Thought du Jour

The question refers to the size of the entire financial sector of the United States, not to individual firms operating in it.

[There is] a broader issue that [Federal Reserve] Chairman Bernanke could not possibly mention in these lectures or elsewhere, but that I wish Professor Bernanke would think about whenever he leaves office. Any complicated economy needs a complicated financial system: to allocate dispersed capital to dispersed productive uses, to provide liquidity, to do maturity and risk transformation, and to produce market evaluations of uncertain prospects. If these functions are not performed adequately, the economy cannot produce and grow with anything like efficiency. Granted all that, however, the suspicion persists that financialization has gone too far.

What would that mean? It would mean that the last x percent of financial activity absorbs more resources (especially intellectual resources) and creates more potential instability than its additional efficiency-benefits can justify. This charmingly subversive suggestion is easy to make, but it is extremely difficult to validate. Yes, it is hard to imagine that the Hedge Fund Operator of the Year does anything that is remotely socially useful enough to justify the enormous (and lightly taxed) compensation that results; but that is not really an argument. Much more significant is the fact that the bulk of incremental financial activity is trading, and trading, while it may provide a little useful public information about market opinion, is largely a way to transfer wealth from those with inferior information and calculation ability to those with more. There is no enhancement of economic efficiency to speak of. This is, you might say, the $64 trillion question. Maybe I shouldn’t wish it on Ben Bernanke.

Robert M. Solow, “How to Save American Finance from Itself – Has financialization gone too far?“, New Republic, 8 April 2013 (free access).

MIT economist Robert Solow is reviewing a new book by Ben Bernanke, titled The Federal Reserve and the Financial Crisis (Princeton University Press, 2013). The book is a transcript of four lectures Bernanke gave in 2012 as part of an undergraduate course at George Washington University. Solow (born 1924) won the Nobel Memorial Prize in 1987.

The excerpt above is the conclusion of a very long review.

Edmund Phelps does not think much of rational expectations, the notion that private investors process all available information, so form generally correct expectations regarding the economy.

Q: In the world envisioned by rational expectations, there would be no hyperinflation, no panics, no asset bubbles? Is that right?

A: When I was getting into economics in the 1950s, we understood there could be times when a craze would drive stock prices very high. Or the reverse: An economy in the grip of weak business confidence, weak investment, would lead to loss of jobs in the capital-goods sector. But now that way of thinking is regarded by the rational expectations advocates as unscientific.

By the early 2000s, Chicago and MIT were saying we’ve licked inflation and put an end to unhealthy fluctuations –- only the healthy “vibrations” in rational expectations models remained. Prices are scientifically determined, they said. Expectations are right and therefore can’t cause any mischief.

At a celebration in Boston for Paul Samuelson in 2004 or so, I had to listen to Ben Bernanke and Oliver Blanchard, now chief economist at the IMF, crowing that they had conquered the business cycle of old by introducing predictability in monetary policy making, which made it possible for the public to stop generating baseless swings in their expectations and adopt rational expectations. My work on how wage expectations could depress employment and how asset price expectations could cause an asset boom and bust had been disqualified and had to be cleansed for use in the rational expectations models.

Q: And how has that worked out?

A: Not well!

Caroline Baum, “Expecting the Unexpected: An Interview With Edmund Phelps”, Bloomberg View, 11 February 2013.

There is more at the link. Columbia University economist Edmund Phelps (born 1933) won the 2006 Nobel Memorial Prize for “his analysis of inter-temporal tradeoffs in macroeconomic policy”.

HT Mark Thoma

MIT economist Andrew Lo reviews 21 diverse books on the financial crisis. Eleven were written by academics, nine by journalists and one by former Treasury Secretary Henry Paulson. Here are the first two paragraphs of his review essay.

In Akira Kurosawa’s classic 1950 film Rashomon, an alleged rape and a murder are described in contradictory ways by four individuals who participated in various aspects of the crime. Despite the relatively clear set of facts presented by the different narrators—a woman’s loss of honor and her husband’s death—there is nothing clear about the interpretation of those facts. At the end of the film, we’re left with several mutually inconsistent narratives, none of which completely satisfies our need for redemption and closure. Although the movie won many awards, including an Academy Award for Best Foreign Language Film in 1952, it was hardly a commercial success in the United States, with total U.S. earnings of $96,568 as of April 2010. This is no surprise; who wants to sit through 88 minutes of vivid story-telling only to be left wondering whodunit and why?

Six decades later, Kurosawa’s message of multiple truths couldn’t be more relevant as we sift through the wreckage of the worst financial crisis since the Great Depression. Even the Financial Crisis Inquiry Commission—a prestigious bipartisan committee of ten experts with subpoena power who deliberated for eighteen months, interviewed over 700 witnesses, and held nineteen days of public hearings—presented three different conclusions in its final report. Apparently, it’s complicated.

Andrew W. Lo, “Reading about the Financial Crisis: A Twenty-One-Book Review“, Journal of Economic Literature 50:1 (March 2012), pp. 151-178.

An ungated version is available here.

Andrew Lo is Professor of Finance at the MIT Sloan School of Management and director of MIT’s Laboratory for Financial Engineering.

The US federal government is currently able to borrow at near-zero rates of interest, but many state and municipal bonds are trading with substantial risk premia–the extra yield investors demand to own these bonds instead of safer Treasury securities.

Peter Orzag (1968-), former director of Barack Obama’s Office of Management and Budget, says that it is almost impossible for states to default on sovereign debt, so holders of state bonds should not be concerned (hence cease to demand risk premia?). Lower levels of government, in contrast, can declare bankruptcy and default on their debt obligations.

[C]ontrary to what many pundits suggest, state governments cannot simply declare bankruptcy. Bondholders are also privileged creditors in almost all states. It is thus difficult for states to default: they would generally have to stop paying employees before they stopped making debt payments.

At the local level, however, the situation is different. Many US cities can declare bankruptcy – and given their numbers a severe crisis in at least one major city is both feasible and quite possible. As a thought experiment, take the top 30 or so cities. Assume any one has only a 2 per cent probability of a severe problem. Then the probability that at least one experiences a crisis is almost 50 per cent.

In such a city-level crisis, the state government could help – as has already occurred in Harrisburg, Pennsylvania. States would be wise to consider in advance their options in this kind of crisis scenario. ….

The bottom line is that there may well be US public debt tremors this year, both during federal debate over raising the debt ceiling and with at least a limited number of crises in local and city governments. The bigger problem, though, lies beyond 2011, as the unsustainability of the federal government’s fiscal trajectory becomes increasingly clear.

Peter Orszag, “America must brace itself for turbulence“, Financial Times, 21 January 2011.

The author, after leaving government service, went to Citigroup, where he is a Vice Chairman of Global Banking.

Before rushing to purchase the supposedly low-risk, high-yielding debt of troubled states, first read this headline story in today’s New York Times.

Policy makers are working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts, including the pensions they have promised to retired public workers.

Unlike cities, the states are barred from seeking protection in federal bankruptcy court. Any effort to change that status would have to clear high constitutional hurdles because the states are considered sovereign.

But proponents say some states are so burdened that the only feasible way out may be bankruptcy ….

Discussion of a new bankruptcy option for the states appears to have taken off in November, after Mr. [Newt] Gingrich [a former House speaker and possible Republican presidential candidate] gave a speech about the country’s big challenges, including government debt and an uncompetitive labor market.

“We just have to be honest and clear about this, and I also hope the House Republicans are going to move a bill in the first month or so of their tenure to create a venue for state bankruptcy,” he said.

Mary Williams Walsh, “Path Is Sought for States to Escape Debt Burdens“, New York Times, 21 January 2011.

The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.

It is hard for non-economists to understand how peculiar the predominant macroeconomic models were. Many assumed demand had to equal supply – and that meant there could be no unemployment. (Right now a lot of people are just enjoying an extra dose of leisure; why they are unhappy is a matter for psychiatry, not economics.) Many used “representative agent models” – all individuals were assumed to be identical, and this meant there could be no meaningful financial markets (who would be lending money to whom?). Information asymmetries, the cornerstone of modern economics, also had no place: they could arise only if individuals suffered from acute schizophrenia, an assumption incompatible with another of the favoured assumptions, full rationality.

Joseph Stiglitz, “Needed: a new economic paradigm”, Financial Times, 20 August 2010.

The full column is posted at Economist’s View.

What should replace these discredited models? On this, Stiglitz reveals little, saying only “a new paradigm, I believe, is within our grasp”. He, with Jeffrey Sachs, George Akerlof, Kenneth Rogoff and other economists, is creating a new paradigm this very moment at the Institute for New Economic Thinking, a think-tank funded by financier George Soros. Stay tuned for further developments.