Wednesday, February 29, 2012

Economic models versus financial system reality

Since your humble blogger began talking about the need for transparency/disclosure in the financial system almost two decades ago, I keep finding out that transparency/disclosure is an idea that is easy to understand at a purely theoretical level, but is very hard to understand at the implementation level.

Cathy O'Neil provides a wonderful example on her Naked Capitalism post: economists don't understand the financial system.
What I felt then and what I still feel is that these super influential economists are so high on their clean, simple economic models of the world (about the only variables of which are GDP, stimulus, and tax rates) that they focus on the model to the exclusion of the secondary issues. 
Sometimes you get important results this way: simplifying models can be really useful. But sometimes it’s really truly misleading to do so, and I believe this is one of those cases. 
I’m left thinking that they (the economists) are so entranced with their simplified world view that still don’t understand what actually fucked up the world in 2007 and 2008, namely the CDO market’s implosion. 
Message to Krugman: this is not exactly like other financial crises, because it’s partly caused by complexity, and nobody seems to have the balls to fix it. The problem is that the financial system has been allowed to get so complicated and so rigged in favor of the people with information, that normal people, including homeowners, credit card users, politicians, and regulators have been left in the dark, and many of the little guys are still stuck in ludicrous contracts left over from the outrageous securitizations that took place in the CDO market. 
Apparently I am not the only one who wonders how the policies that have been adopted to deal with a crisis that started with opaque, toxic securities has never explicitly deal with the opaque, toxic securities or opacity in the system.
What is especially enraging is how these same economists are still the experts that people turn to to help figure out how to get out of this mess, when they don’t actually understand the mess itself.
A point that the Queen of England made when she asked how the economics profession managed not to warn of the crisis in advance.

Confession:  it has always been a sore point with your humble blogger that he predicted the financial crisis and laid out what had to be done to moderate its impact and, since the beginning of the financial crisis, has not been turned to for help in getting us out of the mess.
Why else would a large audience be willing to pay $25 a piece to hear them talk about this? Why else would Obama be considering Larry Summers to lead the World Bank? 
As an aside: please, Mr. President, do not let Summers lead the World Bank. He does not understand the system well enough to lead it. And he is too arrogant to admit what he doesn’t know.
Doesn't this apply to the economists in general?

After all, when you did not predict the financial crisis isn't that a sign that you do not understand the system.

It most clearly is a sign of arrogance that after not predicting the financial crisis economists feel free to pontificate on how to solve the problem created by the financial crisis.  Hello, what insight do you have exactly?
I can introduce you to a bunch of people that may be less imposing but are more informed, more ethical, and wiser. Give me a call any time and we can chat and form a short list of candidates.
Hopefully Cathy, I am on the short list.

Why did I say that transparency/disclosure is easy to understand at the theoretical level, but very hard to understand at the implementation level?

As Yves Smith discussed in her book, ECONNED.
The scientific pretenses of economics got a considerable boost in 1953, with the publication of what is arguably the most influential work in the economics literature, a paper by Kenneth Arrow and Gérard Debreu (both later Nobel Prize winners), the so-called Arrow-Debreu theorem. 
Many see this proof as confirmation of Adam Smith’s invisible hand. It demonstrates what Walras sought through his successive auction process of tâtonnement, that there is a set of prices at which all goods can be bought and sold at a particular point in time. Recall that the shorthand for this outcome is that “markets clear,” or that there is a “market clearing price,” leaving no buyers with unfilled orders or vendors with unsold goods. 
However, the conditions of the Arrow-Debreu theorem are highly restrictive. For instance, Arrow and Debreu assume perfectly competitive markets (all buyers and sellers have perfect information, no buyer or seller is big enough to influence prices), and separate markets for different locations (butter in Chicago is a different market than butter in Sydney). So far, this isn’t all that unusual a set of requirements in econ-land.... 
this paper is celebrated as one of the crowning achievements of economics.
The idea of perfect information and hence perfect transparency/disclosure is an assumption that underpins economics.

If you look at the Nobel prizes that have been awarded, you will find a couple of them have been awarded that call into question this assumption of perfect  information by looking in the area of transparency/disclosure.

Specifically, Joseph Stiglitz for his work on information asymmetry and Robert Akerlof for his work on accounting control fraud.  The fact that both of these are of interest to financial market participants highlights the simple fact that there is not perfect transparency/disclosure (or as I like to call it ultra transparency) in the financial markets.

If banks were required to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details, it would be very difficult for management to engage in accounting control fraud.  Accounting control fraud requires that banks be able to take on greater risk without market participants being able to see the increase in risk and adjusting the pricing of their exposures to reflect this higher risk.

If structured finance securities were required to provide information on the underlying assets as observable events with these assets occur, it would be very difficult for Wall Street to profit from an information asymmetry.  Information asymmetry requires that Wall Street owns the servicers of the underlying assets so that it has tomorrow's news today and disclosure of observable events on the underlying assets is delayed to market participants.

These are just a couple of examples that illustrate the gap between theory and implementation.

More importantly, it makes one ask why do economists stop by awarding Nobel prizes for illustrating the gap between theory and implementation on transparency/disclosure and not offer it up as a solution to a financial crisis that featured opaque, toxic securities?

No comments: