[Welcome Yves Smith and Host, masaccio.] [As a courtesy to our guests, please keep comments to the book. Please take other conversations to a previous thread. - bev]
Yves Smith brings the same clear and concise writing to ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, her explanation of the Great Crash of 2008, that she shows every day at her website Naked Capitalism. Smith points to the abject failure of neoclassical economics as the beginning point for this disaster. The unproven assumptions of this theory were converted into Indubitable Truth by academic economists. Their careers were based on their ability to combine those Indubitable Truths with other unproven assumptions and turn them into mathematical formulas which, they said, explained the way the economy works. These ideas were widely accepted by corporate interests and their shills and think tanks, media elites and politicians, and turned into statutes and regulatory policy. Immediately the vipers on Wall Street exploited every one of the new weaknesses for personal profit, first at the expense of other traders, then at the expense of their own clients, and finally at the expense of taxpayers.
Today’s neoclassical economics started with Paul Samuelson, who realized that if he made certain assumptions, he could turn big chunks of economics into mathematical equations, and explain the US economy in a few formulas. One of his simplifying assumptions is that economy is like a pendulum. No matter where it starts, it swings towards a position of equilibrium, a place where no further motion occurs. Fortunately, and amazingly, that equilibrium is at the point of full employment.
Smith explains that this assumption has no basis in reality. Any moderately complex system has feedback loops. Some are negative, that is self-damping, like pendulums. Others are positive. They generate wilder and wilder swings until they disintegrate. It is easy to think of positive feedback loops in the economy. Smith points to the tragedy of the commons, with a real world example of the over fishing of the Great Banks. Throughout the book she describes feedback loops that contradict the equilibrium hypothesis.
She takes up several of the other mainstays of neoclassical economics, including the efficient market hypothesis and rational expectations theory, and their theoretical children, which formed the basis of financial economics. These ideas led to the complex models used by the geniuses on Wall Street. In order to make the math easier, they all assume that randomness in the economy has a Gaussian or normal distribution. The evidence shows that randomness in financial markets is much more complex, and very difficult to compute. She points to a significant economic theorem that mainstream economists had to ignore, the Lipsey-Lancaster theorem. But those annoying reality thingies didn’t stop them. Any theory is better than none, said Milton Friedman, and the equations flowed.
One of the things economists and their corporate cheerleaders have persuaded politicians and media elites to believe (or say they believe) is that all increases in gross national product are good, regardless of any costs not captured in prices, like pollution and bailouts. Therefore any practice that interferes with the workings of the markets is bound to be bad. This position is so ingrained in the political class that it is not possible to discuss any regulation, no matter how crucial, on its merits. Eventually, it led to the destruction of the regulatory framework of the New Deal and into the wasteland we now inhabit.
Smith then turns to a detailed explanation of the tricks and traps used by Wall Street traders and their supervisors. One of those tricks is that profits to be realized in the future were used to compute bonuses. Smith explains:
If you owned a commercial building, had an unbreakable lease to Uncle Sam, and also bought a contract from a AAA-rated insurer to protect you against increases in your operating costs, no one would consider it reasonable to take the future income, deduct the costs of the insurance policy, discount it back to the present day, and record all the income now. Yet banks did something very much like that on a large scale basis, and paid bonuses on those future earnings.
Of course, many of those future profits did not appear, but the traders and their supervisors had pocketed their bonuses and didn’t care.
Banks thought they could protect themselves from market risks by using models based on neoclassical economics. Smith gives us a tour of the failings of those models, and then explains why even the poorly-designed systems were not enforced. Not surprisingly, it involves bonuses to traders.
Smith shows that a credit bubble lies at the heart of the Great Crash. She shows how the shadow banking system aggravated this bubble, and describes the role of credit default swaps in the subprime mortgage/collateralized debt obligation disaster. These explanations are not quick reading, but they are crystal clear on careful reading.
Smith’s analysis of economic theory and the people who tried out their groundless theories on an unsuspecting public is devastating. Her analysis of Wall Street management and traders is equally devastating. Both groups have inflicted huge losses on all of us, but no one from either group has been held accountable.
It is customary in books like these to come up with a set of proposals to fix things. Smith doesn’t believe real reform is possible, so her
… prescriptions [for reform] assume that the supposed representatives of the public manage to free themselves of the corruption of influence by the financial lobby. Should they fail, the looting will continue, as will corrosion of the notion that the United States and other economies with powerful banking interests are indeed nations of laws.
One final thing. Smith begins her acknowledgments section by recognizing the contributions of the commenters at Naked Capitalism. All of the contributors here join that sentiment.



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Yves, Welcome to the Lake.
masaccio, Thank you for Hosting today’s Book Salon.
Welcome back to Firedoglake!
Thanks! Glad to be here.
Thank you!
Yves! Welcome. So good to have you here.
I don’t want to get whacked by the mods for going OT (well, it really isn’t — just sort-of).
Any news on your Lehman/NY Fed blockbuster story from Friday?
http://firedoglake.com/2010/03/12/ny-fed-under-geithner-implicated-in-lehman-accounting-fraud-allegation/
Hi, Yves. You have a lot of fans here.
You spend a big part of the book explaining the problems with the basic theories of neoclassical economics. Are there any principles of that school that you think are useful for anything more than short-term trading?
Jane,
Thanks for mentioning that post. Lots of links, and some interesting confirming private emails, but people are still digging through and digesting that LOOONG document.
masaaccio,
Thanks for hosting.
If neoclassical economics was used merely as a teaching tool, to show how purely competitive markets worked, and was treated as only one of many possible frameworks, it would still be useful. But aside from the extreme assumptions needed to make it work, one of its big failings is that it is essentially static. Anyone from an engineering background will recognize that the analysis of statics is trivial compared to that of dynamic situations. So we have a model that despite how elaborately developed it appears to be, is woefully inadequate, yet is driving much of policy thinking in the US.
Good afternoon and welcome back to FDL Yves.
I have not had an opportunity to read your book and don’t really have a question but have to say that your title is far more gracious than the one I would have used (which is why you’re the writer and I’m not)
My title would have been more along the lines of “Yeah, I got mine so F*ck Everybody Is Not How to Run an Economy”
So are there dynamic models, and do any of them apply, and how so?
edit: (Where are my manners? Sorry I was just excited.) Hi Yves and thanks for talking with us today!
Surely the Mods would allow you the extra privilege on things like that!
dankine01,
I didn’t have full control over the title, and “F*ck” would NOT have gone over with my publisher! I would have preferred, “How the Invisible Hand is Picking Your Pocket”
Hi Yves. I have a question about CDSs that almost sounds rhetorical, but isn’t really. How could anyone have thought these were a great thing to offer? I can understand the motivation for buying them, they’re a hedge. But as some wise person wrote not too long ago, it’s essentially a bet where the entity buying the CDS understands the risks better than the entity offering. How does that make sense as a business?
Kelly,
They are rather limited. One used in policy is called the Dynamic Stochasitc Equilibrium Model. There are a bunch of different varieties, but they all view economies as self-righting, so the only source of instability is external shocks, like war, the oil crisis, etc.
Keynes, by contrast, believed that economies were fundamentally unstable. The book explains at some length that Keynsianism is NOT Keynes!
I enjoy your work at Naked Capitalism. Do you think that the Bernanke, Paulson, and Geithner intentionally tried to blow up markets in the way they let Lehman go bust. They certainly knew its financial condition. They almost certainly knew what such an event would have on bond and credit markets. Yet they did it anyway. Was it a “stern” lesson that blew up on them, or were they going for some version of the shock doctrine with the real target, not Wall Street, but Congress and the taxpayer?
Since Jane started it, you talked about accounting fraud, and today we learn about Repo 105, an accounting fraud through and through. This book isn’t about accountants, but it is shocking that the profession has sunk this low.
I saw this fraud in the mid-80s in the collapse of the Butcher banking empire in Tennessee. Loans were moved off the books of a loan and thrift and onto a bank before each reporting period, so the State regulators were unaware of the nature of their loan portfolio.
Yes, we do, even though in some cases (mine, for instance) that was a long time ago. They were a simplifying assumption, which we had to understand was only true as long as the conditions that make it simplified were true. If gravity is variable, for instance, then pendulums don’t swing at a constant rate.
It’s astonishing that there is an entire generation of economists who don’t act as though they understand this.
Cujio359,
Well the rational notion is that people are risk averse. That is the general principle behind ALL insurance, that people will pay more to shed risk, particularly extreme risk, than it is really worth. But CDS are a funny beast because the “insurance” has been systematically underpriced. That is largely because a lot of investors use them as a levered way to play bond risk. So the fact that you have buyers and sellers using them for very different types of reason leads to pricing unlike what you’d see in a normal insurance market.
Yves,
One constantly hears that it is practically impossible to separate traditional banking functions from trading and speculation — given the complexity of today’s institutions. I am of the opinion that unless we do so, we are doomed to repeat the past. What is your opinion?
Hugh,
I see it a bit differently. I tend to view Lehman more in terms of incompetence than a plan or plot of some type. Bernanke and the Fed generally just refused to believe we were having a systemic crisis. We had three acute phases before Lehman failed, each time the Fed ran to the rescue, created liquidity and kept adding more and more fancy facilities to help out financial firms. After each crisis subsided, they went into “Mission Accomplished” mode. So I think they saw Lehman as in bad shape, but figured they could kick the can down the road long enough (ideally to the incoming Adminsitration) and Lehman would somehow sort itself out.
It was also politically unacceptable to bail out another firm then (not that I am saying Lehman should have been resuced). Big backlash after Bear
But if I get my money back either way (as a CDS buyer) where is the risk?
econobuzz,
Specualtion is kinda like pornograpy, you know it when you see it.
There are ways to look at firms to separate socially productive speculation (trading related to market making in socially useful products, like corporate bonds) versus risk taking that the taxpayer should not be subsidizing. But that requires pretty intrusive monitoring and oversight. Everyone is trying to find less intrusive solutions, which I don’t think will be very satisfactory.
Yves, it might be helpful to discuss the trading of credit default swaps as it actually occurs.
Hi Yves, and thanks for joining us.
My career on Wall St. informs me that no one can forego the profit that comes with irresponsible behavior. If you don’t rise with the bubble, you’ll be jobless PDQ. And now we have the perfect negative feedback loop, which is: not only do you retain your job by rising with the bubble, you can rely on the USG to bail you out when you fail. What other pattern would a rational Wall Streeter follow?
Having laid out the scenario, what’s the end game?
Yves, thanks for being here. You write with concision and clarity!
cujo,
Ah, but you may not get your money back! Look at AIG, they should not have gotten their money back. Look at the people who got guarantees from monolines, and didn’t understand the fine print, that the contracts deferred payment a VERY LONG time. You introduce performance risk (that the policy may not cover the risks you thought you were guaranteeing) and counterparty risk.
If Lehman was knowingly putting out inaccurate financial statements who was hurt? What sort of liability should the Lehman outside accountants have (Enrst/Young?)?
Welcome Yves!
Your post on The Theory of Positive Thinking by Team Obama was fabulous!
I have an order in for your book.
masaccio,
They aren’t really traded. They are so-called bi-lateral contracts. Someone who wants to be insured (buy protection, in the industry lingo) enters into an agreement with someone who wants to sell protection (collect premiums and bear the risk of loss). So if the person who sold protection wants to lay off that risk, he needs to enter into an offsetting contract with another protection buyer.
Oh pshaw. Lehman wasn’t bailed out because it was a Goldman Sachs competitor. Think it’s as simple as that. Paulson protected GS interests. Period.
eCHAN.
We need to go after the third rail and reform pay.
In the old partnership days, when the top brass could lose ALL THEIR MONEY, you didn’t see such stupid behavior on a large scale.
You need to impose more liability for losses, and/or greatly defer payouts, well in arrears of the bonus year to make sure the profits in that year were real (ie, there was not a subsequent blowup)
Dododododododo. Surely you jest. That is NOT gonna happen. So I ask again, what is the end game?
True, but Bernanke, Geithner, and Paulson had to know things were different in September 2008. Paulson did Fannie and Freddie one weekend and then they had AIG and the 4 remaining investment banks to deal with the next. They took care of all of them, except Lehman. They sold Merrill in a strong arm job, decided to leave GS and MS free standing, though AIG was definitely structured to help GS, and they gave a kiss off to Lehman. Maybe it was just incompetence but it was the kind where the situation was flashing at them in big red lghts and they chose not to see it.
Incompetent, none of them should be let near the financial system ever again, crooked they should be in jail. They should not be in government or resting on their ill-gotten gains (Paulson).
damagedone,
The accountants OUGHT to be liable, but I am pretty dubious that much will be done. We only have 4 big accounting firms left, no one is willing to let another one be put out of business due to malfeasance.
I am not a lawyer, but this looks like a very clear Sarbanes-Oxley violation. The CEO and CFO certified the financial statements. Fuld and the three CFOs prior to the collapse ought to go to jail, but it is really hard to win cases in complex financial suits. But I do expect a lot of private (civil) suits.
eCHAN,
No, I don’t jest. We will have another bigger blowup. It might take as much as 5 years, but it will be even worse. Then we will get reform.
A good policy generally, I think, not just in financial industries. The last couple of decades have certainly seen plenty of examples of executives who took short-term profits at the expense of their companies’ long term futures.
I know that both speculation and trading can be productive activities. My question pertains more to where the capital for doing so comes from. And what kinds of speculation and trading should be allowed with depositors’ funds that are insured.
I just can’t see the advantage of allowing what we think of as traditional banks — that create money when they make loans or other investments — to speculate or trade. (I know that such restrictions would not take care of the shadow banking system.)
Put another way, is it sensible to allow firms like Goldman to be bank holding companies? Or to allow community or regional banks to do the kind of trading and speculation that Goldman does?
Hugh,
You have the timetable a little off. Freddie and Fannie were put into conservatorship I recall on Sept. 6. Lehman was told to BK on Sept 14 (the actual filing was on the 15th). There would have had to have been prep much further in advance for Lehman (even a better prepared BK would have been less awful).
Merrill was NOT subsidized in Sept. That was arm’s length. The subsidy came later, when Merrill deteriorated further.
My thought, much repeated, is depression in 2011. I don’t know how long they can be running these cons, and on the taxpayer’s dime, before the wheels come off, but it can’t be endless.
Yves is much tougher: she calls it looting.
What makes you so sure reform will follow the next blowup? Lots of other possibilities, like worm eaten U.S. financial system gets surpassed by healthier models in other countries. Nothing in evidence now, but I think that’s more likely than reform in the U.S., which is irretrievably stuck in financial hell (or heaven as the PTB would have you believe).
econobuzz,
I differ with you here. It isn’t a matter of depositor funds. The firms that failed or nearly failed were for the most part NOT depositaries, yet they were rescued. That is because they are critical members of the global debt infrastructure, that has become crucial to commerce. So merely getting Goldman out of BHCA status does not solve the problem. Bank or investment bank, Goldman would be backstopped. That’s why we need much tougher regulation.
I’m familiar with your forecast, as you are familiar with my contention that these matters take much longer to work out than rational, sentient humans could possibly imagine.
It shouldn’t be hard to convict; the evidence is there. One huge problem is that juries don’t understand corporate management structures. In the case I described above, a very small organization, the defendant persuaded the jury he didn’t know about the constant motion of the loans, and he got off on that indictment.
econobuzz,
The cost will be too high next time. Even in Chile, in a dictatorship, you saw backpeddaling and reforms (of a sort) when the plutocratic land grab became too costly to the economy as a whole
Yves, you might want to scan my diary just for fun.
Thanks, Andersen did seem to disappear rather rapidly after Enron. You are probably right about Lehman’s accountants. I bet the Ersnt/Young? partners and their insurance companies are sweating though about potential lawsuits.
masaccio,
The record is pretty poor over the last 20 years. The problem with criminal prosecutions is you need to show intent AND pass a “reasonable doubt” threshold. Fancy white collar crime attorneys are great at muddying the waters and confusing juries. A confused jury will not convict in a criminal case.
I think Paulson announced his intention to put Fannie and Freddie into receivership on Friday September 5.
All of the other stuff took place the following weekend of the 13-14. The Lehman bankruptcy announcement was made on the Monday. The AIG deal details came out on the Tuesday (16th).
The decision for the Merrill sale was announced on the 14th:
http://www.nytimes.com/2008/09/15/business/15lehman.html?_r=1&hp&oref=slogin
The following Sunday (21st) the Fed said it would accept applications from GS and MS to become bankholding companies with the attendant access to government credit lines..
Bill Black calls it “Control Fraud.” Different phrase, same criminality.
The problem is wishy washy prosecution. The full power of the state is awesome. But as corps buy pols, the full power of the state is not used against corps.
Pandemic regulatory capture.
Hugh,
Yes, the subsidies (next round) took place after the LEH collapse. The powers that be did not understand the ramifications. Seems like an overcorrection after Bear. With Bear, they seemed to be fearful of its CDS exposures. But Bear and Lehman were almost identical: subscale players with oversized real estate operations.
Thanks. Agree that we need much tougher regulation. And that some of the firms that were saved — and would be saved again — were not depositaries.
But a big part of the problem is that banks that are depositaries still hold huge amounts of toxic assets that seem to still be a problem, no?
Wasn’t at all suggesting that merely separating functions would solve the whole problem, or that problems in the shadow banking system couldn’t grind world commerce to a standstill.
Really admire all your efforts.
That is the thing that needs to change. The statutes need to set up simple strict liability standards; the sentences need to be short, and the punishment needs to be certain.
vegas,
Actually, it is a little different.
Control fraud is strictly a CEO and maybe a few other top insiders affair.
Investment banks are very decentralized, they push P&L responsibility way down in the ranks. So the “frauds” were much bigger scale, as in more people involved.
Yes, I know. It could very well play out longer. There is a spectrum of probabilities. I fell it is important to sound the alarm for when the period of greatest danger begins, and for me that is 2011. It could very well take longer but I feel it would be remiss not to stress the coming danger even if I’m off by a year.
masaccio,
yes, the very fact that SarBox was supposed to prevent this sort of thing, we now have a clear violation and prosecutors can’t get a conviction, or won’t even try? That says there is something very wrong with the rules. That is why focusing on criminality is NOT sufficient. We need more focus on how the rules are badly deficient.
Hugh,
It always amazes me how long bubbles can go before they blow, and the fact that they go on SOOO LONG makes the implosion worse.
True, on terrorism cases the government needs almost nothing to convict. This is another reason why the push to go to miliary commissions is so lame. In the current climate, I think juries would be a lot more amenable to accept the premise of corporate criminality.
I respectfully disagree, and posit that the problem is with those people who feel the rules do not apply to THEM.
CEOs and CFOs know exactly what they’re doing when they SarbOx certify. They just don’t mind if they lie because the payout is huge.
Copy that. Yeah, point taken.
I worked in subprime revolving risk management during the time this thing really took off. We got bought by a Wall St. “bad paper” firm, and the marching orders were subsequently “securitization.” Everyone simply put the ethical blinders on.
I didn’t. I quit in early 2005. Knew this stuff would come to no good.
Hugh,
You may be correct now, the respect for the guys in suits is at an all time low. But you might read Frank Partnoy, Infectious Greed, it goes into detail on some of the chicanery of the 1990s and dot bomb era, he discusses some of the legal issues.
In the Swedish model, or at least my understanding of it, bank managers were personally liable if they didn’t go to the government and come clean on what happened.
Kelly,
Dick Fuld by all accounts is a crazy person. Erin Callan had NO background that suited her to be a CFO.
If there is not a paper trail that shows Fuld KNEW what he was doing was wrong, he can argue, ” I didn’t know this was against the rules, I was told by my troops this was OK and look, even the accountant signed off on it! Who am I to question an accounting firm?”
To borrow a phrase from audio engineering, unlike high-quality speaker systems, economies are “lightly damped, loosely coupled.” Long effects rebound times, consequently.
Really good description. It seems to me the money types have taken the simple notions of contracts and insurance and driven them into first a so called “science,” then a religion. Their hubris is astounding. Just before the failures I read one of them stating that purifying evolution was at work in the market creating a super man.
Reminds me of a bunch of psychiatrists trying to make livings treating each other. — It happens , I am one. :-)
I have not read your blog but hope this can get put into sound bite language. I do believe if the people can understand we can begin to overturn the power of Wall Street and become again more human.
Hugh,
Personal liability would be a massive step forward, could not agree more.
Yves,
The clear pattern is to less & less oversight & regulation. Enron resulted in the laughingly-referred-to-as Sarbanes-Oxley within breathable space. The much worse meltdown of 2008, not a whisper yet.
vegas,
Coupling tigthens in bad times, that’s a perverse element not well understood.
Look at Jan 2008. Congress worried re mortgage market, starts applying pressure late in month to Fred/Fan to do more to unfreeze market. Mortgage spreads on Fred/Fan paper start blowing out in late Feb. This leads some hedge funds to fail and starts the Bear collapse.
And mortgage markets remained frozen.
TalkingStick,
Not to toot my horn even more, but read today’s LONG post, Indefensible Men, discusses Wall Street psychopathy.
I agree; and would like to see more formal control over accounting and lawyering in business transactions. You discuss the Supreme Court’s decision ruling out these groups as aiders and abetters without meeting a ludicrous standard.
On the other hand, I don’t think these guys are afraid of prosecution, and the system should be set up to scare as much fraud out of them as possible. I generally believe that you can deter white collar crime with jail, much more so than blue collar crime.
Well, there you are; crazy and incompetent people running the joint surely blow the notion of static models!
eCHAN,
Correct. We have a full generation of regulatory agencies either cowed into not regulating (Congress would regularly threaten to cut the SECs’ budget, so all they are good at doing any more is insider trading cases) or bred to be in awe of markets/fancy finance (the Fed, to a lesser degree, the OCC). The only regulator with any guts left in the US is the FDIC.
masaccio,
I’ve heard others say the same thing, that merely losing money is not a deterrent to financiers, but they are scared of jail time.
The paper trail the prosecution needs to include in their presentation to a jury is the pay stubs with the name “Richard Fuld” on them.
These Masters of the Universe are paid enormous amounts of money, precisely (by their own words) because they understand these things better than anyone else around. When times are good and the money is rolling in, they say “look at how brilliant I am!” When times are bad, they still get the money by saying “if I wasn’t here, you’d have lost even more.” Either way, the alleged brilliance and grasp of the entire financial universe is what the MOTUs pin their compensation to.
A prosecutor could have a great deal of fun with a collection of quotes from MOTUs about their own incredible understanding of the system, and build a nice little scaffold out of them.
FWIW, I think that regulation and legal prosecution are not a satisfactory answer to any of this. Should we regulate and prosecute? Absolutely. But there are structural problems that need to be addressed legally.
If we leave the same structures in place — the same institutions and practices — regulation and prosecution will not save us.
Yves,
Thanks for your time.
Do you favor a ban on future sales of new CDS’s for anyone using any part of the U.S. financial system (markets, banks, Fed wire and so forth) coupled with allowing the existing contracts to be honored? If not, why not?
Peterr,
In theory, yes, and again I am not expert, but I can see the defense arguing that a discusion of pay is irrelevant and prejudicial.
The pay situation in the US is horrid. I fail to see the justification for people who are mere stewards of firms they did not build walking off with this kind of money. They did not take meaningful risk. No one resents someone who built a good enterprise doing really well, but CEO pay in general is wildy out of control. It is not discussed enough as a major deficiency of our system. The price of having a liquid stock market is that no one can control and oversee CEOs effectively.
econbuzz,
I differ here. Regulations can affect structures. Trust me, give me ten minutes, I can design rules that would make CDS uneconomic. That would in turn force a lot of structural changes.
Yeah, you’re right. What’s the Behavioral Econ phrase? “Asymmetric hedonic win/loss curve.” The coupling indeed becomes much tighter on the downsides.
Thank you Yves, I look forward to reading your book and am grateful for your blog and ahead of the curve breaking financial work on this most serious situation. In regards to the Lehman, initially it sounded like the Treasury and Fed were using the defense and pleading “they didn’t know” that Lehman was doing it. (meaning they were negligent/derelict in their duties and incompetent. Now after reading this NYT article it looks as though the Fed developed a new program (in response to Bear)that enabled the repo situation to occur directly with Fed/Treasury. So although initially I could see some plausibility of those denials (without the emails and full report being dissected)now it looks like those in charge of regulating overseeing them actually encouraged and participated directly in the behavior with Lehman.
Astonishing, but do you think other banks were also doing this, and who or what agency should be looking at this fraud now, and lastly is this program still available and being used or was it just just replaced by more recent congressional bank bailout legislation/actions.
(no wonder the Fed doesn’t want to be audited).
If you were enforcing the regulations also, I would gladly go along.
hownow,
I address the CDS issue longer form in the book. I would like to ban them now, they have virtually no socially valuable uses, and even the ones their proponents claim come at too high a cost (they create huge disincentives to doing credit analysis). But having looked into the market, CDS have become so embedded in how business is done now that an immediate ban would be dysfunctional, possibly destructive. So I advocate regulating them instrusively to discourage their use, with the objective of seeing if that casino can be shut down one the market has been shrunk.
I was thinking about the Ernst Young problem earlier today. But remember that the Enron thing came on top of a number of other, smaller scandals for Anderson.
In any case, while they’re discussing TBTF they need to discuss TBTA (Too Big to Audit) and break up the auditors bc I don’t see how you avoid conflicts with so much concentration.
Yves, thanks for being here, long time reader of nc. Please keep up the good work!
What is the possibility of defanging the TBTFs by moving all Federal/State funds into smaller banks? Wouldn’t it be logical to DEMAND that all State/Federal funds not contribute to the TBTF problem?
Would you say the EU is already moving in this direction by locking Wall St out of certain EU markets?
You are right that the regulators make a difference. Look at the FDIC. Sheila Bair takes her job of protecting the banking system seriously. Chris Cox, who headed the SEC in the Bush administration, was a true believer in markets, pushing useless and pointless insider trading cases instead of dealing with accounting fraud and abusive trading.
Are there any real safe havens? Our economy is dicey. The euro and eurozone look shakey. China is blowing bubbles of its own and Japan is in deflation. Everybody else is fairly dependent on some or all of the above. So precipitating events could not only come from inside but outside the US. It is also not clear how far we can go to address our own problems (even if our elites wanted to) in the absence of international coordination and agreements.
emal,
That program, if you mean the Primary Dealer Credit Facility, was set up to start BEFORE Bear failed (as in it had been announced in Feb. 2008 that it would launch on March 17, 2008). So it was not in response to Bear failure. Indeed, many wondered why the Fed pulled the credit on Bear. It was initially going to lend Bear money for 28 days, which would have allowed it to last long enough to use the facility. And even if the Fed concluded Bear was too sick to be rescued, better to have 28 days to analyze the books, rather than a panicked weekend.
Any chance that with all the discussion of corporate personhood in light of Citizens United we could go after personal liability? Is there a way to get that narrative out there, that if you can vote you must also have some personal responsibility?
empty,
Agree, we need at least a Big 8 again so some can be shot when they screw up big time! Dunno why there is not more ability to punish individual partners (maybe rules need to assign personal liability to audit partners, but then the firms would say no one would ever agree to do audits…)
FWIW, a while back, my college asked if I would address the incoming doctoral students in economics, telling them how my economics training had made a difference. I said in reply that they wouldn’t want to hear what I had to say.
“I learned all I needed to know from the nuns in grammar school when they taught the seven deadly sins — particularly greed.”
The invitation was withdrawn.
Have the SEC assign the auditors and pay them with a size-based fee assessed against all registrants.
Especially when those firms start marketing services that are supposed to make their clients’ bottom lines better. That’s a whole ‘nuther subject, but in a way it’s related to bigness. Once you’re as big as the potential market, you need to find new markets.
Hugh,
I’m not here to give investment advice :-)
But yes, I would be cautious re riskier assets right now.
Yves,
What is your view on restoring Glass-Steagall and size limiting banks’ assets (say $75B or $100B)?
Great description. I like your description of trading as an autistic activity. Mechanical.. There is also the addictive or compulsive aspect. Ir reminds me of the blood lust of war. But what ever, they are cut off from their emotions and the rest of the world. Thus the name narcissism, the root for narcotic.
You are also so on target as to the fact that we are all enchanted by the market and do buy into their grandiosity and notion of entitlement.
.
The whole system has become too big and too consolidated. There are 5 or 6 TBTF. 3 ratings agencies and a small handful of auditors. It’s an echo chambre.
empty,
Corporations have long been persons in the US, that dates back to I think the late 1800s.
The difference here, unlike pretty much every other country, is that corps. here are also limited liability. If the corp goes boom, the losses are limited to the amount of money invested in the co.
By contrast, in Australia and I think some other Commonwealth countries (I am pretty sure the UK), if a company is “trading insolvent”, meaning it is continuing to do business even though it cannot meet its commitments, directors are PERSONALLY liable.
Of course, that didn’t prevent Northern Rock…
hownow.
That is a solution, to take the “client” out of the equation and turn audit into a utility. The “free markets” types would howl,
Hugh,
Yes, we have too much concentration in too many critical activities right now….not at all good.
Like I had money to invest. *g* My point is that other countries or regions of the world are often pointed to as leading the way to recovery, and I don’t see it.
Is it possible Cox was not a true believer (i.e. he and Greenspan both knew they did not understand how current markets function) but rather was faithfully doing what his political and financial masters and sponsors wanted him to do? By the way, OT, but great regular items.
hownow,
With the repo market (the legit kind, not repo 105!) rivaling the size of the regulated banking system, Glass Steagall is not a solution. The markets have evolved beyond that. Repo is effectively backstopped, although NO ONE will admit to that.
Looking forward to this book, and I love the NakedCapitalism blog. You do wonderful work.
If Geithner or NYFED said ok, in effect, to fudging numbers then that might be good defense. Doubt that it is considered ‘legal defense’ though.
hownow,
Cox appears to be, um, brainwashed, but also the SEC was never very effective or involved in overseeing the credit market operations of the investment banks. Look at Lehman. The SEC was Lehman’s regulator, but it basically subcontracted the assessment of Lehman to the Fed. WTF?
Great discussion. Thank you, Yves.
Hugh,
Agreed, the China story in particular is WAY oversold…trees do not grow to the sky, that economy is badly unbalanced, yet the officialdom is pedal to the metal to do more of the same.
damage,
The Fed’s stance will not help Fuld in court. His big defense is “I’m not an accountant, the accountants and my staff signed off on this.”
Yves,
In general under state law in the U.S., corporate officers, directors and employees are personally liable for any torts (e.g., fraudulent financial statements) in which they personally participate (n.b. looks like the Lehman directors got a pass from the examiner).
econbuzz,
I was really space contrained, but I would have LOVED to have discussed in the book the nonsense that goes on in academic economics now. It is almost Stalinist in how dissent is not tolerated and only Right Thought is permitted. Yes, we have some permissible heresies (information asymmetry, behavioral econ, some focus on principal/agent issues) but that’s it.
Aside from the accounting, to which Fuld is either crazy or incompetent as discussed above, surely he cannot plead ignorance to the business purpose of those shady transactions.
In other words, what possible answer could he give to the question of “Mr. Fuld, what was the business purpose of the Repo 105 transactions, i.e. what did you expect to gain or lose for Lehman shareholders?”
Thanks. ECONned shows that the ideas of the economists are clothed in math, but that the controlling issue is not the math but the assumptions. We may not all be able to follow the math, and are entitled to assume that economists do follow the math, but all of us can examine the assumptions.
That gives us a way to deal with these guys.
—————-
I don’t know if you know this or not, but are their any programs in place for citizens or whistleblowers to expose some of these companies? A friend took some info to the SEC about some fraud he found in a publicly traded company. He told the SEC about it (with evidence) and they ignored him.
If the regulators aren’t doing their job, can we? It would also be great for us to get a cut. Say we find out that they are dodging taxes, we could get a percent of the recovered taxes.
We always hear about “citizens journalists” what about “citizen regulators”?
Hopefully, masaccio can explain the history better, but the SEC is one of the great examples of how regulation can be made to fail. They were denied budget they needed, and then thanks to repeal of Glass-Steagall (sp?) among other legislative acts, were robbed of their mission.
Call them a test case for Grover Norquist’s theory of government.
Some words on feedback and math:
Most feedback is a second order derivitabe (as acceleration is a second derivitave of distance).
Positive feedback causes oscillations. These can increase in amplitude to a point of failure.
Negative feedback, carefully apllied, dampens feedback.
Non-linear feeback result in tipping point or strange attractors.
There are higher order of feedback. Rocket controls (rocket engine gymbals) require the fourth derivative feedback to be effective.
All human based systems are non-linear. There are no stable equlibria, becuase all the conditions change and all are interrelated. There are no constants.
There is no know math that can describe the economy. First, all the variables are not know, only some. Second, the interrelations of the variables is not fully understood. Third, non-liner system are chaotic systems, and predictions (the time, duration, and size of an event) in chaotic systems impossible.
hownow,
yes I need to look at the report. Despite all the buzz, I am getting the impression it was actually too kind on quite a few issues. For instance, one reader who knows the terrain says that the report endorsed Lehman’s valuations. Huh? The firm had a $130 billion hole in its balance sheet. Repo 105 is an insufficient explanation. Everyone knew even then that its valuation of two commercial RE deals, SunCal and Archstone, were utterly bogus. If there were so desperate as to mismark highly visible positions, one has to assume mismarking was pervasive.
Yves, do you have any idea whether there are individual academic economists who are willing to admit that their ideas have been given a fair trial and have failed?
masaccio.
That is one bit I had to expunge to make that chapter tidier…the really funny bit is that the despite the effort to use math to make the argument explicit, much of the argument in econ papers is actually in the narrative! So the idea that their “argument” is math, hence rigorous, hence rock solid, is really oversold.
Is that why economists have predicted 10 of the last 3 recessions? And 30 of the last 3 booms?
Obama looks to have the same trait of persisting in failure that Bush had. If Obama was to dump Geithner and Summers, he has about a year from November 2010 (after the elections) to November 2011 (the next Presidential cycle) to do it. After the 2010 election would be the best because he could sell it as making a new start. The later it gets the harder it is to sell that line. But I don’t really see Obama changing horses. I would not be surprised if he stuck with them until the end of his first, and only, term.
Yves.
Very good question which raises the issue of whether it will take 40 years to restore to the SEC the capabilities, spirit, and drive it had in roughly the 1960s (pre-Casey).
Ms. Smith,
A couple of days ago your blog ran an article discussing the real inability for governments to use inflation to ease their sovereign debt. http://www.nakedcapitalism.com/2010/03/guest-post-we-cant-inflate-our-way-out-of-the-debt-crisis-so-what-can-we-do.html; authored by one of your contributors, “Washington.”
Among the supports for that position was a graph from a Joe Weisenthal article showing “Change in government debt:GDP (as a % of GDP) over 1 year” vs. “Year over year rate of inflation.”
The assertion was that if periods of high inflation lead to lowering the debt burden, then one would see more data points in the lower-right quadrant. That interpretation seemed suspect based on the data provided.
“Change in government debt:GDP (as a % of GDP) over 1 year” is the wrong measurement, because GDP is a variable, and we’d be interested in the real value of the debt, not just the nominal value relative to GDP.
What you need to use on the y-axis, for that to be a useful indicator of inflation vs. debt, is the total debt, adjusted for yearly deficits. That way you isolate the debt and the inflation into appropriate constants.
As it stands that graph seems somewhat useless matched with the conclusions drawn from it without also knowing the correlating change in GDP number for each represented point; no?
“Indefensible Men” could not be more succinctly and comprehensively on point, btw. I’m forwarding that link around.
Gee, that is hard.
The neoclassicals are the last to admit they are wrong.
Sharpe admitted his CAPM was wrong, but continued to defend it in the 1970s as useful. He has moved on without admitting error, but his recent remarks are consistent with recognizing his earlier ideas had problems.
Keynes famously reversed himself on monetary policy (his General Theory contradict some of his earlier work).
Krugman has reversed his position on some issues while pretending that he hasn’t shifted ground.
Thinking in development economics has changed, they now support the idea of protecting developing economies so they can build industries to the stage where they can compete internationally. They will admit to a change in thinking.
Your parenthetical comment about incentives jumped out at me here. In reading Andrew Sorkin’s TBTF, I was struck by the many occasions on which individuals and firms on Wall Street were switching between being competitors in a deal to partners putting a deal together cooperatively, or moving from being the provider of a disinterested outside opinion to someone pitching a deal for a client to someone pitching a deal for themselves. I recall one place where two MOTUs met and one cried in frustration “Who are you representing today — me, another client, or yourself?”
It seems to me that the ordinary real estate market regulations are a lot clearer on disclosure of interest. The real estate agent has to be clear about who they work for, and cannot play any other role in those deals.
The more I read about Goldman Sachs, the less I understand why anyone would want to work with them as a client. They seem very devoted to putting their own interests first.
From scandals past, I see Michael Milken is on the Forbes billionnaires list. And John McCain survived the 1980s banking scandal. So crime pays or it effects does not destroy.
spocko,
Economies are too big and complicated to forecast. Econometricians who are honest will say you can forecast pretty well for six months (inertia is powerful) after that, forget it.
When Dean Baker was here a few weeks ago he said that academic economists are as divorced from reality as ever.
Or is it that no one’s figured out the math to apply? Alan Turing is supposed to have figured out mathematically how growth is controlled in embryonic life forms. Eventually, biologists discovered Hox genes and the like that did what he said they would. Turns out they operate somewhat the same way, in that they affect each other, as well as whatever cells they’re operating on. Up until then, few if any biologists thought it was possible.
Plus, just about all math-based theories have their limits, even in physics.
While I agree that we don’t see any really good economic models, I guess I just find this description overly broad.
“I’m proud of you, Bert.”
“Brownie, yer doin’ a heckuva job.”
They never learn.
Timing, duration and magnitude are unpredictable. That there will be ups and downs is inevitable, and the onset of some strage attractors is preceeded by instability.
That said, 9/11 was an example of an event not preceeded by instability. 9/11 was a prime example of an exogonous event.
Bare Sterns & Lehman bros were both a part of the instability, I’d suggest.
Ms. Smith,
On a related note to the policy tools available to us. Bernanke has already stated that the Fed will not pursue a money printing exercise to assist Congress in dealing with our debt. I’m having a hard time understanding that position, considering that we borrow in our own currency from foreign counterparts, which should give us significant leverage, and the alternative is to pursue deflationary policies to debt relief; seemingly being overly gracious to our foreign investors at the expense of American citizens.
The only way Bernanke’s statement makes any sense to me is in light of a belief that no matter how much we devalue our currency, the Chinese will continue to keep their peg, and march down the hole with us, effectively doing nothing to improve the U.S. standing in the global exports market.
Can you provide your insight into what course of correction the U.S. can pursue that will have positive effect, taking account for the stalwart mercantilist policies China seems content to pursue despite all indicators that they shouldn’t?
In other words, is there even a way out of this while the global trade markets are configured as they are?
Peterr,
This is huge problem. It shows up on deals, particularly CDOs. The idea is that if the documents say some parties are massively conflicted, hey, they are in the free and clear.
The FDIC wants in securitizations for parties to disclose their intentions, not just their roles. That would make it hard to create vehicles to dump your risks on your customers, for instance.
damage,
Milken is also a crazy person. Unfortunately, people have more respect for that type than they ought to.
cujo,
Actually, he is not wrong.
Someone told Ken Arrow before he published that the Arrow Debrue theorem, which is seen as one of the crowning achievements of economics, was Turing non computable. He published anyhow and got a Noble prize
Even within in a business, forecasting is mostly BS. We always had to use our CFO’s ROI “profit model,” which ran monthly “stress-tested projections out 5 years.
And, every month, mid-level execs were sweatin’ basis-point bullets over the latest monthly “predicted vs actuals” disparities.
Whereupon the whole thing would be re-jiggered. Lather, rinse, repeat.
I found it all lipstick-on-a-pig stupid.
After writing your book, do you think the genie can be put back in the bottle again. If we have to wait until the next meltdown, will we have the tools, resources, even governmental structures, and people to produce real reform?
Nathan,
Just because a guest post ran does not mean I agree with it. I allow for a broader range of opinion than my own on the blog.
Chaos theory and non-linear feedback (the butterfly effect) are fairly modern math, and unknown to Keynes and the Chicago school.
As I wrote earlier, neither all the variables are known, nor are the interrelations of the known variables.
There can be no models. Even if the techniques exist, we don’t know how to build the models. Even if a model was developed or written, then that raises the really ugly questions of how to calibrate and test the model.
The most depressing part, I think, is the way that politics has invaded the discussion. IMHO, it has rendered economics almost useless for policy purposes. For example, the proposition that government spending necessarily crowds out private spending even when interest rates are near zero and deflation is at the doorstep is just nonsense driven by politics.
Very depressing.
vegas,
People do not like uncertainty. It is more comforting to think you have a handle on the future. Our brains also have limited cognitive capacity, so we cannot handle too many “visions” of what the future might be.
I found Li’s “Gaussian Copula” particularly charming. Hey, what’s not to love? Asian cat with a math PhD? Swoon…
Anytime I see the name “Gauss” associated with some non-physical phenomenon, my hand slides reflexively over my wallet.
As we come to the end of this Book Salon,
Yves, Thank you for stopping by the Lake and spending the afternoon with is discussing your new book and economics.
masaccio, Thank you for Hosting this great Book Salon.
Everyone, if you haven’t bought this great book yet here is a link.
Thanks all.
Yves,
So much for Glass-Steagall. What about size limiting banks (say $75B) and requiring more first tier capital as a way to resolve or eliminate the TBTF issue over time?
Hugh,
The EU is doing a much better job than we are, they may have some approaches debugged when reality sets in among the ruling classes here.
I understand. I was just trying to get your perspective on it, assuming you had read it, because it seemed like entirely the wrong metric, and you’re especially good at sniffing those things out; from everything I read of yours.
Yves, you are not hopeful about reform. Has anyone from Congress, the Administration, staffers, anyone like that contacted you for your thoughts?
“Our brains also have limited cognitive capacity”
Yeah. Basic Taleb there.
As an individual you can short. My money manager is developing a program for when Israel attacks Iran, and the U.S. is drawn in. It may not happen, but the objective probability is a great deal more than 10%. However, my mm program assumes the total drop in equities will not occur on Day One, unlike October 1987. We shall see.
Yes, thanks, Yves.
Thank you, Yves!!
Synoia,
The problem isn’t simply math, it is the type of math econ likes to use. It chooses proof-like formulations. Problems of instability and chaos can be analyzed to a degree (this is beyond my pay scale, but trust me here) but NOT in the type of math taught in the disicpline! They use a very restricted subset of the mathematical tools and methods on offer.
Is Ron Paul’s Austrian school of Economics any better different than the Chicago School? Me I prefer Keynes personally but I thought I’d get your view.
Measurement error could certainly be an issue… ;)
Oh reality is much simpler than you suggest. We have observed what happens when everything is allowed. It’s not pretty. Simple rules would prevent most of it. Duh.
In fact, I’m in favor of a plain vanilla financial system with NO financial innovation. Plain econ data supports the hypothesis that financial innovation is NOT pro-growth, or may (as I expect) be anti-growth.
Yves.
Thank you very much. Great blog by the way; looking forward to the book.
I should have put a :-) face after my comment. I was making the little joke.
(obviously very little)
My other question about “citizen regulators” was real. I keep thinking about all the laid off high roller traders who know HOW the bodies were buried (or taxes evaded) who might want to bring that info forward in exchange for some kind of compensation. And I think about all the people who want to hit the cheaters in the pocketbook and if the regulators have become captive to the people they are regulating someone else needs to apply pressure. So you might have IRS working to help SEC with some sort of citizen regulator providing input/data/whistleblowing.
Of course they might also need some kind of protection. My friend who brought the fraud info to the SEC? The SEC didn’t follow up on it and the company sued him!
Yves, thanks for participating. Your book rips the mask of competence off the faces of economists and Wall Streeters.
Thanks, masaccio and FDL.
hownow,
That might have worked 10 years ago, I am dubious now.
Goldman has a $1 trilionish balance sheet. It runs a very large global infrastructure that depends on a certain level of revenues to support the infrastructure. There are some pieces you can hive off easily, namely all the asset management businesses. But those do not sit on the balance sheet to begin with.
Those trading businesses all have big cross subsidies. How do you break up a Goldman? You cannot simply clone its infrastructure (even if you could clone the people) and have two firms with half the revenue and the same infrasturcture. Neither would be profitable.
RLMiller’s diary is front-paged!
Why does Congress want to raid our best carbon bank?
“financial innovation” or “innovative financial ‘products’” are simply code phrases for inscrutable yet egregiously one-sided financial legal contracts.
I’ve always wondered why mathematics became the language of economics, when the systems seem so much more appropriately viewed algorithmically.
Things,
The Austrians have their merits. Malinvestment and creative destruction are important concepts. The problem is a lot of them get a bit religious.
I do think Keynes was far and away the best mind we had in that discipline in a very long time, many of his important ideas have been marginalized as being too inconvenient.
during the dot.bomb era, give or take a few (I’m 50), skimming an image of an 75? whatever year old NYT some years ago, there was a piece about Ford paying a dividend – and the dividend was a good sized chunk of change relative to the other reported numbers.
it jogged some memories of companies being able to market themselves as growth stocks and not pay dividends during the 70′s / 80′s & then in the 90′s people like bill gates didn’t have to pay people much, just issue them funny money, and the stock casino would pay them, cuz the funny money was gonna double every 18 months cuz … look at my spreadsheet! it doubles every 18 months!!
while we sure as hell had corrupt / non-existant regulation, and more tulip hype than ponzi could have ever wished for, shouldn’t EVERYTHING be traded on open public markets?
IF you want to take your CASH to vegas and put it on black 42, go ahead. Want to try to rig the game … good f’ing luck staying out of an unmarked desert grave.
thanks for your work.
funny how there are more billionaires from America than anywhere – cuz we have more people to make money from – and they’re working hard to make sure we’re all living at about 13 cents above haiti’s wages.
rmm.
You could look at it that way.
vegas,
Yes, “innovation” needs to be expunged in connection with financial products.
Opacity, leverage, and complexity were not side effects of otherwise salutary innovations, they were the point of the innovation. No one got paid more for making markets transparent and efficient. That sort of innovation reduces profits to intermediaries unless you manage to capture massive market share gains, which is pretty unlikely in finance, given ease of copying most “innovations”.
Nathan,
ECONNED discusses the increased use of mathematics at some length, this was a very deliberate push within the disicpline that began in the 1940s and 1950s
Thanks always good to see you here:)
spocko,
Whistleblowers often get crucified, socially we need a better way to protect them from persecution.
In general, I think the pessimism re regulation is way overdone. The industry is large, a lot of people choose for various reasons to leave mid career, it would not take that many savvy people to greatly improve enforcement. But we need to pay them better (not hugely better, but better) so they don’t have incentives to go back to industry (or require a very long cooling off period).
I guess it depends on whether you’re an electron or the current flow…
I’m just reading a Wired article about Li’s theory now. Looks like it might have been useful in very limited situations (mostly academic), but they tried to apply it beyond what it could describe. I’d certainly be uncomfortable using any theory like this, particularly if people didn’t understand what its limitations were.
That problem would be there even if the theory were a straight linear equation, of course.
This is one of the many reasons I’ve never been eager to jump into the stock/financials/etc. market.
I go back to Milken’s observation that “in the gap between perception and reality, there’s money to be made.”
So, the “innovation” part is all about taking slick advantage of transient conditions via pseudo-sophisticated financial legal arcana — really nothing more than woefully asymmetric value propositions shrewdly packaged (and asymmetrically enforceable when the shit goes down, as we have yet again seen writ large).
Oh, only a masochist would be a whistle blower. Name one who hasn’t been crucified.
Yeah. I have his paper. Weak.
Actually I’m not sure I agree. Laws apply feedback, and try to “restrict the system” to a know range of values that look “controllable”. That control is an illusion.
An example of an event that destroys such control would be Climate Change. That would put the system well outside what passes for “controls” or simplicity.
That said, third party insurance is not payable (naked CDS), and the financial indusry spends much of its time looking for high liquidity high return (and high risk games), while eschewing investment in the “productive economy”.
eCHAN,
I am a big believer in plain vanilla, for many of the supposed innovations, the increased value to customer is marginal, but introduces much more complexity and opportunities for bad outcomes, with the main real benefit more fees to the vendors.
It’s really a lot simpler than that. You just need to wake up, put on blindfolders and do what you did yesterday. Since markets go up much more often (dailyly speaking) than they go down, this is a winning strategy. Couple that simple rule with the fact that you’ll be bailed out by the taxpayer, and what could be simpler and more profitable?
LOL!
The exultant executive mantra at our bank was “The best things in life are FEE!“
They are both math.
From what I’ve seen economist use 19th century math, and Quants use math while ignoring the stated assumptions in the proofs they use (aka: Negligence). For example: Ito’s Lemmea clealy states it not valid in a system with large exogenous events.
cujo,
Salmon’s article is a great piece, and if you are remotely commonsensical, you could see how silly his solution was. Oh, we’ll use the risk assumptions embedded in CDS as a proxy for default risk. Yeah, but that means you are using CDS as a prediction market, when the people making those predictions have an inadequate data set to be making decent judgments. Prediction markets work well ONLY when you have enough informed experts setting prices.
So at its root, the logic was circular. But if you had dared say the emperor had no clothes, you would have been dismissed as an idiot.
I’m just being pragmatic. The analogue to climate change in the financial world is innovation. Stop that, and you are back in a world of simple rules for reasonable peeps.
Fine. So how do ‘us analysts’ convince the sophisticats that plain vanilla is the way to go?
eCHAN,
Right,and worse the models reinforce that behavior. Those Value at Risk models work super well on a day-to-day basis, and are lousy at predicting blowups.
My Wall St. job was business cycle forecasting. Let me assure you that no one could be slightly interested. Mercifully I was kicked out with a ‘package’ a decade ago.
eCHAN,
Volcker is trying, but he has too few followers. Look at how plain vanilla was removed from the consumer protection bill. That was THE most useful element, which of course made it most dangerous to the industry.
I think we need to fight higher up the idea chain. The industry is backstoppped, ergo it needs to be regulated as a utility. Then plain vanilla follows.
Synoia,
You are correct here, models regularly applied in situations out of bounds where they are “supposed” to work.
That’s the problem, at least to me. They treated this as if it were a scientific theory, but they didn’t apply the skepticism to it that sound science requires. It’s more like religion. Pretty common thing in the financial world, from my limited observations.
Oh, I have a dear friend who is too young with too little assets to retire, who knows all about biz cycles and who is a sophisticat in math models. Do you think she can find a job on Wall St? Not even close. Been unemployed for about 8 years. Command of the obvious=zero employment opportunities.
Synoia, you might do a Seminal diary on modeling; I think a lot of people who weren’t here might like to learn more about it.
Volcker is sooo ooold school. No one is paying attention to him anymore.
eCHAN,
They love hiring kids. Mid level people have a hugely difficult time getting hired. She would have done better to target a state government, a mid-sized consulting firm, or a company that had complicated forecasting issues (tour companies have exposures in a lot of different currencies, high complexity for the size of their businesses).
Not usually inclined towards conspiracy theories, but could it be that Obama is keeping Volcker in close for reasons other than his wise counsel?
Bill Black (we have corresponded now & then) once congratulated me for my boss not having approved my going back on the company dime to do a 2nd Master’s in Econometrics (prick wanted me to get an MBA instead — we were already overpopulated with ‘em in the Risk Dept). LOL!
Yes, its negligence, but one could not convince a non-math or engineering degree jury…
Cujo,
The religious part is one I’d like very much to write more about. The scientific pretenses of economics have allowed it to hide the fact that it is inherently political (why is this a topic on this blog, for instance?) Economics was once called “political economy” and for good reason.
Thanks, I’ll try.
I’m also a testing expert, and I got into testing becuase it’s the only job I found where the management would pay you for delivering bad news.
The most devastating question in large complex projects is
“How are we going to test that?”
It’s also a facet of “management”.
newton,
I was told he was offered the Treas Sec job, the deal was he’d do it for a year and turn it over to Geithner. Dunno if true, but that puts a different spin on things.
Problem is that Summers is a master infighter, he and Turbo Timmy are joined at the hip, and Volcker is not about to stoop to that sort of thing. But Obama could have overridden that if he bothered.
Volcker’s sudden reemergence looks like window dressing to me.
You got the ‘wet behing the ears’ phemonmenon right. My friend can’t work for the entities you suggest because they are enthrall to innovations.
To me, “economics” is really principally “social psychology” (and all that such implies and extends to) — which is why I have such affinity for the “behavioral economists.”
In addition to being a “Talebist.” And a “Chebychev-ist”. :)
Hah, you got lucky, even if it did not look like it at the time…
Volker’s reemergence looks like desperation to me. Clutching at straws?
vegas,
Yes, economics is the only social science that starts from the assumption that humans are rational. Every other social science focuses hard on irrationality. Worse, economics tends to put humans in very simple situations and assume superhuman cognitive powers, when humans are typically in very complex situations and have only limited capacity for analyzing them.
I believe that. But he is also smart enough to know when he is being stood up and used as a more diffuse target. He can’t both not want to be part of the clutch of idiots, AND stand to take a fall for them.
I worry that he is the cardboard cut-out.
Team Obama’s conduct does look desperate, but you’d never get that from the MSM. And as long as they can manage the optics, they think they are doing well, although the collapsing polls are sorta penetrating their denial mechanisms.
My rationale was that “look, I sit here doing logistic regression and CART models all day for portfolio mgmt, and the econometrics MS is really just a couple of years of every imaginable flavor of regression etc. It’s be a different nuance amid the department.” My direct Sup had approved it, but the Big Dog wouldn’t sign off.
Probably a good thing, as Bill told me. He asked me if I’d like to come to UMKC to do a Doc in white collar criminology. I would do that in a heartbeat were it logistically and financially possible. I love his work.
“humans are typically in very complex situations and have only limited capacity for analyzing them”
Taleb 101. Hunter-gatherer tribal brains trying to rationally traverse ever-shifting complexity.
I think the bigger risk is he may not know what he does not know. His Volcker Rule looks to me to be not the best way to go after the problem (as in he is attacking it at the level of symptoms). Some readers and I have debated whether Volcker is current and being dumb like a fox, or whether his understanding of the industry is somewhat dated.
Great discussion y’all. I gotta go run to the nursing home and sit with my Ma for a while. C YAs. Yves, thanks. I will order your book straight away.
Very instructive, Thank you.
Great discussion.
This has been great fun, and thank you for having me!
I also have a video up at YouTube, hope you will give it a look and encourage the like-minded to view it.
Thanks again!
Volcker, in my personal experience, is a social hermit. I ran into him on a flight to Denver. He’s hard to miss. My then boss (who I disrespected mightily but that’s another story) had been a Volcker assistant in a former life. So I introduced myself to him in the airport waiting area. Conversation was strained, to be polite. Boarding ensuded. Volcker was in first class, and as luck would have it, our bunkhead seats in coach were occupied. So we were stuck in the aisle right by Volcker until it was straightened out. He kept his newspaper up so that he could have no contact with me. The man’s a waste.
Thanks for the discussion. It’s been interesting, to say the least.
Great. A good place to start is Wikipedia. It has a lot of the equations, and even enough on the Gaussian Copula to start with. As you may know, I have written a bit about this stuff; here’s a post with some links.
Swopa is upstairs!
Meet the New Iraqi Government Coalition, (Probably) the Same As the Old Coalition
“I didn’t have full control over the title, and “F*ck” would NOT have gone over with my publisher! I would have preferred, “How the Invisible Hand is Picking Your Pocket””
I’m not sure this “hand” is invisible. I think it’s very visible, we can name names.
While it may be true that the push to de-regulate was, in part, promoted with reference to the “free market” idea(l) (or myth, if you prefer) and was a key cause of the financial sector fraud and collapse, it is NOW the case that GOVERNMENT institutions are fully participant in perpetuating tha fraud.
I think maybe in the US, we’re not accustomed to truly corrupt government, to a government run by organized crime–as I very much believe the US government to be.
I think we have to wonder, then, to what extent is the “free market” still the key devil term, here.
If power and resources continue to be concentrated, with the full assistance the fedgov, are we not faced with the prospect of a corporatist state, in which the “economic opportunity” that Americans take somewhat for granted is VIGOROUSLY narrowed and withdrawn and withheld through the thoroughly captured political process.
We DO see this now. We see this in the way that banks are gambling with their Fed trillions rather than loaning them out. They may be citing “free market” principles to describe why they’re doing that, but what is the term that describes such a concentration of power and the direct overlap of financial and political power.
ie., how do we describe the fact that the finance sector and the government are virtually one and the same? “Free market capitalism” doesn’t seem an apt description of the collosal centralized Frankenstein that is CURRENTLY scr*wing us raw, with effectively unchallenged impunity.
“Free market fundamentalism” may have gotten us here, but I also think we’re crossing the bridge into some other political economy that we don’t really understand. But we’re going to need to talk about it, and I think we’re going to need some new terminology in order to do so.
The “free market” idea(l) was not an inherently “bad” idea. It’s not a “bad” thing to suggest that there SHOULD to be a multiplicity of means of generating resources, rather than being required to rely on a totalitarian state for ones’ resources. A state composed of a tiny elite that can then extract all kind of rents in exchange.
If we HAVE gotten ourselves into such a condition–and it’s possible we have–it may well be a good idea to get OUT of it.
I have recently been on an econophysics kick and the field looks wide open because most of the research doesn’t view or interpret the data in the same way I do. I treat randomness correctly and am not afraid of mathematical equations. I don’t see why Yves Smith would say that randomness is difficult to compute; you just have to do it correctly.
Firm Size: http://mobjectivist.blogspot.com/2010/03/firm-size-entroplet.html
Income Disparity: http://mobjectivist.blogspot.com/2010/03/econophysics-and-sunk-costs.html
City Size: http://mobjectivist.blogspot.com/2010/03/entroplets-of-city-population.html
Human Travel: http://wwww.theoildrum.com/node/6255
Investments: http://mobjectivist.blogspot.com/2010/03/volatile-investment-trap.html
I know the boundaries of the general analysis and that has to do with scaling to the micro level. I stay at the macro level where all the individual game theoretic strategies cancel out and all that is left is entropy and disorder.
And these micro-features cancel out for the same reason that the specifics of the data for individual oil reservoirs (or any other constrained resource) cancel out when aggregated. In other words, beyond a certain point you no longer you need to know the detailed data, and the aggregate is good enough to make predictions or extrapolate the behavior.