Corzine idea

I was just watching Jon Corzine on the Daily Show and I got to thinking about an idea for a research paper. It would be interesting to trace the major Cabinet secretaries (like Defense, Treasury, etc) back to Wall Street. It would be interesting to look at their political ideologies and see how Wall Street has or hasn't influenced them generally over time and was there any bias to a certain political party (or ideology, since the parties have changed)?

Willing to admit it

Arnold Kling posted today about how Economists as a whole do not know what is going on and that their textbook models are wrong. I couldn't agree more. However, I haven't spoken with anyone who has said, "wow this Rational Exepectations model really helped me forecast this crisis."

Two of my colleagues and I spent some time with Johnny Walker this afternoon... wait I mean John Walker of Oxford Economics. He seemed perfectly willing to admit that his workhorse economic model doesn't work well during this time period. I'm not sure how true this is for academic economists who build models, but I would think that most people who spend their time forecasting are perfectly willing to admit that they use them as a tool to think about the economy rather than something absolute.

In principle Kling is right, it is better to admit pseudo-knowledge than not admit it. I just think that professionals are more willing to admit it than he gives them credit for.

How the financial collapse killed libertarianism by partisan hack

I love these death of articles by people ignorant of not just the political philosophy that is their subject, but also the conditions leading to its collapse.

Let us start with his claim that, "after LTCM's collapse, it became abundantly clear to anyone paying attention to this unfortunately esoteric issue that unregulated credit market derivatives posed risks to the global financial system, and that supervision and limits of some kind were advisable." First, credit default swaps as we know them today were still in their infancy in 1998 so it would be difficult to say they were as important to LTCM's collapse as Myron Scholes' shoes were. Second, he's attacking the wrong problem, to me, one of the biggest lessons from LTCM is that risk-models and excessive leverage are a dangerous combination. Those problems were never fixed, but it is hard to say that libertarianism is or isn't the culprit. Libertarians would say that banks who lend money to institutions who use excessive leverage might fail if the bets go wrong, and they should be allowed to fail. Harping on, the author notes that "the Washington Post ran an excellent piece this week on how one such attempt to regulate credit derivatives got derailed." Again, the author fails to distinguish between a credit derivative and a derivative. That article is as much about regulating currency and bond derivatives as it is about CDS.

So here again we are faced with the theory that conservatives, liberals, and a central banker who control the government, conspired together to halt attempts to regulate derivatives. The reader is left to his or her imagination to determine how regulating derivatives would have made a difference. I agree with Ritholtz that the decision to allow investment banks to lever up to more than 30x from their original 15x was a mistake. However, I'm not quite sure what else would have or could have been done. Much of the trade in CREDIT derivatives was to get bad assets or the impact of said assets off their balance sheet, a form of regulatory arbitrage. If they threw up some more regulations, I have little doubt that the industry would have tried to find new, exciting, and complex ways around it.

The author notes that consistent libertarians, as opposed to conservatives like Gramm that he is confusing with libertarians, opposed the bail-out and then he invokes the Great Depression that many could be employed in soup-kitchens. Implicitly he is tying the libertarians with the liquidationist view of the Great Depression. L. White has done a great job explaining how Mellon wasn't a liquidationist and Hayek and Robbins weren't liquidationists.

Finally he argues, "libertarians react to the world's failing to conform to their model by asking where the world went wrong. Their heroic view of capitalism makes it difficult for them to accept that markets can be irrational, misunderstand risk, and misallocate resources or that financial systems without vigorous government oversight and the capacity for pragmatic intervention constitute a recipe for disaster."
First, there are libertarians who believe the market is efficient and there are libertarians who do not believe that. I would say that there are many many more in the latter category. I'm perfectly willing to say that markets can be irrational, misunderstand risk, and misallocate resources. However, I would also be willing to say that almost all of the times when they do this, you can point to a government regulation or a government program that is leading to this. The ABCT doesn't really describe the depth of our current situation on its own, but it sure does a good job explaining how the government encouraged the market to misallocate resources into the housing boom. The difference between the author and I is that I want to see market oversight and market regulation where he only is looking to the government for the solution. Well, I think there are plenty of cases where you can point to the government being the problem.

What's interesting to me, is that the death of socialism was predicted by Hayek and the Austrians several decades before it happened. In all reality, I'll admit that what the Soviets had and Chinese (before Deng) had wasn't really socialism. It was only really tried in the WW1 War Economy in Russia and it failed miserably, as predicted. The system that grew out of it, at least in Russia, was more of a market socialism, mostly socialism, but a little markets and freedom thrown in. Libertarians, mostly Hayekians, have predicted that the global financial system is unsustainable in its current form. Many predicted that the housing boom would lead to a situation like what we're currently experiencing. That's because what we don't have is capitalism and anyone with a brain should realize that. Even before the bail-out bill, we were on our third-way, though not as far to the socialist side as Europe. It's not that this doesn't fit with our model, but when you take our government and say we live in a capitalist country. People like me need and have stood up and said we do not live in a capitalist country. Our theories aren't to blame, our theories told us we would end up in this mess.

Malkiel's Wambulance

"It is very tempting to try to time the market. We all have 20/20 hindsight. It is clear that selling stocks a year ago would have been an excellent strategy. But neither individuals nor investment professionals can consistently time the market." - Burton Malkiel

My problem with this statement is that it is not specific. I would agree with him that investment professionals can't time the market on a short-term or medium-term basis, for the most part. However, pretty much everyone knew without 20/20 hindsight that there were big problems in the financial sector, more than a year ago. Some people, using insights from a variety of schools of thought or just plain, old common sense, got out of the market. You don't need to time the market when it goes up, you just need to know that business cycles happen and it pays to get out of the market when the downturn is coming. The regular investor can index away in the good times, but that doesn't mean that always indexing is the proper course of action.

Risk and Uncertainty

What I don't like about Free Exchange is that I have no idea who the authors are who contribute to it. I don't know to always read and who to take with a grain of salt.

Here they note that modern finance "seeks to turn uncertainty into risk. You cannot quantify uncertainty, and you cannot trade it. It is pre-finance—and it can be corrosive. Risk, on the other hand, is a probability distribution. It is quantifiable. You can model it and analyse it and it has a value. Therefore, you can trade it." They are right on what modern finance seeks to do and the difference between uncertainty and risk. My problem lies with modern finance and actually turning uncertainty into risk.

I view uncertainty and risk from a Knightian lens. Risk is measurable, uncertainty is not: "The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. ... It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We ... accordingly restrict the term "uncertainty" to cases of the non-quantitive type."

So, that leads me to wonder can you actually convert uncertainty into risk or can you only reduce and spread out risk? Knight says that risk has an ex-ante probability distribution. In trying to get life insurance, from my perspective I have uncertainty because I cannot measure my risk, but the insurance company can and from their perspective it's a problem of risk. Subjectively, after I get insurance, I would know that after my death, my family would be taken care of. I would no longer have uncertainty (on this one part of the uncertainty of my death, there's a minimum of two others, like how and when), but the insurance company has gained a risk. Actually that may not be accurate. Maybe it is also uncertainty when it hits the balance sheet of the insurance company? Perhaps it is the subjective determination of the insurance company that makes it risk rather than uncertainty? This explanation seems lacking to me. A probability distribution seems outside of value and outside of the human mind. A more satisfying explanation, to me, is that the payouts on the insurance contract are uncertain by themselves for the individual and when transferred to the insurance company. They become risk when there are enough of them that produce a probability distribution.

As an example from modern finance, if you take a bunch of MBS and pool them into a CDO, you have certainly pooled them, but the pool of assets or the structure do not become a measureable probability distribution. So what you have with CDOs is not risk diversification, but taking a bunch of assets with uncertain payoffs, pooling them in a complex structure, and then sending different levels of uncertainty to people. Risk is not diversified, but different levels of uncertainty are spread out among the owners of the tranches to the CDO.