Things I Was Wrong About

To be honest, I never really expected a financial meltdown of this scale.  Sure, the housing meltdown was inevitable and subprime losses were particularly bad.  But I never envisioned that amplification effects could magnify asset losses through catastrophic deleveraging.  At this point, there have been problems in virtually every sector in finance--from real estate based paper to derivatives, brokerage firms, insurance, interbank lending, corporate lending, money markets.  The next wave will presumably come from hedge fund and private equity withdrawals.  These problems have spread far beyond Wall Street.  Decoupling is dead, as every major economic zone is facing worse conditions.  The Baltic Exchange Dry Index, a measure of shipping, is considerably down.  

The legacy of letting Lehman die is pretty mixed.  As the WSJ reports, Lehman's demise really kicked off the cash crunch.  (By the way, has anyone else noticed that they redesigned the site and are ungating more of their content?  If this is Murdoch's doing, I'm all for him.)  The fact that money market funds owned Lehman bonds contributed to their drop in Net Asset Value below par--kicking in redemptions and a Federal bailout.  Still, while it doesn't look like people took events that seriously after Bear Sterns--including Lehman, which was tardy in finding a buyer--Lehman's fall was enough to ensure a round of bank consolidations and recapitalization.  

And, of course, we are not at a bottom, though I did pick up quite a bit of stuff right around the short-term bottom that we saw.  It'd like to imagine that absent Congress not approving the bailout, we would have seen the worst, but I'm no counterfactual historian.  In any case, trying to time or predict macro events in the economy is as hard as predicting the weather.  No one worries about selling at the exact highest price, so why worry about that when buying?

All that said, I remain optimistic--cautiously exuberant, if you will--about the future.  The "fundamentals" of economic strength are doing well; growth in BRIC and frontier markets is going on a breakneck pace, developed countries remain filled with capital and educated workers, and global flows in capital and ideas remain fluid.  Meanwhile, equities have seen something like an eight year price slump combined with a third-off haircut.  It's always the end of the world when you're facing the full brunt of the crisis, and it's those people who are able to stomach buying into panic that make out like bandits.  

Wow

I really hate House Republicans. I had the WSJ page open, where it had the headline "Dow Crashes 600 as Bailout fails." A few minutes later I click refresh. Everything is the same, except it now says "700."

Immigration

It's sad to hear things like this; that the financial crisis is cutting jobs and educated foreign people are finding it hard to stay in America due to work requirements. It should be obvious that a skill-based system like the ones Britain and Canada have, rather than a work and family run system, makes the most sense. I'm surprised you don't see more liberals argue for such a policy, as it reduces inequality (having more elites drives down the fees they charge) while improving efficiency and equity.

I'm for all sorts of immigration, but you do have to wonder about the long-run impact of tacitly allowing large-scale immigration of relatively poorly educated Hispanics. It's in their best economic interest and helps many people here as well. But you also have the Heckman result that family environments matter for educational attainment, and then the Godin-Katz result that education is driving trends in the distribution of income. I once asked Heckman about the implications of his research on immigration policy, but he was a bit evasive. Well, America will be home to a large number of people with sub-optimal education and income levels persisting across generations. Again, this is probably an optimal welfare transfer, but it's out of synch with the policy for foreign professionals and calls for some public policy (like early childhood intervention).

Capital Gains Tax

The CBO has a bit up on the changes in revenues from individual taxes over time. They find that the revenue from taxes went way up in the Clinton years due to events unconnected with Clinton, rather than changes in the tax code, while tax revenues did change in the Bush years due to new laws. Of the non-legislative gain in tax revenue during the Clinton years, capital gains taxes on the sale of investments constitute about half. Clinton also drastically cut capital gains on housing, so the housing bubble resulted in relatively little in the way of capital gains revenue. This change may be responsible for the rise in house prices; more on this later, data willing.

There's some debate over the ideal capital gains tax rate is. Charles Gibson and a WSJ editorial I once read make the supply-side argument that lowering this rate increases revenue. I'm skeptical, but in any case the variation in taxes gives Clinton an undervedly good reputation for managing the economy and Bush a worse reputation than he deserves. In reality, the rate of economic growth and the pace of tax revenues vary more or less randomly and place huge constraints on what Presidents can do. This fact tends to be ignored by people who expect elected officials to both not overstep their Constitutional boundaries and wield absolutist power to revive the economy.

Basically, I want to stop reading pointless articles on how some things are correlated to other things, because the world is basically random and few people have any influence on or understanding of the events that go on. Okay, that's a little extreme, but at least come up with a defense that (though it may raise an interesting point connecting inequality and women's relative wages) justifies blatant political pandering.

Mad Max

The aftermath of Katrina left much of the southeast United States short on gas as refineries and pipelines shut down. A few weeks ago, I was in Asheville, NC seeing something familiar in the aftermath of Ike. Asheville is at a high altitude and it's hard for gas shipments to reach there after a crisis. It was pretty exciting, really, to see the entire region practically shut down. Many gas stations ran out of gas, others--mostly independent retailers--had prices going up to about $5 a gallon. Some stations tied to the oil majors had lower prices, but had large lines. Traffic plummeted and at the clinic I was working at, many people cancelled appointments.

Well, this is still ongoing. From what I hear, gas is still in short supply, and stations either have no gas or long lines for expensive gas. Police are stationed at pumps, and all sorts of events have been shut down or curtailed. It's a great glimpse at our dependence on fossil fuels, and the chaos and anarchy underling the well-greased market system of tradable goods and services. It's tough to imagine Appalachia with excessive gas prices. Without roads to connect far-flung valley communities and mountain outposts, you either have self-contained hamlets or a handful of denser areas. And without the tourism or expansive mountain cabins, there are few remaining attractions. It's going to be a lot easier to replace this addiction with biofuels or compressed natural gas rather than move to a Japanese or European style of living.

About Those Alphas

The basic premise of hedge funds is that smart people amply compensated can make lots of money. The empirical evidence for this is mixed. On average, including failed firms and management fees, it's doubtful that hedge funds beat a diversified market average (this is the basis for Buffett's bet). But a substantial number of firms have piled up impressive records over the years with high "alphas," or above market performance.

I just came from a talk by Markus Brunnermeier, who circulated the ideas I've discussed before. Much of the talk was focused on the amplification methods that turn a drop in asset prices into a financial meltdown, with some commentary on potential regulatory solutions. The idea is that the old agent-based macroeconomic models really fail to get at the connectedness of modern finance; but he suggested some tools for understanding those links. One was a measure of spillover risk across institutions, measuring by looking at past performance during crises. These turns out to be significant, and there were all sorts of interesting comments.

But Brunnermeier also examined the impact of taking these "tail risks" into account on manager alphas. It makes them disappear. That is, paper gains achieved by hedge funds--which have presumably hedged against shifts in the overall market--come through neglecting the counterparty risk associated with the occasional collapse of financial institutions. That's not to say hedge funds are useless--you would like to have the wealthiest people bear crisis risk, and it might be profitable for them--but it implies that hedge funds as a class rely on undisclosed crisis arbitrage for their profits.

Of course, hedge funds have not peformed as badly as markets in general this crisis, so perhaps this is a phenomenon particularly concentrated among certain strategies (or an artifact of old data, or not yet apparent). But it's more support of the claim that modern profit machines rely more on frauding investors than ouwitting markets.

Financial Magic

A lot of people are very skeptical of the merits of modern finance. After all, financiers pay themselves obscene amounts of money, devise complex schemes to fraud people, and periodically self-destruct while calling for public bailouts. On top of that, they don't made anything you can touch or drop.

It's easy to question whether the best marginal talents headed to Wall Street are really worth their paycheck. Not too long ago, about 40% of corporate profits among companies in the S&P 500 went to the financial setor--a figure which surely represents the extraordinary level of leverage going on, combined with various asset bubbles. This share will certainly go down. But it's also true that finance is an important and value-adding portion of the economy.

Consider an economy without a robust capital market. One of Indira Gandhi's more disastrous policies was nationalizing India's banks. Lending was no longer conducted on the basis of profit, and was rather directed at unprofitable but politically sensitive areas of the economy. India also maintained very high interest rates for a long time. From one perspective, economic development is all about expanding the productive part of the economy, and an efficient financial system is necessary to funnel capital towards the productive sectors and firms. McKinsey estimates that there is a massive gap between India's most and last productive firms, and that closing the gap would yield enormous results. They also find large gains in financial sector reforms. See the Rajan proposal for what that might look like.

Making financial markets ever more efficient brings diminishing returns, but even some of the newer complex products are useful. In general, derivatives allow people to manage the uncertainty and risk inherent in dealing with goods traded on a macro level. The markets for currency, interest rates, equities, and commodities are highly volatile, yet firms and individuals are able to use derivatives to limit potential losses, amplify gains, hedge risks, or guarantee a solid stream of income. Airlines rely on fuel derivatives to control costs, while extraction companies ensure consistent profits amid large shifts in the prices of commodities. Credit default swaps enable people to make investments in corporate and government bonds--giving funding to risky companies and governments that would never otherwise raise capital. Argentina is getting funding exactly because complex finance exists--no one would fund them without protection in the case of default. Even Shiller envisions more complex mortgages--ones that would automatically forgive payments in bad times--as a way to prevent future mortgage crises. Sulpur trading schemes dramatically reduced their emissions in America, and a financial marketplace for carbon is one of the few feasible ways to deal with global warming.

But Warren Buffett calls them weapons of destruction. Well, he also holds long-term equity puts, some credit default swaps, as well as currency positions on his books. Their collapse in market value destroyed his recent profits, but he is likely to profit significantly from them in the long-term. It's long been more profitable to do as Buffett says rather than follow his statements.

The Milton Friedman Institute

Let's just go ahead and get this out of the way. The University of Chicago plans on forming a new research institute on economics with Milton Friedman's name, and many faculty are opposed.

I was excited to see this idea, because Universities are generally such poor stewards of their endowments and intellectual capital. Compare, as Brad DeLong once did, the decisions made by the heads of the University of California system and Harvard during the 1960s. Harvard increased in size, but not by much, becoming essentially a highly profitable hedge fund with some land in Cambridge for tax purposes. The Cal system drastically expanded to cover over a hundred thousand people with high-quality college education. It's hard to imagine that Harvard made the better choice from the point of view of the public, but it's their viewpoint which is universal. If you believe that higher education is worthwhile, then it's bad that top institutions are doing so little to spread knowledge, improve teaching, or jump-start massive research projects (MIT's OCW aside). Are the liberals who run these places so elitist that they believe that knowledge should be restricted? Or are they unable to seriously consider educating more than a few thousand souls a year?

In any case, the MFI was a great way to capitalize on one of the University's core strength's--economics--and dramatically advance the cause of outreach and research (and at low cost to the University, too). You can disagree with the choice of naming it after Friedman, but it was a natural fit given his stature and connection with the University.

This move caused a wave of ill-will and poorly reasoned diatribes. Supposedly the plan would "reinforce among the public a perception that the university’s faculty lacks intellectual and ideological diversity." So the University should not develop one of the few right-of-center departments in economics, let alone academia, out of concerns for perceived intellectual diversity? Set aside for the moment issues of the quality of output (if work is done by University faculty and the charter written by prominent economists--unlike Hoover--then I personally have few concerns). What entitles academics the right to silence the research of others? Have any of the points the critics made justify that?

I don't want to be a scold on this issue. Others do that better than me anyway. I just want to point out the ways in which this employer-run institution fails students, teachers, and the public. Administration is hampered in promoting their key function--research and teaching--by faculty for whom the allocation of power and money between disciplines is more important than agumenting and disseminating knowledge. Expanding college education is essential to reducing inequality, and research is also useful. Unfortunately, we can expect no large initiatives on these goals as long as Administrators cater to the needs of entrenched academic interests. What about Chicago campuses overseas to spread a distinctive form of thinking? The focus could even be on Humanities subjects that are often overlooked elsewhere, or on contructing "Cores" for cultures other than the Western European. Why should it be that expansion and innovation are not even an option for a Chicago-based University, but basically required for a Chicago-based firm? Maybe the people over at the MFI could figure this out.

I am more hopeful for Colleges in the developing world, where hope is more audacious and the do-nothing dons fewer. The Gulf has many proposed institutions and is attracting a lot of interest, there are some interesting Indian proposals, and many Chinese Universities lack the tenure model. And that's not even getting to practices inside the classroom. As Matt Yglesias points out, either lectures are effective at imparting knowledge--in which case we should find the best professors and have them reach the most people --or they're not, in which case we should find a better way.

Regional Disparities

It's a myth that countries grow and that unequal growth is somehow pathalogical. Generally, a few people in a small area start growth, which then feeds into the economy as a whole. Trickle-down does in fact work, which is why the poorest decile of a rich country is much better off than the richest decile in a poor country. When the relevant area to figures out growth coincides with the political grouping--say in Botswana or Hong Kong or Mauritania--we say that the country is getting richer. When that area is inside of a larger political unit, we say that there are regional disparities.

And so you have the well-chronicled fact that India's growth is regionally unbalanced. This is often sold as the claim "western and southern states do well" but there's a bit more to it. This map (blue and red are good, brown and yellow bad) is a little dated--from the 1991 census--and so does not capture recent unequal growth, but does look at some measure of development at a district level.

One thing to note is that the landlocked northern "bimaru" states in the Hindi belt--Bihar, Madhya Pradesh, Rajasthan, Uttar Pradesh are not doing so great. Most inland areas in general are doing fairly poorly as well. Development is largely clustered into two sets of districts: Those near the coast and those along the far northern Delhi-Punjab corridor. Of course, there are some cities here and there that do well, and the whole of Maharashtra appears well-run. Coastal Andhra and Orissa are not uniformly great, but those two states have made a lot of progress in the last fifteen years not seen on the map.
This disparity is a little striking as northern India was for a long time the richest portion of India. It was the seat of the Mauryan, Gupta, and Mughal Empires and home to the British Raj. This wealth persisted even after independence.

Political mismanagment goes a long way towards explaining this gap: National Congress rule tried to eliminate regional imbalances, which involved neglecting the richer states. On the state level, coastal and far Northern states are simply run better than those in the center. Geographical size seems to matter, as smaller states tend to be better run, while the bimaru states are all massive (Though Maharashtra is rather large as well). This was the rationale for breaking off some states from the larger ones, a policy that seems to have worked rather well.

You also have to wonder if being landlocked is a curse, as per Sachs and Collier. State-level variation in GDP in America does not seem to be especially correlated to distance from the coast, but that also reflects massive investments in infrastructure that reduce transportation costs. Those inland states in India that got rich did so by exporting crop surpluses on highways and railways.

Increasing the ties betwen inland India--which includes the bimaru states as well as rural portions of coastal states--into the part of India which is growing rapidly is obviously important. It's also essential to tapping into India's "demographic divididend"--India's relatively youthful workforce. It turns out that this bonanza is largely expected in the high-fertility bimaru states--which already contain about 40% of India's population between them. For labor-intensive industry to take advantage of these workers, inland states will need to be as investment-ready as coastal states. Otherwise, the rich parts of India will see large wage inflation and the poorer parts significant unemployment.

Massive investments in human capital and infrastructure are necessary to close this gap, and accountable governance in smaller states is the way there. Plans for a freight corridor between Delhi and Mumbai along Tokyo-Osaka lines are promising, and the Golden Quadrangle linking major Indian metros is working well. Another corridor from Delhi to Calcutta along the Grand Trunk Road could hit another quarter of the population.

Why Is There A Financial Crisis?

The losses incurred by holders of real estate-backed loans are real. These loans were handed out at the peak of the bubble to people who could not afford them at unsustainable rates. When low downpayments met a collapse in housing prices, many borrowers faced loan values greater than their home values and walked away. This effectively made billions of dollars invested in the commercial paper that was a key workhorse in international finance worthless.

Before the crisis, this fact was evident to many people. Several hedge funds attempted to short the market for such loans, and were destroyed. I know of at least one person, however, who managed to time his trades right and made quite a few billion dollars. However, most people did not face the responsibility that those traders did and continued to buy and sell worthless paper. It's not the "models" that are at fault; other models that actually corrected for the unique credit qualities of recent borrowers would give you higher predicted defaults. Rather, the originate and distribute model reduced the incentives to model correctly and allowed mortgage originators to hand out loans to poor borrowers and resell them into a global savings glut.

So again, the losses from handing out such loans is high. But it's perhaps on the order of $500 billion--severe, but similar to the asset collapse from any bubble. The problems from this crisis, however, have spread into many parts of the finance industry and into the real economy as well. It's a big question how a relatively manageable loss nearly broke down the entire financial system.

One explanation I gave earlier is that marking assets to market overstated the problems for certain firms and caused a crisis in confidence. That's a part of the answer to why there was a spiral, though such transparency is good in general. Here at my day job, many people are interested in this question and I came across other ways to get from "manageable loss" to "end of the world".

A key factor is the extraordinary extent to which modern finance relies on debt. Many people imagine that you can show up on Wall Street and easily make money if you have flexible ethics. Generally though, most people face very efficient markets and thus need to ramp up on leverage to amplify any small inefficiency they find. Investment Banks were among the worst offenders, and their debt was very short-term to boot. As banks faced continual deterioration in their balance sheets, financial requirements forced them to raise more capital. An interesting solution to this problem is Rajan's proposal to replace required capital deposits with catastrophe insurance for banks. The idea is that forcing banks to keep a certain amount of liquidity on the books prevents that capital from being used precisely at the hour of need, so instead banks could contract out for funding conditional on facing a crisis.

There are other liquidity spirals that amplify original shocks. The complexity of the financial toxins spread around induced significant asymmetric information and constraints on knowledge. People don't know what's going on and can't find out, so they reject entire asset classes as worthless in bad times. Finally you end up with classic bank runs when people lose faith in financial institutions altogether. This happened not just in the case of Northern Rock and IndyMac, but was a factor in Bear Sterns, Lehman Brothers, and the rest of the Investment Banks. Tightly linked financial markets run on trust between counterparties, so you have giant network effects that blow up any perceived risk. See James Surowiecki on this point.

The financial system was so highly leveraged and tied together that blaming subprime mortgages is a little besides the point. The entire financial system was in something of a bubble, and was one asset collapse away from destruction. Much smarter regulation will be required to fix and prevent future crises, and that's unlikely to materialize.

Market Theories

I'm not a big critic of the Efficient Markets Theory.  Most of the time, for most equities, the market price provides a reasonable valuation based on aggregating probabilities of the paths of future earnings.  The overwhelming mass of investors fail to beat market averages--including Jim Cramer.  But there are of course a few superb investors whose performance cannot be attributed to chance--the superinvestors of Graham and Doddsville to name a few.  

But it's interesting that decades after the original value investing texts were first published, only a handful of investors have managed to successfully beat the markets--and those who do often employ similar strategies that implicitly weed out the majority of stocks as decently priced.  To me, that implies that just a few people are endowed with the capacity to do something different (They have a different emotional mindset?) while others can't copy.  This is akin to having private information.  Their presence will make the markets more efficient, but it can take some time and they'll make a good deal of money as they do so.  

Portfolio Theory, however, has never made much sense to me.  There is of course a resemblance to Efficient Markets, but the assumptions are crazy.  For one, you have no accounting for Talebian Black Swan risk, which has taken out many people including LTCM.  There's no economic reason that past performance predicts future extreme risk--an event which is by definition low probability.  So-called post-modern Portfolio Theory is a little nicer as it correctly terms risk as the downward portion of volatility, not uncertainty itself.  But another approach is to throw out normalities altogether and focus on fractals, as Mandelbrot does.  I've often thought stock charts appear self-similar at different time scales, and Mandelbrot takes this approach to produce a pattern which echoes Portfolio Theory's randomness for much of the time but with a healthy appreciation for crazy events.  It's promising stuff, and not only because it involves fractals.

Mark to Market Accounting

One of the puzzles of this financial crisis is the rapid spread of problems from subprime mortgages to prime mortgages to commercial mortgages to credit markets to investment banks to insurance companies.  The underlying fundamentals were rather bad, but do they really justify a wholescale collapse of the entire financial sector?

Here is a dissenting opinion from the WSJ opinion pages citing the research of a Yale professor on marking assets to market.  The idea is that while gaining accurate market information on the value of assets is worthwhile, there are certain cases (such as when firms intend to carry securities to maturation) where it's not a helpful calculation, and can in fact increase speculative downward pressure.  I'm not too sure what to think of this idea, but it's interesting.  Certainly I'm taking a close look at financial companies which have been beaten up due to holding assets that the market does not value, but do not have any short term liquidity constraints.  

Blood in the Streets

The big news is that the Treasury is rolling out $700 billion to buy troubled assets of financial institutions to clean the pipes, if you will, of credit markets.  This number is apparently large enough that the financial consuls Bernanke and Paulson feel the need to consult Congress on the issue.  

This measure is troubling in a few ways.  One, it threatens to prolong the crisis by hiding mortgage problems in the government's books.  As I've mentioned before, the danger is the potential for a Japan-style prolonged recession.  This plan saves the worst offenders, while doing little to force banks to deal with their losses and move on.  Moral hazard remains a big issue. 

Two, it's not the best use of taxpayer money.  Yes, this deal could pay for itself over time, but there are better ways to command the government's influence properly.  Zingales and Krugman are both against the deal and have some interesting alternatives.  Krugman would rather the government act as Sweden and nationalize firms to float them at a later date--treating the government as sort of a private equity buyout firm of last resort.  Zingales would use the government to coordinate moves such as eliminating dividends, raising equity, and debt restructuring.

The nice aspect of these deals is that they leverage some of the strongest capacities of government: Coordination, transparency, and liquidity.  Friedman and company tend to categorically despise all government action (except of course on financial intervention), but there are clearly many different sorts of intervention.  Personally, I don't care as much about the raw amount of government spending as the form that government regulation assumes.  Paulson's plan calls for a massive government bailout without holding firms accountable.  Other plans envision a light government footprint paired with reasonable interventions playing on government's strengths to force firms to solve their problems themselves. 

Inequality, Part II

I went to an interesting talk today on risk pricing. The equity premium puzzle is an issue that no one has really resolved yet. The idea is that the long-run return to holding "risky" equities remains excessive to the present day. One answer that the behavioralists give is that humans are simply risk averse, but many people find the degree of risk aversion necessary to explain the phenomenon inplausible.

The speaker's idea was to combine rational agents (with potential differing apetites for risk) with Bayesian agents who lean about the economy. The Bayesians are stupid, but through their learning converge the economy over time to the rational model. There are a few rational agents in this economy--the Warren Buffets--who know what's going on. Over time, these guys get richer and richer. The main conclusion of the paper is that the market can put a high price on risk, one that converges over time to a reasonable price, in an economy populated by smart people and stupid people who are quick learners.

There is a distributional aspect to this model as well, however. The smart people raise their share of income over time, due to their superior knowledge. Of course, in economic shock periods, as now, they do not do so well, but in the long run, under normal economic conditions they make out like bandits. I've discussed before the education model of inequality, which explains how the educated do better than the non-educated. This model, in which there are super-educated people, plausibly explains the movement at the very top of the distribution. This is happening in an institutional setting where it's harder and harder to deny the smartest and most productive people the proper value of their labor. You can wonder what is the optimal tax to apply to this group, but you should also wonder how to join it.

Ancient Americans

One of the myths that's floating around is the romanticized image of hunter-gatherers. Back to at least Rousseau, people have imagined that contemporary society is horrible, but that ancient humans were somehow more in tune with nature.

As with all idealized images, this is not quite true. Ancient societies were considerably more violent, both to each other and neighboring tribes, and were probably responsible for many mega-fauna extinctions. They were probably more prosperous than following agricultural societies, and possibly many contemporary societies.

This idealization extends to ancient Americans, who were thought either savages unfit to manage land or else the best people who ever lived--a standard to which we can compare and degrade our own unsustainable follies. As it turns out, civilization in pre-contact America was extensive, long-lasting, highly urban, highly dependent on agriculture, and had a dramatic impact on the landscape from the Amazonian jungle to the North American plains. The vast herds of buffalo and birds encountered in the 19th century are not a legacy of a pristine past, but a direct result of the deaths of countless residents due to Old World diseases. Ancient societies managed the landscape at will, with many destructive consequences and other good ones. Contemporary societies are doing the same.

It's also interesting that new discoveries are pushing back the dates of the earliest American finds to be contemporary with the earliest Asian river-based civilizations. Somehow, human societies independently discovered parallel technologies and social organizations at around the same time. I guess there is some rate of mental evolution necessary to make these advances which hit a threshold worldwide around that time, aided by global climate trends.