Peter Thiel on Irrational Faith in Economic Growth

Of the financial crisis, Thiel says, “Certain assumptions were just wrong. One was that housing prices would always go up. And that is probably a true assumption in a world where you have massive growth. When you don’t have growth, it’s not true…the reason they made that mistake is because you can’t have growth if there’s no progress on the technology front.”

See more here. 

Behavioral Economics Explains All and Saves All

So says David Leonhardt in the Times. But let’s say you work for a firm that specializes in applying the latest theories in management and organizational behavior.  Idea factories, like HBS and Wharton, spew out cutting edge techniques and models, sending them to dealerships like Boston Consulting Group and McBain. Hordes of 22 year olds fight for the opportunity to work at the dealerships, where they are promptly turned into cubicle donkeys whose sole aim is to help businesses lower the costs of production while maintaining or improving the quality of the product.  It’s all good, there’s nothing new in any of this and you get to write “Management Consultant” on your egg shell white business card.  Yawn.  

But now you’ve read about some great new theories in management consulting, only instead of coming out of HBS or Wharton, these theories have respectable return addresses in economics and psychology departments.  As a purveyor of these theories, your social life immediately changes. Instead of saying management consultant, you get to call yourself a “behavioral economist.”  Suddenly you are a savior and David Leonhardt sings hosannahs, praising everything you have to say as the new new thing:

“The sort of deficit we’re now facing will require some pretty creative plans. Fortunately, there is a group of economists who are almost ideally suited to help Mr. Obama with this task — to come up with budget cuts that can reduce government spending without harming the quality of government services. They’re called behavioral economists.”

Why all the name changing? Why not just call them management consultants? Obviously because these are no ordinary management consultants. They don’t work for profit. They don’t help businesses. These are the holy beasts of the new paradigm, immune to the constraints of common sense and history. They are the agents of change we can believe in.  To the rescue, come forth the behavioral economists: 

“This person would work with Medicare officials to improve drug compliance. He or she would think about how mortgage regulations should be rewritten, how health insurance choices should be presented and how carbon emissions might be cut.”

And the dollar will do this, and the yuan will do that, and the rising tide of the nationalistic nanny state will lift all the subprime dinghies carrying our irrational good grey burghers. Why did our burghers buy those risky subprimes?  Such a foolish question! Obviously the behavioral economists know why! Sez Sendhil Mullainathan of Harvard: 

“It’s impossible to think of the current mortgage crisis without thinking seriously about underlying consumer psychology. And it’s impossible to think of future regulatory fixes without thinking seriously about that issue.”

I’m patiently waiting for all those behavioral economists to announce the record earnings they obtained by acting on their theories in advance of the current crisis.  I’d also like to know how the principal agent problem figures in their analysis, as well as other neoclassical explanations involving the perverse incentives endemic to organizations like Freddie and Fannie. Alternatively, they could always just call themselves management consultants. After all, I hear Goldman and Morgan Stanely are looking for better ways to run their business.

To What Extent Does Behavioral Economics Explain Mania in Finance?

I say very little, but I’m willing to be convinced. One very implausible, but popular line of reasoning runs along these lines: neoclassical economics assumes every agent is rational and fully informed; the euphoria inflating the real estate bubble was obviously not rational; therefore, neoclassical economics fails to explain the current crisis. Having reached this conclusion, it’s only a short step to the corollary that free markets create catastrophic social consequences.

When Alan Greenspan confessed before a congressional committee that he had revised his assumptions about economics in light of current events, people, notably those on the left, took his mea culpa as the symbolic end of a paradigm. Here at last, in public, a former disciple of Ayn Rand, the prophet in the age of turbulence, had finally announced what all those good gray burghers in coastal college towns long suspected: the science of economics is no science at all. Call off all the bets! Anything goes! In Thomas Kuhn’s notorious phrase, normal economic science is out, revolutionary, paradigm shifting economics is in.

In this vein, Niall Ferguson offers his take on the end of Wall Street:

The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. 

But this is the weakest part of Ferguson’s analysis. His greatest insight has nothing to do with rationality assumptions. Instead, his strongest arguments about mania rely on a fairly straight forward concept: old motivations coupled with poor design. Behavioral economics was not the first science to identify the vice of stupidity. And neoclassical economics doesn’t assume away incompetence. If the idealism of internet freebooters inflated the dot-com bubble, then likewise it was a version of the American Dream that inflated this one–the property owning society. As Ferguson says: 

There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.

More interesting to me would be an explanation showing how this generous and confident spirit percolated not just through the financial system, but also through the the populace and their government. In the end I suspect it is less man’s behavioral fallibility that brought us to the brink, but more his good-will.

Michael Lewis Out Scoops Them All

Michael Lewis has a must read article on the implosion of finance. He calls it the end of wall street. It’s an article so clear in its import that, upon reading it, the left wing Lepermessiah at the DailyKos writes: 

Congress and/or Obama must stop these people from looting the treasury. The Bailout is the biggest bank heist in human history. It must be stopped.

Of course, telling a lefty to close the state coffers once they’ve been opened is like telling a rioter heisting a television to return that property to its rightful owner.  Not gonna happen. And who are you to blow whistles at a party? Anyway, underlying all the layers of dogshit–the BBB rated subprimes, the CDOs built on them, the bond rating agencies that gave CDOs USDA approval, Freddie, Fannie, Marx, Ayn Rand, and L. Ron Hubbard–Michael Lewis identifies the seed of destruction as the principal-agent problem. Once investment banks went public, transferring responsibility for loses from a relatively small group of well-informed owners to a much larger and therefore diffuse set of shareholders, the long-term consequences of managing risk poorly became nil for the suits running the investment banks. (Those long term consequences become even more remote if you can count on the time-servers in government to bail you out.) But what’s particularly electrifying about Lewis’s article is that the principal agent problem leads him back to his old nemesis from Liar’s Poker, John Gutfreund, former CEO of Solomon Brothers. Lewis invites the old adversary to lunch and delivers this wonderful scene for us: 

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit. 

No partnership, for that matter, would have hired me or anyone remotely like me. Was there ever any correlation between the ability to get in and out of Princeton and a talent for taking financial risk? 

Now I asked Gutfreund about his biggest decision. [to go public] “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game….

“No,” he said, “I think we can agree about this: Your fucking book [Liar’s Poker] destroyed my career, and it made yours.” With that, the former king of a former Wall Street lifted the plate that held his appetizer and asked sweetly, “Would you like a deviled egg?”

As they say, read the whole thing. It’s a tale full of idiots and the geniuses who benefited from their stupidity. 

But oh yeah, one more thing. The illustrious journal Nature will soon publish this article by Jean-Philippe Bouchaud in which he states: 

Surprisingly, classical economics has no framework through which to understand ‘wild’ markets…We need to break away from classical economics and develop completely different tools.

Someone should make that Frenchman elucidate how Lewis, using concepts at home in the reigning paradigm in economics, is wrong in his diagnosis.

Posner Calls It a Depression

The honorable judge has gone a bit daffy. He writes: 

By undermining faith in free markets, the depression opens the door to more government intervention in the economy and eventually to higher taxes (though probably not until the economy improves). These are not necessarily bad things. Obviously neither the optimal amount of government intervention nor the optimal level of taxation is zero.

So if we accept that the optimal amount of government intervention is not zero, then what?  In a leap of idiocy, a non sequitur of numbing grossness, the judge concludes the optimal level is somewhere between the Truman presidency and the Johnson years. What a joke. 

So taxes will have to rise. Federal taxes as a percentage of Gross Domestic Product are no higher today than they were in the 1940s, 1950s, and 1960s—periods of healthy economic growth. The marginal income tax rate reached 94 percent in 1945 and did not decline to 70 percent until 1964 (it is 35 percent today). A modest increase in marginal rates from their present low level would increase tax revenues substantially…

Applied Nozick: Finessing The Entitlement Theory

Richard Epstein uses Robert Nozick’s entitlement theory of justice to interpret the ideology behind the financial meltdown. From Epstein’s latest Forbes column: 

Behind this lending fiasco lay the strong collective preference for the “patterned principles” of justice that Robert Nozick attacked so powerfully in his 1974 masterpiece, Anarchy, State, and Utopia.

Believers in patterned principles hold that there is some preordained social order that is more just than others. Accordingly, the function of the state is to use the levers of power to manipulate behavior to achieve the desired outcomes. These patterned principles stand in opposition to historical principles of justice, which are content to establish the rules of the game and then let the legal moves by individual players determine the social outcomes. For Nozick, the key rules were rules of justice in acquisition (to set up the initial property rights) and justice in transfer, whereby those rights (and others derived from them) could be exchanged or combined through voluntary transactions.

What were the patterns of justice our time-serving congressmen wished to impose on our society? Apparently one that says the US economy should have 12% of all mortgages issued to low-income borrowers in 1996, 20% in 2000, 22% in 2005 and 28% by 2008. I can’t think of any coherent political philosophy that would specifically set these goals with clear justifications. Time-serving bureaucrats must have simply thought 30% was a good number. It sounds like a fair share of the housing market pie, but then again, why not just say 50%? Hell, let’s say 80%! (Bonus question in applied political philosophy: try to justify any pattern in home-ownership according to Rawls’s Difference Principle.)

On the entitlement theory things would have been different. Channeling Nozick, Epstein makes a plea:

Let people rent or buy in unsubsidized markets and then watch with supreme indifference what residential patterns emerge. That distribution would have been a lot less toxic than the brew generated by our fevered political leaders. So says our frustrated libertarian. 

And so I say, too. When Nozick introduced his entitlement theory back in 1974, he thought he was providing a rights-based argument against competing theories of justice, one powerful enough to outshine the others without having to appeal to the consequences of acting on the theory. Utilitarianism was the bugbear. Nozick had hoped his principles of transfer and acquisition would have greater intuitive moral appeal, enabling the entitlement theory to rise above any type of anything goes consequentialism. Let justice be done tho the heavens may fall–that was the thing. But, intrinsic moral value aside, Epstein’s right here. Applied Nozick turns out to yield the best consequences. Ironically it also satisfies Rawls’s Difference Principle along the way, too.

Paulson Uses Nepotism to Provide Financial Stability

Today, the Wall Street Journal reports that Treasury Sec Paulson will name an old disciple from Goldman Sachs, Neel Kashkari, to manage the $700 billion bailout to buy distressed assets from financial institutions. Mr. Kashkari will get to tell his friends he’s the head of the Office Ministry of Financial Stability. Though Kashkari has an MBA from Wharton, not Harvard, I’m going to say this supports Arnold Kling’s ominous prediction: 

Big Finance and Big Government have much in common. Both are coveted by Harvard graduates. Both are characterized by an arrogant sense of entitlement and importance.

Instead of thinking of the pending bailouts and financial regulation as a new era of government supervisions of markets, think of it as preserving the system in which a Harvard elite controls other people’s money. In fact, very little is likely to change. Reading the news stories about how Secretary Paulson plans to implement the bailout, it seems as though the same people will be in charge of the money. Print some new business cards, change the logo on the front from “Goldman Sachs” to “U.S. Treasury,” and everything else continues as it was. It’s just that it becomes a lot more difficult for ordinary people to opt out of using the elite’s money management services.

Culpable Rating Agencies

S & P, Moody’s & Co., and Fitch–a portfolio manager tells me I shouldn’t overlook the culpability of these rating agencies for misjudging and then cloaking the risk involved in the sub-prime mortgage market. By law, investment banks and other financial entities would have been prohibited from adding so many risky mortgage-backed securities to their books. Pension funds, banks, money market funds, and insurers can only buy debt rated “investment grade” by a Nationally Recognized Statistical Ratings Organization (NRSRO). The SEC doles out this “recognition” and S&P, Moody’s, and Fitch are the only rating agencies so recognized. Since these rating agencies assessed the sub-prime packages as top shelf debt–AAA-the banks took the bait and swallowed the hook. When the debt was finally downgraded, the crunch followed. 

You would think that independent rating agencies would have every incentive to provide reliable information. But that would assume there was an open market for rating agencies, one without any barriers to entry. Unsurprisingly this is not so. According to Forbes: 

Regulators have long kept other agencies from competing with Moody’s, S&P and Fitch, despite their supporting roles in high-profile blowups like Enron and the 1997 Asian financial crisis. How? By requiring that only firms that the Securities and Exchange Commission designates as Nationally Recognized Statistical Ratings Organizations can be the final word on credit quality. Since the NRSRO designation is the only one that matters to world’s largest investors and financial institutions, Moody’s, S&P, and Fitch essentially have a lock on the trillions of dollars in debt issued each year…In order to be considered for the designation, the SEC requires a firm to be “nationally recognized” as an “issuer of credible and reliable ratings” by “the predominant users of securities ratings.” But since predominant users, like pension funds, are required to use NRSROs, smaller firms have a hard time meeting the “nationally recognized” threshold.

Yeah, go figure…

Hedge Fund Managers Deserve Their Salaries Because They’re Smarter

The ever insightful Richard Posner writes: 

I do not think that the government does bear much responsibility for the crisis. I fear that the responsibility falls almost entirely on the private sector. The people running financial institutions, along with financial analysts, academics, and other knowledgeable insiders, believed incorrectly (or accepted the beliefs of others) that by means of highly complex financial instruments they could greatly reduce the risk of borrowing and by doing so increase leverage (the ratio of debt to equity).

Posner fails to consider a host of contributing factors originating from government sources: the moral hazard Freddie and Fannie create, perverse tax incentives (starting in ’97) to overstimulate investment in housing, and the Clinton administration’s policies (again, starting in ’97) to increase home ownership among the poor. Still, the venerable Judge has a point. If all these mortgages were suspect, then why did all those Ivy Leaguers on the trading desks eat them up? Shouldn’t their 150 IQs have included a bullshit detector? Quoth the Seventh Circuit Judge:

It should be noted that because of the enormous rewards available to successful financiers, the financial industry attracted enormously able people. It was not a deficiency in IQ that produced the crisis.

But are they able enough? And were the rewards high enough to attract the most able? The New York Observer has been the first to buttonhole Tom Wolfe and ask him what he thinks of the current crisis. (It’s about time someone got a hold of him, fer Christ sake. Whenever there’s a Wall Street story, a thousand reporters invariably trundle out references to the Bonfire of the Vanities and the Masters of the Universe.) Wolfe has a peculiar theory about the failure of investment banks–it’s brain drain, he says. Instead of turning into cubicle donkeys, the best and the brightest in finance have all found their way to hedge funds, leaving space at the trading desks for all the second-raters out of Harvard. Herr Wolfe:

 there’s nothing as second-rate as investment banks. Every smart and ambitious young man—and forget young women because they don’t play any role in this—wants to be in a hedge fund. And I’d be surprised if the hedge funds implode, they’re just smarter. … What bright guy wants to be an executive for a firm like Lehman Brothers, where you have to hold the hand of disgruntled employees, you hold the hand of disgruntled directors, you’re constantly nice and wearing the right clothes? That’s for real second-raters. … It’s only the bottom of the barrel that’s left in these companies. The new Wall Street is Greenwich, Conn. You don’t need these big glass silos full of people. Look at the number of employees. Lehman? 28,000! And a Greenwich hedge fund can handle the same amount of money with 20 employees. 

And just for kicks, Wolfe adds, “Did I mention to you I’m pimping out my cars?”

Attorney Generalissimo Cuomo to Einhorn: You Know Too Much!

Our man of the hour, David Einhorn, has said academic research and his firm’s experience indicate that whenever management complains about short-selling, it is a sign that management is attempting to distract investors from serious problems. Einhorn said that back in May. I would like to add a corollary to Einhorn’s principle: whenever management convinces regulators and attorney generals that short-selling is a problem, it is a sign that entrenched interests are using the state to protect their firms from the gales of creative destruction. 

Today’s story begins with John Mack of Morgan Stanley working in concert with Lloyd Blankfein of Goldman Sachs to persuade numerous federal officials to ban the short-selling of stocks. Much to their delight, I am sure, Andrew Cuomo entered from stage right, announcing he is opening “a wide-ranging investigation into short selling in the financial market.” (These New York Attorney Generals sure know how to wag a finger!) Unsurprisingly, the attorney general’s logic is impeccable: “Short selling is not illegal,” he says, “but when combined with the spread of wrong information, that is illegal.” So without offering so much as a hint as to what false information has been circulating throughout the markets–the implication of his quote is that the downfall of Lehman was unjustified, since it was based on false information–Attorney Generalissimo Cuomo deftly concludes, “I believe the SEC should freeze short selling of financial stocks on a temporary basis.”

But the problem isn’t that false information is putting undue downward pressure on the price of stocks in the banking industry. The problem is that the information available is damning. Lehman deserved to fail, short-selling of their stock notwithstanding. In fact, short-sellers like Einhorn provide a valuable service, first by trading on this information, but secondly, and most importantly in Einhorn’s case, by making this information public. So what are we to conclude from Mack’s statements? (Other than that he has some influence in the attorney general’s office?)

Michael Lewis raises a good point here. He says one positive upshot of the Lehman collapse is that we’ll finally get to see inside a big Wall Street firm. With Lehman, he writes:

 We’ve just witnessed the largest bankruptcy in U.S. history and we know neither the inciting incident (though there is speculation that sovereign wealth funds decided to stop lending to Lehman Brothers Holdings Inc.), nor the deep cause. But there’s now a pile of assets and liabilities smoldering in New York awaiting inspection.

The assets include subprime mortgage-backed bonds and no doubt many other things that aren’t worth as much as Lehman hoped they might be worth. But it’s the liabilities that are most intriguing, as they include more than $700 billion in notional derivatives contracts. Some of that is insurance sold by Lehman, against the risk of other companies defaulting.

Natural Question

The entire pile might be benign, but somehow I doubt it. We may well find out that Lehman Brothers, in liquidation, has a negative value of hundreds of billions of dollars. In that case the natural question will be: How much better could things be inside Morgan Stanley and Goldman Sachs, both of which were engaged in the same lines of business?

If things are only marginally better for Morgan or Goldman, then investors need to know. They also ought to be allowed to trade on that information. If some bureaucratic time-server manages to forbid short-selling, then contrary to Cuomo’s assertion, they wouldn’t be preventing irrational selling on false information. Oh no, good citizens–they would be preventing you from trading upon the truth.

See also Robin Hanson here. And Michael Lewis again.