Pursuit of Truthiness

my gut tells me I know economics

Archive for November 2012

Were the Roots of the Global Financial Crisis in our Business Schools?

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No. Well, maybe, the proposition does sound like there is something to it, but after reading “The Roots of the Global Financial Crisis are in our Business Schools” I am actually much less convinced of this thesis than I was when I read the title. This is because the article throws a bunch of shit on the wall hoping some will stick, without even considering that some of the shit might be contradictory. But I think it is a good example of how populism that sounds reasonable at first will end up providing its own contradictions.

Two of the main arguments are that people in finance are too self-interested and care too much about profit maximization (and that they learned each of these in business school), and so don’t consider morality or what is good for society generally. Attributing the financial crisis to individual selfishness or to profit maximization might each sound good individually, but can’t work together, which is the whole point of principal-agent theory. Are people acting in their own best interest (work as little as possible, make as much money for yourself as possible, be neutral about what all this means for the firm), or are they acting in the firm’s shareholders’ best interest and trying to maximize profits? Given the actual history of the financial crisis, it seems more realistic to blame selfishness, since many of the firms involved spectacularly failed to maximize their profits, while the compensation structures based on short-term performance allowed many individuals to make a killing in the process of sinking their firms.

Another main bogeyman of the piece is Milton Friedman and the Chicago school of economics, who are claimed to have taken over business education (I wish!). They are blamed for teaching that individuals are rational and selfish utility maximizers, something which was actually in the textbooks of Alfred Marshall and Paul Samuelson well before the ascent of Chicago. More importantly, the very existence of many departments in business schools and financial companies demonstrate that the people involved do not believe in the standard economic model. How much marketing and advertising is based on the premise that the audience is rational? How many investment companies could justify their existence and huge salaries and fees if they really believed in the Efficient Markets Hypothesis, and believed that their clients were also rational and believed the EMH? Basically just index funds, which don’t have the huge salaries and fees anyway. As an economist, it is very hard for me to believe that my kind has had a huge influence over business schools or business practice. Though I may be a bit biased as a member of a department which just left the business school, and to its credit this argument is more empirically wrong than actually contradictory.

The article also blames Milton Friedman specifically for arguing that a corporation’s sole goal should be to maximize profits and shareholder value, rather than also caring about “corporate social responsibility”. What corporate goals should be is up for debate, but I think it is hard to say that the problem was firms being too profit focused. Again, the problem was that many of these firms turned spectacular losses and failed, or would have failed without bailouts. There are many possible reasons for this, which have been discussed to death: compensation structures, previous bailouts and moral hazard, lack of regulation or poorly structured financial regulation, a giant pool of investment-seeking money caused partly by overly loose monetary policy in 2003-4, misregulation and massive subsidies for the housing sector- all these could have encouraged excessive risk-taking that led to giant losses. But it is hard to argue that firms lost money because they were focused on making money. Furthermore, some of the firms which exploded worst were actually known for “corporate social responsibility”.

But suppose the financial crisis was caused by the standard economics model and the business schools- what do we do about it? This article provides further evidence that an argument jumps the shark when its proposed solution is “more Holistic approaches”. This is the epitome of something which sounds vaguely nice but is actually meaningless. Even better, the article calls for “the rejection of the ideology of rational knowledge in favor of one that gives greater weight to experience, or to spirituality”. I couldn’t make this stuff up.

So, the people actually making this argument made themselves into strawmen. What would a better version look like? Is it possible to “steelman” the argument? I would start with the observation that students who have taken economics classes are more likely to defect in the repeated prisoners dilemma, and their selfishness in this case leads them to worse outcomes than those who haven’t taken economics. Then discuss the importance of cooperation in business, especially as work is done by larger teams. Finally and most importantly, look for empirical evidence that firms act differently based on the college major of their management, and see if firms with more business majors and MBA’s actually take more risks and act less socially responsible.

One major advantage blaming business schools is that it can give new life to an old argument. After any financial crisis or other economic problem people tend to blame “greed”. Economists will often reject this argument by asking, “why was there suddenly more greed now? The crisis started suddenly but human nature changes slowly if at all”. But one possibility is that business schools have in fact been teaching people to be greedier. I’m sure one could make a reasonable case for this; but as we have seen, the worst fate for a position is not to be adeptly attacked, but to be ineptly defended.

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Written by James Bailey

November 25, 2012 at 2:03 pm

What Do Markets Predict About Obama’s Second Term?

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While I saw this a Coke vs Pepsi election with no real differences between candidates, it seems that markets do expect some difference. If you believe the Efficient Markets Hypothesis (which I mostly do), then markets will reflect the best guess that can be made about the future by taking all publicly available information into account.

According to prediction markets, there was a 70-80% chance that Obama would win as of Tuesday afternoon; by Wednesday morning after the election this was 100%. So we can try to attribute any change from Tuesday to Wednesday as representing the effect of a ~25% increase in the probability of an Obama presidency. Multiply the effect by 4 to get the total difference between an Obama presidency and a Romney one. (If you believe the prediction markets. I am still kicking myself for not funding accounts in time to arbitrage between them)

The most obvious reaction has been that the US stock market declined about 1.5% from close on Tuesday to opening on Wednesday. This means people think stocks will be about 1.5*4=6% less valuable during an Obama presidency. It is unclear to what extent this should be interpreted as the economy generally doing 6% worse, as opposed to stocks alone being a worse investment as taxes on capital gains and dividends increase / fail to decrease.

Treasury bond yields decreased slightly, meaning that markets think the government is less likely to default under Obama, or alternative assets will perform worse, or both. I’m not used to calculating the TIPS spread, but it looks like nominal 5 year treasury yields decreased by 4 points more than real yields, meaning a 0.04 percentage point decrease in inflation expectations (meaning overall inflation would have been 0.16% higher under Romney? Perhaps people expected him to appoint Mankiw as Fed chair). On the other hand, gold prices increased ~0.5%. No big differences here.

The biggest difference, and in my opinion the best news, seems to be on foreign policy. Intrade has a prediction market on whether Israel or the US will make an overt airstrike on Iran by the end of next year. This declined from 49% to 37% as the election news came in, suggesting the chance of this happening would have been 4*12+49=97% had Romney won. The chance that China will take overt military action against Taiwan also declined from 10% to 3% on Intrade. These markets are thin enough that I don’t claim they are definitely right, but it is still good to see the chance of war declining.

Comparing the changes in these various markets gives a clear demonstration of what economists have often said– the US President has very little influence over the economy, but quite a bit of influence on foreign policy.

Written by James Bailey

November 12, 2012 at 7:42 pm