Pursuit of Truthiness

my gut tells me I know economics

Archive for September 2010

The Big Short

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Michael Lewis’ book The Big Short: Inside the Doomsday Machine has been a popular bestseller even as it received unanimously good reviews from economists- the harshest review I saw was Eric Falkenstein’s “entertaining but doesn’t get to the heart of the issues” take.  So of course a part of me was secretly hoping the book’s arguments would be wrong or oversimplified, and I could explain why and feel superior to everyone else.  But I am afraid it was simply an excellent book.  It is very entertaining, gives a good explanaiton of the crisis (though not mutually exlusive of other potential explainations), and explains complicated financial ideas in a way that most people should be able to grasp.

One of the big themes of the book (though it is not explicitly stated this way) is that the Efficient Markets Hypothesis often fails to apply to U.S. financial markets.  This is often because its assumptions are not met, particularly in bond markets where there are few buyers and sellers and little information is publicly available.  But sometimes large, liquid markets seem to take a surprisingly long time to incorporate publicly available information.  For instance, one small hedge fund claimed that they were the only people really examining the financial statements released by subprime mortgage companies in early 1997, and that it took the market months to look at the same data and realize the firms would soon be bankrupt; the fund’s accountant said “it made me feel good that there was such inefficiency to this market… if the market catches on to everything, I probably have the wrong job.”

Another small hedge fund, Scion Capital, made huge returns when their “decision-making apparatus consisted of one guy [Mike Burry] in a room… poring over publicly available information”.  Lewis tells the entertaining and inspiring stories of how three small, wildly successful hedge funds got started.  My favorite was Cornwall Capital, “two guys in a garage in Berkeley with $110,000 in a checking account”.

One small part of the book gave me an idea for a great economics paper (which has probably been written already).  There is now a great debate about whether “bubbles” can be meaningfully defined, discovered in advance and deflated.  Many argue that once you have a definition of a “bubble” that is meaningful and testable, you will not be able to find any.  But in the book, Mike Burry puts forward the thesis that

“It is ludicrous to believe that asset bubbles can only be recognized in hindsight.  There are specific identifiers that are entirely recognizable during the bubble’s inflation.  One hallmark of mania is the rapid increase in the incidence and complexity of fraud… the FBI reports mortgage-related fraud is up fivefold since 2000.”

I would love to get fraud and financial data by sector and look for relationships.  I am sure others have done this already, but if not it would be cool to test the theory, and if it holds up start making money on it.  (of course, making money by killing the Efficient Markets Hypothesis only serves to make it stronger going forward… it is like Obi-Wan Kenobi.)  Another potential way to make money described in the book is to buy options (which at least as of 2007 were usually priced by assuming a normal distribution of potential prices) on stocks which should have a bi-modal distribution of future prices; it made me wonder if this still works.

As far as an explanation of the financial crisis, the book has two main explanations.  One is that the bond market is opaque and oligopolistic.  “The presence of millions of small investors had politicized the stock market.  It had been legislated and regulated to at least seem fair.  The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure… bond traders could exploit inside information without worrying that the would be caught… in the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.”

The second, and related explanation is that the bond-rating agencies were very bad at their jobs, and only some people realized that.  The Wall Street banks making securities could exploit the flaws in the rating agencies models to get their product rated too highly.  Meanwhile, some investors stupidly trust the rating agencies and buy bonds at high prices assuming their ratings to be correct.  There were many flaws in the rating agency model, perhaps the most surprising to me is that “both Moody’s and S&P favored floating-rate mortgages with low teaser rates over fixed-rate ones”.  Many people focus on the potential corruprtion at the rating agencies and Lewis does bring that up, but his main focus is on stupidity.  “You know how when you walk into a post office you realize there is such a difference between a government employee and other people.  The ratings agency people were all like government employees.  They’re underpaid.  The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for.”

In the epilogue Lewis turns to a third explanation for the crisis: a faulty incentive structure for employees in financial firms.  “What are the odds people will make smart decisions about money if they don’t need to make smart decisions about money- if they can get rich making dumb decisions?”

Before this post gets any longer, I’ll just say: read the book, it tells some great stories.  Also, check out Lewis’ article on the Greek debt crisis.  He manages to interview a lot of important Greeks.  The article is fascinating but somewhat depressing as it makes me wonder how Greece can possibly fix its government and social order; I can understand why Paul Romer proposes giving the EU a bigger role in governing Greece.

Written by James Bailey

September 20, 2010 at 11:34 pm

Public Goods are not Consumed Equally

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We discussed public goods in Micro Theory yesterday, and it was asserted that they are always consumed equally by all parties, whether they are the two consumers in a Kolm Triangle or everyone in a nation or world.  Our professor usually points out assumptions that seem very strong or unrealistic, but he seemed to endorse this one without reservation.

Myself, I don’t see how this comes close to holding for any definition of “public good”, “consumed” or “equally”.  Consider national defense, the archetypical public good.  I don’t think anyone would contend that all Americans pay for national defense equally or derive the same utility from its provision.  The assumption is that we all receive the same “amount” of national defense, though this is admittedly hard to measure (perhaps we get two Major Theatre Wars worth).

In reality though, some members of a nation receive more military protection than others, and often the scarce resources of the military are used to protect some people at the expense of others.  Historically, armies were used to protect the people near a frontier, often from threats that had no chance of harming those in the interior.  The US used forts and raids to protect frontier Americans from Native Americans who posed no threat to those in major east coast cities.  Today our War on Terror is supposed to prevent terrorism, and so benefit people in New York City and Washington more than those in rural Kansas or Montana.  In a two-front war, the military must allocate resources between fronts.  For instance, in WWII the US prioritized the European theatre over the Pacific, so that east coast citizens received more defense resources than those in the west.  Today US forces arrayed against North Korea provide much protection to South Koreans but very little to the majority of Americans one would think to be the relevant “public”.

Other kinds of “public” goods are even more obviously consumed at different levels.  Those without cars don’t “consume” public roads as much as those with them, those without televisions don’t consume public TV, those without boats don’t get as much out of lighthouses.  Even knowledge, especially when broken up into various subdomains, is not consumed equally and in some cases perhaps cannot be consumed directly by all people (if they are not capable of understanding it and it has no “practical” uses).

This seems to be an open and shut case of a super-unrealistic assumption.  So the next questions for an economist are, how much does the math and the theory of public goods rely on it?  Can we generate results if we relax it, and if so what are they?  Have people done this already?  These are the questions I will be thinking about in our further study of public goods.

Written by James Bailey

September 15, 2010 at 1:23 pm