Tuesday, June 09, 2009

Simple Theory

Tyler Cowen has a Simple Theory of the Financial Crisis and he seems to believe that it somehow defends Rational Expectations Theory.

Once we liberate ourselves from applying the law of large numbers to entrepreneurial error, as Black urged us, another answer suggests itself. Investors systematically overestimated how much they could trust the judgment of other investors. Investment banks overestimated how much they could trust the judgment of other investment banks. Purchasers of mortgage-backed securities overestimated how much they could trust the judgment of both the market and the rating agencies as to the securities’ values. A commonly held view was that although financial institutions had made large bets, key decision makers had their own money on the line and thus things could not be all that bad. Proceeding on some version of that assumption, most market participants (and regulators) held positions that were increasingly vulnerable to systemic financial risk. In this regard, an indirect link exists between the current crisis and the massive investment fraud perpetrated by Bernie Madoff. The point is not that all banking is a fraud but, rather, that we rely on the judgments of others when we make our investment decisions. For years, Madoff had been a well respected figure in the investment community. His fraud was possible, in large part, because he was trusted by so many people. The more people trusted Madoff, the easier it was for him to gain the trust of others. A small amount of initial trust snowballed
into a large amount of trust, yet most of that trust was based on very little firsthand information. Rather than scrutinize the primary source materials behind Madoff’s venture, investors tended to rely on the identities and reputations of those who already trusted Madoff. In the run-up to the current crisis, a similar process of informational “cascades” led a great many investors to put excessive trust in highly leveraged banks and other business plans.

In a strict rational expectations model, we might expect some people to overtrust others and other people to undertrust others. Yet, when it comes to the cumulative and reinforcing nature of
social trust, this averaging-out mechanism can fail for at least four reasons. First and most important, a small amount of information can lie behind a significant social trend, as previously explained. One of the most striking features of the current crisis is how many countries it hit at roughly the same time, which suggests some kind of international peer effect.
Second, market participation involves a selection bias in favor of the overconfident. No one aspires to become a CEO for the purpose of parking the company assets in T-bills. Third, incentives were pushing in the wrong direction. The individuals who were running
large financial institutions had an opportunity to pursue strategies that resembled, in terms of their reward structures, going short on extreme market volatility. Those strategies paid off for years but ended in disaster. Until the volatility actually
arrives, this trading position will appear to yield supernormal profits, and indeed, the financial sector was enormously profitable until the assetpricing bubbles burst.

Let me see if I get this: the crisis happened because investors systematically underestimated risk and consequently made reckless decisions. OK, but isn't that sort of like a theory that "explains" World War I by saying "Everybody started shooting at each other."

Well, I have my own theory about why that happened: Investors, economists, regulators, bankers and the general populace had been sold the the theory that markets took care of themselves and regulation was not only unnecessary but counterproductive. The twin prongs of that theory were the Rational Expectations Hypothesis and the Efficient Markets Hypothesis. Trusting those hypotheses, they failed to do the necessary spadework to make those hypothesies approximately true.

The other point Cowen makes is roughly that if some could see the calamity coming, why didn't they make a big profit by betting against the prevailing hysteria? A few did, of course, but making the appropriate bet was a strategy only a few were positioned to exploit, and timing would be critical. You can see the deluge coming, but if you can't tell when it limits your options. Two more points: you might know the horse you are trading for is dying, but the price is going up so fast that you can hope to sell it to a bigger sucker at a higher price before it does. Also, even if you bet correctly, there might be a good chance that the losing bettor won't be able to pay - think AIG.

Finally, how good are these hypotheses in the presence of fraud? The ratings agencies fraudulently rated securities highly to enhance their take on the other side, and outfits like AIG sold insurance contracts that they couldn't cover. The fact is that individuals and even huge hedge funds lack the power and tools to expose many forms of systematic fraud, and must depend on those with supoena power and the power to imprison to sort it out. When those who run the government fail to understand this, crises ensue.

In short, I blame the friggin economists and finance professors, especially those peddling the Chicago Kool Aid.