Thursday, June 11, 2009

artificially depressed interest rates and weak regulation gives bankers rational incentives to increase leverage and make risky loans

From The Atlantic:

Jun 10 2009, 2:26PM

"The Half-Scientific Half-Witchcraft Discipline of Macroeconomics"

The quotation is from a review by J. Bradford DeLong, a well-known macroeconomist at Berkeley, of Sidelsky's great biography of John Maynard Keynes. Riding his witch's broomstick, DeLong has written a review of my book A Failure of Capitalism for his blog, The Week. The review, called "The Chicago School is Eclipsed," appeared on May 29 and can be found at (visited June 10, 2009).

I have been attacked from the Right as an apostate to conservative economics, for I blame our economic crisis on poor management of monetary policy by the conservative icon Alan Greenspan and on excessive deregulation and lax regulation of financial intermediation, I criticize Milton Friedman, Robert Lucas, and other prominent monetarists, and I embrace Keynes, among other heresies. Professor DeLong, however, attacks me from the Left. Here is the opening paragraph of his review:

Richard Posner, leader of the Chicago School of Economics and Fourth Circuit Court of Appeals judge, uses his new book, "A Failure of Capitalism," to try to rescue the Chicago School's foundational assumption that the economy behaves as if all economic agents and actors are rational, far-sighted calculators. In some sense, Posner must try. For without this underlying assumption, the clock strikes midnight, the stately brougham of Chicago economic theory turns into a pumpkin, and the analytical horses that have pulled it so far over the past half- century turn back into little white mice.

I am not in fact "leader of the Chicago School of Economics" and I am not a judge of the Fourth Circuit. (Later in his review DeLong calls me "one of America's leading public intellectuals," with "very wide" influence--both of which statements are incorrect.) I also am not committed to the "foundational assumption" that DeLong states. But neither do I believe, as he does, that our economic crisis was the result of the "irrationality"--indeed the "financial lunacy"--of the owners and managers of commercial banks and other financial intermediaries.

As evidence that it was, DeLong offers four examples, one of which, however--the overcommitment of GM and Chrysler to gas guzzlers--is irrelevant to the behavior of the financial industry. His first example, typical of the three that are drawn from that industry, is that "It was not rational for Bear-Stearns CEO James Cayne, with his own $1 billion fortune on the line, to allow his firm to become hostage to the excessive risks taken by his subordinates in the mortgage markets." But did he know that his subordinates were taking "excessive risks"? And what does the term mean, exactly? Suppose he thought there was a 1 percent chance that he would his fortune, and a 99 percent chance that he would double it? Would taking that chance be irrational? DeLong does not define "irrationality" or "lunacy" and his review does not answer the questions I have put

He is troubled that I should blame the crisis primarily on the combination of too-low interest rates in the early 2000s (Greenspan's mistake) and financial deregulation, because this means that "What is needed, Posner implies, was a Daddy State in the early 2000s that would have kept interest rates high, kept the recovery from the 2001 recession much weaker, and kept unemployment much higher," and also "have restricted financial innovation." Yet he criticizes the rapid growth of derivative markets (that growth was "absurd"),"high-leverage portfolio strategies," and securitization--all instances of financial innovation--and he is silent on the relation between low interest rates and the housing bubble. He seems to think that full employment can be achieved by low interest rates without sparking inflation, for he is critical of "prohibit[ing] the Federal Reserve from seeking full employment through low interest rates." I venerate Keynes, but one of the least persuasive suggestions in the General Theory is that a policy of low interest rates can lead to a perpetual boom, ending the business cycle and wiping out involuntary unemployment.

Yet, inconsistently with his hostility to "a Daddy State," De Long in the review advocates far more extensive regulation of financial intermediation than I do. He commends venture capitalists and hedge funds for having a larger equity stake in their investments--that is, for being less highly leveraged than banks. (He regards 30 to 1 leverage as excessive, though banks with 20 to 1 leverage are regarded, though perhaps not by him, as well capitalized.). And yet at the same time he wants "every financial institution" to be organized in the form of "a bank holding company regulated by the Federal Reserve" with 10 or even 20 percent of its liabilities required to be kept in an account at a federal reserve bank, which would be the equivalent of cash (well, not quite, because the Federal Reserve is experimenting with paying interest on banks' excess reserves--i.e., lendable cash). Venture capital firms and hedge funds are "financial institutions," and so DeLong's analysis implies that they should be forced into the bank holding company mold.

He wants low interest rates, but if all financial institutions are required to keep large cash (or cash-equivalent) reserves, their ability to lend will be curtailed, so interest rates will rise; likewise if their leverage is limited. DeLong does not explain how he proposes to square the circle of low interest rates and conservative lending practices.

He is especially critical of Wall Street compensation practices, such as "large annual bonuses based on annual marked-to-market results." He seems to be gesturing toward the problem, discussed in my book as elsewhere, that a very small annual risk is unlikely to materialize in the immediate future, and therefore a trader may be quite willing to run the risk without regard to the fact that it will grow over time (the probability that a 1 percent annual risk will materialize sometime in the next 10 years is almost 10 percent). Financial firms deal with this problem by having "risk managers" to monitor the traders' deals. An alternative which DeLong favors is compensating traders with "long-run restricted stock" in their company rather than with annual bonuses. The problem, which he does not discuss, is that circumstances entirely outside the control of an individual trader may influence the price of his company's stock. This problem makes it easy to see why such a compensation practice did not emerge in the competition of banks for talent.

DeLong does not discuss my effort in the book to explain how a regime of artificially depressed interest rates and weak regulation gives bankers rational incentives to increase leverage and make risky loans. His claim that lunatics are responsible for our current economic troubles is asserted rather than argued.

He ends his review by saying that I failed to conclude that the economic crisis was the product of a "private-sector failure" rather than a failure of government "because to get there, he [that is, I] would have had to begin his book by acknowledging that it matters that the earth revolves around the sun." Earlier in his review he had compared me to Jesuit astronomers who rejected Copernicus's heliocentric theory. He seems to have a curious religious obsession. At one point in the review he says that "the litany of financial lunacy is longer thane ven the Eastern Orthodox litancy of the saints."

What is one to make of such a review? It seems that DeLong, like Paul Krugman, is a high road / low road thinker/writer. He does sober academic writing part of the time and irresponsible popular writing the rest of the time. That's a common enough pattern, but when it is found in macroeconomists, specifically those who write about the business cycle rather than less ideologically charged macroeconomic topics, it makes one wonder how trustworthy their "scientific" writings are. The economics of the business cycle, as I argue in my book and in earlier entries in this blog, is a weak area of economics, partly because of the difficulty of conducting cogent empirical studies, partly because of stubborn theoretical disagreements (a problem closely related to the empirical difficulties--the rival theories can't be discriminated empirically), partly because of the high ideological stakes and resulting politicization of academic controversy. One can only hope that Professor DeLong is able to keep the two parts of his intellectual life properly separated. "


Don the libertarian Democrat

"DeLong does not discuss my effort in the book to explain how a regime of artificially depressed interest rates and weak regulation gives bankers rational incentives to increase leverage and make risky loans."

I believe that the implicit government guarantees and lax enforcement are the main causes of the crisis. I don't see how my view helps the private sector though, since the implicit government guarantees were lobbied for by the private sector, and the lax enforcement led to an epidemic of fraud and/or just plain fiduciary negligence in the private sector. Both causes have a public and private dimension, which makes sense, since we have a welfare state, which is a public/private hybrid. Only this combo can explain guarantees and deregulation being promoted in tandem. One aspect of the system was simply less obvious.

Following on Kevin B's remarks, I think that my criticism of much of modern economics follows from my disagreement with Milton Friedman on the verification of economic theories. He says to just study the behavior, and forget the reasons. Don't ask businessmen what they're doing, just watch what they do. To me, this is Behaviorism, a not very useful method or theory. When Correlative Explanation is involved, it's especially dangerous, since it has a very hard time dealing with the correlations when they change. Were the reasons behind the behavior involved in Correlative Explanation studied, it's much easier to see that the correlation has weakened or dissolved, rather than looking for scotch tape additions that make the theory no longer useful at all, but are held onto for dear life by many advocates of the theory.

I do want to thank you for one thing. No matter how idiotic you find my posts, you are kind enough to post them, knowing that I'm trying to add to the discussion in my feeble way. Brad DeLong deleted my comments when I disagreed with him, so I stopped posting on his blog. If he found me an idiot, that's fine, but when a person spends the time to seriously comment on a blog, I believe that their comment should be posted. As well, Prof. Krugman's censors seem to not post my comments when I link to other posts. At least that's how I see it. I'm sensing a connection between a dismissive attitude towards others and a thin skin. I like De Long and Krugman very much, and will continue to read their blogs. I do wish, however, they were more civil and understanding to those that they disagree with.

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