Krugman v. The Strawmen

Prof. Krugman battles a strawman argument in his latest column on the perils of insufficient regulation of the financial markets.  He follows his description of the the sub-prime meltdown with this:

But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs.

The market is always right?   My goodness, what maroon could believe that, and isn't it wonderful that Prof. Krugman is here to deride their lunacy?

Back in reality, the efficient market hypothesis does not claim that "the market is always right" - in essence, it claims that the market is always wrong but in ways that cannot be systematically and reliably predicted.  Here is an explanation to which Krugmanites may  rally:

Economists have a rather Zen-like view of stocks. They believe that investors are rational, and that stock prices are therefore unpredictable. It sounds peculiar, but the logic is ironclad. Rational investors would take into account everything they know -- all the information available about where profits, interest rates, technology and so on are going -- when buying or selling stock. So stock prices would already reflect all available knowledge, and would change only when new information came in. And new information is, by definition, unpredictable -- otherwise it wouldn't be new -- which means that changes in stock prices would be unpredictable too. Q.E.D.

Except, of course, that real investors aren't entirely rational. Being human, they are driven by fear, greed and the madness of crowds. In principle this should create patterns in stock prices, and in principle you can use those patterns to outperform the market. Good luck. But while it may be very hard to tell whether the market is overvalued or undervalued (remember that Alan Greenspan warned of "irrational exuberance" when the Dow was at about 6,500), one thing is for sure: It fluctuates more than it should.

That comes from Krugman himself of course, who understood perfectly well the concept of efficient markets when Clinton was President.  But since the Krug 2007 has such confidence in the ability of regulators to foresee that which is opaque to the rest of us, let's continue this benchmarking exercise by re-reading his stock market forecast as of January 2000, written on the eve of the great tech market collapse:

Why was the market so easily spooked? Presumably because everyone -- me included -- is even more confused than usual about what stocks are really worth these days...

...In fact, current stock prices already have built in the expectation of economic performance that not long ago we would have considered incredible; performance that is merely terrific would be seen as a big letdown.

So which will it be -- terrific or incredible? We all have our opinions -- being a pessimist by nature, I think that things will be merely terrific -- but nobody, and I mean nobody, really knows. And a rational market would accept this ignorance, and wait for some actual evidence in favor of one side or the other.

Of course, it doesn't work that way. Yesterday, something -- if I knew what, I would be a lot richer -- caused investors to become slightly less convinced than they had been the day before that we are living in the best of all possible worlds. And the result was a huge destruction of paper -- um, I mean virtual -- wealth.

But hey, it's still a terrific economy. Or do I mean incredible?

Helpful.  The bubble was obvious later, of course.  And Krugman subtly acknowledges that even if the market is not rational, it is irrational in ways that cannot be predicted.

Well, back to the current morass.  Krugman is correct that individual dealmakers are not returning their once-handsome bonuses, which is one area of skewed incentives - people who arrange complicated deals can reduce the hazards of asymetric information by keeping their own money in the deal (and this is a point a savvy investor will explore prior to writing a check).  That said, some major banks have lost billions in their own deals, so we presume they were as surprised as their investors by the dismal performance of the underlying assets.

Among the credit rating agencies Moody's and Standard and Poor's have spent a century building a reputation for providing credible analysis of complicated deals so they had a huge incentive to get these deals right - oops.

As to the omniscient and benevolent regulators Krugman envisions (NO, not the ones that made the Asian crisis worse!), I suspect that if, in their wisdom, they had prevented the sub-prime meltdown, it would have simply by saying "no" to  all sorts of loans, some of which would, with the benefit of hindsight, have merited that "no".  But not all - per the WSJ, roughly half of sub-prime borrowers should have qualified for a conventional mortgage.

As a practical matter, I can scarcely see Democrats standing by while a Federal regulator exhorted banks to reduce their lending to women, minorities and those with low or uncertain incomes, but obviously that is how it would have played out in Krug-world.

BONUS IRONY:  Surely I am not alone in being struck by the fact that the Nutroots (of which I am deeming Krugman to be an honorary member) spend a small fraction of their time deriding the Republicans as seeking a strong father figure to protect them from terrorists and brown people, and a large fraction of their time clamoring for a strong government leader to protect them from everything else?

And surely I am not alone in thinking that the previous sentence is staggeringly clumsy?

All agreed, then, so I'll quit calling you Shirley.

Comments

[clarice]

Maybe not today, maybe not tomorrow but soon I plan to steal this thought:"Surely I am not alone in being struck by the fact that the Nutroots (of which I am deeming Krugman to be an honorary member) spend a small fraction of their time deriding the Republicans as seeking a strong father figure to protect them from terrorists and brown people, and a large fraction of their time clamoring for a strong government figure to protect them from everything else?"

[MayBee]

Definitely steal worthy!! I love that, TM!

And though they despise Evangelical Christians, they themselves pray for the trinity of Krugman, Olbermann, and Froomkin to deliver them from evil.

[glasater]

Krugman was featured as a guest host/color commentator on CNBC a week or so ago on one of the morning shows.
He showed what a "maroon" he is and didn't get too much air time.

[glasater]

This is the seeming topic of the CNBC day.

[SPQR]

Tom, a superb takedown of Krugman. Top notch work.

[anduril]

Sorry to intrude, but I think Andy McCarthy's article on FISA at Human Events is so good that it should be read by everyone who give's a rip about national security.  It is a brilliantly simple explanation of the looming train wreck that is FISA "reform."  It's called FISA Reform Debacle in the Making.  Read it.  Really.

[Georg Felis]

It takes a pretty poor economist to get beaten up by a strawman arguement, but Krugman did it again.

[fishbane]

Hm, If you ignore the fact that Krugman and many other economists have been sounding the alarm about housing prices since about 2000, I suppose you can believe that. I know Greenspan is the patron-saint of free markets, but I find it hard to believe that even as he was warning of problems in the market, in his own opaque way, he was dropping interest rates to keep it going until he bailed, people still believe this is just the rise and fall of a business cycle.

Execs at construction and real estate companies didn't - many of them sold large quantities of stock in their own companies last year. Go figure.

[Charlie (Colorado)]

Surely I am not alone in being struck by the fact that the Nutroots (of which I am deeming Krugman to be an honorary member) ....

Honorary?

Sadly, Georg already hit my other snarky remark.

[danking70]

Krugman vs. the Strawmen

Down goes Krugman!!!Down goes Krugman!!!

[Elliott]

Autoeconomic asphyxiation.

[Charlie (Colorado)]

Autoeconomic asphyxiation.

There's a phrase to be preserved in lucite for future generations.

[Patrick R. Sullivan]

For the perspective of a grown-up economist, Steve Cecchetti has a four parter that begins here. From Part 1:

Even with intense oversight by the governmental authorities – in the United States we have the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve, as well as state banking authorities – crises continue to come. One reason for this is the natural tendency of officials to fight the last battle; looking for systemic weaknesses revealed by the most recent crisis. So, when complex automated trading schemes were thought to have contributed to the October 1987 stock market crash, circuit breakers were put in place that shut down computers-based order systems when indices move by more than a certain amount. In the aftermath of the Asian crisis, the IMF created new lending facilities in an attempt to address issues of contagion – in essence, to deal with countries that were innocent victims of problems created elsewhere. And when LTCM collapsed there was a flurry of activity to understand and the potential impact of what were called “highly leveraged institutions”.

As necessary as each of these reforms may have been, we are not going to stop tomorrow’s crises by looking backward. Financial innovators will always seek out the weakest point in the system. Innovations will both exploit flaws in the regulatory and supervisory apparatus, and manipulate the inherent limitations of the relationship between asset managers and their investor clients. The 2007 crisis provides examples of both of these.

....Managers of financial institutions will always search for the boundaries defined by the regulatory apparatus, and they will find them. After all, detailed regulations are a guide for how to legally avoid the spirit of the law. And the more detailed the rules, the more ingenious the avoidance. This brand of ingenuity is very highly rewarded, so I am sure these strategies will continue.

....Both individuals and government officials need to make adjustments. Individual investors need to demand more information and they need to get it in a digestible form. As individuals we should adhere to the same principle that President Ronald Reagan followed in agreements over nuclear weapons with the Soviet Union: Trust, but verify. We should insist that asset managers and underwriters start by disclosing both the detailed characteristics of what they are selling together with their costs and fees. This will allow us to know what we buy, as well understand the incentives that our bankers face.

As for government officials, most of the lessons point to clarifying the relative riskiness associated with various parts of the financial system. Elsewhere I have suggested that at least some of the problems revealed by the current crisis can be ameliorated by increasing the standardization of securities and encouraging trading to migrate to organized exchanges.

[Walter]

This is the point in the discussion where I drag out my old anecdote:

Back in the halcyon days of August, 2001, my college buddy (and fellow Deadhead!) was called upon by that august firm, Standard and Poors. As an analyst, he rendered the Firm's opinion on the bonds used by Silverstein to finance his purchase* of the World Trade Center (enthusiasts will recall that the transaction closed on August 24, 2001). His deathless prose?

'The security for these bonds is not as good as gold, it is better than gold.'

*Yeah, I know, it was a 100-year-lease. It reads better as 'purchase'. Cry me a river and then tell me the NPV of the difference between the two.

[Walter]

Autoeconomic asphyxiation.

Elliot,

I wanted to tell you that I've really enjoyed your comments lately. Not just the debate live-blogging, but the everyday observations as well.

Thanks.

(I reserve the right to repost this in a thread Elliot is likely to read.)

[cathyf]

I'm going off to read the Steve Cecchetti link, to find out if he mentions what I think is an important factor: Demography Is Destiny.

My parents were born in the mid-30's. They are a small birth cohort because times were tough. They are especially small compared to the Baby Boom (of which their children are at the tail end of.) As they were in their peak investing-for-retirement years (80's and early 90's) the Boomers were coming into their peak productivity and consumption period. So my parents' were investing money when investment money was relatively scarce (because their birth cohort is small) and in high demand to be put to productive use by us Boomers (because our birth cohort is so large.) The markets boomed, while volatilities were fairly low. (Even in 1987 the annual volatility was 15%...)

Ok, compare that to what the Boomers are facing in our prime investing-for-retirement years. There are way more of us, so more investment capital. There are way fewer folks in the baby bust generation, so there are fewer productive projects out there. Both of those together mean that we will have a much harder time making every tick of investment return -- or, in the starkest terms, we will have to invest in far riskier investments to get the same returns as our parents got, or if we invest in things as safe as our parents did, we will have to settle for very anemic returns.

And that's what I think was the fundamental force behind this whole subprime mortgage debacle. Supply and demand -- there is this huge amount of capital sloshing around in hedge funds. There is this huge amount of capital sloshing around in 401K's and IRA's and other relatively "safe" and "prudent" vehicles. All of the prudent money out there is driving down returns on low-risk and medium-risk investments, and so the hedge funds are going out looking for higher returns. Which they are finding exactly where you expect to find the highest returns -- in the highest risk investments.

Ok, so we plug the regulatory holes that allowed this particular high-risk investments -- but the fundamental problem is that they didn't lose nearly enough money for it to matter. There is still way too much capital chasing way too few good investments, and so the rest of it is going into crappy investments.

[Elliott]

Thank you for your kind words, Walter.* Sorry about the Tigers.

I truly appreciate the opportunity to read the insights TM and all** who comment at this great place dispense. For my own contributions to bring enjoyment makes it that much better.

*In homage, there will be footnotes.

**Okay, okay, there are exceptions.

[Rick Ballard]

"There is this huge amount of capital sloshing around in 401K's and IRA's and other relatively "safe" and "prudent" vehicles."

Yup. More than $17 trillion, throwing off more than $2 billion per day in income and demanding that the money runners sprint for the entire marathon.

Odd that the doom mongers never note that the Boomers are going to start recycling that dough on a wholesale basis beginning in January. It must be a secret.

[Walter]

Drat. First rule of compliments is to spell the name right. Sorry!

Thanks for the sympathy. It's still the best season since before I was born.* The semester I 'attended' MU, the team won no games at home and only one overall. I'm still living the dream.

---
* Well, by some measures, ever. But who's counting?

If your comments get long enough (I'm sure at least a few of mine qualify), you get to refer to your annotations as endnotes.

[battery]

If your comments get long enough (I'm sure at least a few of mine qualify), you get to refer to your annotations as endnotes.

[sophy]

Welcome to our game world, my friend asks me to buy some wakfu gold .