wald (1951), McKenzie (1959), and Arrow and Debreu (1954) can be used, with the assumption that markets exist for all commodities at all future moments and in all contingencies, to represent macroeconomic reality by simple aggregation. The resulting picture of macroeconomic reality, however, has several disturbing features. For one thing, competitive general equilibrium is efficient, so that it is incompatible with the unemployment of any resources productive enough to pay their costs of utilization. This is difficult to reconcile with the common observation of widely fluctuating rates of unemployment of labor and of capacity utilization of plant and equipment. General equilibrium theory reduces economic production and exchange to the pursuit of directly consumable goods and services, and as a result has no real role for money... The general equilibrium theory can accommodate fluctuations in output and consumption, but only as responses to external shocks to resource availability, technology or tastes. It is difficult to reconcile these relatively slowly moving factors with the large business-cycle fluctuations characteristic of developed capitalist economies. In assuming the clearing of markets for all contingencies in all periods, general equilibrium theory assures the consistency... of individual consumption, investment, and production plans, which is difficult to reconcile with the recurring phenomena of financial crisis and asset revaluation that play so large a role in actual capitalist economic life...

Keynes' theory, on the other hand, offers a systematic way around these problems. Keynes views money as central to the actual operation of developed capitalist economies, precisely because markets for all periods and contingencies do not exist to reconcile differences in agents' opinions about the future. Because agents cannot sell all their prospects on contingent claims markets, they are liquidity constrained. In a liquidity constrained economy there is no guarantee that all factor markets will clear without unemployed labor or unutilized productive capacity. Market prices are inevitably established in part by speculation on an uncertain future. As a result the economy is vulnerable to endogenous fluctuations as the result of herd psychology and self-fulfilling prophecy. From this point of view it is not hard to see why business cycle fluctuations are a characteristic of a productively and financially developed capitalist economy, nor why the potential for financial crisis is inherent in decentralized market allocation of investment...

But there are many loose ends in Keynes' argument. In presenting the equilibrium of short-term expectations that determines the level of output, income and employment in the short period, for example, Keynes argues that entrepreneurs hire labor and buy raw materials to undertake production because they form an expectation as to the volume of sales they will achieve when the production process runs its course... But Keynes offers no systematic alternative account of how entrepreneurs form a view of their prospects on the market to take the place of the assumption of perfect competition and market clearing. This turns out, in detail, to be a very difficult problem to solve.

Given the supply of nominal money, a fall in prices appears to be a possible endogenous source of increased liquidity. Keynes argues that the money price level is largely determined by the money wage level, but offers no systematic explanation of the dynamics governing the movements of money wages.

Though money is the fulcrum on which his theory turns, Keynes does not actually set out a theory of the economic origin or determinants of money. As a result it is difficult to relate the fluctuations in macroeconomic variables such as the velocity of money to the underlying process of the circulation of commodities.

On point after point Keynes' plausible macroeconomic concepts raise unanswered questions about the microeconomic behavior that might support them.

Thus economics in the late 1960s suffered from a classical scientific dilemma in that it had two theories, the microeconomic general equilibrium theory, and the macroeconomic Keynesian theory, each of which seemed to have considerable explanatory power in its own domain, but which were incompatible. The search for a synthesis which would bridge this gap seemed to me to be a good problem to work on. From the beginning the goal of my work in this area was to alter and generalize competitive equilibrium microeconomic theory so as to deduce Keynesian macroeconomic behavior from it.

In the succeeding years I approached this project from two angles. One was to fiddle with general equilibrium theory in the hope of introducing money into it in a convincing and unified way. The other was to rewrite as much as possible of Keynesian macroeconomics in a form compatible with competitive general equilibrium.

This latter project came to fruition first as a close collaboration with Miguel Sidrauski, and resulted in a book Monetary and Fiscal Policy in a Growing Economy (Foley and Sidrauski, 1971)... Our joint work... sought to develop a canonical model with which it would be possible to analyze the classical problems of the impact of government policy on the path of output of an economy... Following my notion that the price of capital goods are determined in asset markets, and the flow of new investment adjusts to make the marginal cost of investment equal to that price, we assumed a two-sector production system, so that there would be a rising marginal cost of investment. The asset equilibrium of the model is a generalization of Sidrauski's (and Tobin's) portfolio demand theory, which in turn is a generalization of Keynes' theory of liquidity preference. One of my chief goals was to sort out rigorously and explicitly the relation between stock and flow variables, so that we analyzed the model as a system of differential equations in continuous time, a setting in which the difference between stock and flow concepts is highlighted. At each instant asset market clearing of money, bonds, and capital markets in stocks together with labor and consumption good flow market clearing determine the price of capital, the interest rate, the price level, income, consumption and investment. Government policies determining the evolution of supplies of money and bonds together with the addition of investment flows to the capital stock move the model through time in a transparent trajectory. The book considers the comparative statics and dynamics of this model in detail...

Monetary and Fiscal Policy in a Growing Economy had a mixed reception... The fact that we did not derive the asset and consumption demands of households from explicit intertemporal expected utility maximization turned out to be an unfashionable choice for the 1970s, when the economics profession was persuaded to put an immense premium on models of "full rationality." Sidrauski and I were quite aware of the possibility of such a model, which would have been a generalization of his thesis work. At a conference at the University of Chicago in 1968, David Nissen presented a perfect foresight macroeconomic model that made clear that this path would lead directly back to the Walrasian general equilibrium results. Since I didn't believe in the relevance of that path to the understanding of real macroeconomic phenomena, I thought the main point in exploring this line of reasoning was to show how unrealistic its results were...

The project of a macroeconomic theory distinct from Walrasian general equilibrium theory rests heavily on the distinction between stock and flow equilibrium. In Keynes' vision, asset holders are forced to value existing and prospective assets speculatively without a full knowledge of the future. Our model represented this moment through the clearance of asset markets. In the Walrasian vision this distinction is dissolved through the imaginary device of clearing futures and contingency markets which establish flow prices that imply asset prices. The moral of Sidrauski's and my work is that some break with the full Walrasian system along temporary equilibrium lines is necessary as a foundation for a distinct macroeconomics. Once the implications of the stock-flow distinction in macroeconomics became clear, however, the temptation to finesse them by retreating to the Walrasian paradigm under the slogan of "rational expectations" became overwhelming to the American economics profession....

In my view, the rational expectations assumption which Lucas and Sargent put forward to "close" the Keynesian model, was only a disguised form of the assumption of the existence of complete futures and contingencies markets. When one unpacked the "expectations" language of the rational expectations literature, it turned out that these models assumed that agents formed expectations of futures and contingency prices that were consistent with the aggregate plans being made, and hence were in fact competitive general equilibrium prices in a model of complete futures and contingency markets. Arrow and Debreu had made the assumption of the existence of complete futures and contingency markets to give their version of the Walrasian model the appearance of coping with the real-world problems posed by the uncertainty of the future. To my mind, the rational expectations approach amounted to making the perfect-foresight assumptions that I had already considered and rejected on grounds of unrealism in the course of working with Sidrauski... What the profession took to be an exciting breakthrough in economic theory I saw as a boring and predictable retracing of an already discredited path.

To my mind the most appealing feature of the Foley-Sidrauski approach to microfoundations is that it allows for the possibility that individuals make mutually inconsistent plans based on heterogeneous beliefs about the future. This is what the rational expectations hypothesis rules out. Auxillary assumptions such as sticky prices must then be imposed in order to make the models more consonant with empirical observation.

In contrast, the notion of temporary equilibrium (introduced by John Hicks) allows for the clearing of asset markets despite mutually inconsistent intertemporal plans. As time elapses and these inconsistencies are revealed, dynamic adjustments are made that affect prices and production. There is no presumption that such a process must converge to anything resembling a rational expectations equilibrium, although there are circumstances under which it might. The contemporary literature closest to this vision of the economy is based on the dynamics of learning, and this dates back at least to Marcet and Sargent (1989) and Howitt (1992), with more recent contributions by Evans and Honkapohja (2001) and Eusepi and Preston (2008). I am not by any means an insider to this literature but my instincts tell me that it is a promising direction in which to proceed.

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Update (11/20). Nick Rowe (in a comment) directs us to an earlier post of his in which the importance of allowing for mutually inconsistent intertemporal plans is discussed. He too argues for an explicit analysis of the dynamic adjustment process that resolves these inconsistencies as they appear through time. It's a good post, and makes the point with clarity.

Some of the comments on Nick's post reflect the view that explicit consideration of disequilibrium dynamics is unnecessary since they are known to converge to rational expectations in some models. My own view is that a lot more work needs to be done on learning before this sanguine claim can be said to have theoretical support. Furthermore, local stability of a rational expectations equilibrium in a linearized system does not tell us very much about the global properties of the original (nonlinear) system, since it leaves open the possibility of corridor stability: instability in the face of large but not small perturbations. (Tobin made a similar point in a paper that I have discussed previously here.)

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Update (12/13). Mark Thoma and Leigh Caldwell have both posted interesting reactions to this. There's clearly a lot more to be said on the topic but for the moment I'll just link without further comment.

Herbert Scarf's 1964 Lectures: An Eyewitness Account

2010-11-17T17:57:00.010-05:00

In the fourth volume of The Makers of Modern Economics is a fascinating autobiographical essay by Duncan Foley that traces the arc of his career as an economist and reflects upon developments in the discipline over the past four decades. Duncan describes his first exposure to economics at Swarthmore, his interactions with Tobin as a graduate student at Yale, the introduction in his doctoral dissertation of a concept of equity (now called envy-freeness) that does not depend on interpersonal comparisons of utility, his enormously fruitful collaboration with Miguel Sidrauski at MIT on the microfoundations of macroeconomics, his disillusionment with the rational expectations revolution, and his growing interest in heterodox economics at Stanford and subsequently at Barnard and Columbia.

There's enough material there for several interesting posts, but here I'll confine myself to reproducing Duncan's vivid recollection of a two semester course in mathematical economics taught by Herbert Scarf in 1964 (links added):

After the free pursuit of individual learning fostered by the Swarthmore Honors program, I found the return to traditional classroom teaching at Yale a difficult transition... I was frustrated in these courses not just by the tedium and ineffciency of the class lecture style, but by the tendency for instructors who knew a great deal about the substance and practice of their subjects to waste time rehearsing mathematical and theoretical topics they did not understand very well and often misconstrued...

The great exception to this pattern of misdirected pedagogy was Herbert Scarf's year-long course in Mathematical Economics. Scarf knew this material as well as anyone in the world, and had the gifts of patience, clarity of exposition, and personal charisma to convey it brilliantly and effectively. Scarf's teaching was a revelation to me of what could be accomplished in the classroom, with the appropriate attention to systematic organization, consistently careful preparation, and a judicious balance of lecture and discussion to maintain contact with the level of students' understanding. My notes from this course comprise a better and more complete reference for the topics than any book that has since been published.

The passage of time has revealed that the content of Scarf's course was just as remarkable in its depth and insight as the presentation. Remaining mostly within the realm of finite-dimensional spaces, and emphasizing duality and practical algorithms for the construction of solutions, Scarf gave a thorough tutorial on the mathematics of optimization, starting with linear programming via the simplex method and continuing through Kuhn-Tucker theory, dynamic programming, turnpike theory through Roy Radner's algorithmic approach, and integer programming. Since a huge proportion of economic models boil down to an optimization problem, this survey effectively unified and clarified an immense range of economics for the student. When Peter Diamond was working with James Mirrlees on the problem of optimal taxation (Diamond and Mirrlees, 1971a,b), for example, Scarf's approach helped me to grasp the relation between the complexity of their comparative statics results and the nonconvex structure of the constraint set (the intersection of the set of allocations that are resource and technology-feasible and those that can be supported by distorting taxes) in this problem. The study of these formal problems also convinced me that most economic theory depends on strong assumptions of convexity to assure the tractability of the resulting optimization problem, and that in situations where convexity is inherently absent or implausible it is very difficult to make much progress by traditional methods.

Scarf's course continued with a systematic review of general equilibrium theory, starting from the separating hyperplane approach to the Second Welfare Theorem, and including Gérard Debreu's proof (1959) of existence of a competitive equilibrium, the first presentation of Scarf's algorithmic approach to the calculation of competitive equilibria (1973), the theory of the core and its asymptotic equivalence to competitive equilibrium, and Scarf's own crucial counterexamples to the stability of competitive equilibrium under tâtonnement dynamics with more than two commodities (1960). The critical lesson Scarf emphasized in this discussion was the fact that the competitive equilibrium cannot, except in special cases such as representative agent economies, be represented as the solution of a mathematical programming problem. In other words, the Walrasian system does not generally admit a potential function. As a corollary to this observation we see that the comparative statics of competitive general equilibrium theory inherently lacks the organizing structure of convex programming, so that, for example, equilibrium prices are not in general monotonic functions of endowments. These observations planted the seeds in my mind of what grew to be grave doubts about the Walrasian system. These doubts do not focus on the logical consistency of the system, but on its adequacy as a useful representation of real economic relations...

In retrospect we can see that Scarf's course mapped out the whole development of high economic theory for the next twenty or twenty-five years. The theoretical literature of this period has largely been concerned with generalizing the concepts he taught to more sophisticated commodity spaces (such as infinite-dimensional spaces and spaces of stochastic processes), and rediscovering the general properties and limitations of competitive equilibrium theory in these contexts. This has been a source of both wonder and concern to me. I am amazed at how prescient a mind like Scarf's can be about the future development of a field, guided purely by superb mathematical instincts. But what does this imply about the theoretical fertility of economics during this period? If the core theoretical ideas that have dominated the field since were all present in the Yale classroom in 1964, it suggests that economic theory has been in a scholastic, formalistic phase of development during this period, primarily focusing on working out increasingly esoteric implications of well-established concepts.

Duncan tells me that he still has his notes from this course and that Scarf, who recently retired from teaching, remains full of vigor.

In subsequent posts I hope to discuss Duncan's reflections on the microfoundations of macroeconomics, his work with Sidrauski, his concern that the rational expectations revolution was a step backwards in the development of the theory, and his view that "some break with the full Walrasian system along temporary equilibrium lines is necessary as a foundation for a distinct macroeconomics." (The Hicksian concept of temporary equilibrium allows for asset market clearing in the face of heterogeneous beliefs and mutually inconsistent intertemporal plans.) These are themes that I have touched upon in previous posts and would like to revisit soon. In the meantime, let me repeat my plea to the fellows of the Economteric Society to nominate Duncan for election to their ranks.

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Update (11/18). Glenn Loury writes in to say:

I never had much interaction with Scarf, but his pedagogic virtuosity and mastery of mathematical economics circa 1970 reminds me of... Stanley Reiter, whom I encountered as a raw assistant professor at Northwestern in the 1970s. Stan, a close friend and occasional collaborator with Leo Hurwicz, was director of the Math Center at Northwestern (forerunner of MEDS), and in the late 1970s had a huge impact on young scholars like Paul Milgrom, Bengt Holmstrom, Mark Satterthwaite and Roger Myerson...

I don't think I agree with the claim that much of "high economic theory" since the 60s has been dotting "i's" and crossing "t's". That was true through the mid-seventies, perhaps, but the asymmetric information, mechanism design, incomplete contract theory revolutions (Hurwicz/Myerson/Maskin, eg.) -- and the emergence of deeply insightful applied theory in a variety of fields from labor and I/O to money, finance and trade suggest otherwise to me.

I basically agree with Glenn on this latter point but, in Duncan's defense, the focus of his essay was on the microfoundations of macroeconomics and the futility of simply aggregating the Walrasian system. And on this dimension I think that progress has been limited at best.

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Update (11/18). A wonderful comment by Jonathan Conning:

I too sat in Herb Scarf's Yale Micro Theory classroom and still remember the stunned awe that I and my classmates felt at the end of his first lecture with us, which happened to be on the simplex algorithm.

My only regret is that that semester at Yale (1990) we only got a handful of micro lectures from Scarf and so did not get the full "systematic review of general equilibrium theory" that Foley mentions.

I have little to say to improve on Duncan's glowing description of a Scarf lecture except to note that by 1990 the Hillhouse basement classroom had smooth sliding blackboards (which I do not imagine they had in 1964). This meant that there were always three blackboards in use, as he could fill one blackboard full of equations and slide it to conceal or reveal what had been written before. One of the things I recall most vividly is how artfully and efficiently Scarf used those boards, and how rarely he used the eraser. A lecture which might have started with definitions and theory that might have taken a detour through an expertly chosen example to reinforce intuition would in the end always return, with the smoothest glide of a hand to reveal again exactly the right portion of the board to bring the lecture full circle back to the climactic point he wanted. Everything seemed expertly choreographed and timed down to the very last second.

I hope that other former students of Scarf will somehow stumble upon this post.

Glenn Loury on Peter Diamond

2010-10-11T12:01:00.003-04:00

Glenn Loury has kindly forwarded me a letter he wrote earlier this year in appreciation of Peter Diamond, one of the co-recipients of this year's Nobel Memorial Prize in Economics. The tribute was written for the occasion of Diamond's retirement, and seems worth publishing today:

April 20, 2010
Prof. James Poterba, Chair
Department of Economics
Massachusetts Institute of Technology

Dear Jim:

It is a pleasure to contribute a brief note of tribute to Peter Diamond, on this occasion of celebration for his work as scholar and teacher.

Peter was an inspiration and role model for me during my student years at MIT. My encounters with him -- in the classroom and in his office -- left an indelible impression. I recall going over to the Dewey Library shortly after arriving in Cambridge, in the summer of 1972, and digging out Peter's doctoral dissertation. This was a mistake! Peter's reputation as a powerful theorist had been noted by my undergraduate teachers at Northwestern. I wanted to see how this reputed superstar had gotten his start. Just how good could it be, I wondered? I had no idea! What I discovered was an elegant, profound and exquisitely argued axiomatic treatment of the general problem of representing consumption preferences over an infinite time horizon, extending results obtained by his undergraduate teacher and the future Nobel Laureate, Tjallings Koopmans.

I prided myself on being a budding mathematician in those years. Yet, Peter's effortless mastery in that dissertation of the relevant techniques from topology and functional analysis, and his successful application of those methods to a problem of fundamental importance in economic theory -- all accomplished by age 23, younger than I was at the moment I held his thesis binder in my hands! – was simply stunning. This set what seem to me then, and still seems so now, to be an unapproachable standard. I was depressed for weeks thereafter!

Even more depressing was what I discovered as I got to know Peter better over the course of my first two years in the program: that mathematical technique was not even his strongest suit! An unerring sense of what constitute the foundational theoretical questions in economic science, and a rare creative gift of being able to imagine just the right formal framework in the context of which such questions can be posed and answered with generality -- this, I came to understand, is what Peter Diamond was really good at.

And so, I learned from him in those years what turned out to be the most important lesson of my graduate educational experience -- that, in the doing of economic theory and relative to the behavioral significance of the issue under investigation, technique is always a matter of secondary importance -- neither necessary nor sufficient for the production of lasting insights. I learned this from the careful study of Peter's seminal contributions to growth theory, the theories of taxation and social insurance, the theories of choice under uncertainty and the allocation of risk-bearing, the theories of legal rules and institutions, and the theory of unemployment. I also learned this from Peter's elegant and comprehensive lectures on the work in these areas of himself and that of other scholars. And so I came -- slowly and fitfully, because I was rather attached to the joys of doing mathematics for its own sake -- to see the world the way that Peter Diamond saw it. And, in the process, I became a much better economist.

Peter graciously agreed to be the second reader on my dissertation, even though I was writing outside of his areas of specialization at the time, and my intellectual indebtedness to him only increased over the course of my last two years at MIT. It has by now become rather clear that I shall never be able to discharge that debt.

So, thanks Peter, for your extraordinary generosity as a teacher, and for your unmatched example as a scholar.

Glenn C. Loury
Merton P. Stoltz Professor of the Social Sciences
Professor of Economics and of Public Policy
Brown University

The following passage from the letter is worth repeating:

And so, I learned from him in those years what turned out to be the most important lesson of my graduate educational experience -- that, in the doing of economic theory and relative to the behavioral significance of the issue under investigation, technique is always a matter of secondary importance -- neither necessary nor sufficient for the production of lasting insights.

I have had very little time for blogging recently, thanks to two new courses, but if I can find the time I'd like to write a post on Diamond's classic 1982 paper on search, and the wonderful coconut parable he used in order to illuminate the theory.

Hot Potatoes

2010-10-05T11:45:00.003-04:00

RT Leuchtkafer follows up on his earlier remarks with a comment in the Financial Times:

After a detailed four-month review of the flash crash, looking at market data streams tick-by-tick and down to the millisecond, the SEC concluded that a single order in the e-mini S&P 500 futures market ignited an inferno of panic selling. It was over in about seven minutes, and $1,000bn was up in smoke.

Within hours of the SEC’s report, the CME Group, owner of the Chicago Mercantile Exchange, issued a statement to point out that the suspect e-mini order was entirely legitimate, that it came from an institutional asset manager (that is, the public), and was little more than 1 per cent of the e-mini’s daily volume and less than 9 per cent of e-mini volume during and immediately after the crash.

How did this small bit of total volume cause such a conflagration?

You do it with computers. Specifically, you do it with unregulated computers. You pay rent so your machines sit inside the exchanges, minimising travel time for your electrons. You pay licence fees so your computers eat their fill of super-fast proprietary data feeds, data containing a shocking amount of information on everyone’s orders, not just on your own.

And when your computers spot trouble, such as a larger than expected sell-off, they dump inventory and they shut down – because they can.

No one knows what a “larger than expected sell-off” might be, but on May 6 a single hedge that added just an extra 9 per cent of selling pressure was enough to cause chaos.

When that happened, the SEC’s report says, high-frequency traders “stopped providing liquidity and began to take liquidity”, starting a frenzied race for anyone willing to buy. The report likened the panic to a downward-spiralling game of “hot potato” where, as HFT firms bought beyond their risk limits, they pulled their own bids and frantically sold to anyone they could, which were often just other HFT firms, who themselves quickly reached their risk limits and tried to sell to anyone they could, and so on – into the abyss. Fratricide ruled the day. Firms then fled the market altogether, accelerating the sell-off.

Punch drunk, markets rebounded when other market participants realised what had just happened and jumped into the market to buy.

Fair enough, some might say. Markets do panic, and sometimes for no reason. But the larger HFT firms register as formal marketmakers, receiving a variety of regulatory advantages, including greater leverage. All of this extends their enormous reach and power. In the past, they fulfilled certain obligations and observed certain restraints as a quid pro quo for those advantages, a quid pro quo intended to keep them in the market when markets were under stress and to prevent them from adding to that stress. Over the past few years, however, decades-long obligations and restraints all but disappeared, while many advantages stayed.

Computing power also opened marketmaking to a field of unregistered, or informal, high-frequency marketmakers, what investor and commentator Paul Kedrosky termed the “shadow liquidity system”. Exchanges will pay you to do it, too, just as they pay formal marketmakers, and require little in return.

The result is a loose confederation of unregulated, or lightly regulated, high-frequency marketmakers. They feed on what many consider confidential order information, play hot potato in volatile markets, and then instantly change the game to hide-and-seek if even a single hedge hits an unseen and unknowable tipping point.

The only quibble I have with this analysis is that too many different classes of algorithmic trading strategies are being bundled together under the HFT banner. In particular I would like to see a distinction made between directional strategies that are based on predicted short term price movements, and arbitrage based strategies that exploit price differentials across assets and markets. Both of these can be implemented with algorithms, rely on rapid responses to incoming market data, and involve very short holding periods. But they have completely different implications for asset price volatility. It is the mix of strategies rather than the method of their implementation that is the key determinant of market stability.

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Update: Leuchtkafer writes in to say:

I should have been clear in the piece I was talking specifically about market making strategies.

I appreciate the clarification, and agree with his characterization of the new market makers.

RT Leuchtkafer on the Flash Crash Report

2010-10-01T18:40:00.002-04:00

The long-awaited CFTC-SEC report on the flash crash has finally been released. I'm still working my way through it, and hope to respond in due course. In the meantime, here is an email (posted with permission) from the very interesting RT Leuchtkafer, whose thoughts on recent changes in market microstructure have been discussed at some length previously on this blog:

It's natural for any critic to focus on what he wants in the report, and I'm no different.

From the report, in the futures market: "HFTs stopped providing liquidity and instead began to take liquidity." (report pp 14-15); "...the combined selling pressure from the Sell Algorithm, HFT's and other traders drove the price of the E-Mini down..." (report p 15)

And in the equities market: "In general, however, it appears that the 17 HFT firms traded with the price trend on May 6 and, on both an absolute and net basis, removed significant buy liquidity from the public quoting markets during the downturn..." (report p 48); "Our investigation to date reveals that the largest and most erratic price moves observed on May 6 were caused by withdrawals of liquidity and the subsequent execution of trades at stub quotes." (p 79)

It's also natural - if ungraceful - for a critic to say "I told you so." OK, I'm no ballerina, and I told you so (April 16, 2010):

"When markets are in equilibrium these new participants increase available liquidity and tighten spreads. When markets face liquidity demands these new participants increase spreads and price volatility and savage investor confidence."

"...[HFT] firms are free to trade as aggressively or passively as they like or to disappear from the market altogether."

"...[HFT firms] remove liquidity by pulling their quotes and fire off marketable orders and become liquidity demanders. With no restraint on their behavior they have a significant effect on prices and volatility....they cartwheel from being liquidity suppliers to liquidity demanders as their models rebalance. This sometimes rapid rebalancing sent volatility to unprecedented highs during the financial crisis and contributed to the chaos of the last two years. By definition this kind of trading causes volatility when markets are under stress."

"Imagine a stock under stress from sellers such was the case in the fall of 2008. There is a sell imbalance unfolding over some period of time. Any HFT market making firm is being hit repeatedly and ends up long the stock and wants to readjust its position. The firm times its entrance into the market as an aggressive seller and then cancels its bid and starts selling its inventory, exacerbating the stock's decline."

"So in exchange for the short-term liquidity HFT firms provide, and provide only when they are in equilibrium (however they define it), the public pays the price of the volatility they create and the illiquidity they cause while they rebalance."

Finally, the report should put paid to the notion that HFT firms are simple liquidity providers and that they don't withdraw in volatile markets, claims that have been floating around for quite a while.

What happens next?

In a follow-up message, Leuchtkafer adds:

I'd like to note there were many other critics who got it right, including (most importantly) Senator Kaufman, Themis Trading, David Weild, and others. They all deserve a shout out.

To this list I would add Paul Kedrosky.

Firms that began to "take liquidity" during the crash would have suffered significant losses were it not for the fact that many of their trades were subsequently broken. I have argued repeatedly that this cancellation of trades was a mistake, not simply on fairness grounds but also from the perspective of market stability:

By canceling trades, the exchanges reversed a redistribution of wealth that would have altered the composition of strategies in the trading population. I'm sure that many retail investors whose stop loss orders were executed at prices far below anticipated levels were relieved. But the preponderance of short sales among trades at the lowest prices and the fact that aberrant price behavior also occurred on the upside suggests to me that the largest beneficiaries of the cancellation were proprietary trading firms making directional bets based on rapid responses to incoming market data. The widespread cancellation of trades following the crash served as an implicit subsidy to such strategies and, from the perspective of market stability, is likely to prove counter-productive.

The report does appear to confirm that some of the major beneficiaries of the decision to cancel trades were algorithmic trading outfits. But I need to read it more closely before offering further comment.

Economic Consequences of Speculative Side Bets

2010-09-04T11:33:00.001-04:00

The following column was written jointly with Yeon-Koo Che and is crossposted from Vox EU with minor edits and links to references.

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There is arguably no class of financial transactions that has attracted more impassioned commentary over the past couple of years than naked credit default swaps. Robert Waldmann has equated such contracts with financial arson, Wolfgang Münchau with bank robberies, and Yves Smith with casino gambling. George Soros argues that they facilitate bear raids, as does Richard Portes who wants them banned altogether, and Willem Buiter considers them to be a prime example of harmful finance. In sharp contrast, John Carney believes that any attempt to prohibit such contracts would crush credit markets, Felix Salmon thinks that they benefit distressed debtors, and Sam Jones argues that they smooth out the cost of borrowing over time, thus reducing interest rate volatility.

One reason for the continuing controversy is that arguments for and against such contracts have been expressed informally, without the benefit of a common analytical framework within which the economic consequences of their use can be carefully examined. Since naked credit default swaps necessarily have a long and a short side and the aggregate payoff nets to zero, it is not immediately apparent why their existence should have any effect at all on the availability and terms of financing or the likelihood of default. And even if such effects do exist, it is not clear what form and direction they take, or the implications they have for the allocation of a society's productive resources.

In a recent paper we have attempted to develop a framework within which such questions can be addressed, and to provide some preliminary answers. We argue that the existence of naked credit default swaps has significant effects on the terms of financing, the likelihood of default, and the size and composition of investment expenditures. And we identify three mechanisms through which these broader consequences of speculative side bets arise: collateral effects, rollover risk, and project choice.

A fundamental (and somewhat unorthodox) assumption underlying our analysis is that the heterogeneity of investor beliefs about the future revenues of a borrower is due not simply to differences in information, but also to differences in the interpretation of information. Individuals receiving the same information can come to different judgments about the meaning of the data. They can therefore agree to disagree about the likelihood of default, interpreting such disagreement as arising from different models rather than different information. As in prior work by John Geanakoplos on the leverage cycle, this allows us to speak of a range of optimism among investors, where the most optimistic do not interpret the pessimism of others as being particularly informative. We believe that this kind of disagreement is a fundamental driver of speculation in the real world.

When credit default swaps are unavailable, the investors with the most optimistic beliefs about the future revenues of a borrower are natural lenders: they are the ones who will part with their funds on terms most favorable to the borrower. The interest rate then depends on the beliefs of the threshold investor, who in turn is determined by the size of the borrowing requirement. The larger the borrowing requirement, the more pessimistic this threshold investor will be (since the size of the group of lenders has to be larger in order for the borrowing requirement to be met). Those more optimistic than this investor will lend, while the rest find other uses for their cash.

Now consider the effects of allowing for naked credit default swaps. Those who are most pessimistic about the future prospects of the borrower will be inclined to buy naked protection, while those most optimistic will be willing to sell it. However, pessimists also need to worry about counterparty risk - if the optimists write too many contracts they may be unable to meet their obligations in the event that a default does occur, an event that the pessimists consider to be likely. Hence the optimists have to support their positions with collateral, which they do by diverting funds that would have gone to borrowers in the absence of derivatives. The borrowing requirement must then be met by appealing to a different class of investors, who are neither so optimistic that they wish to sell protection, nor so pessimistic that they wish to buy it. The threshold investor is now clearly more pessimistic than in the absence of derivatives, and the terms of financing are accordingly shifted against the borrower. As a result, for any given borrowing requirement, the bond issue is larger and the price of bonds accordingly lower when investors are permitted to purchase naked credit default swaps.

This effect does not arise if credit default swaps can only be purchased by holders of the underlying security. In fact, it can be shown that allowing for only “covered” credit default swaps has much the same consequences as allowing optimists to buy debt on margin: it leads to higher bond prices, a smaller issue size for any given borrowing requirement, and a lower likelihood of eventual default. While optimists take a long position in the debt by selling such contracts, they facilitate the purchase of bonds by more pessimistic investors by absorbing much of the credit risk. In contrast with the case of naked credit default swaps, therefore, the terms of lending are shifted in favor of the borrower. The difference arises because pessimists can enter directional positions on default in one case but not the other.

While this simple model sheds some light on the manner in which the terms of financing can be affected by the availability of credit derivatives, it does not deal with one of the major objections to such contracts: the possibility of self-fulfilling bear raids. To address this issue it is necessary to allow for a mismatch between the maturity of debt and the life of the borrower. This raises the possibility that a borrower who is unable to meet contractual obligations because of a revenue shortfall can roll over the residual debt, thereby deferring payment into the future.

As many economists have previously observed, multiple self-fulfilling paths arise naturally in this setting (see, for instance, Calvo, Cole and Kehoe, and Cohen and Portes). If investors are confident that debt can be rolled over in the future they will accept lower rates of interest on current lending, which in turn implies reduced future obligations and allows the debt to be rolled over with greater ease. But if investors suspect that refinancing may not be available in certain states, they demand greater interest rates on current debt, resulting in larger future obligations and an inability to refinance if the revenue shortfall is large.

A key question then is the following: how does the availability of naked credit default swaps affect the range of borrowing requirements for which pessimistic paths (with significant rollover risk) exist? And conditional on the selection of such a path, how are the terms of borrowing affected by the presence of these credit derivatives?

For reasons that are already clear from the baseline model, we find that pessimistic paths involve more punitive terms for the borrower when naked credit default swaps are present than when they are not. More interestingly, we find that there is a range of borrowing requirements for which a pessimistic path exists if and only if such contracts are allowed. That is, there exist conditions under which fears about the ability of the borrower to repay debt can be self-fulfilling only in the presence of credit derivatives. It is in this precise sense that the possibility of self-fulfilling bear raids can be said to arise when the use of such derivatives is unrestricted.

The finding that borrowers can more easily raise funds and obtain better terms when the use of credit derivatives is restricted does not necessarily imply that such restrictions are desirable from a policy perspective. A shift in terms against borrowers will generally reduce the number of projects that are funded, but some of these ought not to have been funded in the first place. Hence the efficiency effects of a ban are ambiguous. However, such a shift in terms against borrowers can also have a more subtle effect with respect to project choice: it can tilt managerial incentives towards the selection of riskier projects with lower expected returns. This happens because a larger debt obligation makes projects with greater upside potential more attractive to the firm, as more of the downside risk is absorbed by creditors.

The central message of our work is that the existence of zero sum side bets on default has major economic repercussions. These contracts induce investors who are optimistic about the future revenues of borrowers, and would therefore be natural purchasers of debt, to sell credit protection instead. This diverts their capital away from potential borrowers and channels it into collateral to support speculative positions. As a consequence, the marginal bond buyer is less optimistic about the borrower's prospects, and demands a higher interest rate in order to lend. This can result in an increased likelihood of default, and the emergence of self-fulfilling paths in which firms are unable to rollover their debt, even when such trajectories would not arise in the absence of credit derivatives. And it can influence the project choices of firms, leading not only to lower levels of investment overall but also in some cases to the selection of riskier ventures with lower expected returns.

James Tobin (1984) once observed that the advantages of greater “liquidity and negotiability of financial instruments” come at the cost of facilitating speculation, and that greater market completeness under such conditions could reduce the functional efficiency of the financial system, namely its ability to facilitate “the mobilization of saving for investments in physical and human capital... and the allocation of saving to their more socially productive uses.” Based on our analysis, one could make the case that naked credit default swaps are a case in point.

This conclusion, however, is subject to the caveat that there exist conditions under which the presence of such contracts can prevent the funding of inefficient projects. Furthermore, an outright ban may be infeasible in practice due to the emergence of close substitutes through financial engineering. Even so, it is important to recognize that the proliferation of speculative side bets can have significant effects on economic fundamentals such as the terms of financing, the patterns of project selection, and the incidence of corporate and sovereign default.

Lessons from the Kocherlakota Controversy

2010-08-28T08:56:00.009-04:00

In a speech last week the President of the Minneapolis Fed, Narayana Kocherlakota, made the following rather startling claim:

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

The proposition that a commitment by the Fed to maintain a low nominal interest rate indefinitely must lead to deflation (rather than accelerating inflation) defies common sense, economic intuition, and the monetarist models of an earlier generation. This was pointed out forcefully and in short order by Andy Harless, Nick Rowe, Robert Waldmann, Scott Sumner, Mark Thoma, Ryan Avent, Brad DeLong, Karl Smith, Paul Krugman and many other notables.

But Kocherlakota was not without his defenders. Stephen Williamson and Jesus Fernandez-Villaverde both argued that his claim was innocuous and completely consistent with modern monetary economics. And indeed it is, in the following sense: the modern theory is based on equilibrium analysis, and the only equilibrium consistent with a persistently low nominal interest rate is one in which there is a stable and low level of deflation. If one accepts the equilibrium methodology as being descriptively valid in this context, one is led quite naturally to Kocherlakota's corner.

But while Williamson and Fernandez-Villaverde interpret the consistency of Kocherlakota's claim with the modern theory as a vindication of the claim, others might be tempted to view it as an indictment of the theory. Specifically, one could argue that equilibrium analysis unsupported by a serious exploration of disequilibrium dynamics could lead to some very peculiar and misleading conclusions. I have made this point in a couple of earlier posts, but the argument is by no means original. In fact, as David Andolfatto helpfully pointed out in a comment on Williamson's blog, the same point was made very elegantly and persuasively in a 1992 paper by Peter Howitt.

Howitt's paper is concerned with the the inflationary consequences of a pegged nominal interest rate, which is precisely the subject of Kocherlakota's thought experiment. He begins with an old-fashioned monetarist model in which output depends positively on expected inflation (via the expected real rate of interest), realized inflation depends on deviations of output from some "natural" level, and expectations adjust adaptively. In this setting it is immediately clear that there is a "rational expectations equilibrium with a constant, finite rate of inflation that depends positively on the nominal rate of interest" chosen by the central bank. This is the equilibrium relationship that Kocherlakota has in mind: lower interest rates correspond to lower inflation rates and a sufficiently low value for the former is associated with steady deflation.

The problem arises when one examines the stability of this equilibrium. Any attempt by the bank to shift to a lower nominal interest rate leads not to a new equilibrium with lower inflation, but to accelerating inflation instead. The remainder of Howitt's paper is dedicated to showing that this instability, which is easily seen in the simple old-fashioned model with adaptive expectations, is in fact a robust insight and holds even if one moves to a "microfounded" model with intertemporal optimization and flexible prices, and even if one allows for a broad range of learning dynamics. The only circumstance in which a lower nominal rate results in lower inflation is if individuals are assumed to be "capable of forming rational expectations ab ovo".

Howitt places this finding in historical context as follows (emphasis added):

In his 1968 presidential address to the American Economic Association, Milton Friedman argued, among other things, that controlling interest rates tightly was not a feasible monetary policy. His argument was a variation on Knut Wicksell's cumulative process. Start in full employment with no actual or expected inflation. Let the monetary authority peg the nominal interest rate below the natural rate. This will require monetary expansion, which will eventually cause inflation. When expected inflation rises in response to actual inflation, the Fisher effect will put upward pressure on the interest rate. More monetary expansion will be required to maintain the peg. This will make inflation accelerate until the policy is abandoned. Likewise, if the interest rate is pegged above the natural rate, deflation will accelerate until the policy is abandoned. Since no one knows the natural rate, the policy is doomed one way or another.

This argument, which was once quite uncontroversial, at least among monetarists, has lost its currency. One reason is that the argument invokes adaptive expectations, and there appears to be no way of reformulating it under rational expectations... in conventional rational expectations models, monetary policy can peg the nominal rate... without producing runaway inflation or deflation... Furthermore... pegging the nominal rate at a lower value will produce a lower average rate of inflation, not the ever-higher inflation predicted by Friedman...

Thus the rational expectations revolution has almost driven the cumulative process from the literature. Modern textbooks treat it as a relic of pre-rational expectations thought... contrary to these rational expectations arguments, the cumulative process is not only possible but inevitable, not just in a conventional Keynesian macro model but also in a flexible-price, micro-based, finance constraint model, whenever the interest rate is pegged... the essence of the cumulative process lies not in an economy's rational expectations equilibria but in the disequilibrium adjustment process by which people try to acquire rational expectations... under a wide set of assumptions, the process cannot converge if the monetary authority keeps interest rates pegged... the cumulative process is a manifestation of this nonconvergence.

Thus the cumulative process should be regarded not as a relic but as an implication of real-time belief formation of the sort studied in the literature on convergence (or nonconvergence) to rational expectations equilibrium... Perhaps the most important lesson of the analysis is that the assumption of rational expectations can be misleading, even when used to analyze the consequences of a fixed monetary regime. If the regime is not conducive to expectational stability, then the consequences can be quite different from those predicted under rational expectations... in general, any rational expectations analysis of monetary policy should be supplemented with a stability analysis... to determine whether or not the rational expectations equilibrium could ever be observed.

To this I would add only that a stability analysis is a necessary supplement to equilibrium reasoning not just in the case of monetary policy debates, but in all areas of economics. For as Richard Goodwin said a long time ago, an "equilibrium state that is unstable is of purely theoretical interest, since it is the one place the system will never remain."

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Update (8/29). From a comment by Robert Waldmann:

I think that it is important that in monetary models there are typically two equilibria -- a monetary equilibrium and a non-monetary equilibrium.

The assumption that the economy will end up in a rational expectations equilibrium does not imply that a low nominal interest rate leads to an equilibrium with deflation. It might lead to an equilibrium in which dollars are worthless.

I'd say the experiment has been performed. From 1918 through (most of) 1923 the Reichsbank kept the discount rate low (3.5% IIRC) and met demand for money at that rate.

The result was not deflation. By October 1923 the Reichsmark was no longer used as a medium of exchange.

In fact, the only stable steady state under a nominal interest rate peg in the Howitt model is the non-monetary one.

On Broken Trades and Bailouts

2010-08-19T20:29:00.007-04:00

Back in 1980, Avraham Beja and Barry Goldman published a theoretical paper in the Journal of Finance that explored the manner in which the composition of trading strategies in an asset market affects the volatility of prices. Their main insight was that if the prevalence of momentum based strategies was too large relative to that of strategies based on fundamental analysis, then the dynamics of asset prices would be locally unstable: departures of prices from fundamentals would be amplified rather than corrected over time. More importantly, they argued that the relationship between the composition of strategies and market stability was discontinuous: there was a threshold (bifurcation) value of this population mixture that separated the stable from the unstable regime, and an imperceptible change in composition that took the market across the threshold could result in dramatic increases in volatility.

The Beja/Goldman analysis can be taken a step further: not only does market stability depend on the composition of trading strategies, but the profitability of different trading strategies, and hence changes in their relative population shares over time, depend very much on whether one is in a stable or an unstable regime. In a stable regime prices track fundamentals reasonably well, which makes it possible for technical strategies to extract information from incoming market data without going through the trouble and expense of fundamental research. Such strategies can therefore prosper and proliferate, provide that they remain sufficiently rare. But if they become too common, markets are destabilized, asset price bubbles can form, and the value of fundamental information rises. When a major correction arrives, it is the fundamental strategies that prosper, the composition of trading strategies is shifted accordingly, and market stability is restored for a time. This process of endogenous regime switching provides one possible interpretation of the empirical phenomenon known as volatility clustering.

From this perspective, it is critically important that technical trading strategies to be allowed to suffer losses when market instability arises. The cancellation of trades in almost 300 securities after the flash crash of May 6 did exactly the opposite, by providing an implicit subsidy to destabilizing strategies. The excuse that this was done to protect retail investors whose stop orders were executed as prices fell to insane levels is unconvincing. According to the SEC's own report on the crash, most trades against stub quotes of five cents or less were short sales, and there was also considerable upward instability, with prices rising well beyond the reach of ordinary retail investors. (Shares in Sotheby's, for instance, changed hands at ten million dollars per round lot.) The cancellation of trades was therefore a bailout of some funds (heavily reliant on algorithmic trading) at the expense of others, and this prevented a stabilizing shift in the market composition of trading strategies.

A similar argument could be made about the effects of the Troubled Asset Relief Program. It has recently been claimed, for instance by Alan Blinder and Mark Zandi, that TARP has been a "substantial success" because it averted a second Great Depression at a cost to taxpayers that is turning out to be much lower than originally feared:

The Troubled Asset Relief Program was controversial from its inception. Both the program’s $700 billion headline price tag and its goal of “bailing out” financial institutions—including some of the same institutions that triggered the panic in the first place—were hard for citizens and legislators to swallow. To this day, many believe the TARP was a costly failure. In fact, TARP has been a substantial success, helping to restore stability to the financial system and to end the freefall in housing and auto markets. Its ultimate cost to taxpayers will be a small fraction of the headline $700 billion figure: A number below $100 billion seems more likely to us, with the bank bailout component probably turning a profit.

Yves Smith is unpersuaded by such figures, which she attributes to "back door, less visible bailouts, super cheap interest rates, [and] regulatory forbearance." But even if one were to take at face value the Blinder-Zandi estimates of the revenue consequences of TARP, there remain potentially harmful effects on the size composition of firms and the distribution of financial practices. The institutions that were bailed out made directional bets that either failed directly, or were with counterparties that would have failed in the absence of government support. Smaller institutions making such mistakes were allowed to go under, while larger ones were bailed out. Quite apart from the unfairness of this, the policy could be severely damaging to the stability of the system over the medium run.

This point was made a couple of months ago in a speech by Richard Fisher of the Dallas Fed (and expanded upon by Tyler Durden and Ashwin Parameswaran shortly thereafter):

Big banks that took on high risks and generated unsustainable losses received a public benefit... As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition...

The system has become slanted not only toward bigness but also high risk... Clearly, if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult. In this manner, high risk taking by big banks has been rewarded, and conservatism at smaller institutions has been penalized...

It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises.

Fisher goes on to argue for strict limits on the size of individual financial institutions relative to that of the industry. So does Nouriel Roubini:

Greed has to be controlled by fear of loss, which derives from knowledge that the reckless institutions and agents will not be bailed out. The systematic bailouts of the latest crisis – however necessary to avoid a global meltdown – worsened this moral-hazard problem. Not only were “too big to fail” financial institutions bailed out, but the distortion has become worse as these institutions have become – via financial-sector consolidation – even bigger. If an institution is too big to fail, it is too big and should be broken up.

But were the bailouts really necessary to avoid a global meltdown? Blinder and Zandi argue that the alternative would have been completely catastrophic:

The financial policy responses were especially important. In the scenario without them, but including the fiscal stimulus, the recession would only now be winding down, a full year after the downturn’s actual end... The differences between the baseline and the scenario based on no financial policy responses... represent our estimates of the combined effects of the various policy efforts to stabilize the financial system — and they are very large. By 2011, real GDP is almost $800 billion (6%) higher because of the policies, and the unemployment rate is almost 3 percentage points lower. By the second quarter of 2011 — when the difference between the baseline and this scenario is at its largest — the financial-rescue policies are credited with saving almost 5 million jobs.

Here the baseline is the set of policies actually pursued (including fiscal and financial policies) and it is being compared to the case of "no financial policy responses." However, as Yves Smith and Barry Ritholtz have pointed out, this is an absurd counterfactual. Barry argues that the proper point of comparison ought to be what should have been done, which in his view is the following:

One by one, we should have put each insolvent bank into receivership, cleaned up the balance [sheet], sold off the bad debts for 15-50 cents on the dollar, fired the management, wiped out the shareholders, and spun out the proceeds, with the bondholders taking the haircut, and the taxpayers on the hook for precisely zero dollars. Citi, Bank of America, Wamu, Wachovia, Countrywide, Lehman, Merrill, Morgan, etc. all of them should have been handled this way.

The net result of this would have been more turmoil, lower stock prices, and a sharper, but much shorter economic contraction. It would have been painful and disruptive — like emergency surgery is — but its better than an exploded appendix.

And today, we would have a much healthier economy.

Whether or not one agrees with this assessment, Yves and Barry are surely correct in arguing that counterfactuals other than the hands-off policy ought to be considered before one accepts the emerging conventional wisdom that the authorities handled the crisis well.

What the broken trades trades of May 6 and the bailouts of 2008 have in common is that they were both impulsive decisions, designed to deal with immediate concerns, and executed with little regard for their long term consequences. As I said in an earlier post, these decisions were made under enormous pressure with little time for reflection, and mistakes made in such circumstances would ordinarily be forgivable. But to insist that the best available course of action was taken, and that any alternative would have had devastating economic costs, is neither credible nor wise.

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Update (8/20). The comments on this post by Andy Harless, David Merkel and Economics of Contempt are worth reading. Andy thinks that I am attacking a straw man and that the Ritholtz proposal was not even feasible, let alone optimal. David questions the use by Blinder and Zandi of a forecasting model to generate counterfactuals, given the appalling performance of such models in predicting the crisis in the first place. And here's Economics of Contempt:

"Smaller institutions making such mistakes were allowed to go under, while larger ones were bailed out."

I have to take issue with that statement. Yes, large banks were bailed out, but hundreds upon hundreds of small banks were bailed out too! Fully 836 financial institutions were bailed out using TARP money, the vast majority of which were small banks. While it's true that most of the bank failures have been small banks, there were large banks that were allowed to fail too -- e.g., Lehman, WaMu.

As for Barry Ritholtz's alternative scenario, there are too many basic factual errors to take it seriously. For one thing, receivership wasn't available to non-commercial banks. It was also legally impossible to separate AIGFP from AIG, since AIG had unconditionally guaranteed all of AIGFP's liabilities, and all their trades included cross-default provisions. A lot of the actions Barry proposes were literally impossible to do. It's simply not a credible list, and I'm surprised that you would fall for it.

Finally, I think it's unfair to say that the bailouts created bad precedents without also mentioning that we now have a resolution authority for non-bank financial institutions. How are decisions that were made without the availability of a resolution authority proper precedents for decisions that will be made with a resolution authority? You would never say that decisions made in pre-FDIC bank failures are proper precedents for post-FDIC bank failures, would you?

These are all good points. I probably should have been a bit more skeptical when discussing the Ritholtz scenario. I did not intend to endorse his proposal, only to suggest that we need to think through a broad range of counterfactuals in evaluating the response to the crisis. But of course these counterfactuals must be feasible given the tools available at the time, and his point about the resolution authority is well taken.

What bothered me most about Geithner's congressional testimony was his claim that "the government’s strategy regarding AIG was essential to our success in confronting the worst financial crisis in generations." That is, in averting an economic calamity, there was no alternative to the government making massive payouts on privately negotiated speculative bets. This is a bold claim with very serious consequences and ought not to be made lightly. In particular, the consequences of alternative scenarios has to be traced out with some seriousness.

On Teachable Moments and Non-Conversations

2010-08-18T05:30:00.010-04:00

The latest in the series of consistently interesting dialogues between Glenn Loury and John McWhorter has been posted:

Among the themes explored in this conversation is the manner in which a steady stream of "race-related events" are turned in a media frenzy into "teachable moments" and calls for a "national conversation on race." As examples they cite the Gates arrest a year ago, the recent vilification and vindication of Shirley Sherrod, Harry Reid's characterization of Obama's dialect, Hilary Clinton's comments on the King legacy, and Jim Clyburn's response to these comments -- all part of a long list of racially charged incidents that briefly occupy the national spotlight from time to time.

Glenn, for one, is terribly weary of the "melodramatic dance that we do about race and racial etiquette in this society" in the wake of such events:

I’m tired of the national non-conversation on race... we’re not talking about real things… we’re mired in a kind of superficial morality of expressive convention… what can and cannot properly be said by right thinking people… fingerpointing… grandstanding… moralizing… real genuine moral engagement with serious problems in our society… gets short shrift while everyone is posturing… checking the scorecard to see what the exactly correct way of expressing something is… I’m just so weary of this.

John agrees that the "posturing" and "witch-hunting" is little more than "a theatrical production that we are taught to pretend is an engagement with something substantial."

In contrast to the loud (if brief) responses to these so-called teachable moments, there is almost total silence in the public sphere about the really serious issues with which we need to be grappling. Here's Glenn:

One million African American men under lock and key on any given day… structured, reproduced inequality of a raced nature… violent crime perpetrated by black people often on other black people at enormous scale… children with no prospect to realize their God-given talents or their human potential because the institutions designed to facilitate their development have failed them totally… these are the things that demonstrate that society is not in a post-racial moment, and they turn out to be a lot less about theatrics and a lot more about politics, policy, candor… if we wanted to have a conversation on race we’d have to start with some of the really hard stuff, and I’m afraid it wouldn’t be as easy as hunting out politically incorrect racists and then calling them what they are.

Ta-Nehisi Coates has also recently addressed the issue of national non-conversations, arguing that we learn nothing because we aspire not to know:

I keep hearing people bantering about this notion of a national conversation on race, and I have finally figured out why it rankles so... Expecting an American conversation on race in this country, is like expecting financial advice from someone who prefers to not check their bank balance. It's not that the answers, themselves, are pre-ordained, its that we are more interested in answers than questions, in verdicts than evidence...

Put bluntly, this is a country too ignorant of itself to grapple with race in any serious way. The very nomenclature -- "conversation on race" -- betrays the unseriousness of the thing by communicating the sense that race can be boxed from the broader American narrative, that you can somehow talk about Thomas Jefferson without Sally Hemmings; that you can discuss Andrew Jackson without discussing his betrayal of the black artillerymen who fought at the Battle of New Orleans; that you can discuss the suffrage without Sojourner Truth, Ida B. Wells or Frederick Douglass; that you can discuss temperance without understanding the support of the Klan; that you can discuss the path to statehood in Florida without discussing Fort Gadsen; that you can talk Texas without understanding cotton, and so on.

It's not so much that we don't know -- it's that we aspire to not know. The ignorance of the African-American thread in the broader American quilt -- the essential nature of that thread -- is willful... Race isn't a "distraction" from Obama's agenda -- it's the compromised, unsure ground upon which this country walks everyday...

Talk is overrated. There can be no talk with people who've conditioned themselves out of listening. This is the country we've made. This is the country we deserve.

Coates returns to this theme in a follow-up post prompted by Jim Webb's column on diversity:

I think the fact that we don't really have the implements to carry out this much ballyhoed conversation were really brought home by Jim Webb's piece "The Myth Of White Privilege"... The title, itself, is a device meant to drive conservatives to cheering, liberals to howling, and the whole of them all to page-clicking and reading, In short, it proceeds not from any desire to conversate, as we say, but to provoke strong emotion, and hopefully, page-views... I hate unthinking equivalence, but its quite clear to me that liberals and conservatives both have prominent camps that enjoy yelling.

But its still worth teasing out the intentions and the argument. The questions, themselves, are serious and worthy ones: What is "white privilege" to those who are white and poor, seemingly in perpetuity? Does Affirmative Action exist to promote diversity or historical redress? Is it both? If so, why? Who should be on the receiving end of such redress? Do immigrants from the Caribbean and Africa count? How do Native Americans fit in? What does it mean to have Affirmative Action for white women, many of whom will in turn marry white men?

How do we, specifically, define Affirmative Action? Is it any effort at diversity by anyone, anywhere? Do the questions I listed change depending on the venue? When I was hired, surely the Atlantic relished the idea of adding an African-American to their masthead. Was that Affirmative Action? If so, was it different than what happens, say, at Harvard? Was it bad?

How much does Affirmative Action actually affect white workers? How much discrimination are they actually suffering? In what spheres is this discrimination most prevalent? Are poor whites actually losing out to "people of color?" Do we have any stats on how many people have been affected by Affirmative Action? How broad is its impact?

I'm not really interested in answering any of these questions here and now, so much as I'm interested in asserting their validity, and asserting that they will always be ill-served by an 800 word op-ed with an inflammatory title. My sense is that there are answers to all of these queries. But I don't think we much care to have them. Jim Webb's piece, most regrettably, followed in the tradition of Henry Louis Gates' column on reparations, in that it is a sign post, a line of demarcation. An exclamation point, as opposed to a question mark.

The "conversation around race" is, itself, a kind of tribalism, wherein you look for ways to justify -- instead of interrogate -- your most elemental feelings.

Loury and McWhorter also discuss the Webb column at some length in their dialogue, and also consider the questions posed there to be serious and worthy. In addition, they feel that the column is indicative of a major shift in the manner of public expression regarding race. Here's Glenn again:

I think that the whole regime of genuflection at the altar of correct racial expression is on the verge of collapse… I sense in the air around me here, in the kinds of things that people are saying… Obama’s ascendancy … has contributed to that… as Obama’s success has made it easier for people to breach the etiquette of racial expression, the conversation is going to get a little rougher… people are going to let go of stuff that they’ve been holding on to for a while.

John puts it as follows: "there’s a sea change coming... we can predict, when people start letting it out… a lot of it is going to be pent up… some of it is going to come out infelicitously phrased."

The conversation that Coates has given up on is happening already, and he is at the heart of it (as are Loury and McWhorter). But it is being drowned out by the shrillest voices, and I fear that the yelling will be ramped up for a while longer before it eventually subsides.

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Sara Mayeux's response to the Webb column is also worth reading; she argues that the inflammatory title may well have been chosen by an "overzealous copyeditor." My own thoughts on the Gates arrest may be found here, and some reflections on an extraordinary essay by Ralph Ellison (that demonstrates brilliantly the essential nature of the "African American thread in the broader American quilt") here.

Glenn and I co-taught a course on Group Inequality at the Universidad de Los Andes in July, and were interviewed by Dinero while in Bogotá. (The interview was conducted in English, and translated for publication.)

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Update (8/18). Maxine Udall has a characteristically thoughtful follow-up.

History Versus Expectations in Sub-Saharan Africa

2010-08-07T20:48:00.005-04:00

Ngozi Okonjo-Iweala believes that sub-Saharan Africa "is on the verge of joining the ranks" of the so-called BRIC nations:

What trillion dollar economy has grown faster than Brazil and India between 2000 and 2010 in nominal dollar terms and is projected by the IMF to grow faster than Brazil between 2010 and 2015? The answer may surprise you: it is Sub-Saharan Africa... At a time when Asian equity and debt markets are saturated and no longer offer substantial returns, SSA could be poised to provide the best global risk-return profile.

She supports these claims with a wealth of data on recent trends in growth, inflation, exchange reserves, foreign direct investment flows, receipts from international tourism, spreading democratization, declining gender disparities, and improved security.

But Ngozi is also careful to note that this projected take-off is by no means a foregone conclusion. She argues that a concerted development effort is necessary, including a "big push" on investments in education and infrastructure. In order to finance this, she proposes the diversion by donor nations of a portion of anticipated future foreign aid in order to back a current bond issue, effectively securitizing these flows. While such an initiative would help close an infrastructure funding gap over the next few years, Ngozi maintains that its most important effect would be to "change perceptions overnight about Africa as a place to do business."

The idea that coordinated optimism about the future prospects of a region could be a critical determinant of its subsequent growth performance was advanced in a classic paper by Rosenstein-Rodan in 1943, building on earlier work by Allyn Young. The argument is based on the fact that the development of any particular industry may only be privately profitable if an entire set of interlocking industries were emerging simultaneously. Hence the need for a "big push":

Complementarity of different industries provides the most important set of arguments in favour of a large-scale planned industrialisation... It might easily happen that any one enterprise would not be profitable enough to guarantee payment of sufficient interest or dividend out of its own profits. But the creation of such an enterprise... may create new investment opportunities and profits elsewhere... If we create a sufficiently large investment unit by including all the new industries of the region, external economies will become internal profits out of which dividends may be paid easily.

Or, as Paul Krugman put it in his influential paper on history versus expectations, "the doctrine of Rosenstein-Rodan" entails the following claim: "the willingness of firms to invest depends on their expectation that other firms will invest, so that the task of development policy is to create convergent expectations around high investment."

Krugman's goal in that paper was to point out that there are a many contexts in which multiple equilibria of the kind that concerned Rosenstein-Rodan arise, and to address the question of how one of these is eventually selected:

Once one has multiple equilibria, however, there is an obvious question: which equilibrium actually gets established? Although few have emphasized this point, there is a broad division into two camps... On one side is the belief that the choice among multiple equilibria is essentially resolved by history: that past events set the preconditions that drive the economy to one or another steady state... On the other side, however, is the view that the key determinant of choice of equilibrium is expectations: that there is a decisive element of self-fulfilling prophecy...

The distinction between history and expectations as determinants of the eventual outcome is an important one. Both a world in which history matters and a world of self-fulfilling expectations are different from the standard competitive view of the world, but they are also significantly different from each other. Obviously, also, there must be cases in which both are relevant. Yet in the recent theoretical literature models have tended to be structured in such a way that either history or expectations matter, but not both... in the real world, we would expect there to be circumstances in which initial conditions determine the outcome, and others in which expectations may be decisive. But what are these circumstances?

It's clearly an important question, and in order to address it Krugman builds a simple two-sector model with increasing returns in one sector and constant returns in the other. There are two long run equilibria, each of which involves complete specialization in one of the two goods. If the initial state of the economy involves incomplete specialization there will be movement of resources across sectors. But in which direction?

If shifts in resources across sectors cannot be costlessly reversed, then such movements will depend not only on current inter-sectoral wage differences, but also on anticipated future differentials, which in turn depend on expectations about the future movements of resources across sectors. Krugman shows that there is a range of initial conditions, which he calls the overlap, from which either one of the two long run states can be approached if and only if it is expected to be realized. If initial conditions lie outside this range, then history is decisive, otherwise expectations matter a great deal in affecting the eventual pattern of specialization.

The overlap may be viewed as a zone of uncertainty within which coordinated optimism can have major economic effects. Outside this zone, for better or worse, we are shackled by our history. Within it, expectations become crucially important.

The question, then, is whether or not sub-Saharan Africa is now in or around this zone of uncertainty where expectations can be a critical determinant of its future development performance. Shanta Devarajan has recently pointed to a number of success stories that seem to suggest the stirrings of something major:

In recent years, a broad swath of African countries has begun to show a remarkable dynamism. From Mozambique’s impressive growth rate (averaging 8% p.a. for more than a decade) to Kenya’s emergence as a major global supplier of cut flowers, from M-pesa’s mobile phone-based cash transfers to KickStart’s low-cost irrigation technology for small-holder farmers, and from Rwanda’s gorilla tourism to Lagos City’s Bus Rapid Transit system, Africa is seeing a dramatic transformation. This favorable trend is spurred by, among other things, stronger leadership, better governance, an improving business climate, innovation, market-based solutions, a more involved citizenry, and an increasing reliance on home-grown solutions. More and more, Africans are driving African development.

I quoted this passage in an earlier post as a counterpoint to William Easterley's rather startling claim that "78 percent of the difference in income today between sub-Saharan Africa and Western Europe is explained by technology differences that already existed in 1500 AD – even before the slave trade and colonialism." My quarrel is not with this statement as an empirical claim, but rather with its implication that the heavy hand of history will continue to weigh inexorably upon the region. Sometimes we are bound by the past and sometimes not, and it is important to recognize opportunities to break free when they arise. And such an opportunity may well be emerging right before our eyes in Africa.

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I am grateful to E. Somanathan for reminding me of the paper by Rosenstein-Rodan, and to Joao Farinha for his thoughtful and informative responses to my earlier post on this topic.

Equilibrium Analysis

2010-07-28T19:24:00.002-04:00

In a recent post on his (consistently interesting) blog, David Murphy questions the value of equilibrium analysis in economics and finance, and points to two earlier posts of his in which the same point is made. Here he is in July 2007:

An interesting post on the Street Light Blog, on currency misalignments, suggests an interesting question: is economics an equilibrium discipline? The very idea of a misaligned FX rate suggests that the natural state is an aligned one: perhaps the fundamentals move faster than the markets adjust, so FX is never in equilibrium. Perhaps (in the language of statistical mechanics) the relaxation time is much longer than the average time between forcings.

And here, in August 2008:

My own view is that finance is not an equilibrium discipline, mostly, so while classical economics might work well in explaining the price of coffee... it does rather less well in asset allocation or explaining the return distribution of financial assets. Rather new news arrives faster than the market can restore equilibrium after the last perturbation, meaning that most of the time equilibrium is not a useful concept.

In a 1975 paper that remains worth reading to this day, James Tobin was explicit about the limitations of equilibrium analysis in understanding large scale economic fluctuations:

Keynes's General Theory attempted to prove the existence of equilibrium with involuntary unemployment, and this pretension touched off a long theoretical controversy. A. C. Pigou, in particular, argued effectively that there could not be a long-run equilibrium with excess supply of labor. The predominant verdict of history is that, as a matter of pure theory, Keynes failed to prove his case.

Very likely Keynes chose the wrong battleground. Equilibrium analysis and comparative statics were the tools to which he naturally turned to express his ideas, but they were probably not the best tools for his purpose... The real issue is not the existence of a long-run static equilibrium with unemployment, but the possibility of protracted unemployment which the natural adjustments of a market economy remedy very slowly if at all. So what if, within the recherché rules of the contest, Keynes failed to establish an "underemployment equilibrium"? The phenomena he described are better regarded as disequilibrium dynamics.

Tobin then goes on to develop a dynamic disequilibrium model of the macroeconomy (discussed at length here) which has a unique equilibrium characterized by full employment, steady inflation, and correct expectations. He shows that even if this equilibrium is locally stable, so that small perturbations are self-correcting, it need not be globally stable: sufficiently large shocks to the economy can result in cumulative divergence away from equilibrium unless arrested by a significant policy response. This seems to describe what we have experienced over the past couple of years better than any equilibrium model of which I am aware.

Note that Tobin's model is deterministic. The problem here is not that the economy is being buffeted by frequent shocks that arrive before a transition to equilibrium can occur, it is that the internal dynamics of adjustment simply do not approach the equilibrium from certain (large) sets of initial states even in the absence of shocks. The idea that the instability of steady growth with respect to disequilibrium dynamics is an important feature of modern market economies, and cannot be neglected in a comprehensive theory of economic fluctuations was forcefully advanced by Richard Goodwin as far back as 1951, and Paul Samuelson had explored the possibility even earlier. As Willem Buiter has recently lamented, this line of research in macroeconomics simply dried up about a generation ago.

Another area in which equilibrium analysis is likely to be inadequate is in the study of asset markets with significant speculative activity. Price and volume dynamics in such markets depend not just on changes in fundamentals but also on the distribution of trading strategies, and this in turn adjusts under pressure of differential performance. The idea of an equilibrium composition of trading strategies is a contradiction in terms: if there were any such thing there would be a new strategy that could enter to exploit the resulting regularity. It is the complexity of this disequilibrium process that allows information arbitrage efficiency to be approximately satisfied, while allowing for significant departures from fundamental valuation efficiency (the distinction, naturally, is also due to Tobin.)

Finally consider Hyman Minsky's financial instability hypothesis, built on the paradoxical idea that stability itself can be destabilizing. In Minsky's framework stable expansions give rise to increasingly aggressive financial practices as those firms having the greatest maturity mismatch between assets and liabilities profit relative to their closest competitors. The resulting erosion in margins of safety increases financial fragility, interpreted as the likelihood that a major default will trigger a crisis of liquidity. Such a crisis eventually materializes, devastating precisely those firms whose actions gave rise to greater fragility. The balance of financial practices is then shifted in favor of increased prudence, and the stage is set for another period of stability. Trying to give this analysis an equilibrium interpretation is a futile exercise; expectations of financial market tranquility are self-falsifying, and no fixed distribution of financial practices can be stable.

Given the potential of disequilibrium dynamic models to illuminate our understanding of the economy, why are they generally neglected in contemporary economics? In part it is because the quality of a disequilibrium model is hard to evaluate and the dynamics are necessarily arbitrary to a degree. There is a professional consensus on how equilibrium analysis should be done, but none (so far) when it comes to disequilibrium analysis. Furthermore, equilibrium models can be enormously insightful, even in applications to macroeconomics and finance. The work of John Geanakoplos on the leverage cycle is a case in point, and Abreu and Brunnermeier's paper on bubbles and crashes is another. I have used equilibrium methods frequently and will continue to do so. But it seems that there ought to be greater space in the profession for serious work on the dynamics of disequilibrium.

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Update (7/31). In an email (posted with permission) David Murphy adds:

One of the main reasons people study equilibrium models is that they are an order of magnitude easier, mathematically, than non-equilibrium. If you consider a simple problem like cooling, for instance, the equilibrium version is high school physics, and the non-equilibrium version is still a research problem (with useful application to the improvement of annealing methods). Economists in my experience are very comfortable with the maths they know (a bit - stress a bit - of stochastic calculus), but they are not willing to venture much further because it gets really, really hard quite quickly. Hence the 'we have a hammer, everything looks like a nail' problem.

I think this is correct as far as analytical results are concerned; proving theorems (aside from convergence-to-equilibrium results) with the standard toolbox is not easy in disequilibrium models. But if one adopts a computational approach the reverse may be true. I, for one, find it easier to write an algorithm to simulate a recursive system than one that requires the computation of fixed points in high dimensional spaces. But (as noted above) there does not exist anything close to a professional consensus on how the quality of such models should be evaluated, and so they are usually rejected out of hand at most mainstream journals.

East Asian Tigers and African Lions

2010-07-25T12:44:00.029-04:00

William Easterly has recently argued that contemporary poverty in African nations may largely be accounted for by technological differences that date back for centuries, if not millennia:

1500 AD technology is a particularly powerful predictor of per capita income today. 78 percent of the difference in income today between sub-Saharan Africa and Western Europe is explained by technology differences that already existed in 1500 AD – even before the slave trade and colonialism. Moreover, these technological differences had already appeared by 1000 BC. The state of technology in 1000 BC has a strong correlation with technology 2500 years later, in 1500 AD...

A large role for history is still likely to sit uncomfortably with modern development practitioners, because you can’t change your history. But we have to face the world as it is, not as we would like it to be...

In a recent speech in Kampala, Gordon Brown offered a prognosis (coupled with a long list of policy recommendations) that was decidedly less gloomy about the future of Africa. Building on the observation that the continent is "full of more untapped potential and unrealised talent than any other," Brown continued as follows:

Twenty years ago nobody would have predicted that China and India would be the big drivers of growth and political superpowers they have become. And there is no reason to believe the countries of Africa cannot make similar leaps in the decades to come.... just as people have spoken of an American century and an Asian century, I believe we can now speak of an African century...

I believe the new African growth will come from five sources;
a faster pace of economic integration in Africa's internal market, and between your market and those of other continents, facilitated by investment in infrastructure
a broader based export-led growth, founded on new products and services
investment in the private sector from African and foreign sources in firms that create jobs and wealth
the up-skilling of the workforce, including through the acceleration of education provision, IT infrastructure and uptake and finally through
more effective governance to ensure that effective states can discharge their task of creating growth and reducing poverty
Each of these five priorities will be difficult to achieve. But we should remember the value of the prize. Because if we can agree a new model of post-crisis growth then Africa - already a 1.6 trillion economy - will continue to grow even faster than the rest of the world. This is not my assessment, but that of the world's leading companies and analysts. For example a report just published by the McKinsey Global Institute claims that Africa's consumer spending could reach 1.4 trillion dollars by 2020 - a 60% increase on 2008. In other words in ten years African consumer spending will be as big as the whole African economy is today.

It is those sorts of projections which mean people are now rightly talking not just of East Asian tigers, but of African lions.

Brown is careful to note that this rosy scenario is a "possibility rather than a probability" and that "it will happen through choice not chance." But, as Shanta Devarajan has recently observed, the choices necessary to make it happen are already being made:

In recent years, a broad swath of African countries has begun to show a remarkable dynamism. From Mozambique’s impressive growth rate (averaging 8% p.a. for more than a decade) to Kenya’s emergence as a major global supplier of cut flowers, from M-pesa’s mobile phone-based cash transfers to KickStart’s low-cost irrigation technology for small-holder farmers, and from Rwanda’s gorilla tourism to Lagos City’s Bus Rapid Transit system, Africa is seeing a dramatic transformation. This favorable trend is spurred by, among other things, stronger leadership, better governance, an improving business climate, innovation, market-based solutions, a more involved citizenry, and an increasing reliance on home-grown solutions. More and more, Africans are driving African development.

Shanta links to a long list of emerging African success stories.

While the economic consequences of an African resurgence will be major, the social implications could be even more profound. I believe that the rise of the African lions will do more to shatter racial stereotypes in the United States and elsewhere than any government policy or electoral outcome. But that is a topic for another post.

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Update (7/25). I do not dispute the empirical claims made by Comin, Easterly and Gong, nor mean to suggest that that Brown's speech and Devarajan's post have any bearing on these claims. But I have serious doubts about the relevance of their findings for identifying future centers of economic dynamism or for shaping development policy. History can matter for long periods of time (for instance in occupational inheritance or the patrilineal descent of surnames) and then cease to constrain our choices in any significant way. Once reliable correlations can break down suddenly and completely; history is full of such twists and turns. As far as African prosperity is concerned, I believe that a discontinuity of this kind is inevitable if not imminent.

From an overview of the McKinsey report referenced by Brown:

While Africa's increased economic momentum is widely recognized, less known are its sources and likely staying power... Africa's growth acceleration was widespread, with 27 of its 30 largest economies expanding more rapidly after 2000. All sectors contributed, including resources, finance, retail, agriculture, transportation and telecommunications. Natural resources directly accounted for just 24 percent of the continent's GDP growth from 2000 through 2008. Key to Africa's growth surge were improved political and macroeconomic stability and microeconomic reforms... total foreign capital flows into Africa rose from $15 billion in 2000 to a peak of $87 billion in 2007... Today the rate of return on foreign investment in Africa is higher than in any other developing region.

David Blackwell, 1919-2010

2010-07-18T23:33:00.013-04:00

The renowned mathematician David Blackwell died on July 8 at the age of 91.

I first came across Blackwell's name in a widely-cited paper by Kalai and Lehrer on learning in repeated games. Kalai and Lehrer identified conditions under which players with different initial subjective beliefs about each others' strategies will nevertheless converge to behavior that approximates a Nash equilibrium of the repeated game. In establishing this, the authors relied heavily on the Blackwell-Dubins Theorem:

Our proof of the convergence to playing an ε-Nash equilibrium is divided into three steps. The first establishes a general self-correcting property of Bayesian updating. This is a modified version of the seminal Blackwell and Dubins' (1962) result about merging of opinions... When applied to our model, the self-correcting property shows that the probability distributions describing the players' beliefs about the future play of the game must converge to the true distribution. In other words, the beliefs and the real play become realization equivalent.

While Blackwell's work is familiar in economics largely through this result, he is also known for the Rao-Blackwell Theorem and his book (with Meyer Girshick) on the Theory of Games and Statistical Decisions. [Update: A much fuller discussion of his influence and contributions may be found here.]

Blackwell earned his doctorate in mathematics at the age of 22 from the University of Illinois, where his thesis adviser was Joseph Doob. He then spent a year at the Institute for Advanced Study in Princeton, where his cohort included Shizuo Kakutani, Paul Halmos, Leonard Savage, and Alfred Tarski. He was elected to the National Academy of Sciences in 1965 and was the sole recipient of the John von Neumann Theory Prize in 1979 (sandwiched between Nash and Lemke in 1978 and Gale, Kuhn and Tucker in 1980).

While his accomplishments are stellar and many, it is also worth contemplating the many slights that Blackwell had to endure over the course of his career:

Blackwell was appointed a Postdoctoral Fellow at the Institute for Advanced Study from 1941 for a year. At that time, members of the Institute were automatically officially made visiting fellows of Princeton University, and thus Blackwell was listed in its bulletin as such. This caused considerable ruckus as there had never been a black student, much less faculty fellow, at the University... The president of Princeton wrote the director of the Institute that the Institute was abusing the University's hospitality by admitting a black... Colleagues in Princeton wished to extend Blackwell's appointment at the institute. However, the president of Princeton organized a great protestation... When it was time to leave the institute, Blackwell knew no white schools would hire him, and he applied to all 105 Black schools in the country. After instructorships at Southern University and Clark College, Dr. Blackwell joined the faculty of Howard University from 1944 as an instructor... In three years, Blackwell had risen to the rank of Full Professor and Chairman.

Blackwell eventually moved to Berkeley in 1954 (after having previously been denied a position there due to "racial objections"). He became the first black professor to be tenured there, chaired the department of statistics from 1957 to 1961, and remained at the University until his retirement in 1988.

It takes a particular kind of strength to manage such a productive research career while tolerating the stresses and strains of personal insult, and carrying the aspirations of so many on one's shoulders. Blackwell was more than a brilliant mathematician, he was also a human being of extraordinary personal fortitude.

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I am currently in Bogotá co-teaching a course with Glenn Loury at the (very impressive) Universidad de Los Andes. I am grateful to Glenn for bringing to my attention the news that Blackwell had recently passed away.

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Update (7/19). Jeff Ely has linked to two other posts in appreciation of Blackwell: Eran Shmaya focuses on his work while Jesús Fernández-Villaverde writes (in Spanish) about his life. Both are well worth reading. Here's an extract from Eran's wonderful post:

We game theorists know Blackwell for several seminal contributions. Blackwell’s approachability theorem is at the heart of Aumann and Maschler’s result about repeated games with incomplete information... Blackwell’s theory of comparison of experiments has been influential in the game-theoretic study of value of information... Another seminal contribution of Blackwell, together with Lester Dubins, is the theorem about merging of opinions, which is the major tool in the Ehuds’ theory of Bayesian learning in repeated games. And then there are his contributions to the theory of infinite games with Borel payoffs (now known as Blackwell games) and Blackwell and Fergurson’s solution to the Big Match game.

One conspicuous aspect of many of Blackwell’s awesome papers is that they are extremely short — often a couple of pages long. He had an amazing ability to prove theorems in the right way, and he wrote with eloquence and clarity. He is the only writer I know who uses the 'as the reader can verify' trick productively, exactly at those occasions when the reader will indeed find it easier to convince himself in the validity of an assertion than to read a formal proof of it. It is very rare that I succeed in reading proofs in papers that were written dozens of years ago: Notations and perspectives change, and important results are usually reproduced in clearer way over the years. But Blackwell’s papers are still the best place to read the proofs of his theorems...

I hope I am not forcing my own agenda on Blackwell’s research when I say that for him game and decision theory were a tool to study conceptual questions about the meaning of probability and information. At any rate, he was clearly interested in these questions... I hope the game theory society will find a way to celebrate Blackwell’s contribution to our community.

Kevin Bryan has also put up a nice post on Blackwell.

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Update (7/20). Stergios (in a comment on this post) observes that "Blackwell also made fundamental contributions to the theory of stochastic processes" and that his "renewal theorem is taught in any doctoral level course on stochastic models." And Glenn Loury has emailed me a link to a paper by Jacques Crémer "nicely expositing one of Blackwell's more influential results in statistical decision theory."

Andrew Gelman (and his commenters) have more. And Anandaswarup Gadde links to a wonderful profile from about a year ago:

Doob’s foundational work would help broaden the field of mathematics to a dizzying array of uses in science, economics and technology. So it came as no surprise when in 1942, Jerzy Neyman of the University of California at Berkeley asked if Doob were interested in going West.

“No, I cannot come, but I have some good students, and Blackwell is the best,” he replied.

“But of course he’s black,” Doob continued, “and in spite of the fact that we are in a war that’s advancing the cause of democracy, it may not have spread throughout our own land.”

The quote, repeated in the book “Mathematical People,” says a lot about the times and even more about David H. Blackwell... who started as an Illinois undergraduate in 1935 and finished with a doctoral degree six years later, all accomplished at a time when residence halls were whites-only, and approximately 100 blacks were included in the student body of nearly 12,000.

What would be the odds of the son of a railroad worker from Centralia – whose parents did not complete high school and whose Depression-era teaching prospects were limited to segregated schools – becoming one of the top theoretical mathematicians (black or white) in the world?

Almost too hard to compute...

After earning a UI doctoral degree in mathematics in 1941 at the age of 22, Blackwell completed a year at the Institute for Advanced Study in Princeton, N.J., where he worked with, among others, John von Neumann, father of modern game theory.

Berkeley’s Jerzy Neyman – who had been unable to persuade Doob to join his department – wanted to offer Blackwell a position but appeared to have come up against a deal-breaker.

In an oral history interview at Berkeley, Blackwell, now 90 years old and in “fair” health, recalled what he learned years later – that the Texan wife of the department head told her husband she “was not going to have that darky in her house.”

The job offer never came.

Blackwell focused his efforts instead on realistic career aspirations for a person of color at the time. In 1942 he applied to 105 historically black colleges, received three offers and eventually landed at Howard University in Washington, D.C., in 1944, where he remained for 10 years...

Back at Berkeley, Neyman had never forgotten Blackwell and finally hired him in 1954, where he would stay for the remainder of his career.

Read the whole thing.

To a Man with a Hammer

2010-07-15T21:02:00.006-04:00

In an article published about a month ago, Richard Thaler argued that a behavioral propensity to accept "risks that are erroneously thought to be vanishingly small" was responsible for both the devastating oil spill in the Gulf of Mexico as well as the global financial crisis. This prompted James Kwak to respond as follows:

Don’t get me wrong: I like behavioral economics as much as the next guy. It’s quite clear that people are irrational in ways that the neoclassical model assumes away, and you can’t see human nature quite the same way after hearing Dan Ariely talk about his experiments on cheating. But I don’t think cognitive fallacies are the answer to everything, and I don’t think you can explain away the myriad crises of our time as the result of them.

Dan Ariely is among the best of the behavioral economists and a wonderful communicator but, like Thaler, seems to have fallen victim to a different kind of behavioral propensity: to a man with a hammer everything looks like a nail. Consider, for instance, his recent comments on the subprime mortgage crisis:

Behavioral economics argues that... people will often make the same mistake, and the individual mistakes can aggregate in the market. Let’s take the subprime mortgage crisis, which I think is a great example (but a very sad reality) of the market working to make the aggregation of mistakes worse. It is not as if some people made one kind of mistake and others made another kind. It was the fact that so many people made the same mistakes, and the market for these mistakes is what got us to where we are now...

Imagine that we understood how difficult it is for people to calculate the correct amount of mortgage that they should take, and instead of creating a calculator that told us the maximum that we can borrow, it helped us figure out what we should be borrowing. I suspect that if we had this type of calculator (and if people used it) much of the sub-prime mortgage catastrophe could have been avoided.

There's no doubt that mistakes were made in the sense that borrowers, lenders and purchasers of mortgage backed securities entered positions that they later came to regret. But they did so because such behavior had been profitable in the recent past, not because they were expressing cognitive lapses in the manner of subjects in controlled experiments. More generally, behavior in financial markets is subject to strong selection pressures based on performance, and if deviating from psychologically typical behavior pays off consistently, then such deviations will proliferate. Laboratory experiments are therefore a poor guide to financial practices, the distribution of which can fluctuate significantly over time.

This kind of promiscuous application of behavioral economics to everything under the sun has become extremely widespread. And now two prominent behavioral economists, George Loewenstein and Peter Ubel have taken notice:

It seems that every week a new book or major newspaper article appears showing that irrational decision-making helped cause the housing bubble or the rise in health care costs... behavioral economics has spawned a number of creative interventions [but] the field has its limits. As policymakers use it to devise programs, it’s becoming clear that behavioral economics is being asked to solve problems it wasn’t meant to address.

This is a point that I have made on several occasions to little effect. But the stature of Loewenstein and Ubel within the behavioral economics community might cause their reflections to be taken more seriously. And the choice is not simply one between behavioral economics and rational choice: agent-based computational models (among the earliest of which were developed by Thomas Schelling) constitute a promising alternative for the study of adaptive behavior in complex systems.

Rationality and Fragility in Financial Markets

2010-07-11T01:19:00.004-04:00

In a recent paper on financial innovation and fragility, Gennaioli, Shleifer and Vishny argue that investors (and often also financial intermediaries) are hobbled by certain systematic cognitive biases that cause them to neglect unlikely events when assessing asset values. They argue that such "local thinking" results in the creation and excessive issuance of engineered securities that are widely believed to be close substitutes for more traditional safe assets, but turn out to be much riskier than initially anticipated. This psychological regularity, they believe, accounts for a number of historical episodes of financial instability:

Many recent episodes of financial innovation share a common narrative. It begins with a strong demand from investors for a particular, often safe, pattern of cash flows. Some traditional securities available in the market offer this pattern, but investors demand more (so prices are high). In response to demand, financial intermediaries create new securities offering the sought after pattern of cash flows, usually by carving them out of existing projects or other securities that are more risky. By virtue of diversification, tranching, insurance, and other forms of financial engineering, the new securities are believed by the investors, and often by the intermediaries themselves, to be good substitutes for the traditional ones, and are consequently issued and bought in great volumes. At some point, news reveals that new securities are vulnerable to some unattended risks, and in particular are not good substitutes for the traditional securities. Both investors and intermediaries are surprised by the news, and investors sell these “false substitutes,” moving back to the traditional securities with the cash flows they seek. As investors fly for safety, financial institutions are stuck holding the supply of the new securities (or worse yet, having to dump them as well in a fire sale because they are leveraged). The prices of traditional securities rise while those of the new ones fall sharply.

The authors claim that this sequence of events describes not only the recent experience with collateralized debt obligations and money market funds, but also earlier episodes of financial innovation, including prepayment tranching of collateralized mortgage obligations in the 1980s.

In order to explore precisely the implications of local thinking in the context of financial innovation, the authors construct a model based on a number of stark, simplifying assumptions. There are two assets: a traditional safe security and a risky asset that has three possible terminal payoffs. The worst case outcome for the risky asset is also the least likely to occur (this is a crucial assumption). Investors are homogeneous and highly risk averse. Financial innovation takes the form of separating the cash flows from the risky asset into two components: a "safe" security that earns the the worst case payoff regardless of the actual outcome, and a risky residual claim. Under rational expectations this innovation is welfare improving, and the quantity of the substitute issued is precisely such that all such claims would be covered even if the worst case loss were to materialize. That is, the substitute security really is safe.

Under local thinking, the least likely event (which is also the worst case outcome) is simply neglected, and beliefs about the other two outcomes are correspondingly inflated. The intermediate outcome is now (mistakenly) perceived to be the worst, and a greater quantity of the substitute security is issued than could be honored if the actual worst case outcome were to be realized. Now suppose that some bad news arrives, conditional on which the objective probabilities of the three outcomes are altered in such a manner as to make the intermediate outcome the least likely. Local thinking then causes investors to become excessively pessimistic: the worst case outcome not only becomes suddenly salient, but the less disastrous intermediate outcome is neglected and the decline in the price of the asset previously thought to be safe is greater than it would be under rational expectations.

The development of a theoretical framework within which common elements of various historical episodes can be examined is clearly a worthwhile exercise. But what troubles me about this paper (and much of the behavioral finance literature) is that the rational expectations hypothesis of identical, accurate forecasts is replaced by an equally implausible hypothesis of identical, inaccurate forecasts. The underlying assumption is that financial market participants operating under competitive conditions will reliably express cognitive biases identified in controlled laboratory environments. And the implication is that financial instability could be avoided if only we were less cognitively constrained, or constrained in different ways -- endowed with a propensity to overestimate rather than discount the likelihood of unlikely events for example.

This narrowly psychological approach to financial fragility neglects two of the most analytically interesting aspects of market dynamics: belief heterogeneity and evolutionary selection. Even behavioral propensities that are psychologically rare in the general population can become widespread in financial markets if they result in the adoption of successful strategies. As a result, asset prices disproportionately reflect the beliefs of investors who have been most successful in the recent past. There is no reason why these beliefs should consistently conform to those in the general population.

I have argued previously for the further development of this ecological perspective on financial instability, and similar themes have been explored elsewhere; see especially Macroeconomic Resilience and David Murphy. As I said in an earlier post, a bit too much is being asked of behavioral economics at this time, more than it has the capacity to deliver.

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Update (7/11). David Murphy follows up with characteristic clarity:

I would even go further, because this argument neglects the explicitly reflexive nature of market participant’s thinking. (Call it social metacognition if you really want some high end jargon.) Traders can both absolutely understand that a behavioral propensity is rare and likely to lead to catastrophe and behave that way: they do this because they believe that other market participants will too, and behaving that way if others do will make money in the short term. Even if you think that it is crazy for (pick your favourite bubblicious asset) to trade that high, providing you also believe others will buy it, then it makes sense for you to buy it along with the crowd. Moreover, worse, you may well believe that they too think it is crazy: but all of you are in a self-sustaining system and the first one to get off looks the most foolish (for a while). Most people are capable of spotting a bubble if it lasts long enough: the hard part is timing your exit to account for the behaviour of all the other smart people trying to time their exit too.

I agree completely. There are many examples of prominent fund managers trying to grapple with this problem during the bubble in technology stocks a decade ago. This is why markets can (approximately) satisfy what James Tobin called information arbitrage efficiency while failing to satisfy fundamental valuation efficiency.

Innovation, Scaling, and the Industrial Commons

2010-07-03T17:41:00.011-04:00

When Yves Smith makes a strong reading recommendation, I usually take notice. Today she directed her readers to an article by Andy Grove calling for drastic changes in American policy towards innovation, scaling, and job creation in manufacturing. The piece is long, detailed and worth reading in full, but the central point is this: an economy that innovates prolifically but consistently exports its jobs to lower cost overseas locations will eventually lose not only its capacity for mass production, but eventually also its capacity for innovation:

Bay Area unemployment is even higher than the... national average. Clearly, the great Silicon Valley innovation machine hasn’t been creating many jobs of late -- unless you are counting Asia, where American technology companies have been adding jobs like mad for years.

The underlying problem isn’t simply lower Asian costs. It’s our own misplaced faith in the power of startups to create U.S. jobs... Startups are a wonderful thing, but they cannot by themselves increase tech employment. Equally important is what comes after that mythical moment of creation in the garage, as technology goes from prototype to mass production. This is the phase where companies scale up. They work out design details, figure out how to make things affordably, build factories, and hire people by the thousands. Scaling is hard work but necessary to make innovation matter.

The scaling process is no longer happening in the U.S. And as long as that’s the case, plowing capital into young companies that build their factories elsewhere will continue to yield a bad return in terms of American jobs...

There’s more at stake than exported jobs... A new industry needs an effective ecosystem in which technology knowhow accumulates, experience builds on experience, and close relationships develop between supplier and customer. The U.S. lost its lead in batteries 30 years ago when it stopped making consumer-electronics devices. Whoever made batteries then gained the exposure and relationships needed to learn to supply batteries for the more demanding laptop PC market, and after that, for the even more demanding automobile market. U.S. companies didn’t participate in the first phase and consequently weren’t in the running for all that followed...

How could the U.S. have forgotten [that scaling was crucial to its economic future]? I believe the answer has to do with a general undervaluing of manufacturing -- the idea that as long as “knowledge work” stays in the U.S., it doesn’t matter what happens to factory jobs... I disagree. Not only did we lose an untold number of jobs, we broke the chain of experience that is so important in technological evolution... our pursuit of our individual businesses, which often involves transferring manufacturing and a great deal of engineering out of the country, has hindered our ability to bring innovations to scale at home. Without scaling, we don’t just lose jobs -- we lose our hold on new technologies. Losing the ability to scale will ultimately damage our capacity to innovate.

Grove recognizes, of course, that companies will not unilaterally change course unless they face a different set of incentives, and that this will require a vigorous industrial policy:

The first task is to rebuild our industrial commons. We should develop a system of financial incentives: Levy an extra tax on the product of offshored labor. (If the result is a trade war, treat it like other wars -- fight to win.) Keep that money separate. Deposit it in the coffers of what we might call the Scaling Bank of the U.S. and make these sums available to companies that will scale their American operations. Such a system would be a daily reminder that while pursuing our company goals, all of us in business have a responsibility to maintain the industrial base on which we depend and the society whose adaptability -- and stability -- we may have taken for granted... Unemployment is corrosive. If what I’m suggesting sounds protectionist, so be it... If we want to remain a leading economy, we change on our own, or change will continue to be forced upon us.

Neither Grove's diagnosis nor his proposed solutions will persuade those who are convinced that protectionism of any kind is folly. I am not entirely convinced myself, and suspect that he may be underestimating the likelihood (and consequences) of cascading retaliatory actions and a collapse in international trade. But the argument must be taken seriously, and anyone opposed to his proposals really ought to come up with some alternatives of their own.

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Update (7/4). In an email (posted with permission) Yves adds:

On the one hand, you are right, any move towards protectionism (or even permitted-within-WTO pushback against mercantilist trade partners) could very quickly get ugly. But the flip side is I wonder if we have a level of global integration that is inherently unstable (both for Rodrik trilemma reasons, international economic integration with insufficient government oversight creates political problems, plus the Reinhart/Rogoff finding that high levels of international capital flows are associated with financial crises). If so, we may have a short run (messiness of reconfiguration) v. long term (costs of really big financial crises) tradeoff.

This is a good point. The purpose of my post was to highlight Grove's analysis of the symbiotic relationship between innovation and scaling (which I think is both interesting and valid), and to challenge those who are opposed to his reform proposals to explain how they would deal with the situation in which we find ourselves. Passive tolerance of mass unemployment, widening income inequality, and withering innovative capacity is not an option.

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Update (7/4). Tyler Cowen is predictably dismissive of Grove's article, but (less predictably) seems not to have read it very closely. What Grove means by scaling is the process by means of which "technology goes from prototype to mass production" as companies "work out design details, figure out how to make things affordably, build factories, and hire people by the thousands." This is not about increasing returns to scale as economists normally use the term (declining average costs as a function of output). So Tyler's claim that "at best, given the logic of [Grove's] argument, this would imply a tax only on the increasing returns industries" is not correct. And I cannot imagine what he means when he says that the "big exporting success these days is Germany, which has less "scale" than does the United States." Less scale in what sense? Population or per-capita income differences between the two countries are entirely irrelevant here. Is he trying to say that Germany engages in less scaling (and hence more offshoring) than does the United States? This would be relevant, but is empirically dubious.

Like Tyler, I am not convinced that Grove's policy proposals are wise. But his analysis of the relationship between innovation and scaling and the need for a policy response really does deserve to be read with more care.

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Update (7/6). Tim Duy follows up with a characteristically detailed and thoughtful post. His bottom line:

Something more than cyclical forces is weighing on the American jobs machine. Here I have tried to extend the Grove/Smith/Sethi discourse with additional focus on absolute declines in manufacturing jobs and distressing declines in capacity growth rates. These trends may be critically important in understanding the dismal performance of US labor markets. If they are in fact critical, they raise serious questions about US trade policy – questions that few in Washington want to address. Given the extent to which manufacturing capacity has already been offshored, those questions go far beyond the recently announced tiny shift in Chinese currency policy. Simply put, accepting the importance of manufacturing capacity and the possibility that offshoring has had a much more deleterious impact on the US economy than commonly accepted would require a significant paradigm shift in the thinking of US policymakers. If you scream “protectionist fool” in response, then you need to have a viable policy alternative that goes beyond the empty rhetoric of “we need to teach better creative thinking skills in schools.” That answer is simply too little too late.

It's worth reading the entire post to see the data and reasoning that drives him to this conclusion.

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I'll be away at a (very interesting) conference for the next couple of days and will be slow to respond to comments and emails.

Market Microstructure and Capital Formation

2010-07-02T18:45:00.004-04:00

In an earlier post I argued that recent changes in technology have altered the distribution of trading strategies in asset markets, with information extracting strategies becoming more prevalent at the expense of information augmenting strategies. Specifically, there has been a dramatic increase in the market share of strategies based on rapid responses to market data using algorithms and co-location facilities. One consequence is that the data itself becomes less reliable over time, resulting in greater price volatility and occasional severe disruptions. The flash crash of May 6 was a striking example.

While my focus has been on market stability, this kind of transformation in microstructure probably has a number of other important effects. In recent testimony before the joint CFTC-SEC committee on emerging regulatory issues, David Weild has argued that one of these consequences is on the size distribution of publicly traded companies, and on capital formation more generally:

There has been a computer arms race unleashed on Wall Street by changes in regulation and technology... [This] is displacing fundamental investing with computer‐trading based strategies and has created new forms of systemic risk, a loss of investor confidence, and a disastrous decline in primary (IPO) capital formation and the number of publicly listed companies in the United States.

From 1997 to Year End 2009 there has been a 40% decline in the number of publicly listed (i.e., NYSE, AMEX and NASDAQ) companies in the United States. On a GDP weighted basis, we have seen a more than 55% decline in the number of publicly listed companies. Today’s market structure has lost the ability to support small capitalization companies and initial public offerings (IPOs) on the scale necessary to help drive the US economy. The U.S. now annually delists twice as many companies as it lists and this trend has been going on since the advent of electronic trading... the unemployment crisis in the United States has been partly caused by changes to debt and equity capital market structure and the events of May 6 may give us an opportunity to come to grips with the notion that we have entered into an era where trading interests are eclipsing fundamental investment and economic interests.

Fundamental investing, or so‐called “information increasing” activities, are being displaced by trading, or so‐called “information mining” activities. The growth in indexing and ETFs may be exacerbating this problem.

In addition, stock market structure today is geared for large‐capitalization stocks with typically symmetrical order books but disastrous for the vast majority of small‐capitalization stocks with asymmetrical order books (where there is not naturally an offsetting buy order to match against a sell order and vice versa)... The “Flash Crash” was an example of where even normally liquid securities went to a state of “asymmetry” and price discovery broke down...

[Until] all trades, quotes and other messages in all interrelated markets are tagged and traceable to the trading venue, broker and ultimate investor, and disclosed to the market, markets will not be perceived as fair... With full tagging, tracking and reporting and the application of posttrade analysis and test bed techniques such as Agent‐Based Models, regulators and market participants will... once and for all be in a position to judge the impact of other participants and to regulate and plan accordingly...

It may be time to admit that what works for large, naturally visible companies, is the antithesis of what is needed by small companies and it is these small companies that are essential to grow our markets, reduce unemployment, restore US competitiveness and drive the US economy.

I am not aware of any academic research that links market microstructure to the size distribution of publicly listed companies in the manner suggested here, and I am grateful to David for for bringing his testimony and supporting documents to my attention. The issue is clearly of considerable importance and deserving of greater scrutiny.

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Update (7/2). In an email (posted with permission) David adds:

I did a presentation to the ISEEE (International Stock Exchange Executives Emeriti) at the end of April. The audience consisted of about 25 mostly former senior stock exchange executives... I was taken aback by the reaction of people from places like the Zurich Stock Exchange, Australian, New Zealand, Bovespa and others who were of the opinion that these electronic market structures (specifically, compressed spread-trading centric electronic continuous auction markets) are hurting primary capital formation in many of their countries as well.

For me, having run strategy for investment banking, research, institutional sales and trading at a major Wall Street firm, it is pretty simple - If one can't make money supporting small cap stocks, one won't support small cap stocks...

This has had two effects:
The investment banks tell issuers that they have to do a much larger ($75 million) IPO; minimum IPO sizes have increased at much faster than the rate of inflation.
Aftermarket support for IPOs has withered because issuers lose money providing it (unless the companies are much larger).

It is commonly argued that the rise of algorithmic trading has resulted in increased liquidity, although this claim is by no means universally accepted. David (if I understand him correctly) is arguing that even if liquidity has increased for some classes of securities, it has declined for others, with detrimental net effects on capital formation.

Happiness and the World Cup

2010-07-02T06:50:00.000-04:00

Tyler Cowen considers the question of which team's victory in the World Cup would result in the greatest overall happiness, and concludes (based on the number and intensity of fans) that it would be Brazil. As far as the immediate effects of a victory are concerned, this is probably about right. But could there not also be consequences for global economic growth and financial stability?

Hein Schotsman of ABN AMRO has looked at these broader economic effects and comes to the conclusion that a victory by a large economy currently running a significant trade surplus would be best. This leads him to the one obvious candidate:

According to a detailed analysis of the 32 countries in this year’s tournament, Mr. Schotsman is convinced that a win by the Germans would boost the global economy. Here’s how: Germany is among the world’s biggest economies and has a large trade surplus. A win by the Germans would boost domestic confidence and spending, thus increasing imports from other countries.

“A German victory will result in a relatively big dent in the German trade surplus, which is best for the stability of the world economy. This is just what is badly needed after the credit crisis,” Mr. Schotsman said in a report released Tuesday called Soccernomics 2010.

Maybe so. But as far as my own happiness is concerned, I would like to see Argentina prevail against Germany tomorrow. Lionel Messi has been the player of the tournament so far and I would hate to see his team eliminated.

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I thank Ingela Alger for alerting me to this story and sending me references. For those not fully fluent in Dutch, Schotsman's paper may be upload to Google Translate for a reasonably comprehensible rendering.

On Blogs and Economic Discourse

2010-06-29T10:09:00.008-04:00

I was making my way back from a conference yesterday and completely missed the uproar over Kartik Athreya's provocative essay on economics blogs. Athreya argued, in effect, that most such blogging is done by ill-informed hacks who ought to be ignored while properly trained experts (such as himself) are left in peace to do the difficult work of making progress in the field. The original post has been taken down but (as a telling reminder that no public statement can subsequently be made private in this day and age) a copy may be viewed here.

The response from the accused was swift and brutal (see Thoma, DeLong, Sumner, Rowe, Cowen, Kling, Avent, Yglesias and Wilkinson for a sample). I don't want to pile on, and there's little I can add to what others have already said. But I'd like to take this opportunity to reiterate and expand upon a couple of points that I have made in previous posts about the rapidly changing role of blogs in economic discourse.

My view of the matter is almost diametrically opposed to that of Athreya: I consider these changes to be both irreversible and potentially very healthy. In a post commemorating the birthdays of two excellent economics blogs, I made this point as follows (see also Andrew Gelman's follow-up):

The community of academic economists is increasingly coming to be judged not simply by peer reviewers at journals or by carefully screened and selected cohorts of students, but by a global audience of curious individuals spanning multiple disciplines and specializations. Voices that have long been silenced in mainstream journals now insist on being heard on an equal footing. Arguments on blogs seem to be judged largely on their merits, independently of the professional stature of those making them. This has allowed economists in far-flung places with heavy teaching loads, or those who pursued non-academic career paths, to join debates. Even anonymous writers and autodidacts can wield considerable influence in this environment, and a number of genuinely interdisciplinary blogs have emerged...

This has got to be a healthy development. One might persuade a referee or seminar audience that a particular assumption is justified simply because there is a large literature that builds on it, or that tractability concerns preclude reasonable alternatives. But this broader audience is not so easy to convince. Persuading a multitude of informed, thoughtful, intelligent readers of the relevance and validity of one's arguments using words rather than formal models is a far more challenging task than persuading one's own students or peers. If one can separate the wheat from the chaff, the reasoned argument from the noise, this process should result in a more dynamic and robust discipline in the long run.

In fact, the refereeing process for blog posts is in some respects more rigorous than that for journal articles. Reports are numerous, non-anonymous, public, rapidly and efficiently produced, and collaboratively constructed. It is not obvious to me that this process of evaluation is any less legitimate than that for journal submissions, which rely on feedback from two or three anonymous referees who are themselves invested in the same techniques and research agenda as the author.

I suspect that within a decade, blogs will be a cornerstone of research in economics. Many original and creative contributions to the discipline will first be communicated to the profession (and the world at large) in the form of blog posts, since the medium allows for material of arbitrary length, depth and complexity. Ideas first expressed in this form will make their way (with suitable attribution) into reading lists, doctoral dissertations and more conventionally refereed academic publications. And blogs will come to play a central role in the process of recruitment, promotion and reward at major research universities. This genie is not going back into its bottle.

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Update (6/30). Andrew Gelman follows up with a long and thoughtful post on the role of blogs in academic research across different fields:

Sethi points out that, compared to journal articles, blog entries can be subject to more effective criticism. Beyond his point (about a more diverse range of reviewers), blogging also has the benefit that the discussion can go back and forth. In contrast, the journal reviewing process is very slow, and once an article is published, it typically just sits there...

Can/should the blogosphere replace the journal-sphere in statistics? I dunno. At times I've been able to publish effective statistical reactions in blog form... or to use the blog as a sort of mini-journal to collect different viewpoints... And when it comes to pure ridicule... maybe blogging is actually more appropriate than formally writing a letter to the editor of a journal.

But I don't know if blogs are the best place for technical discussions. This is true in economics as much as in statistics, but the difference is that many people have argued (perhaps correctly) that econ is already too technical, hence the prominence of blog-based arguments is maybe a move in the right direction...

Statistics, though, is different... even the applied stuff that I do is pretty technical--algebra, calculus, differential equations, infinite series, and the like... Can this sort of highly-technical material be blogged? Maybe so. Igor Carron does it, and so does Cosma Shalizi--and both of them, in their technical discussions, clearly link the statistical material to larger conceptual questions in scientific inference and applied questions about the world. But this sort of blogging is really hard--much harder, I think, than whatever it takes for an economics professor with time on his or her hands to regularly churn out readable and informative blogs at varying lengths commenting on current events, economic policy, the theories of micro- and macro-economics, and all the rest...

On the other hand, the current system of scientific journals is, in many ways, a complete joke. The demand for referee reports of submitted articles is out of control, and I don't see Arxiv as a solution, as it has its own cultural biases. I agree with Sethi that some sort of online system has to be better, but I'm guessing that blogs will play more of a facilitating informal discussions rather than replacing the repositories of formal research. I could well be wrong here, though: all I have are my own experiences, I don't have any good general way of thinking about this sort of sociology-of-science issue.

One minor point of clarification: I did not say (or mean to imply) that blogs would replace journals as the primary repositories of academic research. My point was simply that blogs are fast becoming an integral part of the research infrastructure and that, looking ahead, many innovative ideas will find initial expression in this format before being subject to further development along more traditional lines.

Gamesmanship and Collective Reputation

2010-06-22T09:39:00.003-04:00

I've often wondered why diving is so prevalent in football. Even if one manages to fool a referee occasionally, the act is captured on video for all to see and inevitably hurts the reputation of the player and his team. Quite apart from the resulting ridicule, there are also long term costs on the field. Referees are more likely to be suspicious when they see players with tarnished reputations tumbling like bowling pins with little apparent contact. Some legitimate fouls may not be called as a result, and there's always the possibility that a player may be cautioned or sent off for unsportsmanlike conduct. So the whole culture of diving, and the fact that it has been embraced so thoroughly by certain teams while being avoided and frowned upon by others, has always been a bit of a puzzle to me.

In a fascinating article, Andrea Tallarita provides some rationalization for this behavior. He explains that diving is a part of a broad range of calculated tactics that are used to get into an opponent's head, inducing frustration, loss of concentration and overreaction. Zidane's costly headbutt of Materazzi in the 2006 World Cup final is the most famous of many examples. Here's how Tallarita explains the approach:

Perhaps nothing has been more influential in determining the popular perception of the Italian game than furbizia, the art of guile... The word ‘furbizia’ itself means guile, cunning or astuteness. It refers to a method which is often (and admittedly) rather sly, a not particularly by-the-book approach to the performative, tactical and psychological part of the game. Core to furbizia is that it is executed by means of stratagems which are available to all players on the pitch, not only to one team. What are these stratagems? Here are a few: tactical fouls, taking free kicks before the goalkeeper has finished positioning himself, time-wasting, physical or verbal provocation and all related psychological games, arguably even diving... Anyone can provoke an adversary, but it takes real guile (real furbizia) to find the weakest links in the other team’s psychology, then wear them out and bite them until something or someone gives in - all without ever breaking a single rule in the book of football.

Viewed in this light, the prevalence of diving starts to make a bit more sense. Even if one doesn't win the immediate foul or penalty, the practice can unsettle an opponent and induce errors. And a reputation for diving can cause an opponent to avoid even minimal, routine contact. This is gamesmanship, pure and simple.

But if gamesmanship is so rewarding, why are some teams reluctant to embrace it? Why do the Spanish play such a clean version of the game and consider these tactics to be beneath them, while their closest neighbors, the Italians and Portuguese, have no such qualms? Here is Tallarita's explanation:

Ultimately, these differences come from two irreconcilable visions of the game. The Spanish style understands football as something like a fencing match, a rapid and meticulous art of noble origins where honour is the brand of valour. To the Italians, football is more like an ancient battle, a primal and inclement bronze-age scenario where survival rules over honour.

But this just begs the question: why are the visions of the game so different in nations that are geographically and culturally so close? I think that the answer (or at least part of it) lies in the fact that once a collective reputation has been established, it becomes individually rational for new entrants to the group to act in ways that preserve it. This mechanism was explored in a very interesting 1996 paper by Jean Tirole in which he explains why "new members of an organization may suffer from an original sin of their elders long after the latter are gone."

The reason why the past behavior of the group affects the incentives of current and future members is that past behavior is not perfectly observable at the level of the individual. Groups consist of overlapping cohorts, with older members mixed in with newer ones. Those older members who have behaved "badly" in the past and thus ruined their reputations have no incentive to behave "well" currently. But suspicion also falls on the newer members, who cannot be perfectly distinguished from the older ones. This suspicion alters incentives in such a manner as to make it self-fulfilling. Even if the entire group would benefit from a change in reputation, this may be impossible to accomplish. Lifting the reputation of the group would require several cohorts to behave well despite being presumed to behave badly, and this is a sacrifice that does not serve their individual interests.

While I have used Tirole's model here to account for variations across teams in their levels of gamesmanship, his own motivation is much broader: he is interested in understanding variations across societies in levels of corruption and differences among firms in their reputation for product quality. And one can think of numerous other examples in which history has saddled a group with a reputation that is hard to shake because doing so requires significant and sustained collective sacrifices from current and future members.

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Update (6/25). An excellent comment (as usual) by Andrew Oh-Willeke:

The notion that cultural founder effects have great institutional legacies also has strong implications for bankruptcy policy and for policy related to government bureaucracies.

It suggests that completely shutting down one organization, even if it will be replaced by a new organization doing the same thing with the same technology should often be preferred to trying to reorganize existing organizations, because the failure of the troubled firm or bureaucratic unit may be a problem with organizational culture that would otherwise persist, rather than more "objective" factors.

This might also suggest that seemingly absurd economic development strategies, like Attaturk's law mandating that all men wear bowler hats, may have more merit to them than they seem to at an obvious level. The example Malcolm Gladwell used of this phenomena was the increased safety record that was observed at Korean Airlines when flight crews started to use English rather than Korean.

I hope to say more about this in a subsequent post.

An alternative (and perhaps complementary) perspective on heterogeneity in behavior across teams comes from Cyril Hedoin at Rationalité Limitée, who argues that there are major differences across national leagues in gamesmanship norms, sustained by the sanctioning of those who fail to conform to local expectations.

I'm in Istanbul for a conference at the moment and will be slow to respond to emails and comments for a few days.

The Diving Champions of the (Football) World

2010-06-20T20:01:00.000-04:00

Aside from early losses by Germany and Spain, the biggest surprise of the World Cup so far is probably the inability of Italy (the reigning champions) to win either of their first two games. First they drew with Paraguay, ranked 31st in the world, and then again today against 78th ranked New Zealand.

In both cases the Italians came back from a goal behind, and in the latter game did so on the basis of a dubious penalty. De Rossi's spectacular dive after getting his shirt gently tugged by Smith was a wonder to behold, revealing yet again that the Italians are undisputed masters of the simulated foul. Even the Wikipedia entry on the art of diving acknowledges this:

Diving (or simulation - the term used by FIFA) in the context of association football is an attempt by a player to gain an unfair advantage by diving to the ground and possibly feigning an injury, to appear as if a foul has been committed. Dives are often used to exaggerate the amount of contact present in a challenge. Deciding on whether a player has dived is very subjective, and one of the most controversial aspects of football discussion. Players do this so they can receive free kicks or penalty kicks, which can provide scoring opportunities, or so the opposing player receives a yellow or red card, giving their own team an advantage. The Italian national football team have been well known to use this tactic... In fact, their victory at the 2006 FIFA World Cup has been overshadowed by the sheer volume of controversial dives.

While the anecdotal (and video) evidence against Italy is strong, it would be useful to have a statistical measure of diving on the basis of which international comparisons could be made. One possibility is to use data on fouls suffered. For instance, in the latest game, Italy was fouled 23 times while New Zealand suffered just 10 fouls. Either New Zealand is an unusually aggressive (or clumsy) team, or a number of the "fouls" suffered by Italy were simulated.

Since data on fouls committed and suffered is readily available for all World Cup games, it should be possible to sort all this out statistically. Suppose that in any game, the total number of fouls suffered by a team depends on three factors: its propensity to dive (without detection), the opponent's propensity to foul, and idiosyncratic factors independent of the identity of the teams. Then, with a rich enough data set, it should be possible to identify the diving propensity of each team. There are subtleties that could confound the analysis, but a good forensic statistician should be able to handle these. Perhaps Nate Silver will take up the challenge?

In the meantime, for a lesson on how not to dive, enjoy this legendary "posthumous" effort by Gilardino in a 2007 game between AC Milan and Celtic:

On Tail Risk and the Winner's Curse

2010-06-19T06:49:00.006-04:00

Richard Thaler used to write a wonderful column on anomalies in the Journal of Economic Perspectives. Here's an extract from a 1988 entry on the winner's curse:

The winner's curse is a concept that was first discussed in the literature by three Atlantic Richfield engineers, Capen, Clapp, and Campbell (1971). The idea is simple. Suppose many oil companies are interested in purchasing the drilling rights to a particular parcel of land. Let's assume that the rights are worth the same amount to all bidders, that is, the auction is what is called a common value auction. Further, suppose that each bidding firm obtains an estimate of the value of the rights from its experts. Assume that the estimates are unbiased, so the mean of the estimates is equal to the common value of the tract. What is likely to happen in the auction? Given the difficulty of estimating the amount of oil in a given location, the estimates of the experts will vary substantially, some far too high and some too low. Even if companies bid somewhat less than the estimate their expert provided, the firms whose experts provided high estimates will tend to bid more than the firms whose experts guessed lower... If this happens, the winner of the auction is likely to be a loser.

Thaler goes on to point out that the winner's curse would not arise if all bidders were rational, for they would take into account when bidding that conditional on winning the auction, the valuation of their experts is likely to have been inflated. But he also presents evidence (from laboratory experiments as well as field data on offshore oil and gas leases and corporate takeovers) that bidders are not rational to this degree, and that the winner's curse is therefore an empirically relevant phenomenon. Many observers of the free agent market in baseball would agree.

In Thaler's description, the winner's curse arises despite the fact that bidder estimates are unbiased: their valuations are correct on average, even though the winning bid happens to come from someone with excessively optimistic expectations. Someone familiar with this phenomenon would therefore never conclude that all bidders are excessively optimistic simply by observing the fact that winning bidders tend to wish that they had lost.

By the same token, when firms like BP and AIG are revealed to have underestimated the extent to which their actions exposed them (and numerous others) to tail risk, one ought not to presume that they were acting under the influence of a psychological propensity to which we are all vulnerable. Those who had more realistic (or excessively pessimistic) expectations regarding such risks simply avoided them, and by doing so also avoided coming to our attention.

And yet, here is the very same Richard Thaler arguing that a behavioral propensity to accept "risks that are erroneously thought to be vanishingly small" was responsible for both the financial crisis and the oil spill:

The story of the oil crisis is still being written, but it seems clear that BP underestimated the risk of an accident. Tony Hayward, its C.E.O., called this kind of event a “one-in-a-million chance.” And while there is no way to know for sure, of course, whether BP was just extraordinarily unlucky, there is much evidence that people in general are not good at estimating the true chances of rare events, especially when human error may be involved.

There is certainly a grain of truth in this characterization, but I feel that it misses the real story. As the analysis underlying the winner's curse teaches us, those with the most optimistic expectations will take the greatest risks and suffer the most severe losses when the low probability events that they have disregarded eventually come to pass. But tail risks are unlike auctions in one important respect: there can be a significant time lag between the acceptance of the risk and the realization of a catastrophic event. In the interim, those who embrace the risk will generate unusually high profits and place their less sanguine competitors in the difficult position of either following their lead or accepting a progressively diminishing market share. The result is herd behavior with entire industries acting as if they share the expectations of the most optimistic among them. It is competitive pressure rather than human psychology that causes firms to act in this way, and their actions are often taken against their own better judgment.

This ecological perspective lies at the heart of Hyman Minsky's analysis of financial instability, and it can be applied more generally to tail risks of all kinds. As an account of the (environmental and financial) catastrophes with which we continue to grapple, I find it more compelling and complete than the psychological story. And it has the virtue of not depending for its validity on systematic, persistent, and largely unexplained cognitive biases among professionals in high stakes situations.

Both James Kwak and Maxine Udall have also taken issue with Thaler's characterization (though on somewhat different grounds). James also had this to say about behavioral economics more generally:

Don’t get me wrong: I like behavioral economics as much as the next guy. It’s quite clear that people are irrational in ways that the neoclassical model assumes away... But I don’t think cognitive fallacies are the answer to everything, and I don’t think you can explain away the myriad crises of our time as the result of them.

I agree completely. As I said in an earlier post, I can't help thinking that too much is being asked of behavioral economics at this time, much more than it has the capacity to deliver.

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Update (6/20). In a response to this post, Brad DeLong makes two points. First, he observes that those who underestimate tail risk can make unusually high profits not just in the interim period before a catastrophic event occurs, but also if one averages across good and bad realizations:

To the extent that the optimism of noise traders leads them to hold larger average positions in assets that possess systemic risk, their average returns will be higher in a risk-averse world--not just in those states of the world in which the catastrophe has not happened yet, but quite possibly averaged over all states of the world including catastrophic states.

This is logically correct, for reasons that were discussed at length in Brad's 1990 JPE paper with Shleifer, Summers and Waldmann. But (as I noted in my comment on his post) I don't think the argument applies to the risks taken by BP and AIG, which could easily have proved fatal to the firms. One could try to make the case that even with bankruptcy, the cumulative dividend payouts would have resulted in higher returns than less exposed competitors, but the claim seems empirically dubious to me.

Brad's second point is that my distinction between the ecological and psychological approaches is unwarranted, and that the two are in fact complementary. Here he quotes Charles Kindleberger:

Overestimation of profits comes from euphoria, affects firms engaged in the production and distributive processes, and requires no explanation. Excessive gearing arises from cash requirements that are low relative both to the prevailing price of a good or asset and to possible changes in its price. It means buying on margin, or by installments, under circumstances in which one can sell the asset and transfer with it the obligation to make future payments. As firms or households see others making profits from speculative purchases and resales, they tend to follow: "Monkey see, monkey do." In my talks about financial crisis over the last decades, I have polished one line that always gets a nervous laugh: "There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich."

The Kindeberger quote is wonderful, but the claim is about interdependent preferences, not cognitive limitations. I don't doubt that cognitive limitations matter (I started my post with the winner's curse after all) but I was trying to shift the focus to interactions and away from psychology. In general I think that the Minsky story can be told with very modest departures from rationality, which to me is one of the strengths of the approach.

An Extreme Version of a Routine Event

2010-06-15T16:30:00.001-04:00

The flash crash of May 6 has generally been viewed as a pathological event, unprecedented in history and unlikely to be repeated in the foreseeable future. The initial response was to lay blame on an external source for the instability: fat fingers, computer glitches, market manipulation, and even sabotage were all contemplated. But once it became apparent that this was a fully endogenous event, arising from interactions among trading strategies, it was time to drag out the perennial metaphor of the perfect storm. Consider, for instance, the response from Barclays Capital:

Thursday’s market action, in our opinion, did not begin and end with trading errors and/or exchange technology failures. Nor, as some commentators are suggesting, were quantitative trading strategies primarily responsible for the events that unfolded. All of these forces may have contributed to the voracious sell-off, but our analysis suggests that last Thursday’s events were more a function of a “perfect storm,” to borrow a cliché phrase.

Resorting to this tired analogy is both intellectually lazy and dangerously misleading. It lulls one into a false complacency and suggests that there is little one can (or needs to) do to prevent a recurrence. And since the correction was quick, and trades at the most extreme prices were canceled, it could even be argued that little damage was done. Might this not reflect the resilience of markets rather than their vulnerability?

But consider, for a moment, the possibility that far from being a pathological event, the flash crash was simply a very extreme version of a relatively routine occurrence. It was extreme with respect the the scale of departures of prices from fundamentals, and the speed with which they arose and were corrected. But it was routine in the sense that such departures do arise from time to time, building cumulatively rather than suddenly, and lasting for months or years rather than minutes, with corrections that can be rapid or prolonged but almost impossible to time.

Viewed in this manner, the flash crash can provide us with insights into the more general dynamics of prices in speculative asset markets, in much the same manner as high speed photography can reveal intricate details about the flight of an insect. The crash revealed with incredible clarity how (as James Tobin observed a long time ago) markets can satisfy information arbitrage efficiency while failing to satisfy fundamental valuation efficiency. The collapse and recovery of prices could not have been predicted based on an analysis of any publicly available market data, at least not with respect to timing and scale. And yet prices reached levels (both high and low) that were staggering departures from fundamental values.

So what can we learn from the crash? The SEC report on the event contains two pieces of information that are revealing: the vast majority of trades against stub quotes of five cents or less were short sales, and there were major departures of prices from fundamentals in both directions, with a number of trades executed at ten million dollars per round lot. It is very unlikely that these orders came from retail investors; they were almost certainly generated by algorithms implementing strategies that involve directional bets for short holding periods in response to incoming market data.

While the algorithmic implementation of such strategies is a relatively recent development, the strategies themselves have been around for as long as securities markets have existed. They can be very effective when sufficiently rare, but become increasingly vulnerable to major losses as they become more widespread. Their success in stable markets leads to their proliferation, which in turn causes the information in market data to become progressively more garbled. These strategies can then become mutually amplifying, resulting in major departures of prices from fundamentals. When the inevitable correction arrives, some of them are wiped out, and market stability is restored for a while. This process of endogenous regime switching finds empirical expression in the clustering of volatility.

The reason why departures of prices from fundamentals were so quickly corrected during the flash crash was because the discrepancies were so obvious. It was common knowledge among market participants that a penny per share for Accenture or a hundred thousand for Sotheby's were not real prices (to use Jim Cramer's memorable expression) and therefore presented significant and immediate profit opportunities. Traders pounced and sanity was restored.

But when departures of prices from fundamentals arise on a more modest scale, a coordinated response is more difficult to accomplish. This is especially the case when securities become overvalued. Bubbles can continue to expand even as awareness of overvaluation spreads because short selling carries enormous downside risk and maintaining short positions in a rising market requires increasing amounts of capital to meet margin requirements. Many very sophisticated fund managers suffered heavy losses while attempting to time the collapse in technology stocks a decade ago. And many of those who recently used credit derivatives to bet on a collapse in housing prices might well have met the same fate were it not for the taxpayer funded rescue of a major counterparty.

Aside from scale and speed, one major difference between the flash crash and its more routine predecessors was the unprecedented cancellation of trades. As I have argued before, this was a mistake: losses from trading provide the only mechanism that currently keeps the proliferation of destabilizing strategies in check. The decision is not one that can now be reversed, but the SEC should at least make public the list of beneficiaries and the amounts by which their accounts were credited. Dissemination of these simple facts would help to identify the kinds of trading strategies that were implicated. And it is information to which the public is surely entitled.

The New Market Makers

2010-06-04T18:03:00.013-04:00

In an earlier post I noted that according to the SEC's preliminary report on the flash crash of May 6, the vast majority of executions against stub quotes of five cents or less were short sales. This, together with the fact that there was also significant "aberrant behavior" on the upside (with Sotheby's trading for almost a hundred thousand dollars a share, for instance) led me to believe that most of this activity was caused by algorithmic trading strategies placing directional bets based on rapid responses to incoming market data.

Two strategies in particular -- momentum ignition and order anticipation -- were explicitly mentioned as potentially destabilizing forces in the SEC's January Concept Release on Equity Market Structure. The SEC invited comments on the release, and dozens of these have been posted to date. There is one in particular, submitted by R.T. Leuchtkafer about three weeks before the crash, that I think is especially informative and analytically compelling (h/t Dr. Duru).

Leuchtkafer traces the history of recent changes in market microstructure and examines the resulting implications for the timing of liquidity demand and supply. The comment is worth reading in full, but here are a few highlights. First, a brief history of the rise of the new market makers:

The last 15 years have seen a radical transformation of the equities markets from highly concentrated, semi-automated and intermediated marketplaces to highly distributed, fully automated and nominally disintermediated marketplaces. Along with or because of these changes, we have seen the rise of new classes of very profitable, aggressive, and technologically savvy participants previously unknown in the U.S. markets. When markets are in equilibrium these new participants increase available liquidity and tighten spreads. When markets face liquidity demands these new participants increase spreads and price volatility and savage investor confidence.

These participants can be more destructive to the interests of long-term investors than most have yet imagined... What is legal in today's market includes an exchange that sells real-time data to high frequency trading ("HFT") firms telling those firms exactly where hidden interest rests and in what direction. What is legal is the replacement of formal and regulated intermediaries with informal and unregulated intermediaries. What is legal is the proliferation of high-speed predatory momentum and order anticipation algorithms unrestrained by the anti-manipulation provisions of the Exchange Act. What is legal is a market structure that dismantled the investing public's order priorities and gave priority to speed and speed alone and then began charging for speed. What is legal is the widespread lack of supervision of the most aggressive and profitable groups of traders in American history. What is legal is exactly what the Release says it is worried about, "a substantial transfer of wealth from the individuals represented by institutional investors to proprietary firms..."

A HFT market making firm does not need to register as a market maker on any exchange. To the regulatory world it can present itself as just another retail customer and make markets with no more oversight than any other retail customer... Some HFT firms do register as market makers. By doing so they get access to more capital through higher leverage, they might get certain trading priority preferences depending on the market center, and they get certain regulatory preferences. They are usually required to post active quotes but quote quality is up to the market center itself to specify and some market centers have de minimis standards... Formal and informal market makers in the equities markets today have few or none of the responsibilities of the old dealers. That was the trade-off as markets transformed themselves during the last decade. In exchange for losing control of the order book and giving up a first look at customer order flow, firms shed responsibility for price continuity, quote size, meaningful quote continuity or quote depth. The result is that firms are free to trade as aggressively or passively as they like or to disappear from the market altogether.

The main problem, as Leuchtkafer sees it, is access to data feeds that make it possible to predict and profit from short term price movements if the information is processed and responded to with sufficient speed:

A classic short-term trading strategy is to sniff out an elephant and trade ahead of it. That is front-running if you are a fiduciary to the elephant but just good trading if you are not, or so we suppose.

Nasdaq sells a proprietary data feed called TotalView-ITCH that specifies exactly where hidden interest lies and whether it is buying or selling interest... Market making, statistical arbitrage, order anticipation, momentum and other kinds of HFT firms are an obvious customer base for this product... The complete details of limit order books can be used to predict short term stock price movements. An order book feed like TotalView-ITCH gives you much more information than just price and size such as you get with the consolidated quote. You get order and trade counts and order arrival rates, individual order volumes, and cancellation and replacement activity. You build models to predict whether individual orders contain hidden size. You reverse engineer the precise behavior and outputs of market center matching engines by submitting your own orders, and you vary order type and pore over the details you get back. If you take in order books from several market centers, you compare activity among them and build models around consolidated order book flows. With all of this raw and computed data and the capital to invest in technology, you can predict short term price movements very well, much better and faster than dealers could 10 years ago. Order book data feeds like TotalView-ITCH are the life's blood of the HFT industry because of it and the information advantages of the old dealer market structure are for sale to anyone.

But this raises a puzzling question: if the information advantages are truly "for sale to anyone" then free entry should drive down profitability until the return on investment is comparable to other uses of capital. In fact, entry has been substantial: "In 2000 as the HFT revolution started, dealer participation rates at the NYSE were approximately 25%. In 2008, the year NYSE specialists phased out, HFT participation rates in the equity markets overall were over 60%." How, then, can one explain the fact that by Leuchtkafer's own estimates, "HFT market making was 10 to 20 times more profitable in 2008 than traditional dealer firms were in 2000, before the HFT revolution?"

One intriguing possibility that Leuchtkafer does not consider is that entry generates increasing tail risk, so while ex ante expected profitability is reduced, this does not show up as declining realized profitability until a major market event (such as the flash crash) materializes. If this interpretation is correct, then some HFT firms must have made significant losses on May 6 that were reversed upon cancellation of trades. This implicit subsidy encourages excessive entry of destabilizing strategies.

The standard argument against increased regulation of the new market makers is that it would interfere with their ability to supply liquidity. Leuchtkafer argues, instead, that the strategies used by these firms cause them to demand liquidity at precisely those moments when liquidity is shortest supply:

HFT firms claim they add liquidity and they do when it suits them... At any moment when they are in the market with nonmarketable orders by definition they add liquidity. When they spot opportunities or need to rebalance, they remove liquidity by pulling their quotes and fire off marketable orders and become liquidity demanders. With no restraint on their behavior they have a significant effect on prices and volatility. For the vast majority of firms whose models require them to be flat on the day their day-to-day contribution to liquidity is nothing because they buy as much as they sell. They add liquidity from moment to moment but only when they want to, and they cartwheel from being liquidity suppliers to liquidity demanders as their models rebalance. This sometimes rapid rebalancing sent volatility to unprecedented highs during the financial crisis and contributed to the chaos of the last two years. By definition this kind of trading causes volatility when markets are under stress.

Imagine a stock under stress from sellers such was the case in the fall of 2008. There is a sell imbalance unfolding over some period of time. Any HFT market making firm is being hit repeatedly and ends up long the stock and wants to readjust its position. The firm times its entrance into the market as an aggressive seller and then cancels its bid and starts selling its inventory, exacerbating the stock's decline. Unrestrained by affirmative responsibilities, the firm adjusts its risk model to rebalance as often as it wants and can easily dump its inventory into an already declining market. A HFT market making firm can easily demand as much or more liquidity throughout the day than it supplies. Crucially, its liquidity supply is generally spread over time during the trading day but its liquidity demands are highly concentrated to when its risk models tell it to rebalance. Unfortunately regulators do not know what these risk models are. So in exchange for the short-term liquidity HFT firms provide, and provide only when they are in equilibrium (however they define it), the public pays the price of the volatility they create and the illiquidity they cause while they rebalance. For these firms to say they add liquidity and beg to be left alone because of the good they do is chutzpah...

The HFT firms insist they add liquidity and narrow effective spreads and they do at many instants in time during the day. They also take liquidity and widen realized spreads as they rebalance in narrow time slices and in the aggregate they can easily be as disruptive as supportive.

Paul Kedrosky made the same point immediately following the flash crash, and it is also mentioned in the SEC report. As part of the solution, Leuchtkafer proposes that certain trading strategies be prohibited outright:

The SEC should define both "momentum ignition" and "order anticipation" strategies as manipulation since they are both manipulative under any plain meaning of the Exchange Act. These strategies identify and take advantage of natural interest for a trader's own profit or stimulate artificial professional interest, also for the trader's own profit. They do so by bidding in front of (raising the price) or offering in front of (depressing the price) slower participants they believe are already in the market or that they can induce into the market. They both depend on causing short term price volatility either to prey on lagging natural interest or on induced professional interest. Any reasonable definition of "manipulation" in the equity markets should explicitly ban them by name.

I don't have any quarrel with this analysis and recommendation, but it's also useful to look at the problem from a somewhat broader perspective. Generally speaking, stability in financial markets depends on the extent to which trading is based on fundamental information about the securities that are changing hands. If too great a proportion of total volume is driven by strategies that try to extract information from market data, the data itself becomes less informative over time and severe disruptions can arise. Banning specific classes of algorithms is unlikely to provide a lasting solution to the problem unless the advantage is shifted decisively and persistently in favor of strategies that feed information to the market instead of extracting it from technical data.

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Update (6/5). Also worth reading is a more recent comment (dated May 27) by Leuchtkafer on the Concept Release, dealing with some proposed policy responses to the flash crash:

It is strange to hear that "reform" should include a ban on stop loss orders, as if the United States equity markets are at risk because Mrs. Betty Johanssen of Red Lake, Minnesota posted a 300 share stop loss order in 3M, or that our equity markets are at risk because of a 200 share market order in Procter and Gamble. If this is where we end up, we will have failed. It will be an admission that since we won't or can't reform the shadow liquidity system, the only idea we have left is to ban even retail-sized unpriced liquidity demands...

The conventional window now also includes single stock circuit breakers. As I commented earlier... single stock circuit breakers may be useful in the same sense in which air bags are useful to Toyotas, but they don't cure sudden acceleration problems. The car still surges and crashes, but with air bags we can hope the occupants are a little more protected when it does. There is urgency to do something because political and economic exigencies demand action... circuit breakers are something we can do quickly as we continue to try to understand what happened on May 6.

Absolutely correct. Banning market orders or instituting automated single stock circuit breakers deals with symptoms rather than causes; a deeper analysis of structural defects in the current system is essential.

An Outsider's View of Modern Macroeconomics

2010-05-25T11:02:00.015-04:00

Following up on a testy exchange with David Andolfatto, Mark Thoma has written a thoughtful post in which he discusses the state of modern macroeconomic theory, the appropriateness of appeals to professional authority, the shortcomings of some canonical models, and the way forward. I posted a brief comment in response, with a few constructive suggestions for mainstream macroeconomists from the perspective of an outsider. I have made these points on various occasions before, and reproduce them here (slightly edited and expanded with links to earlier posts):

Rational expectations is not a behavioral hypothesis, it's an equilibrium assumption and therefore much more restrictive than "forward-looking behavior". It might be justified if equilibrium paths were robustly stable under plausible specifications of disequilibrium dynamics, but this needs to be explored explicitly instead of simply being assumed.
Think about whether a theory of economic fluctuations should be shock-dependent (in the Frisch-Slutsky tradition) or shock-independent (in the Goodwin tradition). Go back and look at Goodwin's 1951 Econometrica paper to appreciate the importance of the distinction.
Build models in which leverage, collateral, and default play a central role. The work of John Geanakoplos on this is an excellent starting point. He uses equilibrium theory but allows for heterogeneous priors (so differences in beliefs can persist even if they are common knowledge.) More broadly, take a close look at Hyman Minsky's integrated analysis of real and financial activity.
Do not assume that flexible wages and prices imply labor market clearing. They do in equilibrium (by definition) but wage and price flexibility in disequilibrium can make matters worse. Keynes recognized this, and Tobin explored these mechanisms formally. Arbitrary assumptions of "sticky prices" are not necessary to account for persistent unemployment or under-utilization of capacity.
Finally, show some humility. There are anonymous bloggers out there, some self-taught in economics, who may know more about the functioning of a modern economy than you do.

The last point is directed at David Andolfatto, whose arrogant appeal to professional authority jolted the normally polite Mark Thoma to respond with (justifiable) belligerence. Andolfatto's entire post was dripping with condescension, but I found the following passage particularly disturbing:

DeLong tells us that we can learn a lot of economics from Krugman. You will be forgiven for wondering whether DeLong can even tell whether he is learning economics or not. DeLong is, as far as I can tell, an historian.

As I said on Mark's blog, it could be argued that economic historians (and historians of thought) have had more useful things to say about recent events than the highest of high priests in macroeconomics. Andolfatto seems to be confusing an understanding of modern macroeconomic theory with an understanding of the modern macroeconomy. The two are not the same, and the former is neither necessary nor sufficient for the latter.

Contrast the tone of Andolfatto's post with the following passage from a recent essay by Narayana Kocherlakota, president of the Minneapolis Fed:

I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not. Of course, from a longer view, macroeconomists let policymakers down much earlier, because they did not provide policymakers with rules to avoid the circumstances that led to the global financial meltdown.

Because of this failure, macroeconomics and its practitioners have received a great deal of pointed criticism both during and after the crisis. Some of this criticism has come from policymakers and the media, but much has come from other economists. Of course, macroeconomists have responded with considerable vigor, but the overall debate inevitably leads the general public to wonder: What is the value and applicability of macroeconomics as currently practiced?

Kocherlakota goes on to defend the many advances made in macroeconomic research over the past four decades, but openly acknowledges the enormous challenges that remain. He goes on to say:

The seventh floor of the Federal Reserve Bank of Minneapolis is one of the most exciting macro research environments in the country. As president, I plan to learn from our staff, consultants, and visitors.

I hope that some of those visitors (real or virtual) will be voices of dissent from beyond the inner circle of research macroeconomics. It is in this spirit of openness that my comments are offered.

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Update (5/26). One item that I'd like to add to the list above is methodological pluralism. For instance, there is interesting work in macroeconomics using agent-based computational methods; see, for instance, the 2008 book on Emergent Macroeconomics by Delli Gatti, Gaffeo, Gallegati, Giulioni, and Palestrini. As I have said before, such models can provide microfoundations for macroeconomics in a manner that is both more plausible and more authentic than is the case with highly aggregative representative agent models.

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Update (5/26). Some useful perspective from Malaise Precis:

The dustup between Mark Thoma and David Andolfatto... is perhaps more symptomatic of the divide between - at extreme risk of too much simplification - "new" macroeconomists and "old" macroeconomists. The macroeconomists of my generation were taught DSGE models. Facts were "stylized" facts, i.e. first and second moments of "key" economic variables such as GNP, investment and consumption. During my entire 6 years at graduate school things like institutional details and historical events that may have affected the economy were laid aside or treated as not being "relevant" to the model. Economies were frictionless and markets always cleared. Sure, some frictions were eventually introduced but perhaps the biggest elephant in the room was that the curriculum cultivated us with a certain attitude that:
There are those who can build DSGE models and there are those who can't.
All partial equilibrium models can be dismissed off hand.
All structural equation models are completely irrelevant especially those not based on DSGE models. (IS-LM or Keynesian "cross" models are definitely in this category.)
Any paper that does not present a model can be dismissed - this included narratives as well as historical papers.
Perhaps the economists who fail to understand history will be doomed to repeat [it]?

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Update (5/27). David Andolfatto has posted an uncommonly gracious follow-up to his earlier remarks. As Mark points out in response, "it is possible to find shrill, over the top attacks on all sides of the debate on macroeconomic policy." What bothered me about David's earlier post was not the harshness of the language but the idea that some people are simply not qualified to speak out on certain issues. I believe that we economists need (and should welcome) voices from outside our narrow areas of specialization, and indeed outside our discipline.

Blame the Instructions, Not the Machines

2010-05-23T09:51:00.000-04:00

Following the dramatic flash crash on May 6, there has been a lot of attention paid to the mechanics of trading (automation, frequency, scale and speed) but not enough to the kinds of strategies that are being implemented using these mechanisms. Trading algorithms do whatever they are instructed to do, and market movements result from the distribution of instructions and not the technology used to implement them. Technology certainly matters, but in an indirect way. Just as changes in climate can alter the distribution of species in an ecosystem, driving some to extinction and allowing others to proliferate, new technologies can alter the distribution of strategies among the population of traders. Major changes of this kind can affect systemic stability, in the case of markets and ecosystems alike.

The variety of trading strategies in use is vast, but I find it useful to partition them into two broad categories: those that are information augmenting and those that are information extracting. The first group of strategies are based on some form of fundamental analysis: examination of balance sheets, growth potential, and risk, for instance, and trading based on departures of prices from estimated valuations. Such strategies require the investment of resources in information gathering, and end up feeding information to the market. The other class of strategies use market data itself to direct trades. These could be non-directional and arbitrage-based, or directional strategies based on such factors as momentum. This latter class of strategies use volume, price, and other market data as a basis for entering and exiting positions.

A market dominated by information augmenting strategies will tend to be stable and to track information as it arises in the economy. But information extracting strategies can be very profitable in stable markets as long as they react quickly and forcefully to new market data. Changes in technology have made rapid responses to market data feasible on a large scale, resulting in an increase in total market wealth that is invested on the basis of such strategies. The problem is that if too many people are using such strategies, there isn't enough information getting into prices systematically, and certain technical strategies can start generating mutually amplifying responses to noise.

The SEC-CFTC preliminary report on the crash contains a wealth of information and some interesting clues about the kinds of strategies that may have been implicated. First, "approximately 200 securities traded, at their lows, almost 100% below their previous day’s values." These trades, "occurred at extraordinarily low prices – five cents or less – which indicates an execution against a “stub” quote of a market maker." The overwhelming majority of these trades, it turns out, were short sales:

During the period of peak market volatility, 2:45 p.m. to 2:55 p.m., the broken trades executed at five cents or less were primarily short sales. Short sales account for approximately 70.1% of executions against “stub” quotes between 2:45 p.m. and 2:50 p.m., and approximately 90.1% of executions against “stub” quotes between 2:50 p.m. and 2:55 p.m.

In other words, the trades at the most extreme prices were not generated by retail investors whose stop loss orders were converted to market sell orders as prices fell: they were generated by short selling in a falling market.

Also interesting is the case of securities that displayed "aberrant behavior" on the upside:

Sotheby’s (BID) is actively traded and has a narrow bid-ask spread from 2:44 p.m. through 2:49 p.m. after which volume is low but bid and ask quotes remain stable. However, after about 2:57 p.m. volume spikes dramatically and trades are executed at a high (presumably stub) quote of approximately $100,000... BID trades through the national best offer multiple times between 2:57:05 p.m. and 2:57:12 p.m. This includes trades at approximately $100,000 which is presumably a top-end stub quote.

A single round lot of shares in Sotheby's would have cost ten million dollars at this price. Given that the orders were executed, it seems inconceivable to me that they came from retail investors.

What kinds of strategies could have been responsible for these trades? In January of this year the SEC published a Concept Release on Equity Market Structure that explicitly discussed the destabilizing consequences of certain strategies used by proprietary trading firms. Of special concern were strategies based on order anticipation and momentum ignition:

One example of an order anticipation strategy is when a proprietary firm seeks to ascertain the existence of one or more large buyers (sellers) in the market and to buy (sell) ahead of the large orders with the goal of capturing a price movement in the direction of the large trading interest... The type of order anticipation strategy referred to in this release involves any means to ascertain the existence of a large buyer (seller) that does not involve violation of a duty, misappropriation of information, or other misconduct. Examples include the employment of sophisticated pattern recognition software to ascertain from publicly available information the existence of a large buyer (seller), or the sophisticated use of orders to “ping” different market centers in an attempt to locate and trade in front of large buyers and sellers... An important issue for purposes of this release is whether the current market structure and the availability of sophisticated, high-speed trading tools enable proprietary firms to engage in order anticipation strategies on a greater scale than in the past.

A very different type of potentially destabilizing strategy seeks to engineer and exploit momentum in prices:

Another type of directional strategy that may raise concerns in the current market structure is momentum ignition. With this strategy, the proprietary firm may initiate a series of orders and trades... in an attempt to ignite a rapid price move either up or down. For example, the trader may intend that the rapid submission and cancellation of many orders, along with the execution of some trades, will “spoof” the algorithms of other traders into action and cause them to buy (sell) more aggressively. Or the trader may intend to trigger standing stop loss orders that would help cause a price decline. By establishing a position early, the proprietary firm will attempt to profit by subsequently liquidating the position if successful in igniting a price movement.

Order anticipation and momentum ignition are just extreme cases of a broad range of directional strategies that are either information extracting or seek to trigger information extracting algorithms. If too great a share of total market activity is driven by such strategies, major departures of prices from fundamentals will arise sooner or later. It is important, therefore, to allow such strategies to take heavy losses when they do eventually misfire. Macroeconomic Resilience has an excellent analytical post on the crash that makes a similar point:

Policy measures that aim to stabilise the system by countering the impact of positive feedback processes select against and weed out negative feedback processes – Stabilisation reduces system resilience. The decision to cancel errant trades is an example of such a measure. It is critical that all market participants who implement positive feedback strategies... suffer losses and those who step in to buy in times of chaos i.e. the negative-feedback providers are not denied of the profits that would accrue to them if markets recover. This is the real damage done by policy paradigms such as the “Greenspan/Bernanke Put” that implicitly protect asset markets. They leave us with a fragile market prone to collapse even with a “normal storm”, unless there is further intervention as we saw from the EU/ECB. Of course, every subsequent intervention that aims to stabilise the system only further reduces its resilience.

By canceling trades, the exchanges reversed a redistribution of wealth that would have altered the composition of strategies in the trading population. I'm sure that many retail investors whose stop loss orders were executed at prices far below anticipated levels were relieved. But the preponderance of short sales among trades at the lowest prices and the fact that aberrant price behavior also occurred on the upside suggests to me that the largest beneficiaries of the cancellation were proprietary trading firms making directional bets based on rapid responses to incoming market data. The widespread cancellation of trades following the crash served as an implicit subsidy to such strategies and, from the perspective of market stability, is likely to prove counter-productive.

James Tobin's Hirsch Lecture

2010-05-15T21:02:00.000-04:00

James Tobin's Fred Hirsch Memorial Lecture "On the Efficiency of the Financial System" was originally published in a 1984 issue of the Lloyds Bank Review, and republished three years later in a collection of his writings. Willem Buiter discussed the essay at some length about a year ago in a provocative post dealing with the regulation of derivatives. Both the original essay and Buiter's discussion of it remain well worth reading today as guides to the broad principles that ought to underlie financial market reform.

In his essay, Tobin considers four distinct conceptions of financial market efficiency:

Efficiency has several different meanings: first, a market is 'efficient' if it is on average impossible to gain from trading on the basis of generally available public information... Efficiency in this meaning I call information arbitrage efficiency.

A second and deeper meaning is the following: a market in a financial asset is efficient if if its valuations reflect accurately the future payments to which the asset gives title... I call this concept fundamental valuation efficiency.

Third, a system of financial markets is efficient if it enables economic agents to insure for themselves deliveries of goods and services in all future contingencies, either by surrendering some of their own resources now or by contracting to deliver them in specified future contingencies... I call efficiency in this Arrow-Debreu sense full insurance efficiency.

The fourth concept relates more concretely to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to to their more socially productive uses. I call efficiency in these respects functional efficiency.

The first two criteria correspond, respectively, to weak and strong versions of the efficient markets hypothesis. Tobin argues that the weak form is generally satisfied on the grounds that "actively managed portfolios, allowance made for transactions costs, do not beat the market." He notes, however that efficiency in the second (strong form) sense is "by no means implied" by this, and that "market speculation multiplies several fold the underlying fundamental variability of dividends and earnings."

My own view of the matter (expressed in an earlier post) is that such a neat separation of these two concepts of efficiency is too limiting: endogenous variations in the composition of trading strategies result in alternating periods of high and low volatility. Nevertheless, as an approximate view of market efficiency over long horizons, I feel that Tobin's characterization is about right.

Full insurance efficiency requires complete markets in state contingent claims. This is a theoretical ideal that is impossible to attain in practice for a variety of reasons: the real resource costs of contracting, the thinness of potential markets for exotic contingent claims, and the difficulty of dispute resolution. Nevertheless, Tobin argues for the introduction of new assets that insure against major contingencies such as inflation, and securities of this kind have indeed been introduced since his essay was published.

Finally, Tobin turns to functional efficiency, and this is where he expresses greatest concern:

What is clear that very little of the work done by the securities industry, as gauged by the volume of market activity, has to do with the financing of real investment in any very direct way. Likewise, those markets have very little to do, in aggregate, with the translation of the saving of households into corporate business investment. That process occurs mainly outside the market, as retention of earnings gradually and irregularly augments the value of equity shares...

I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this 'paper economy', not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitation nth-degree speculation which is short sighted and inefficient...

Arrow and Debreu did not have continuous sequential trading in mind; when that occurs, as Keynes noted, it attracts short-horizon speculators and middlemen, and distorts or dilutes the influence of fundamentals on prices. I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.

Recall that these passages were published in 1984; the financial sector has since been transformed beyond recognition. Buiter argues that Tobin's concerns about functional efficiency are more valid today than they have ever been, and is particularly concerned with derivatives contacts involving directional bets by both parties to the transaction:

[Since] derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution. Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.

The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults. Defaults, insolvency and bankruptcy are key components of a market economy based on property rights. There involve more than a redistribution of property rights (both income and control rights). They also destroy real resources. The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved. There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners. But there is such a thing as insolvency for losers, if the losses are large enough.

The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple. The party purchasing the insurance should be able to demonstrate an insurable interest. [Credit Default Swaps] could only be bought and sold in combination with a matching amount of the underlying security.

The debate over naked credit default swaps is contentious and continues to rage. While market liquidity and stability have been central themes in this debate to date, it might be useful also to view the issue through the lens of functional efficiency. More generally, we ought to be asking whether Tobin was right to be concerned about the size of the financial sector in his day, and whether its dramatic growth over the couple of decades since then has been functional or dysfunctional on balance.