it was perfectly valid to discuss money in abstract, mathematical, ultra-complex terms, without any reference to tangible human beings

TO BE NOTED:

1
Draft review essay for London Review of Books. Third draft
Safer than Safe
FOOL’S GOLD: HOW UNRESTRAINED GREED CORRUPTED A DREAM,
SHATTERED GLOBAL MARKETS AND UNLEASHED A CATASTROPHE by
Gillian Tett. Little, Brown, 338 pp., £12.99, 30 April, 978 1 4087 0167 6
Donald MacKenzie
Few people’s reputations have been improved by the credit crisis. One is the BBC’s
Robert Peston; another Vince Cable. A third is Gillian Tett, capital markets editor of
the Financial Times. Prior to the crisis, she and her team were the only mainstream
journalists who covered in any detail the then arcane, technical world of ‘credit
derivatives’ (of which more below). Tett saw – however imperfectly – the huge risks
that were accumulating unnoticed within that world, and spoke out about them.
Fool’s Gold begins in a conference room in Nice in spring 2005. Tett admits
that at that point she was baffled by the technical language – ‘Gaussian copula’,
‘attachment point’, ‘delta hedging’ – being spoken by the participants. However,
before joining the FT she had conducted fieldwork in Soviet Tajikistan for a PhD in
social anthropology, and the ethnographer in her re-awoke. The conference reminded
her of a Tajik wedding. Those attending it were forging and refreshing social links,
and celebrating a tacit worldview – in this case, one in which ‘it was perfectly valid to
2
discuss money in abstract, mathematical, ultra-complex terms, without any reference
to tangible human beings’.
Who were the key actors in the ceremony, those up on the conference hall’s
stage? She whispered the question to the man sitting beside her. ‘They used to all
work at J.P. Morgan. … It’s like this Morgan mafia thing. They sort of created the
credit derivatives market.’ The answer surprised her. J.P. Morgan was not Goldman
Sachs: it wasn’t an exciting bank. It bore the name of America’s most celebrated
financier, but it was ‘dull’: safe, boring, perhaps a little snobbish. (When its current
chief executive, the now well-respected Jamie Dimon, joined the bank from Bank
One, which was headquartered in Chicago, Tett reports one Morgan banker muttering
‘Not another retail banker from Hicksville, USA!’)
The core of Tett’s fine book, which is by far the most insightful of the first
wave of books on the crisis, is the story of J.P. Morgan’s credit derivatives team. For
all the bank’s traditionalism – the door staff at its London offices wear uniforms that
would not be out of place outside the Ritz – it was quietly innovative, and its blueblooded
heritage did not block all diversity. One of the team’s driving forces was a
young Englishwoman, Blythe Masters; another, Terri Duhon, makes no secret of her
upbringing in a trailer in Louisiana; central to its technical work was an Indian
mathematician, Krishna Varikooty. Boisterousness that would have horrified John
Pierpont Morgan was tolerated. Tett describes how at one off-site gathering in
Florida, one of the team’s managers broke his nose when he was being pushed into a
hotel swimming pool by drunken colleages.
3
The team’s pivotal innovation was a December 1997 deal they called ‘Bistro’
(Broad Index Secured Trust Offering). For a decade, banks had been experimenting
with credit derivatives, which are ways of separating out the ‘credit risk’ involved in
lending (the risk that borrowers will default on their obligations, failing to make the
required interest payments or not repaying their loans) and making that risk into a
product that can be bought and sold. Bistro helped turn this tentative activity into big
business.
Bistro transferred to external parties the credit risk of loans totalling $9.7
billion that J.P. Morgan had made to 307 companies. The scheme was an influential
version of the CDOs (collateralised debt obligations) that I described in LRB on 8
May 2008. Like other CDOs, Bistro was divided into ‘tranches’, of which originally
there were two. Investors in the lower or ‘junior’ tranche received a healthy rate of
return, 375 basis points over Libor (London interbank offered rate), which is the
average rate at which a panel of leading banks report they can borrow from other
banks. (A basis point is a hundredth of a percentage point.) This compensated the
junior investors for the fact that their investments would bear the initial losses,
beyond a small reserve built up during the deal’s first five years, should any of the
307 borrowers default.
Only if those losses were to exceed the entirety of the investments in the
junior tranche would the holders of Bistro’s senior tranche – which paid only 60 basis
points over Libor – suffer. The loans that made up Bistro were well-diversified across
industries, and predominantly to blue-chip companies, so losses to Bistro’s senior
tranche seemed unlikely enough to Moody’s, one of the three leading credit rating
4
agencies (the others are Standard & Poor’s and Fitch), that it awarded the tranche its
highest rating, Aaa.
Aaa was a rare distinction. Only a dozen corporations and less than two dozen
governments were judged worthy of it: neither Italy nor Japan, for example, has an
Aaa rating. (As readers will know, Standard & Poor’s has indicated that the UK is
now also in some danger of losing its top rating.) Blythe Masters had formidable
powers of persuasion, which helped when selling a deal that ‘look[ed] like a science
experiment, with all those arrows’, as one investor quoted by Tett described Bistro’s
documentation. Yet 60 basis points over Libor, for an investment judged safer than
the sovereign bonds of some of the world’s leading economies, was the most
powerful argument of all: an investor would normally struggle to find an Aaa
investment that yielded as much as Libor.
For J.P. Morgan, Bistro solved one problem and potentially addressed a
second. First, while the 307 corporations were low risks, even the most creditworthy
borrowers can default. So $9.7 billion in loans to the 307 corporations was a
significant constraint on the bank’s future lending. Bistro removed that constraint.
Second, the Basel Capital Accord, signed by the world’s leading banking regulators in
1988 and implemented by them in 1992, forced banks to carry reserves equal to 8
percent of their risk-weighted lending. While certain categories of lending – to other
OECD banks, for example – qualified for a reduced reserve requirement, loans to
even the safest industrial corporation incurred the full 8 percent, a figure that bankers
felt was far larger than justified by the risks involved. J.P. Morgan hoped that the
transfer of credit risk achieved by Bistro would persuade regulators to reduce that
5
requirement considerably, and Tett reports that Blythe Masters and her colleague Bill
Demchak pushed the Federal Reserve and the Office of the Comptroller of the
Currency to clarify what exactly would be needed to achieve that.
Bistro differed from earlier CDOs in that it did not, in fact, transfer to external
investors all the credit risk of the $9.7 billion of loans. The junior and senior tranches
amounted in total to only $700 million; the bank believed that the chances of losses
ever exceeding that figure were too tiny for it to be worth paying investors to shoulder
them. The regulators, however, demanded that the bank do something to remove that
residual ‘unfunded risk’ before they would relax the 8 percent capital requirement.
The residual risk was like a topmost tranche, sitting on top of the senior
tranche; it would come into play only if losses wiped out the latter in its entirety. The
senior tranche was Aaa, as safe as it gets; the residual ‘super-senior’ tranche (as the
J.P. Morgan team christened it) was thus safer than safe. To satisfy the regulators,
however, the team turned to the Financial Products division of the leading US insurer,
AIG. Sharing J.P. Morgan’s analysis that the super-senior tranche was ultrasafe, AIG
agreed to insure it against all remaining losses, charging an annual premium of only a
fiftieth of 1 percent of the sum insured. From the viewpoint of AIG Financial
Products, it was small-scale business but apparently highly profitable: by covering an
effectively non-existent risk, the firm earned $1.8 million a year.
In that little afterthought to Bistro – what to do with the super-senior tranche –
lay the germ of much of the credit crisis, especially of its disastrous effects on many
of the world’s leading banks. Bistro-like deals started in the world of corporate
6
borrowing, but from 1999 onwards began also to be implemented in the world of
consumer debt, especially mortgages. There was actually longer experience of
packaging mortgages into securities than of packaging corporate debt into CDOs, and
mortgage-backed securities had acquired an admirable reputation for safety.
Mortgage-backed securities have a structure like that of CDOs, with different tranches
carrying various levels of exposure to risk. The safest, Aaa, tranches of those
securities had impeccably default-free records, and even the riskier tranches had
performed well: indeed, on average generally better than corporate bonds with the
same ratings. It wasn’t that people never defaulted on their mortgages – they did –
but the securities were designed to take this into account, for example by building up
reserve funds (analogous to but usually proportionately larger than Bistro’s small
reserve) that would absorb the anticipated losses. For many years, such provisions
proved in general fully adequate.
What happened from 1999 on was that mortgage-backed securities, which
already represented one layer of packaging of debt, then started to be repackaged into
CDOs, thus creating a ‘Russian doll’ product: a tranched, packaged product each of
the components of which was itself a tranche of a packaged product. Given their
excellent reputation, putting mortgage-backed securities rather than corporate bonds
or loans inside CDOs might seem a small step. Yet when in 1999 Bayerische
Landesbank, which had become involved in the US mortgage market, approached J.P.
Morgan to package $14 billion of bundles of mortgages and other forms of
predominantly consumer debt into a Bistro structure, there were initially serious
doubts within the Morgan team.
7
The problematic issue was correlation( NB DON ), which is at the core of evaluating a
CDO. Low correlation means that defaults are essentially idiosyncratic events, with
the consequence that only the bottommost tranche of a typical CDO is at significant
risk. In contrast, high correlation means that if defaults happen they tend to cluster,
and the clustering of defaults puts investors in the higher, apparently safer, tranches at
risk of loss.
Participants in the emerging credit-derivatives market tended to be confident
that they had a fair grasp of the correlation( NB DON ) of corporate defaults. The rating agencies
had large databases of such defaults from which the extent of clustering could be
inferred at least roughly, and other market participants often took the easily measured
level of correlation between the moves of different corporations’ stock prices as a
guide to the correlation of their net asset values. (The link between the latter and
default is that the most important cause of corporate default is bankruptcy, which can
be though of as happening when a corporation’s net asset value falls below zero: that
is, when its liabilities exceed its assets.) Clearly, the correlation of the asset values of
two different corporations was unlikely to be zero, since general economic conditions
will affect both. Nor, however, were corporate asset correlations thought likely to be
1.0, the value that indicates perfect correlation. 0.3 was a commonly-used figure.
That, for example, was the standard level of correlation between the asset values of
firms in the same industry that Standard & Poor’s initially assumed in CDO
Evaluator, the software system it began using in 2001 in the rating of CDOs.
The credit crisis has inured us to gigantic numbers – losses measured in
billions or trillions of dollars – but we need to pay attention to its little numbers as
8
well as its big ones if we’re going to understand it properly. A correlation of 0.3 was
modest. If it was correct it would be highly unlikely that the senior tranche of a CDO
such as Bistro would suffer a loss – unlikely enough to warrant an Aaa rating – and
effectively inconceivable that the supersenior tranche would be hit.
However, the analysis that had initially produced the widely-used figure of
0.3 was of corporate debt. How could one estimate the equivalent correlation for
mortgage-backed securities? Paradoxically, their very safety was a disadvantage in
this respect: there was effectively no record of default that could be scrutinised for
traces of clustering. Nor did such securities trade often enough for the correlation of
their prices to be measured: most investors in them simply held them until they
matured. Intuitively, though, it seemed conceivable that defaults in bundles of
mortgages or other forms of consumer debt could be quite highly correlated, because
of the likely role played by matters such as the overall unemployment level, and that
could make a CDO based upon mortgage-backed securities an unduly risky product.
In an interview I conducted with her, Terri Duhon, who led the Bayerische
Landesbank mortgage-backed CDO, told me that this caused some of her J.P. Morgan
colleagues initially to doubt whether the deal should proceed: they argued that ‘there
is no way that we should be doing this because it’s way too correlated’. Tett reports
that Krishna Varikooty, for example, was concerned by a correlation risk that seemed
to him to be unquantifiable. Intensive discussion and analysis, and very conservative
structuring of the deal eventually led to agreement that it was safe to go ahead (it
helped that unlike in many more recent deals the ratings of the underlying assets were
high – around 95 percent had Aaa ratings – and it contained no securities based on
9
subprime mortgages). Yet the reservations remained, and J.P. Morgan was only ever
to construct one further large CDO, and a limited number of smaller ones, in which
the underlying assets were bundles of mortgages.
In consequence, the bank remained on the sidelines as the previously largely
distinct worlds of CDOs and of mortgage-backed securities became increasingly
linked from 2002 on. It was an encounter of two subtly different cultures, with for
example quite different mathematical approaches. (Understandably, Tett, the former
anthropologist, limits the more ethnographic aspect of her analysis to only on one of
those cultures, that surrounding CDOs.) The CDO world developed explicit and
increasingly elaborate models of correlation – the ‘Gaussian copula’ that initially
puzzled Tett is a correlation model – while the mortgage world handled the
phenomenon entirely implicitly. In most investment banks, and also – as far as I have
been able to discover – in the New York head offices of the rating agencies, separate
groups or departments handled mortgage-backed securities and CDOs based on
corporate debt. In the investment banks, for instance, those different departments
seem to have had surprisingly little to do with each other. The two cultures never
really merged; instead, the CDO, a structure invented by the corporate-debt world,
was applied to the products of the mortgage world.
Members of both cultures now see the encounter as corrupting. ‘They’ –
constructors of CDOs based on mortgage-backed securities – ‘took our tools’ and
misused them, one specialist in corporate credit derivatives told me a few weeks ago.
Those with a background in mortgage-backed securities blame CDOs (with some
justice) for being indiscriminate buyers of those securities, concerned only with their
10
ratings and the spreads (increments over Libor) they offered. Two experienced
industry observers, Mark Adelson and David Jacob,1 suggest that the fatal point was
when CDOs became the almost the only purchasers of the riskier tranches of
mortgage-backed securities. Previously, those tranches were either guaranteed
against default by specialist insurers, or bought by canny investors with their firms’
own money at risk, who would carefully assess the risks involved. These insurers and
investors acted as a brake on the riskiness of the lower tranches, and thus on the
overall riskiness of mortgage-backed securities, and they demanded a healthy rate of
return for taking on their risks. They were displaced by those buying tranches in
order to package them into CDOs, who were prepared to buy them at lesser rates of
return, and who cared a lot less about their riskiness, because those risks were going
to be passed on to the investors in the CDOs.
With the brake removed, the construction of CDOs based on mortgage-backed
securities became a fast-moving assembly line (participants frequently turn to
machinic metaphors when describing the process). Brokers sold mortgages knowing
that they could readily be sold on in the form of mortgage-backed securities. Instead
of having to worry whether the couples sitting on the other side of their desks really
had the wherewithal to keep up their payments, all that mattered was the dozen or so
quantitative characteristics – such as borrowers’ FICO (Fair Isaac Corporation)
creditworthiness scores – that influenced rating agencies’ mortgage models. The
constructors of mortgage-backed securities no longer had to satisfy specialist insurers
or experienced investors: CDOs had an apparently insatiable demand for those
securities.
1 Their papers can be found at http://www.adelsonandjacob.com/
11
Essential to the assembly line was that the higher tranches of its final products
– CDOs in which the underlying assets were mortgage-backed securities – be able to
gain Aaa ratings. A critical issue was the likely correlation of mortgage-backed
securities. Standard & Poor’s, for example, used the same system, CDO Evaluator,
that it employed for CDOs based on corporate debt, and it employed the same modest
baseline correlation assumption, 0.3, for mortgage-backed securities that it initially
used for corporations within the same industry. (S&P would later reduce this last
figure, while increasing its assumption about cross-industry correlation. These
baseline correlation figures could be increased by the analysts rating a specific CDO
if it was highly concentrated in a particular industry or consumer-debt sector.) I
haven’t been able to ascertain the equivalent figures used by the other agencies,
whose methods differed somewhat from Standard & Poor’s, but the similarity of their
ratings to S&P’s suggest similar judgements. My focus is on S&P here simply
because – commendably – it seems to have been more explicit than the other agencies
in laying out in CDO Evaluator’s publicly-available documentation these crucial
assumptions underpinning how the system worked.
The choice of 0.3, or a number close to it, as the baseline was critical: one
specialist has told me that even a moderate increase in the baseline correlation
assumption, for example to 0.5, would have made many CDOs based on mortgagebacked
securities much less attractive, perhaps even not economically viable.
However, as far as I can discover, analysing CDOs built out of mortgage-backed
securities using only modest correlation levels seems in general to have been
uncontroversial. Certainly, the performance of mortgage-backed securities – which,
12
as noted above, had in general been better than that of corporate bonds – offered little
reason to be more stringent when rating CDOs based on them. For example, S&P’s
statistical analyses suggested a correlation of mortgage-backed securities lower than
0.3; the latter figure was retained as a baseline because it was understood that the
correlation would rise when economic conditions became less benign.
Had the world remained as it was in 2002, the agencies’ assumptions and
ratings might well have turned out to be perfectly appropriate. The trouble with an
assembly line, though, is that it produces identical products. The only person outside
of J.P. Morgan I’ve so far found who thought, at the time, that the correlation
estimates being used to analyse CDOs of mortgage-backed securities were much too
low had discovered this by accident. In a previous job as an auditor, he was checking
the statistical tables that the sellers of mortgage-backed securities provide to
prospective buyers. These tables show the breakdown of the underlying loans by
state, FICO score, loan-to-value ratio, and so on. When checking the tables for one
security, he inadvertently used the loan tape (the underlying mortgage data) for
another, and found almost complete agreement. ‘These deals’ – apparently different
mortgage-backed securities – ‘were the same deal’, he told me. Even geographical
dispersion of the underlying mortgages across the US (a desirable feature when an
individual mortgage-backed security was considered in isolation, because it reduced
exposure to the vagaries of particular local housing market) had the paradoxical effect
of increasingly the homogeneity of different mortgage-backed securities. In a
situation of severe economic stress – falling house prices, rising unemployment – not
just some of those securities would perform badly: they all would. Instead of
correlation remaining modest, my interviewee came to fear that it would be nigh on
13
perfect.
Specialists in mortgage-backed securities in the US have not been entirely
surprised at the fraud and malpractice in mortgage lending that has come to light: it
was always present, and changed only in scale( NB DON ). (There had been an earlier US
subprime crisis in the late 1990s, which only specialists seem to remember.2 It was
much more limited in its scale, but it revealed extensive over-optimistic accounting by
lenders.) That mortgage defaults have risen, and the value of repossessed homes
fallen, is not in itself surprising to specialists, although the size of the changes
certainly is. At least some of them did begin to suspect that longstanding statistical
relationships – for example between individuals’ credit scores and the risk of them
defaulting on their mortgages – had ceased to be valid, but as far as I can tell that
suspicion arose only in 2006, by which time the processes that led to the credit crisis
were well underway. One problem, for instance, seems to have been that with
individuals’ scores increasingly determining their access to credit and the rates of
interest they had to pay, they found ways to manipulate those scores. A modest webbased
industry developed which arranged (in return for fees of around $1,000-$2,000
per person) for people – in some cases, apparently dozens of people – with low credit
scores to be added as ‘authorised users’ to the credit card account of someone with a
high score and an impeccable payment record. Within one to three months, the
benefits of the primary cardholder’s regular payments fed through into improvements
in the credit scores of the card’s ‘renters’.
If, however, CDOs backed by mortgages had worked as the J.P. Morgan team
2 It is discussed in the final chapter of an excellent book that, while more limited in scope and more
technical than Tett’s, deserves to be better known: Laurie S. Goodman et al., Subprime Mortgage
Credit Derivatives (Wiley 2008, $80.00, 978-0-470-24366-4).
14
had envisaged when designing Bistro, the losses to investors in those CDOs that the
US housing bubble and its collapse have caused, though very large, would have been
spread widely across the many institutions that bought the tranches of such CDOs. As
Tett notes, what has shocked the members of that team – many of whom now work
for other banks and hedge funds, but still stay in touch – is the concentration of such
losses, especially at apparently sophisticated global banks such as Bear Stearns,
Lehman Brothers, UBS, Citigroup, Merrill Lynch, Morgan Stanley and the Royal
Bank of Scotland.
The primary vehicle by which risk was concentrated was Bistro’s afterthought,
the super-senior tranches of CDOs. Even the riskiest mortgage-backed CDOs – those
that predominantly bought the ‘mezzanine’ (next-to-lowest) tranches of mortgagebacked
securities – have super-senior tranches that are bigger than all the other
tranches put together. These super-senior tranches were hard to sell to most outside
investors, because the need for attractive returns on lower tranches means a supersenior
tranche can offer only a slender increment over Libor. By 2005, Tett reports,
that spread was as low as 15 basis points.
So many banks did as J.P. Morgan did with Bistro: they kept the super-senior
tranches, sometimes insuring them via AIG or the specialist bond insurers. (Adelson
and Jacob point out the resultant irony. Risks that the mortgage experts in the
insurers would have charged heavily for or perhaps even declined were insured in
packaged form in huge amounts – and quite cheaply – by different departments of the
same firms.) If only a handful of deals had been insured in this way, it would have
made perfect sense. As Tett notes, however, AIG insured super-senior tranches
15
totalling $560 billion. Its bail-out by the US taxpayer dwarfs that of any bank, and as
John Lanchester wrote in the LRB on 28 May, it keeps rising (the current total is $173
billion), but AIG cannot be allowed to fail, because the loss of these crucial supersenior
insurance contracts could bring much of the banking system down with it.
Perhaps most surprising of all, top banks also bought super-senior tranches
originated by other banks. If you are a top bank, you can borrow at around Libor
(that, after all, is what Libor means); if you are particularly well regarded, it may be
possible to borrow at a rate a tiny bit lower than Libor. So you could borrow at Libor
or below, buy a tranche that seemed safer than safe, and from it earn a slender spread
over Libor. It looked like free money. It was especially tempting to traders whose
banks ‘charged’ them for their use of capital, in the systems by which traders’ P&L
(profit and loss) is measured, at around Libor, and credited them with the small
additional spread that super-senior tranches offered. The slenderness of the spread
meant that you had to do the trade on a very large scale to earn a really big bonus, so
traders did just that.
As I’ve already indicated, the vulnerability of super-senior is correlation.
Losses on uncorrelated assets are unlikely ever to impact on super-senior tranches.
When correlation approaches 1.0, however, a CDO’s asset pool starts to behave like a
single investment. It may suffer no defaults, or it may default effectively in its
entirety. If the latter happens, even the super-senior tranche, safer than safe, is
doomed.
As the US historian of economics Perry Mehrling points out, events in
16
financial markets cast their shadows ahead of them, not behind. What has haunted the
banking system for the last two years is above all the shadow of the gigantic, systemwide
default of the super-senior tranches of all the CDOs based on those US
mortgage-backed securities issued towards the end of the bubble( NB DON ). (Residential
mortgages have been the focus of most of the attention, but there are also lots of
problems with commercial mortgages.) Although, alas, the losses will not stop there,
most immediately at risk have been CDOs made up primarily of the mezzanine
tranches of subprime mortgage-backed securities issued from late 2005 on. Defaults
have risen enough, the value of repossessed homes has fallen enough, and the
structure and composition of these securities has been similar enough, that as far as I
can tell almost all such tranches have been or will be wiped out in their entirety. So if
a CDO contains little else but such tranches, even its super-senior portion faces closeto-
total losses. So far, only a limited part of those losses have actually been realised,
but the banking system is braced for the rest of them – and, with the massive aid of
taxpayers, it is hopefully now well enough capitalised to survive it and the other
losses that sharp recession will bring.
Unfortunately, this analysis – that the crux of the problem has been not in
CDOs per se but in the uncomfortable encounter between the world of CDOs and that
of mortgage-backed securities – remains only a hypothesis. The world of corporate
CDOs has itself manifested some of the phenomena of the mortgage CDO assembly
line: increasingly risky loans were made to private equity firms and to other highlyindebted
corporate borrowers because it was possible to package and sell on those
loans in the form of CDOs. I’ve just come back from New York, where I questioned
some of those I spoke to on the magnitude of the problems that may lurk below the
17
still comparatively quiet surface of this other sector of the CDO market, which, while
not as large as as the mortgage sector, is still huge. My interviewees seem convinced
that while the problems are real they do not approach the same scale: the amount of
truly irresponsible lending to corporations was much smaller. I hope they are right.
At its heart, the tale Tett tells is a moral one. She believes that the history of
the J.P. Morgan credit derivatives team shows that banking can be technically
innovative while remaining responsible( NB DON ). Her readers may fear that the anthropologist
has here simply gone native, but I don’t think so. I have met a good number of those
she is writing about, and have studied many of the events she has, and I largely share
her judgement. In particular, J.P. Morgan’s decision not to set up a mortgage CDO
assembly line (despite Dimon at one point wanting one) has meant that the bank has
not suffered the catastrophic losses that so many of its peers have; unlike theirs, its
solvency has never been in doubt. It is too easy right now to condemn all of those
who work at the heart of the financial system as either rogues or fools: for example,
Tett reveals that Blythe Masters, who stands out because even today female senior
bankers are relatively rare, gets hate mail. So Tett is right to emphasise that despite
all the pressures and all the temptations, prudent banking was still practised ( NB DON ) –
sometimes – even at the centre of history’s largest-ever credit bubble.
9 June"

refuting the idea that an increase of thrift will necessarily increase investment.

TO BE FILED: From the Ludwig von Mises Institute:

"An Interview with G.L.S. Shackle

An often-controversial figure within the penumbra of Austrian economics, G.L.S. Shackle, through his books (which include Epistemics and Economics, Time in Economics, and Decision, Order, and Time in Human Affairs) and articles has developed a radically subjectivist approach to economics.

Born in Cambridge, England, in 1903, Shackle began his formal training relatively late in life under F. A. Hayek, his "discoverer," at the London School of Economics. This interview was conducted by Richard Ebeling in the fall of 1981.

AEN: When you were a student at the London School of Economics in the 1930s, I understand that you had an opportunity to participate in the Hayek-Robbins seminar.

SHACKLE: Yes. Well, It was really Hayek's seminar. There were two seminars, one on Monday afternoons, which was Robbins's, and a more work-a-day pedestrian affair. The high-powered one was the Hayek seminar on Thursday evenings. These seminars were star-studded, with marvelous lectures: Hayek was there, Robbins came once or twice, and there were also John Hicks, Nickolas Kaldor, Abba Lerner, and Ursula Hicks.

We had a constant stream of people of various degrees of eminence--some of them very eminent--coming to the school. They didn't come to the Hayek seminar necessarily, but they sometimes gave lectures in the afternoon. These were people many of whom were taking refuge from what was going on in Central Europe. Some of them were famous--Karl Popper, for instance. I heard him give the first lecture he ever gave in England. Then there was Gottfried Haberler, and Fritz Machlup; Paul Rosenstein-Rodan was also in London. That was the sort of seething excitement at the London School in those years. For anyone really hooked on the subject, it was absolutely thrilling.

AEN: What topics were discussed in Hayek's seminar?

SHACKLE: Well, of course, Hayek was writing the book which came out in 1941, under the title The Pure Theory of Capital. A student would write a paper with the topic largely of his own choosing; anything acceptable to Hayek would be discussed--money, and various aspects, I suppose, of capital theory--but I'm afraid I can't remember in detail now. Hayek used to give me the manuscript of The Pure Theory at Capital to read, as he was always rewriting the draft. I read several versions of it.

AEN: Sir John Hicks has portrayed the 1930s as a period of great intellectual battles between what he portrays as the "Hayekians" versus the budding Keynesians. What are your memories of that time?

SHACKLE: Well, I don't think it can really be said to have started until a small group of us went down to Cambridge on a Sunday afternoon in October 1935. That's where we heard Joan Robinson and Richard Kahn and really learned about Keynes's The General Theory. I didn't really understand what The General Theory was going to be all about until I heard Joan Robinson. I don't think you can say that a real battle began until after The General Theory had made some impact on us in that way--perhaps not even until after it came out. But up to 1935 there was a strong Hayekian influence at the LSE--people were greatly sold on Hayek's views as expressed in Prices and Production; I should say that included Hicks and Lerner and Kaldor.

AEN: If you go through the economics journals for the couple of years after the appearance of The General Theory in 1936 and read the reviews of the book, e.g., Hicks's first review, Frank Knight's, Joseph Schumpeter's, Jacob Viner's, Dennis Robertson's, and so on down the line, every one of them criticized the book severely. And if one compiles a list of all the criticisms made in those reviews, there is very little in Keynes's arguments left unchallenged. Yet, within a few years, the book became the volume guiding economic theorists. Given the opposition to it by so many leaders in the profession, why?

SHACKLE: Well, I think the opposition was because the book's object was to overturn the established theory of value, which it did. I think it's fair to say that the accepted, the received, theory of value and distribution in those days could not possibly account for involuntary unemployment because its premises included something very like perfect knowledge; and, if everyone had perfect knowledge, why should they have allowed a disaster like the early 1930s? It didn't make sense. The received theory of value and distribution up to the early 1930s was a theory of perfectly successful adjustment, perfect coordination. And, if things are perfectly coordinated, there's no reason why anybody should be involuntarily unemployed.

Keynes pointed out that there was this contradiction requiring an explanation and he explained it. His theory of involuntary unemployment is perfectly simple and can be expressed in a paragraph, or in a sentence. If you express it in a sentence, you simply say that enterprise is the launching of resources upon a project whose outcome you do not, and cannot, know. The business of enterprise involves investment, the investing of large amounts of resources--huge sums of money--in things whose outcome you cannot be certain of, which could perfectly well turn into a disaster or a brilliant success.

The people who do this kind of investing are essentially gamblers and they can lose their nerve. And if they decide to withdraw from trade, they sweep their chips up from the table. If they decide it's too risky, if their nerve gives out and they can't bring themselves to go on investing, they cease to give employment and that is the explanation. When business is at all unsettled--when there's any sign at all of depression--or when there's been a lot of investment and people have run out of ideas, or when their goods are not selling quite as fast as they have been, they no longer know what the marginal value product of an extra man is--it's non-existent. How can you say that a certain number of men have a certain marginal productivity when you can't know what the per unit value of the goods they would produce if you employed them would sell for?

AEN: Let me present an alternative for you. Let's take someone like Philip Wicksteed in his book, The Common Sense of Political Economy. Now from beginning to end almost every page in Wicksteed is loaded with the words "anticipation" and "expectations." He analyzes consumer's marginal utility evaluations as well as production activity, in terms of the forward-looking perspective of the actors. So there was a different tradition other than Knightian perfect competition in existence that used expectations in a process sense. Let me make a point about analyzing the Great Depression. The money supply was contracting in the early 1930s--a fact that seems to have been not clearly understood at that time, but which we now appreciate. It is possible to interpret this in a Wicksellian framework, i.e., of the money rate being above the natural rate. The structure of production was being artificially "shortened," so to speak, instead of "lengthened." Using Wicksell in this manner, within a Wicksteedian framework, one can analyze the Great Depression as a cumulative contraction in an environment of incorrect expectations--and without a Keynesian framework.

SHACKLE: Yes, yes I can see that. That certainly is very interesting indeed. Especially the reference to Wicksell. Yes, I do see that, but I must say I still think that Keynes didn't really get right home on his target until he wrote his 1937 article on "The General Theory of Employment" in the Quarterly Journal of Economics. There he put the whole weight on uncertainty and I still think that that is the real point. That "involuntary unemployment" merely means that there are people who haven't enough faith in their expectations to give employment.

AEN: An aspect that the Austrians have emphasized, particularly in the recent works of Israel Kirzner, e.g. his book Competition and Entrepreneurship, is that the market operates through the coordinating activities of the entrepreneur. The entrepreneur is the one who searches for opportunities, for profits from arbitrage. The market process over time tends to weed out the "poor" entrepreneurs, who suffer losses, while the "good" entrepreneurs reap profits and gain additional control over factors of production. As a consequence, the people who at any moment in time will be making production decisions will tend to be those entrepreneurs who are the "confident" entrepreneurs, i.e., who tend to see the future better than others. Why would you expect the sudden collapse of confidence, when the market is always tending to give control to those who show the most confidence?

SHACKLE: Yes, well, I think that I would say that they may have confidence, but it will have to survive some terrible shocks. I mean, there will always be shocks and things that really upset all calculations. I can't really quite believe in the idea of steady improvement, you know. After all, some of these men, they're very clever entrepreneurs, are not all working together, they're trying to undermine each other's positions, they're working against each other and trying to outdo each other.

AEN: There's an aspect of Keynes's analysis that Austrians find particularly unsatisfactory, that being his emphasis on analyzing economic phenomena primarily in "macro" or aggregate terms. Now, it seems that both in the Treatise on Money and in The General Theory, required micro-relationships are the very aspects Keynes glossed over in dealing purely at the macro level. The micro-economic relationships are surely the essential ones in an analysis to determine whether a "macro" situation represents a condition of equilibrium or disequilibrium.

SHACKLE: Yes, I'm sure you're right. Keynes, no doubt, in dealing with aggregates, was too "aggregated." I quite agree with what you say. I once used a little diagram in which a lot of arrows are going up vertically, with the arrows representing the value of particular investment projects, which will be invested in if the rate of interest goes down. Now, there'll be for each of these projects a level of cost of construction. Their value has to go up high enough to be above the cost of construction. If the rate of interest goes down far enough, it will bring some of them up into the realm of profitability; if it goes down even further, it'll bring more of them up, and so on. Well, there's no hint of that in The General Theory. The marginal efficiency of capital is just this thing you compare with the interest rate, isn't it?

AEN: The multiplier and the consumption function, it seems to me, suffer from the same problem. For certain analytical purposes, it may be useful to refer to the "total" level of consumption, but surely, again, what matters is whether the relative demands for and supplies of different consumer goods are "right."

SHACKLE: Well, you see, I think that one of the things that Keynes was best at was simplifying and encapsulating ideas like the consumption function. I think he would have agreed that economics is an imprecise subject and that the best you can do sometimes, if a problem is full of difficulties, is cope with it by wrapping it up tightly and saying "we're going to treat this as a whole." And I think that's what he did in the consumption function. I think, of course, he did so because he was very much concerned with refuting the idea that an increase of thrift will necessarily increase investment. So, I think his own answer would have been that you have to go in for these rather "black box" ideas, because they're the only way of coping with the intolerable complexity and the elusiveness of things.

AEN: You have emphasized the importance of expectations--that expectations are a product of an individual's subjective perception of opportunities laying before him. The argument is made that a problem with radical subjectivists is that it almost seems as if they aren't sure if reality exists, as if everything is just a product of the mind, totally unrelated to objective reality. How would you respond to that?

SHACKLE: I think that's the view some take. I can only speak for myself and I don't say that objective reality doesn't exist--this is a philosophical problem far out of my depth. But I do think that what we do in our actions is based on what goes on in our own minds, and one way I have tried to put it is that the things which you can choose amongst have to be made by yourself. You can only choose actions and acts. When people say, I'm choosing a new suit, or I'm choosing a house, what they're really saying is, I'm choosing which one to buy. It's the actions they're choosing. I think that the action must be formulated in one's own mind--it's a work of art, it's a work of imagination. Your list of choosable things has to be constructed or composed by yourself before you can choose

AEN: Some economists would respond by saying that you've made this conception so broad, so general, that there's almost no determinism left in it. You can't say whether this will happen or that will happen. How would you respond to that?

SHACKLE: In the most radical way, I'm afraid. I think there is pretty complete in-determinacy. I did spend a lot of energy trying to see if I could devise any theory of how expectations are formed and I ended with the conclusion that expectations are far too elusive and subtle to find out any principles or rules to explain their emergence. They're based on suggestions and you get suggestions from any mortal thing that happens--that you happen to read, that you happen to hear. You get suggestions from anywhere. No mortal person can say where they come from. That, you see, is the trouble.

Economics started as an attempt to imitate physics, Newtonian physics, and I think in doing so, it got off on the wrong foot. You could ask an historian to explain the institutions in England in the eighteenth century, but would you try asking him what is going to happen during the next century? He'd say, "my goodness, man, of course I can't tell you that!" He'd absolutely reject the notion of that sort of prediction. Well, if an historian can't do it, why should an economist be able to do it?

AEN: This ties in with your view of what "choice" means in neoclassical or mainstream economics.

SHACKLE: It really does right down to the philosophical bedrock because if we claim that every choice can be completely explained by or wholly accounted for via circumstances and tastes and if you like, by knowledge, then we are living in a determinist world. It may be that determinism doesn't exclude ignorance. The amount of ignorance that a person suffers from may itself be determined by his history, his educational history, and his circumstances. But I think if you can explain every choice completely, then you really are a determinist taking up a determinist point of view. I find it difficult to see the point of calling it choice, if it is completely determined.

If we can really explain any choice completely, we are saying we can point to causes which made this choice inevitable. It's the only thing that could have happened in the circumstances. We really are saying that the person who made the choice is merely a link in the machine, he's just a connecting-rod, which means he's not a maker of history in any real sense. Well, it may be that it's a foolish ambition to try to think of human history as made by human beings, but I see Man as a "beginning," a chooser which cannot be fully explained. He is an uncaused cause. I don't think you can really say much more.

AEN: I take it that you don't hold much confidence or faith in attempts at economic prediction through econometric techniques.

SHACKLE: No, frankly I don't. I shall be shot out of the profession even further than I have been already; this will be the end of my career, if it hasn't ended many years ago. However, I will be honest and say that I don't think that economics can yield constants of the kind that physics does. Physicists have constants, e.g., the acceleration due to gravity, the table of atomic weights. I don't believe that economics can have constants like that, You might make measurements which are all right for today. But, there are countless people whose interest it is to make nonsense of those measurements tomorrow. Well, now I have really been quite honest.

AEN: If one takes that position, then a question could be asked of you: Given what you have said, what should economists do?

SHACKLE: I think they should give up giving advice, except on the most hesitant, the most broad grounds. I think they should introduce an ethical element, a more than ethical element. If a man is asked whether public expenditure should be cut or not, he perhaps should say, "Well, if we cut it, we shall cause a great deal of misery; if we don't cut it, we don't know what the consequences will be, but we can't at least have this misery on our consciences". This sort of argument is not an economic argument, it's an argument with one's conscience.

For very many years I've not believed in welfare economics as a scientific construction. My idea of welfare economics is that you choose an administrator, a man with a conscience himself, and broad sympathy, with a generous mind and then you say, "Leave it to him!" I don't believe you can do any better. Those economists who are going to give advice, or who are going to be advisors either to government or to business, should have their training based in economic history, and they only need as much theory as you find up to the second year textbook.

AEN: How would you respond to the rebuttal that, aren't you, in a sense, suggesting that economics become historicism. General theory may exist, at a very simple or fundamental level, e.g., the concept of marginal utility, but, beyond that, all we ever have is the historical record and what was historically relevant in the past may not be for our period.

SHACKLE: No, it may not. And it won't be. Well, it's a very nihilistic position and I realize that.

AEN: In a sense, what you're suggesting is that a very large proportion of what has been built up in over two hundred years in economics as a discipline needs to be set aside, that it throws into question the very notion of what most economists view as what is required of economics to be a science?

SHACKLE: I've been saying for almost forty years that economics isn't a science, and we ought not to call it a science."

lies an ever-shifting horde of homeowners, bankers, business owners, unwitting investors -- in short, people

TO BE NOTED: From Knowledge@Wharton:

Hope, Greed and Fear: The Psychology behind the Financial Crisis Published : April 15, 2009 in Knowledge@Wharton

To explain the current economic crisis, the world of finance has a particular lexicon -- including, for example, credit default swaps, mark-to-market and securitized subprime mortgages. Psychologists, on the other hand, might use very different terms: hope, greed and fear.

The language of psychology helps to address the fact that behind every cut-and-dried statistic about falling home prices and other indicators of economic decline, lies an ever-shifting horde of homeowners, bankers, business owners, unwitting investors -- in short, people. And people often pay no heed to fine-tuned economic models by doing things that are not rational, are not in their best interest, and are justified not by numbers -- but by emotion.

"There are spreadsheets and financial statements and models and rules and regulations," said Carolyn Marvin, a professor at the University of Pennsylvania's Annenberg School for Communications. "On the other hand, there are these feelings we have."

Emotion, it can be argued, not only helped to lead America into the current economic crisis but may also be helping to keep it there. At a recent conference called, "Crisis of Confidence: The Recession and the Economy of Fear," sponsored by the University of Pennsylvania's Department of Psychiatry and the Psychoanalytic Center of Philadelphia, an interdisciplinary panel explored the psychological elements behind today's economy.

"Is there a systematic way to think about our feelings when it comes to the economy?" asked Marvin, the panel moderator. The word "confidence" itself has a double edge to it, encompassing optimism on the one hand and delusion on the other. And could there be a psychological tinge to economic vocabulary itself? "The powers that be are avoiding the word 'depression,'" Marvin pointed out, "which describes not only a state of the market but certainly a clinical condition."

Psychological factors are at work behind the crisis, the panel agreed, although each focused on a different element: mania and over-optimism behind the housing bubble, a lack of self-control by consumers hooked on debt, and the shock and feelings of betrayal of many Americans who thought they were making safe investments, but now find themselves facing a frightening and uncertain future.

'An Aspect of Mania'

Like so many others in history, today's economic crisis began with a bubble, according to Wharton finance professor Richard Herring. "Bubbles occur when people are willing to buy something simply because they believe they can sell it for a higher price. [Bubbles] often have an aspect of mania."

Property bubbles are nothing new, said Herring, who presented a chart of home prices during a 400-year period in Herengracht, a canal area in central Amsterdam. Over those centuries, real home prices increased annually by only 0.2% on average, "but in between, [they were] up 100%, down 50%. There was huge volatility."

Real estate booms and busts happen in very long cycles -- on average about every 20 years. Consequently, when housing prices are going up, few remember that they ever went down. This was certainly the case in the recent crisis, since housing prices only went up between 1975 and 2006. According to Herring, property markets are especially prone to booms and busts because of their nature: They have no central clearinghouse of information about prices, transaction costs are high and trading is infrequent, and the supply of property is relatively fixed in the short term. Because the cycles are decades long, it is difficult to tell what a piece of property should be worth in the long run. "We really don't know what the price should be, so it's always difficult to tell whether you are looking at a bubble or simply improving fundamentals of the economy."

Housing booms and busts are "almost always linked to the banking system," Herring added. "When something good happens in an economy, it tends to drive up real estate prices, and banks tend to lend to support that, because people now have collateral." Optimism about rising prices feeds the frenzy, and as an increasing number of novice investors enter the market, prices and enthusiasm also increase. "You get into this upward spiral that can take you a very long way for a very long time. You may ask where the supervisors and regulators are in all of this, and often, they tend to support it. They really like to see loans that are collateralized by real estate because it's tangible."

Call it "the fallacy of misplaced concreteness," Herring quipped, showing a slide of a half-built skyscraper from a recent property boom-gone-bust in Thailand, "but really it's the fallacy of misplaced concrete." Again, emotion plays heavily into the cycle. People suffer "disaster myopia," either because they simply can't imagine a downturn happening, or they assume the probability of it happening is so low that it really isn't worth worrying about, Herring stated.

Ever-rising Home Prices

"I think we agree that over-optimism is perhaps a lot of what got us into this mess," said Wharton business and public policy professor Jeremy Tobacman, a panel participant. "There was rampant over-optimism about housing prices."

Tobacman pointed to a survey by Case and Shiller in 2003 of homeowner attitudes in four major markets -- Boston, Milwaukee, Los Angeles and San Francisco. In all four markets, more than 80% of homeowners surveyed said they believed home prices would rise over the next few years. When homeowners were asked how much they expected the price to change in the next months, mean responses ranged from 7.2% in Boston to 10.5% in Los Angeles.

"Even more astonishing than these one-year numbers are the numbers for decades," Tobacman noted. When faced with the question, "On average over the next 10 years, how much do you expect the value of your property to change each year?" homeowners in Milwaukee said they expected prices to rise by 11.7%. Homeowners in San Francisco said they expected a 15.7% return.

People often make poor economic choices because they are overly optimistic about what they will do in the future, Tobacman said. For example, people transfer credit card balances over to cards with high long-term interest rates because they believe they will pay everything off before the much lower teaser rate expires. (Most don't.) Borrowers who default on payday loans typically pay interest amounting to 90% of the loan's principal before they finally give up and stop making payments.

One study of a health club found that members who worked out on average just four times a month chose to pay a monthly membership fee of $85, even though the gym also offered a pay-as-you-go rate of $10 per visit. "When people are polled about their beliefs [as to] what they're going to do, there is a radical refusal to accept reality," said Tobacman. "Myopia may be willful in that we don't want to contemplate undesired outcomes."

In the recent bubble, both buyers and lenders were overly optimistic about what the future would bring. Buyers ignored the possibility that they might not be able to keep up on payments because they assumed the prices of homes would go up and they would be able to sell or refinance. Likewise, lenders ignored the possibility of default because rising home prices had made it easy to get bad loans off the books. Tobacman shared a quote from John Kenneth Galbraith's The Great Crash, a history of the events leading up to the Great Depression: "The bankers were also a source of encouragement to those who wished to believe in the permanence of the boom. A great many of them abandoned their historic role as the guardians of the nation's fiscal pessimism and enjoyed a brief respite of optimism."

Said Tobacman: "I think the question is, when exactly does this powerful impetus to believe in a rosy future get disciplined by the market and when does it get out of hand?"

The explosion of consumer debt behind the crisis is also an issue of self-control, University of Pennsylvania psychology professor Angela Lee Duckworth noted. "It's a perennial human problem, to delay gratification. We all struggle, from little children to the oldest and wisest, with the problem of self-control."

Duckworth defined self-control as the ability to negotiate a situation in which there are two choices and one is obviously superior, but the other choice is nevertheless more tempting. For example, a dieter faced with a chocolate cake knows that it is best not to eat it, but often makes a choice to eat it anyway. In the case of the housing bubble, homebuyers failed to exercise self-control when they bought larger homes than they knew they could afford. Lenders failed to exercise self-control when they chose to write shaky mortgages in order to bank short-term profits.

For years, Americans have saved less and consumed more, Duckworth said. She pointed to the conclusion of a recent editorial in The Wall Street Journal by Chapman University research associate Steven Gjerstand and Chapman University economics professor and 2002 Nobel Laureate Vernon L. Smith: "A financial crisis that originates in consumer debt, especially in consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge," the editorial stated.

Added Duckworth: "It seems that my father was right during those conversations around the dinner table when he would say, 'Americans are living beyond their means.' I guess we were. And I think that's in part because all human beings want to live beyond their means."

Self-control is an aptitude that changes dramatically over a lifetime, according to Duckworth. This is because the prefrontal cortex, the area of the brain that allows human beings to control impulses and delay gratification, matures more slowly than other parts of the brain. "Sub cortical regions and the brain stem are more or less online as soon as you're born, if not very soon after ... so emotion and impulse in these areas are functioning at full throttle" right away, she said. But the prefrontal cortex is not fully developed until a person is much older -- somewhere in the late 20s and possibly as late as the early 50s.

"There's a lag problem here, where we have our emotions and we have our impulses ... but you have to wait until you're at least 25 before the frontal cortex is in great shape to actually rein in those lower-level desires."

Studies by psychologist Walter Mischel that measure how well a preschool child could delay gratification (asking the child to choose between eating one marshmallow now or getting two later) predicted a range of outcomes that happened later in life, from SAT scores to divorce to use of crack cocaine, Duckworth noted. "I think that these almost unbelievable findings are in fact believable, because Walter Mischel was able to distill in a simple testing situation the classic human dilemma that we all face every day, which is: more later, or a little bit now?"

These and later studies on delayed gratification have shown that self-discipline is a bigger predictor of later success than other factors such as I.Q., Duckworth stated. A better understanding of the psychology of self-control could help "develop government policies that would presumably accommodate the realities of human nature."

A Question of Trust

"What happens when the bubble breaks, as it inevitably does?" Herring asked. The pendulum swings back to the other extreme. "People find it all too easy to imagine that bad things can happen to the market and they withdraw. And they tend to overshoot. They will act very, very risk averse for quite a long time until they are persuaded that [real estate] is once again a safe asset to hold."

According to David M. Sachs, a training and supervision analyst at the Psychoanalytic Center of Philadelphia, the crisis today is not one of confidence, but one of trust. "Abusive financial practices were unchecked by personal moral controls that prohibit individual criminal behavior, as in the case of [Bernard] Madoff, and by complex financial manipulations, as in the case of AIG." The public, expecting to be protected from such abuse, has suffered a trauma of loss similar to that after 9/11. "Normal expectations of what is safe and dependable were abruptly shattered," Sachs noted. "As is typical of post-traumatic states, planning for the future could not be based on old assumptions about what is safe and what is dangerous. A radical reversal of how to be gratified occurred."

People now feel more gratified saving money than spending it, Sachs suggested. They have trouble trusting promises from the government because they feel the government has let them down.

He framed his argument with a fictional patient named Betty Q. Public, a librarian with two teenage children and a husband, John, who had recently lost his job. "She felt betrayed because she and her husband had invested conservatively and were double-crossed by dishonest, greedy businessmen, and now she distrusted the government that had failed to protect them from corporate dishonesty. Not only that, but she had little trust in things turning around soon enough to enable her and her husband to accomplish their previous goals.

"By no means a sophisticated economist, she knew ... that some people had become fantastically wealthy by misusing other people's money -- hers included," Sachs said. "In short, John and Betty had done everything right and were being punished, while the dishonest people were going unpunished."

Helping an individual recover from a traumatic experience provides a useful analogy for understanding how to help the economy recover from its own traumatic experience, Sachs pointed out. The public will need to "hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again." In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.

"Once a person has been traumatized, promises ... are experienced as dangerous -- not safe -- because they require trust to believe," said Sachs. "It is up to the victim to decide when she can trust again. This takes time."

Maybe the hedgies are finally realizing that the only thing worse than too much regulation is too little.

From Reuters:

"When hedge funds embrace regulation

Post a comment (1)

Posted by: Felix Salmon

Tags: hedge funds, regulation

Paul Singer, the ardent Bush supporter and laissez-faire capitalist who runs the $13 billion Elliott Associates hedge fund, has an astonishing op-ed in today’s WSJ:

Now we must create a new regulatory infrastructure that will meet three fundamental tests… finally, it must bring all investors and traders — regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual or government agency — under the regulatory umbrella…
I understand the inclination among free-market conservatives to dismiss the government’s regulatory efforts as misguided. Some government actions over the past year have been reactive and incomplete. Yet these actions have been large and reasonably fast, which were the critical elements for the survival of the system.

The op-ed comes in the wake of the G20 meeting which agreed that hedge funds should be regulated, so maybe Singer is simply bowing to reality here. But this is still something of a watershed moment. Singer is one of the most politically astute hedge-fund managers in America, and where he goes the rest of the industry is probably likely to follow.
So if you thought there would be a lot of pushback from the hedge-fund industry against proposals to regulate it, think again. The industry will want a say in how any legislation is worded, of course. But it has also lost hundreds of billions of dollars over the past couple of years as a result of insufficient regulation of the global financial system. Maybe the hedgies are finally realizing that the only thing worse than too much regulation is too little."

Me:

It’s an excellent post:

“But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.”

Bingo!

“Government action could easily spill over into gross over-reach (like the bonus-tax fiasco). But a combination of private responsibility and practical government regulation will help ensure that the capitalist system continues to be a source of opportunity and prosperity for people throughout the world.”

Can you say “libertarian Democrat”?

Here’s a comment from long ago:

“Saturday, October 4, 2008
The Path To Re-Regulation
Gross on regulation resulting from this crisis:

“In the meantime, a surge in regulation of the financial sector will be unleashed, probably an inevitable result of the problems and rescues of recent months.

“Twelve to 24 months down the road, all of these high-flying investment banks and banks will be reregulated and downsized,” Mr. Gross said. “They won’t become arms of the government, but they will be supervised and held on a tight leash.”

The greater regulation should draw investors back to the market and away from what seems to be their current financial strategy — stuffing their cash in mattresses.”

One of the probable downsides of a crisis like this is the problem of over-regulation resulting, which is why I favor enough regulation to keep this kind of crisis from occurring. However, as even Gross admits, some regulation is necessary for investors to re-enter the market. Let’s hope we strike a better balance this time.”

In other words, you actually need regulation in order to:
1) Get people investing again
2) Get people to buy into our system at all

I also agree here:

“Reform must begin with a regulatory regime focused on “behavior” instead of “systemically important institutions.” Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.”

Choose Human Agency Explanations over Mechanistic ones if you want to do some real good.

Finally, congratulations on your new venue. Reuters is terrific. For one thing, they had some of the earliest reporting on the possible social disruptions and dislocations in this crisis.

As well, their page on African news is the best I’ve found. Try it:

http://af.reuters.com/

- Posted by Don the libertarian Democrat

From the WSJ:

"By PAUL SINGER

President Barack Obama took his proposed financial regulatory reforms to London this week for the G-20 meeting, while free-market advocates objected. While many of Mr. Obama's ideas warrant skepticism, conservative opposition to any expanded role for government is a mistake. There is an urgent need for a new global regulatory initiative that addresses the primary cause of the financial collapse: highly leveraged and concentrated positions.

Reform must begin with a regulatory regime focused on "behavior" instead of "systemically important institutions." Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.

It's true that monetary policy was too lax for too long, and the government encouraged lending to people who were unlikely to repay their loans. But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.

In the past decade, most global financial institutions built highly leveraged balance sheets -- sometimes as high as 30 to 1 -- that were stuffed with risky assets. These institutions also bought on a large scale for their own accounts the same securities they sold to their customers. Our anachronistic regulatory framework didn't catch the problems, and warped incentives and compensation schemes fueled the risk-control failures that eventually brought on the crisis we face today.

Now we must create a new regulatory infrastructure that will meet three fundamental tests. First, it must assess and measure risks accurately, including the compounded risks of herding (traders being similarly situated and forced to unwind simultaneously). Second, it must impose significant margin requirements on all exposures. And finally, it must bring all investors and traders -- regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual or government agency -- under the regulatory umbrella. These three measures will diminish volatility and reduce the likelihood of a future financial collapse.

Creating a regulatory system that reflects the modern-day realities of financial markets is not as difficult as it may appear. The financial structures that destabilized our markets have definable characteristics. They are either long or short (and have a particular exposure to) the movement of an underlying asset, index, or instrument (such as a tranche of mortgage-backed security).

It is critical that any new regulatory initiative have a global mandate and contain mechanisms to prevent "risk infection" by countries that try to dodge risk controls. There are legitimate concerns about the time needed to devise a global risk-management system and staff it with individuals with the requisite sophistication and experience. But there are relatively simple solutions.

First, the government can hire private firms to assist in assessing risks posed by complicated financial instruments. Despite the failure of financial CEOs to understand the wizardry invented by their own "rocket scientists," there are independent firms such as Duff & Phelps that can make sense of these products and serve as objective advisers.

Second, interim steps can be adopted to immediately rein in leverage and risk, such as increasing margin requirements for certain types of instruments. For example, in order to initiate credit default swaps, all parties (including dealers, who currently put up little or nothing) should be required to post deposits or reserves of at least 15%, if hedged against a credit instrument of the same company, and 30% otherwise.

And, given that there are many long-standing programs of position reporting, it would not be revolutionary to implement globally-enforced reporting for large positions related to equities, real estate, currencies, commodities and interest rates. But this would only be effective if these positions were accurately analyzed in terms of their exposure to the movement of the underlying reference assets, regardless of the form of the positions or existing regulatory coverage.

I understand the inclination among free-market conservatives to dismiss the government's regulatory efforts as misguided. Some government actions over the past year have been reactive and incomplete. Yet these actions have been large and reasonably fast, which were the critical elements for the survival of the system.

Government action could easily spill over into gross over-reach (like the bonus-tax fiasco). But a combination of private responsibility and practical government regulation will help ensure that the capitalist system continues to be a source of opportunity and prosperity for people throughout the world.

Mr. Singer, founder and CEO of Elliott Management Corp., is chairman of the Manhattan Institute and on the board of Commentary magazine."

"These efforts, akin to avoiding bank runs in prior periods"

Robert Barro in the WSJ:

"Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called "multiplier" effect of government spending on economic output is greater than one -- Team Obama is reportedly using a number around 1.5.

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy's total output expands by enough to create the airplane or bridge without requiring a cut in anyone's consumption or investment.

The explanation for this magic is that idle resources -- unemployed labor and capital -- are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.( THIS IS TRUE )

What's the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff( ONLY IN AN ECONOMIC CRISIS ). Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out( THE FEAR AND AVERSION TO RISK IS NOT RATIONAL ). In other words, there is something wrong with the price system.( THERE IS. FEAR AND AVERSION TO RISK. )

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall( WE SHOULD DO THIS ). So, something deeper must be involved -- but economists have not come up with explanations, such as incomplete information, for multipliers above one.

A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP -- consumption, investment and net exports( NOT IN A CALLING AND PROACTIVITY RUN ). In other words, the social cost of one unit of additional government purchases is one.

This approach is the one usually applied to cost-benefit analyses of public projects. In particular, the value of the project (counting, say, the whole flow of future benefits from a bridge or a road) has to justify the social cost. I think this perspective, not the supposed macroeconomic benefits from fiscal stimulus, is the right one to apply to the many new and expanded government programs that we are likely to see this year and next.( HERE I COMPLETELY AGREE )

What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II. The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists.

I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.( ONE COULD ARGUE THAT THE WAR, BEING A WAR, EFFECTED PEOPLE'S ATTITUDES IN ANY NUMBER OF WAYS. )

We can consider similarly three other U.S. wartime experiences -- World War I, the Korean War, and the Vietnam War -- although the magnitudes of the added defense expenditures were much smaller in comparison to GDP. Combining the evidence with that of World War II (which gets a lot of the weight because the added government spending is so large in that case) yields an overall estimate of the multiplier of 0.8 -- the same value as before. (These estimates were published last year in my book, "Macroeconomics, a Modern Approach.")

There are reasons to believe that the war-based multiplier of 0.8 substantially overstates the multiplier that applies to peacetime government purchases. For one thing, people would expect the added wartime outlays to be partly temporary (so that consumer demand would not fall a lot( THAT DOESN'T FOLLOW. A WAR COULD IN FACT DAMPEN DEMAND BY EFFECTING HUMAN BEHAVIOR. ). Second, the use of the military draft in wartime has a direct, coercive effect on total employment. Finally, the U.S. economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays. In any event, when I attempted to estimate( THAT'S ALL YOU DID ) directly the multiplier associated with peacetime government purchases, I got a number insignificantly different from zero.

As we all know, we are in the middle of what will likely be the worst U.S. economic contraction since the 1930s. In this context and from the history of the Great Depression, I can understand various attempts( YES ) to prop up the financial system. These efforts, akin to avoiding bank runs in prior periods( YES. THAT'S WHY I CALL THEM A CALLING RUN AND A PROACTIVITY RUN. ), recognize that the social consequences of credit-market decisions extend well beyond the individuals and businesses making the decisions.

But, in terms of fiscal-stimulus proposals, it would be unfortunate if the best Team Obama can offer is an unvarnished version of Keynes's 1936 "General Theory of Employment, Interest and Money." The financial crisis and possible depression do not invalidate everything we have learned about macroeconomics since 1936.

Much more focus should be on incentives for people and businesses to invest, produce and work. On the tax side, we should avoid programs that throw money at people and emphasize instead reductions in marginal income-tax rates -- especially where these rates are already high and fall on capital income. Eliminating the federal corporate income tax would be brilliant( TARGETED TOWARDS INVESTMENT. ). On the spending side, the main point is that we should not be considering massive public-works programs that do not pass muster from the perspective of cost-benefit analysis( I AGREE ). Just as in the 1980s, when extreme supply-side views on tax cuts were unjustified, it is wrong now to think that added government spending is free."

I'm beginning to realize that economists are using preposterous views of Human Agency as a matter of course. Wars can have a myriad of effects, and simply assuming that, if they don't last long, consumption will remain the same, seems totally unjustified to me. Much depends on the nature and context of the war. Barro sees people as robots. I don't. One reason economics is so useless to us is its use of and reliance on Mechanistic Explanations.

Still, his recommendations are like mine. One reason is that I believe that the focus on the amount of the stimulus is also a mechanistic explanation. Tax incentives are a Human Agency approach. Spending money on a cost-benefit basis is more like common sense and fiscal prudence. There is some sense in government spending when investors are frozen by the fear and aversion to risk. However, the spending should still be prudent and wise. It should not mechanistically be spent in order to hit an artificial target.

"Any new framework gives agents a reason to abandon their anchor to fear; and gives them a chance to reattach themselves to hope."

From Leigh Caldwell on Vox:

"This column argues responses to the recession should not be based on unrealistic expectations of rational behaviour. It argues that models of bounded rationality provide reasons that traditional macroeconomic policy responses may fall short and suggests more sophisticated solutions that could break the crisis’s psychological hold on markets.

Responses to the recession should not be based on unrealistic expectations of rational behaviour( TRUE ). We now know enough about real, flawed human psychology to be able to take some account of it in policy setting( I AGREE. BUT I SEE A PLACE FOR PHILOSOPHICAL ANALYSIS AS WELL. ).

The “homo economicus” model of rational agents, acting to maximise utility in the possession of all available information, is not realistic( TRUE ). It is hardly a credible way to look at human beings – but we tolerate it because it is simple enough( AND USEFUL ENOUGH ) to allow equilibrium analysis which often gives reasonable predictions (TRUE ).

However, these equilibrium models are not serving very well in today’s situation. Standard monetary policy and (to a lesser extent) Keynesian theories are based on rational-actor assumptions. They give broad recommendations about monetary loosening and fiscal expansion – which central banks and governments are rightly trying out. But growth is not resuming.

Bounded rationality is the broad term for behavioural models that do not follow the rational-maximiser formula. There is not yet a generally accepted alternative model. Lots of individual non-rational behaviours have been discovered, but they are grafted onto a rather clunky ‘rational actor with bits’ instead of forming a coherent behavioural model.

However, the best place to test a new theory is often at the edges of the old one, where the existing model breaks down. So the current troubles in the financial and real economy may be a good opportunity to try out some alternative models and see which give a reasonable description of what we see.( GO AHEAD )

Models of bounded rationality

Different models of bounded rationality vary basic assumptions of the rational agent model in different ways. Some of those assumptions are:

• Utility is discounted over time in a consistent way
• People have access to all relevant information
• All relevant information is expressed through market prices
• People can instantly weigh up the change in utility given by any buying or selling decision
• People act to maximise their utility

Therefore, the typical way to create a bounded rationality model is to relax one or more of these criteria.

The first class of model explores different time discount rates. Experiments show that people apply a high discount on utility( OR SAFETY ) in the present – they prefer £100 now to £120 next year – but a lower one in the future – they prefer £120 in four years to £100 in three (Loewenstein and Prelec 1992). This, arguably, contributes to explaining recent huge variances between overnight and three-month interest rates.

Perhaps our psychological instincts reflect a pragmatic sense of the risk of a promise not being fulfilled, and the modern financial system has evolved to provide a confidence in the future that does not come naturally. If so, then the financial markets are no longer successfully filling that role. This short-long imbalance is an important cause of disappearing credit( OK ).

A second kind of bounded rationality reflects the idea that people do not have access to all relevant information. Danielsson and de Vries (2008) discuss an important example – information asymmetry – and an interesting solution – enforced transparency( CATE. IS THIS YOUR IDEA? ). Many agents, short of crucial information, have had to make guesses; clearly this has led to many of the write-offs we have seen in the last 15 months.

A third approach relaxes the constraint that prices express all the information needed to make decisions. This classical assumption works only when there is a sufficiently liquid market, with defensible property rights. If enforceability is at risk (for instance when there is a significant chance of bankruptcy) then we can use derivatives or insurance to provide secondary price information about the risk of default( A GOOD USE OF CDSs ). If the market for these derivatives is not big enough or does not trade publicly, we lose that price signal.( OK )

In these situations, we need to use non-price signals to make economic decisions, and we do not have good models for interpreting those messages. This leads to inconsistent or irrational decisions on resource allocation.( OK )

A fourth category of model removes the assumption that people can make an accurate calculation of the utility that a decision will provide. These models include satisficing (Simon 1956) and rational ignorance (Downs 1957). Another is the concept of anchoring or habit – which suggests that we rely on familiar choices( OR NARRATIVES FROM HISTORY ) to avoid the mental effort and risk of picking alternatives. This behaviour can be seen in the credit markets, where an aggressive conservatism appears to be in control of lending decisions.

The fifth alternative to the rational model is to ask what happens if people do not act to maximise utility. Indeed, is there any single quantity called utility? Alternative models of decision making include multi-dimensional (“vector”) utility functions (for example Rios 1987), value modelling (Gordijn 2001) and psychological attempts to understand subconscious mental drivers – which have rarely been explored in economics. My own research suggests that a concept called “local utility gradient” drives behaviour.¹

Intuitively, the current financial environment seems to expose a lack of rationality in market participants( MY POINT ). The task for researchers is to find whether specific irrationalities provide evidence to support any particular behavioural models( YES ).

Policy implications

Whichever model of behaviour is assumed, policymakers should ask what the models indicate for macroeconomic policy. This question has been considered in a conference on “behavioural macroeconomics” at the Boston Federal Reserve in 2007.² No doubt the old solutions will work, given enough time. But today, with a much better understanding of economic behaviour, we could design more sophisticated solutions which would work faster.

A clear example comes from the concept of anchoring. Anchoring creates a tendency to fixate on one option too long when we might profitably switch to another –it limits the effects of all kinds of quantitative changes in policy. If a bank is scared to lend at a spread of 2.5%, anchoring implies it is unlikely to start lending when the spread increases to 3% or even 4%. This demands a qualitative change in conditions so that the bank can no longer make a simple marginal comparison but is forced to re-evaluate( EXACTLY. THIS IS THE POINT OF TARGETING INCENTIVES THAT CAN ALLOW A REASSESSMENT OF RISK. ) its likely returns from scratch.

The same effect is at play with fiscal easing. When state borrowing breached the government’s self-imposed 40% debt ceiling, the anchor was broken and little credibility may be given to promises of future prudence as debt reaches 45%, then 55% of GDP and beyond. However if a new anchor is created, say at the Eurozone’s 60% level, this creates a qualitative limit – immediately more credible than an arbitrary quantity. This anchor in turn can change behaviour in the government debt market because it gives agents( YES ) a new focus for their decisions.

If the utility gradient model is correct, it is better to enter the recession sharply – even at the cost of a big immediate reduction in GDP – if it creates an expectation that we have hit the bottom. When people believe it can only get better from here, they will act accordingly – investment and spending will start( A GOOD POINT ).

I do not suggest that behavioural and psychological considerations are the only cause of the crisis. But they make a substantial contribution to its persistence( OK ).

The paradoxical conclusion is that it may not matter what new institutions or new rules are designed – as long as something is done. Any new framework gives agents( YES ) a reason to abandon their anchor to fear( EXACTLY MY POINT ); and gives them a chance to reattach themselves to hope. This – the converse of Keynes’ paradox of thrift – is what will ultimately rescue the world economy.

References

Danielsson, Jon and Casper de Vries, “Money Market on Strike”, Financial Times Economists’ Forum 9 November 2008
Downs, Anthony. An Economic Theory of Democracy. New York: Harper, 1957.
Gordijn, Jaap and Hans Akkermans. “A Conceptual Value Modeling Approach for e-Business Development”. Proceedings of the Workshop Knowledge in e-Business, pp 29-36 (2001)
Loewenstein, G. and D. Prelec, “Anomalies in Intertemporal Choice: Evidence and an Interpretation”, Quarterly Journal of Economics 107, no. 2 (May 1992), pp 573-597
Rios, S., “An Interactive Sequential Approach to Multicriteria Decision Making”, Extracta Mathematicae 2, no. 1, pp 26-28 (1987)
Simon, Herbert. “Rational choice and the structure of the environment”. Psychological Review, 63, pp 129-138 (1956).

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1 This research is underway and not yet published, but will be published as “Multidimensional utility and a model of bounded rationality”, by Intellectual Business in 2009. A summary of this and other ongoing research is available at http://www.intellectualbusiness.org/
2 Janet Yellen’s speech to this conference provides an excellent summary of relevant literature."

An excellent Human Agency Explanation approach.