...Archive for June 2007

Synthetic greater fools

Yves Smith at Naked Capitalism, riffing on a post by James Hamilton, ponders the question of why some CDO investors might have bought securities that were “losers at the start”. Hamilton suggests that investors must not have understood what they were doing. As Yves puts it, “[H]ow could investors be so dumb? The buyers were institutional investors, after all. These guys are supposed to be pros.” Yves suggests that underwriters, sometimes believing their own hype, sometimes with adroit porcine cosmetology, did a great job of selling iffy paper. Here’s another explanation, on the buy-side.

Do you remember the “greater fool” theory of investing from the late-1990s? For many high-flying internet stocks, the disconnect between stock prices and “fundamental” valuation was so obvious that buyers knew they were purchasing securities which, if held for the long-term, offered negative expected return. But it was quite rational to buy them anyway, so long as it seemed likely that someone else, a “greater fool”, would buy them at an even higher price than the one you paid. Most serious players understood there would be a reckoning someday, but that there was lots of money to be made today regardless. The risk-return tradeoff on playing the fool for just a little while was quite favorable. Those willing to take big chances for a short time, and smart enough not to try to play “double-or-nothing” indefinitely, did very, very well for themselves.

At first blush, today’s markets look nothing like the heady stockmarkets of the 1990s. After all, many of the securities that seem overvalued now rarely trade: structured credits backed by mortgages, commercial debt, credit cards, etc. Generally an underwriter sells an offering to institutional investors, who may plan to hold the paper to maturity. If secondary markets are thin, if no one is buying or selling, who could be the greater fool?

But, in fact, it is not “institutions” that buy this paper, but managers who are paid for performance. And from a manager’s perspective, all these securities do trade, about once a year, when bonuses and performance fees are taken. During bonus season, hypothetical valuations of illiquid securities become converted into liquid nonrefundable cash, just like during an ordinary sale. Institutions effectively purchase securities from themselves, at arbitrarily high prices, and pay their managers a commission for the privilege. Financial innovation truly has been a wonder these last years. Institutions have cut out the middlemen and become their own greater fools, to the benefit of managers and the detriment of other stakeholders.

Many managers would be quite content with short, lucrative careers followed by long, wealthy retirements. They are faced with opportunities to “earn” money on so grand a scale that a rational person, looking at historical norms, would sacrifice a lifetime’s wages for a few good years. At extremes, shame and legal risk constrain manager behavior. But, to the degree individual managers can attribute self-interested behavior to evolving norms and standards in their profession, they are protected. A “safe” position, from a manager’s perspective, is one in which losses to the portfolio they manage are likely to be accompanied by widespread losses elsewhere, so that blame attaches to vast, vague “systemic” problems, and not to the manager personally, who was, after all, only one person, doing her job like so many others. Surely no liability, and no great ostracism, should attach to that.

Like a polluter earning immediate visible profits but exacting diffuse, hard-to-measure costs, managers at hedge funds, endowments, and pension funds are producing cash and “diffusing” risk whose costs will eventually be borne by someone. Institutions may now be their own greater fools, but the rest of us, apparent bystanders, may turn out to be the greatest fools of all.

The Bear and the Dragon

Gather ’round ye cassandras and dark oracles, nigh the time is come! The wounded bear roars and writhes, and surely, surely! his claws at last will prick the green tumescence of the credit pimple, and a pustulence of default and devaluation will gurgle across the land!

Or not. The crisis at two hedge funds managed by Bear Stearns has all the markings of a systemic-crisis-threatening event. (If you’ve not been following, tsk. Naked Capitalism has been doing a phenomenal job covering the story.) But I don’t think anything bad is going to happen, because the bear and his friends in the forest (hedgehogs?) are, ultimately, protected by the Dragon.

First let’s review the what happened. Bear managed a hedge fund that made leveraged bets in illiquid CDOs backed by subprime mortgages. That was a winning strategy for a long time, so, by popular demand, Bear opened a second fund taking on even more (um, “enhanced”) leverage to reap those juicy mortgage yields. But, things have gone suddenly wrong in mortgageland, and the funds were forced to inform investors that they had lost a lot of money. Investors found themselves locked in, with lenders demanding that the funds put up more collateral or face forced liquidation of their assets.

Forced liquidation would have been, um, bad, from a green-pustulence-flowing-in-the-streets perspective. There are lots of hedge funds holding illiquid, hard-to-value synthetic debt based on iffy mortgages. With help from debt-rating agencies, fund managers are employing the strategy Wile E. Coyote would have followed, if he were smart enough to understand Gaussian copulas and stuff. It’s called “Don’t Look Down!” Since exotic securities don’t trade very often, there is no clear market price, no clear value to which funds have to “mark” their portfolios. So hedge fund managers use models to make educated guesses of what their securities are worth. Since managers earn fees by seeming to perform well, they tend to use models that, lo and behold, spit out optimistic, all-is-well valuations of their portfolios. However, a “fire sale” at Bear would put Wall Street Panglossians under pressure, as all of a sudden market prices, not very nice market prices, would be attached to securities quite similar to the ones in their own portfolios.

Let’s understand what we mean by “pressure” here. Imagine you’re a hedge fund manager sitting on a pile of leveraged rocket science that you privately think has lost much of its value. You have two choices. You can use a model that captures your intuition, and mark down the assets, forfeiting any performance fees and your seven figure job too. Or you can hold tight, keep the faith. If you make it to the end of the year, you get a big performance fee, which you get to keep even your faith turns out to have been misplaced and your investors lose money. This is a no-brainer, right? Keep da faith!

But there is a wrinkle. If you take that hefty bonus, but you really did know that the fund didn’t perform as advertised, well, there are technical terms for that. Theft. Fraud. The language of high finance can be arcane, but maybe you get my drift here. Currently hedge funds are relying on safety in numbers. If “industry best practice” is to value CDOs and XYZPDQs optimistically, then, hey, you can’t be faulted for following “industry best practice”, can you? But if anyone can make it stick that you knew, or should have known, your portfolio was trash… well, that’s bad. Plausible deniability is the whole game here. If very low asset prices from some hedge-fund yard sale get published in the Wall Street Journal, some fund manager might get nervous, and mark down his assets too, bragging about “integrity” and other unprofitable hogwash. All of a sudden, “industry best practice” is what he’s doing, and you’ve got to follow along or take a chance on Sing Sing. With each capitulation, each markdown, investors get more and more nervous, more and more inclined to remove funds, forcing more sales, liquidations, lower prices, a death spiral, the Great Depression.

There might have been some danger of this sort of thing happening on Friday, but the danger has passed. Bear put up 3.2B of its own money to save one of its funds. (Well-collateralized repo financing we are told, but if the collateral is trash… let’s just call it a “mezzanine tranche”.) That seems to have been enough to persuade creditors, some of whom had threatened to pull the plug abruptly and start selling, to give Bear some space to work out the debts of the other (more toxic) fund at, um, a measured pace. Does that matter? After all, if the assets are impaired, fire sale or no, they’re not going to fetch a good price, right? It might go slo-mo, but the same scenario should unfold eventually, no?

I don’t think so. Here’s where the dragon comes in. Several years ago, Nouriel Roubini and Brad Setser warned very plausibly that the United States’ current account deficits were unsustainable, that developing countries like China would not be able to fund America’s huge and growing deficits for very long at all. They were (quite honorably) wrong. Among other things, they expected that China’s central bank would be unwilling or unable to accept the future financial losses implied by massive purchases of US debt (which is likely to lose value in terms of the China’s Yuan). China has instead accelerated its USD purchases, proving its willingness to accept very large losses (or else high future inflation) in order to meet its primary objectives: stability and growth.

Stability and growth remain China’s objectives, and a financial crisis beginning in New York is every bit as threatening as a stock market crash in Shanghai. China could not have acted fast, as the US Fed did during the LTCM crisis. But, so long as only a few funds are in crisis and the unwindings are “orderly”, I think China will find it in its interest to be a “bagholder of last resort”, purchasing a few assets at prices high enough to prevent cascading markdowns or defaults against margin lenders. Fund investors will still lose money, but that rarely has systemic implications. As hedge fund proponents frequently point out, hedge fund investors are hedge fund investors because they can afford to lose money. (That’s not really true, but we’ll let it go here.) China won’t buy anything directly. Look for secretive hedge funds claiming that US mortgage assets are undervalued, great opportunities, despite the continued freefall of housing. Just as fire sales threaten to puncture confidence and lead to mass markdowns, apparent arms-length purchases at high prices reassure that optimistic models are fine, permitting fund managers to do what they want to do — report good performance and take their fees without jeopardy.

Of course, if confidence in valuations does break, no one could bail out the whole market, it is too big. Eventually there may be some kind of reckoning. But the logic of the moment, in New York, Washington, and Beijing, is that in the long-run we are all dead, so let’s put stuff off as long as possible and hope for the best. Anything that can be bailed out will be bailed out. The money is there, eager, and ready.

The Economics of Subsidy

Here’s Dani Rodrik on export subsidies:

[T]he economic case for countervailing duties is extremely weak. (The standard economist’s line is that you should respond to other countries’ export subsidies by sending them a thank-you note, not by shooting yourself in the foot in return.) But presumably there is some (second-best or political) reason why WTO rules sanction countervailing against subsidies.

This paragraph struck me as delightfully odd. Two facts that don’t get along are stuck together and left to eye one another warily:

  1. Export subsidies are so widely perceived as harmful to recipient nations that the World Trade Organization, a body whose “overriding purpose is to help trade flow as freely as possible“, countenances trade barriers to combat them.
  2. Standard economics suggests that an export subsidy represents a windfall to recipient nations, an opportunity and a boon, not a harm at all.

What gives? In the wide and wonderful field of economics, is there no room at all for the commonplace observation that a subsidy often does harm to its recipient?

In everyday life, we know that in order to do more good than harm with a subsidy, we often need to make predictions about how the recipient will respond to the grant. Offering to cover an 18-year-old’s college tuition is very different than cutting a no-strings-attached check, even if the money’s the same either way. Some 18-year-olds would be better off with the cash than a paternalistic tuition grant. But most probably would not be.

This sort of analysis is a priori out of bounds to any economics that views people as rational maximizers. If the best thing a teenager could do with a couple hundred thousand dollars is to turn it into a four-year annuity for college, the utility maximizing teenager will do that. If she chooses to do something else, by revealed preference, that must be the better choice. Right? No.

We reject this kind of reasoning in real-life, even when considering fully competent adults. If we can understand why it is not nice to put a slice of apple pie on a struggling dieter’s plate, or why very low introductory “teaser rates” on a home mortgage can entice borrowers into dangerous situations, why can’t we understand that certain kinds of subsidies increase the likelihood an economy will trade short-term gains for long-term harms? Of course we do understand that, even the WTO understands it, but economics as a discipline has a remarkably hard time coming to terms with the intuition. Human choice is endogenous and stochastic, not exogenous and rationally determined.

There’s an important distinction between noting that certain subsidies increase the likelihood of bad outcomes for a recipient and suggesting that the provider of a subsidy is therefore culpable for the outcomes. It’s usually counterproductive to blame someone else’s generosity for ones own poor decisions, even if the generosity was cynical and the bad consequences were anticipated by the donor. A crucial feature of subsidy is that it may be refused. A dieter may prefer not to be tempted by the sights and smells of heaven à la mode. But if a host insists on offering, she should still refuse the pie. At the national level, things are more complicated. An export subsidy likely to cause long-term harm to a nation may unambiguously benefit some individuals. How does a nation “refuse the pie”?

By enacting countervailing import tariffs, according the the WTO. But that seems like poor table manners, like raising a middle finger when a simple “No, thank you” would do. If only they could get over the logic of “might as well eat”, economists would have little trouble devising polite but firm ways of saying no.

We’d still miss the pie. But maybe that’s for the best.

Felix Salmon on Inflation

Felix Salmon has a very nice take on core vs headline inflation:

[I]t does seem clear that there is a significant and positive gap emerging between headline inflation (which includes food and energy prices) and core inflation (which strips them out). The gap is essentially a tax on poverty.

The poor spend a much larger percentage of their income on food and energy than the rich do, and they don’t benefit much from large drops in microprocessor prices. If this gap is sustained going forwards, then the real income of the poor is going to be eroded by inflation much more quickly than the real income of the rich. Not that there’s much the poor can do about it. The rich, on the other hand, have the Federal Reserve on their side, since the Fed targets the core inflation rate.

Combine this analysis with the Fed’s particular vigilance against rising wage costs (the only thing that helps poorer people get richer) and you might wonder whether the Fed is a beneficent, technocratic manager of monetary policy, or a covert agent of class warfare against the poor.

OK. That’s a bit much. There are very good reasons for stripping out food and energy prices out of inflation measures, and paying special attention to wages. Inflation is bad not because some particular price level is ideal, but because some prices are sticky. A rapidly changing general price level will leave many prices glued to non-equilibrium values, impairing price signals in the economy and harming efficiency. Food and energy are not stripped out just because they are volatile. (There are lots of techniques for smoothing or averaging time series. Trimmed means and medians can be used to get a smoother view of distinct monthly datapoints.) Food and energy are left out of the core because their prices are not sticky, so price changes in these sectors are unlikely to distort the real economy.

Similarly, wages are particularly sticky, and can almost never go down in nominal terms. When wages rise above equilibrium levels, the Fed finds itself between a rock and a hard place. If it maintains price stability, overpriced wage levels exert a drag on the real economy. To get the economy chugging at full potential, the Fed will have to “accommodate” some inflation to bring wages back down in real terms. But a jump in the price-level may create self-fulfilling inflation expectations among workers and firms, leading to a “wage-price spiral” that is hard to slow down once it gets going. It’s better for everyone, therefore, if the Fed is diligent about not letting wages get ahead of themselves to begin with.

That’s all well and good. But aren’t house prices downward-sticky too? There are indeed very good reasons for the Fed to pay less attention to food and energy, and very much attention to wage levels.

But isn’t it odd that right and proper theory somehow requires that the Fed to tilt the playing field towards capital and the already wealthy, and to fight any increase in the bargaining power of people who neither speculate nor to borrow, but who work every day and live off the proceeds?


Note: I’m pretty sure I first read the justification outlined above for stripping food and energy from core measures somewhere on David Altig’s excellent macroblog. I can’t find the specific post, but alotta love to him anyway. (It’s possible, since I can’t find the post, that I’m misattributing this argument to Altig. If I am, sincere apologies, but good vibes anyway for his very thoughtful blog.)

Update: It looks like the argument about stripping food and energy from core inflation may have been cribbed from Mark Thoma rather than David Altig. All the brilliant econobloggers kind of look the same to me. Anyway, see this post by Mark Thoma.

Update History:
  • 15-June-2007, 10:00 p.m. EDT: One really should get ones attributions straight before posting. Anyway, replaced my vague attribution to David Altig with a specific attribution to a Mark Thoma post.
  • 15-June-2007, 10:25 p.m. EDT: Added a comma.
  • 16-June-2007, 12:15 a.m. EDT: Tightened up the text a bit (last paragraph of the main essay).

Orthodox Economics: Descriptive, or Tranformative?

Like you, dear reader, I was transfixed by last week’s lovely debate on heterodox economics. One of the subtexts of that conversation was a simple question: Why can’t we all just get along? Nearly all the heretics conceded that orthodox economics is useful and interesting. The defenders-of-the-one-true-faith generally conceded that there are deep, unresolved mismatches between fundamental tenets of mainstream economics and how people actually behave. In fact, as the orthodox-but-still-hip Dani Rodrik suggested that the usefulness of orthodox economics comes from exploring precisely how and why neoclassical fairy tales don’t come true.

But if that’s the case, it seems odd that one admittedly broken paradigm would so ruthlessly dominate the profession. Why is it that, as Thomas Palley notes

Orthodox lefties (e.g. DeLong, Krugman, and Rodrik) believe the Arrow-Debreu framework not only provides a good starting point for thinking about the economy, [but that] it is the only point.

After all, there are a lot of flawed approaches to economics that we could use to help us think about what we cannot understand. Why is the neoclassical error so special that, as Max Sawicky points out

The duty of orthodoxy is clear: deny departmental positions and resources to inferior research programs and purify the top journals of incorrect thinking, all understood as maintaining high standards. After you deny them professional positions, standing, resources, and exposure, the only thing worse that could be done is to commit errant economists to mental institutions.

That characterization may be over the top. But even defenders of the mainstream concede that pursuing other approaches is an uphill battle. Here’s Mark Thoma:

If you choose the heterodox path, you will be on the outside, and you need to understand that going in. You might get lucky and gain respect over time, and if you make a really big splash economics departments may then start hiring people in the area, but don’t expect that because it’s unlikely to happen. At best, you might become part of a small group with common ideas and interests, but larger acceptance will be elusive (though not impossible). It will be harder to publish, your colleagues will wonder why you’ve drifted so far out of the mainstream, the work you do publish won’t get the respect you think it deserves either within your department or in the profession more generally — it’s likely to be a frustrating experience on a lot of fronts. That’s how it’s going to be.

Why? What’s so special about one broken framework that those who choose other approaches must toil like monks under a vow of obscurity?

There are lots of possible answers, many of which were hashed over last week. But it strikes me that perhaps we are all missing the point. Perhaps orthodox economics isn’t even trying to describe how the world works. Perhaps the project is really about how the world should work. If life can imitate art, why couldn’t life imitate a model?

Here’s a famous bit from Marx:

The bourgeoisie, wherever it has got the upper hand, has put an end to all feudal, patriarchal, idyllic relations. It has pitilessly torn asunder the motley feudal ties that bound man to his “natural superiors”, and has left no other nexus between people than naked self-interest, than callous “cash payment”. It has drowned out the most heavenly ecstacies of religious fervor, of chivalrous enthusiasm, of philistine sentimentalism, in the icy water of egotistical calculation.

So, as a writer, this guy is a bit overwrought. But there is a powerful idea here. Marx does not claim that human beings are “naturally” given to egotistical calculation. Instead he claims that however “man” might have been, social change is possible that transforms him into what we now refer to as a “rational maximizer”. The assumptions of neoclassical economics are not a priori true in this view, but they can be made true.

Think about that. Mull it over. And while you do, let a photomontage play upon your inner eye. Here’s Adam Smith, with his beneficient invisible hand. Now David Ricardo is explaining why selfish nations trade, and how trade has no losers but makes everybody better off, and interdependent. Slip forward in time and admire the elegant theorems of Coase, Arrow, and Debreu. This is a happy story. This is a great story. If only Marx were right, if only human beings could become something like efficient, selfish, rational maximizers, then we can prove, prove, that we would end up with the best of all possible worlds, by a certain definition.

Viewed in this light, the vehemence of the orthodox project makes a certain sense. It is not interesting to harp on the fact that people are not as they ought to be, and therefore our theorems and models don’t accurately describe the world. We know that. We build models to make sense of the deviations, so we can correct the “market failure”, the human flaw. Our job is not to describe the world as it is, but to understand how it is different from what it ought to be, and to fix it. The “MIT Keynesians” are open to using government to remedy human error, while more traditional neoclassicals view the Leviathan as a wildcard too large and dangerous to risk. They imagine that some more decentralized process — something more like the dynamic Marx himself described — could effect the necessary transformation. Both groups agree, though, that the project is to make the hopeful logic of economics actually work in this messy and often hopeless world.

What would a “heterodox economist” have to offer here? Those weird lefties who, contra Marx, think that Homo Economicus is so unreal as to be irrelevant, who view the world through prisms of power, institution, race, caste, or gender, amount to nothing more or less than fatalists. It is not the accuracy of alternative descriptions that is at issue, but where they lead — conflict, grievance, and struggle. For heterodox economists the end of history is where it began, nature red in tooth and claw.

By the way, I write not to bury but to praise. I think Marx was right about the transformational nature of capitalism, about its capacity to hew egotistical calculators out of flesh, blood, and claw. I sit at my desk surrounded by health insurance forms, bank and brokerage statements, tax documents. My colleagues come from everywhere, from I don’t know where, I can’t keep track of whether a hundred years ago their grandparents tried to kill my grandparents or vice versa. The orthodox, or bourgeois, project has succeeded marvelously, and for all that has been lost (and much has been lost), I am glad of it. I’ll go with the neoclassicals or with the MIT Keynesians, whatever. Whatever works.

But (more Marx) orthodox economics contains the seeds of its own destruction if it fails to recognize the degree of its own delusion. When Ricardo’s lovely story is not in fact working out, we should admit that to ourselves. Our goal is to create the preconditions whereby our optimistic models would actually predict. If we have failed to do that, then clinging to the behaviors that our models prescribe may lead to outcomes, um, inconsistent with general welfare. We may have to fly by the seat of our pants for a while, and then try again to get it — that is, us — right.


Bloggers mentioned:

Update History:
  • 15-June-2007, 09:20 p.m. EDT: In light of this, added attributory links, for various allusions. “Leviathan” alludes to Thomas Hobbes, and “nature red in tooth and claw” is taken from In Memoriam by Tennyson.

Nations are places

It’s obvious that nations are places, right? But somehow that fact is lost in much of the debate over trade and immigration. Instead, the argument usually goes something like this: Trade and immigration help some people and hurt others, though gains should exceed losses in the aggregate. How do we weigh benefits to winners against harms to losers?