Two books that attack conventional economic modeling, especially in light of the financial crisis. I have a preview copy of Economics for Independent Thinkers, by Daniel Nevins. I have a review copy of The End of Theory, by Richard Bookstaber. I am likely to recommend the former. The latter is certain to make it onto my list of “best books of the year.”
It is interesting that both authors have backgrounds in applied option pricing. So do I. Is it a coincidence that we all ended up taking heterodox positions? If you toss in Fischer Black and Nassim Taleb, you start to wonder if there isn’t something in the option pricing water.
A reader points to Diane Coyle’s negative review of Bookstaber. She writes,
his complaints about economics are both wearily familiar territory and decreasingly true; economics is and has been changing a lot. In finance specifically, think of Andrew Lo’s new book, Adaptive Markets.
I disagree with her on all counts. One indication that Coyle has missed the point is that she thinks that Bookstaber’s critique applies only to macro/finance. I can readily apply it to the way economists model the demand for health insurance, the demand for home ownership, and principal-agent contracts, among other microeconomic phenomena.
I am drafting a review essay, which reads in part,
If I could reduce it to a bumper sticker, it would read, “Stare more at the world and less at your model.”
…All of the major fields in economics are inclined to follow strict technical procedures at the expense of realism. In the 1500s, if mapmakers had been similarly inward-looking and rigid, they would have continued to draw maps of the globe that ignored the lands discovered by Columbus and subsequent explorers, insisting that “The state of cartography is good.”
Turning to a relatively minor passage that resonated with me, here is Bookstaber’s description of the role of collateral in repurchase agreements and derivative bets on p. 159:
Let’s say your bookie demands that you put up $20,000 of collateral for a marker on a $15,000 bet. You give him your gold Rolex watch, worth $20,000. He comes back to you a week later and tells you that you need to put up another $3,000. Why? “People, they aren’t so much interested in these Rolexes anymore. It’s marked down to $17,000.” …You say, “Wait, I see prices for watches just like it, anywhere from $20,000 to $24,000.” He says, “Hey, do you owe them money or do you owe me money? You’ve got the marker, and I’ve got the watch, and I say that today it’s worth $15,000.”
By appraising collateral, notably mortgage securities, at low values, investment banks like Goldman Sachs caused runs on other firms. Gary Gorton termed it the “run on repo.”
[note: the following paragraph is my own. Although I cannot confirm that Bookstaber would endorse it, to me it seems likely that he would.]
But it was not just repo. The run on AIG was to demand collateral for credit default swaps. Think of a credit default swap as flood insurance and think of collateral as used because you don’t entirely trust that the insurance company will have the wherewithal to pay off. You have a house near a river, and when you get flood insurance you have the insurance company give you some Treasury bills as collateral, until the insurance policy expires. Then, a big rain comes, and the river starts to rise. Your house is still dry, but you are more worried, so you ask for more Treasury bills as collateral. That is what Goldman Sachs and the other investment banks did to AIG during the crisis. As it turned out, most of the houses never got flooded (that is, most of the bonds that AIG insured did not default), but the demands to put up more safe securities as collateral became impossible to meet, especially because similar demands were being made all over Wall Street for firms engaged in derivatives and repurchase agreements.
The quoted passage does not in any way capture the book’s larger, more ambitious theme. I was struck by it because it fit my understanding of what happened, which policy makers at the time seemed to me to miss. Had they been cognizant of the real problem, they would have applied a remedy closer to the one that I was proposing at the time. I called this the “stern sheriff” model, and it would have meant telling Goldman and other firms to stop making their outlandish collateral calls.
People talk about going off the gold standard as alleviating recoveries, but they neglect to consider that softer money may facilitate booms and that there are alternative ways to be dovish during busts.
Using the house (price) as collateral for the (inflationary) loan is problematic to begin with, it is pro-cyclical in both the boom and the bust.
The bookie isn’t going to crash the entire economy by over-pricing rolexes when rolexes are overpriced and then underpricing them on the downward slide. But Goldman probably could figure out how to manage it!
“Outlandish capital calls” sounds like 20/20 hindsight (and more anti-bank bias). There was no market for RMBS, no ability to roll debt, and no cash. Both the market and regulators were pushing the rating agencies to downgrade securities and money market funds (as well as heavily levered investment vehicles) were unwinding en mass, or at least trying to, except the marks they were getting were pennies on the dollar, i.e. exactly what Goldman was asking (pursuant to terms it bargained for).
In general, it seems odd to criticize the firm that correctly predicted the direction of the housing market and the correlated risk of a marketwide decline in home prices, instead of the insurer that joyfully took their premiums for a risk it did not even attempt to understand. AIG didn’t know its ass from its elbow — which is also why it was in no position to tell Goldman itself that its calls were “outlandish” because AIG had no clue.
In the moment everybody knew this was a problem. Some banks were even complaining of short attacks. It is not as hindsight as it sounds.
Wasn’t the basic point of TARP to overpay for the distressed assets? So, it is not that it wasn’t widely known that the assets were being transiently under-priced and that under-pricing was detrimental to the overall market.
Therefore, I don’t think it is hard to know you are doing the wrong things, I think it is hard to not do them even when you know it. That’s why the impulse for having the central government do it, even though they are often just as likely to be pro-cyclical.
Of course people knew there was a pricing problem — it was as simple as “how to value an illiquid asset (whose creditworthiness was linked to its liquidity)?” And certainly, the long side was complaining that the short side was being unreasonable (and the short side would say, “then sell it and tell me what the value is” and around and around they’d go).
It’s still hindsight bias to say, “well, nothing ultimately defaulted, so the short side was obviously ‘outlandish.'” That TARP was instituted because the government could go long where no one else was willing to go — and again, with a low degree of confidence of the spread between “fundamental” value and mark-to-market value — is consistent with the notion that these assets were untradeable.
More importantly, whose management / SH ought to have been rewarded? Clueless insurers and monolines who got rich on risk they made no effort to understand, or hard nosed skeptics that anticipated a correction?
No one is saying that the short side was wrong. However, the holders of credit default swaps were taking options positions, not short positions. And while those options are still out of the money, making margin calls is contractually legal but still evil. Beating your counterparty because your bet wins is fair and square. Beating them by making margin calls on a bet you ultimately lose is sleazy.
Especially when they have a hot-line to the White House.
I have a question, who was more facilitative on a percentage and net basis: Warren Buffett, or the government?
MS, I don’t think we disagree that much, just in some fine points I’m trying to figure out exactly where.
Seems that little or no attention is paid to the simple fact that the value of the securities are tied to the default rate.
That was what caused the entire blowup.
Totally understood — I think the disagreement is whether Goldman should be regarded as the (or a) bad guy. Prof. Kling’s observation is (I think) that the underlying assets turned out to be creditworthy for the most part, therefore GS was “sleazy” for exercising its right to demand collateral from its insurer. He would have preferred that GS take a bigger hair cut or simply grit its teeth.
My reaction is that — at the time — there was a tremendous amount of uncertainty over the actual value of the assets, and therefore I don’t understand how Prof. Kling is so sure that GS asked for too much. I also think the “backdoor bailout” narrative is too conspiratorial to be plausible, again, given how much uncertainty there was, how rapidly evolving conditions were, and how many other factors and firms were in play — there was no preexisting script on how, in the event of crisis, to wipe out AIG’s common, price and restructure its illiquid assets, replace management, and create a unique security for the benefit of Treasury (with funding from FRBNY, if I remember correctly).
AIG tried to raise private money and it couldn’t, i.e. everyone appeared to agree with Goldman that AIG was not going to be money good (or they remembered prior bailouts). Even worse, AIG barely knew it was in trouble until Goldman started asking for collateral because it was so high on its own supply. If there is a bad guy in this story (or a firm that should have born the brunt of uncertainty), I just don’t see it as Goldman. That Goldman did not, in retrospect, end up needing the additional called collateral (perhaps because of the bailout) does not change that analysis much, in my opinion, because hindsight is always 20/20.
Again, you could argue that the government should have left Goldman and AIG to fight it out amongst themselves (and test the mettle of an already oversubscribed bankruptcy court system). But once you decide not to proceed with that approach, I disagree that “stick it to Goldman” would have been the way to go.
Agreed.
But where “sleazy” comes into the equation is selling instruments to people while you are shorting those instruments.
Except the reason AIG didn’t face those losses were what the government did to fund, stabilize, and then recover those values. Perhaps AIG should have been allowed to go bankrupt. Certainly the lawyers would have made out. The problem would then have been pushed to its creditors. The more liquid ones like Goldman probably could have coped with it. Other, less liquid ones would then have faced runs, and as they failed their creditors would face runs on down the line. The flaw is believing this would stop without bailouts somewhere down the line. Where you choose to draw the line can change and matters, but there is no not drawing the line, or in not drawing the line you really do end up with a depression.