Archive for the Category financial regulation


Avoid asymmetries

In a recent post I pointed to a weird asymmetry.  Even though bubble theory proponents think that prices are more likely to fall after a large run-up, those who correctly predict that prices will go even higher seem less famous (at least in America) than those who correctly predict the bubble will burst (which is allegedly the easier market call.)  I suggested this is just a part of the general problem of cognitive bias, which leads people to see patterns where there is actually nothing more than randomness.

In the comment section of a recent Tyler Cowen post, Rajiv Sethi made the following observation:

Let me repeat that I admire Scott Sumner, the coherence of his vision, and his general approach to blogging (as laid out in his amazing birthday post). But I think that his faith in market efficiency is misplaced and his glib dismissal of those who take bubbles and crashes seriously (we suffer cognitive illusions) baffling.

On a certain level I agree with Sethi (who is a very smart guy.)  There’s nothing people like less than for someone to respond to their argument by calling them irrational, or suggesting they have bad motives.  But this also raises an interesting problem for the bubble theorists.  Unless I’m mistaken, most anti-bubble theories assume some sort of irrationality among market traders, or dare I say, cognitive illusions.  (Which is supposedly “proven” by economic experiments which in fact do nothing of the sort.)  I’m not sure Sethi was actually complaining about my cognitive illusions comment, although I got that impression.  But if so, is it really any different from what the bubble theorists assume about asset market participants?

I need to constantly repeat a very important point; I’m not arguing the EMH is true.  I’m arguing the EMH is useful and that anti-EMH models are not useful.  The reason I don’t think the EMH is true is because I believe market participants do have cognitive illusions.  And the reason I don’t think the anti-EMH theory is useful is because I think academics and policymakers are equally susceptible to cognitive illusions.

Paul Einzig made the same basic argument back in 1937:

“On June 9, 1937, this veteran monetary expert [Cassel] published a blood-curdling article in the Daily Mail painting in the darkest colours the situation caused by the superabundance of gold and suggesting a cut in the price of gold to half-way between its present price and its old price as the only possible remedy.  He took President Roosevelt sharply to task for having failed to foresee in January 1934 that the devaluation of the dollar by 41 per cent would lead to such a superabundance of gold.  If, however, we look at Professor Cassel’s earlier writings, we find that he himself failed to foresee such developments, even at much later dates.  We read in the July 1936 issue of the Quarterly Review of the Skandinaviska Kreditaktiebolaget the following remarks by Professor Cassel:  ‘There seems to be a general idea that the recent rise in the output of gold has been on such a scale that we are now on the way towards a period of immense abundance of gold. This view can scarcely be correct.’ . . . Thus the learned Professor expected a mere politician to foresee something in January 1934 which he himself was incapable of foreseeing two and a half years later.  In fact, it is doubtful whether he would have been capable of foreseeing it at all but for the advent of the gold scare, which, rightly or wrongly, made him see things he had not seen before.  It was not the discovery of any new facts, nor even the weight of new scientific argument that converted him and his fellow-economists.  It was the subconscious influence of the panic among gold hoarders, speculators, and other sub-men that suddenly opened the eyes of these supermen. This fact must have contributed in no slight degree towards lowering the prestige of economists and of economic science in the eyes of the lay public.” (1937, pp. 26-27.)

Sub-men and supermen.  Hmmm . . . I wonder into which group Paul Krugman would place himself?

Now let’s see if we can draw a broader set of conclusions from this pattern, these asymmetries.  We’ve seen bubble predictors are treated differently from bubble deniers, and in the previous post we saw that conservatives were gung ho about focusing on commodity prices, except when commodity prices showed a desperate need for much easier money.  Can we find a third example?

How often have you heard people remark that high gasoline prices are caused by the machinations of oil market speculators?  But we know that the net demand for oil by speculators averages out to roughly zero in the long run.  This means that for every period where speculators are raising prices, there is another period where they are reducing prices.  But how often in general conversation do you hear people say:

Hmmm, gas is really cheap right now, I wonder if speculators are depressing the price?

Because I’m a mind reader, I can answer the question for you.  Zero times.  And it’s not just because people prefer to talk about bad news, they don’t even think speculators depress oil prices.

The world is full of this sort of asymmetrical thinking.  And it’s almost always a sign of sloppy thinking, of cognitive illusions.  And it often leads to bad public policy.

PS.  This isn’t an exact analogy, but notice that narcotics and sex transactions are usually considered bad if money is involved.  But in most societies the selling of sex and drugs is considered far worse than the buying of sex and drugs, even though each participant has an equal role in the transaction.  A sign of bad public policy?

PPS:  Five minutes after posting this I came across another example. We think that people who make lots of money are evil villians, whereas people who lose lots of money are innocent victims.  Consider the following:

Earlier that year, Picard claimed in court filings that Picower was a key beneficiary of Madoff’s scheme. The trustee said Picower had withdrawn $7.8 billion from Madoff’s firm since the 1970s, even though he only deposited $619 million. Picower “knew or should have known that [he] was profiting from fraud, because of the highly implausible high rates of return” on his accounts, the trustee said.

Right after the Madoff scandal broke all the brain-dead critics of laissez-faire said “see, this shows that unregulated capitalism doesn’t work.”  Eventually people pointed out that we don’t have unregulated capitalism, the SEC is supposed to prevent these sorts of abuses.  Even worse, someone told the SEC about the Madoff fraud, and even pointed to absurdly high and persistent rates of return that anyone with half a brain knew were impossible.  Or anyone who believes in the EMH knew were impossible.  But apparently the SEC is one of those groups that doesn’t find the EMH to be “useful.”  So they ignored the whistle-blower.  Now when we find someone who actually made off with lots of money from Madoff (pun intended) we react in horror.  Surely that rich bastard knew he couldn’t be earning that money legitimately!

That’s right, the supposedly expert SEC is given a pass in not responding to these high returns, as people keep insisting this shows we need still more regulation.  But the person that benefited, who like all humans would just love to think his success was well earned, that it resulted from his investment acumen, is somehow obviously guilty.

I give up.

Scandinavian simplicity

My favorite piece of furniture is an elegant rosewood desk that was custom made in Denmark.  Like most of my possessions, I bought it out of someone’s house.  This was back before Craigslist (I basically stopped buying stuff at age 45; thank God they don’t depend on me for sales tax revenue.)  Of course Scandinavian furniture is known for its “less is more” aesthetic, although I’d say Ikea overdoes the “less” part.  There’s a difference between timeless elegance and dorm room utilitarian.

I believe that there are some artistic theories that mix ethics and aesthetics.  I suppose simplicity is seen as being more honest.  Keat’s truth is beauty.  The Bauhaus aesthetic was linked to socialist ideals, whereas the Italian Baroque was associated with the Counter-Reformation.

I’m not a big fan of attempts to mix ethics and aesthetics, but when it comes to politics and economics, I definitely think less is more.  I was reminded of this when frequent commenter Malavel sent me a new Swedish regulation requiring at least 15% down-payments on all mortgages.  That’s it, no bells and whistles, just 15%.  Check out the simplicity of this press release.

Sweden also has an income tax that is much simpler than ours (yes, I know that’s faint praise), where many (most?) taxpayers simply receive a bill in the mail.  Their vouchers for education don’t require you to live in Milwaukee, or enter a lottery.  Everyone in the country is eligible, and their kids are free to go to any approved school; public, not-for-profit, or for-profit.

In America, the left told us that the banking fiasco was caused by “de-regulation,” which allowed banks to run amok making sub-prime loans.  The right insisted it was the government’s fault; Fannie Mae and Freddie Mac and FDIC creating moral hazard.  Both are partly right.  In response our legislators produced a 1000 page bill that failed to address any of the alleged causes of the crisis.  Not only are sub-prime loans not banned, but FHA is actually encouraging more sub-prime lending.  The GSEs got off scot-free, and FDIC has not been reformed at all.  It’s still insuring wildcat banks in the South, who take taxpayer-insured deposits and lend the money out to highly risky construction projects.

If only we could have an economic policy regime that reflected the simplicity and elegance of Scandinavian furniture.  When I saw the Fed’s alphabet soup of special vehicles created to address the financial crisis, I pretty much knew we were in trouble.  The Fed forgot that its duty was very simple—just provide enough money to keep the price level rising at 2%.

The left was ecstatic about the appointment of Elizabeth Warren.  I have nothing against her, although I was a bit puzzled to learn that the main lesson of this crisis was that we needed to do a better job of protecting the financial industry’s consumers.  (Scratches head.)  But let’s say I’m wrong, and she’s the superwoman her supporters believe her to be.  How does that really help us?  Before too long the Republicans will be back in power, and she’ll be out of a job.

If you are visiting a dysfunctional tropical country, it’s common to have people talk wistfully of the need for a “strong man” to be put in charge.  But with the possible exception of Singapore, that almost never works.  Unless you put into place a democratic, transparent and non-corrupt system of governance, there is a real danger of back-sliding as the strong man becomes corrupted by power, or is replaced by someone less honest.

It’s sad that we’ve reached the point where Congress writes a 1000 page bill that completely fails to address the problems that caused the worst economic disaster since the 1930s, and then we instead pin all our hopes on Elizabeth Warren.  The elation that greeted her appointment was the sort of thing you’d expect from a mob of supporters when a Putin or Chavez announces he’ll run again, as there is “no one else capable of doing the job.”

In art and architecture it is not always true that simplicity is best.  I’ll take Borromini’s Quattro Fontane over Le Corbusier’s Radiant City.  But in politics and economics the simplest and most transparent regulatory regime is generally best.  K.I.S.S.

PS.  Of course the Swedish program has problems just like any other system. But progressive skeptics might be surprised by the nature of those problems:



One of the first independent schools, Botkyrka Friskola, was started by an ex-communist in a low-income, immigrant suburb of Stockholm. With an emphasis on individual student responsibility, familial involvement, and efficient use of technology, it now has over 2000 students waiting for one of its 240 places and a continuous stream of educators interested in imitating its success (Svangren 1998).

Public Vouchers and Public Controls

Though public vouchers are invigorating the Swedish education system and broadening the educational choices available to families, they have come with some strings attached. The first of these is the government’s demand that independent schools select their pupils on a first-come, first-served basis. Special exceptions are granted only for siblings of current students, students with special needs, and those who live in the immediate vicinity of the school (Gustafsson 1998). Most independent schools are happy to accept students on this basis and would have done so even without this regulation.

The condition makes it difficult, however, for a school to establish a particular learning environment and does nothing to guarantee the equal access it was set up to ensure. Per Svangren, the principal of Botkyrka Friskola, hoped his school would become a challenging, multicultural environment for immigrant families poorly served by the local municipal school but, as its reputation grew, Swedish families in neighbourhoods with better schools began applying early. The school had to take the students who applied first, so it was forced to reject those whom its leaders believed would not only benefit most but also contribute most to the school’s unique environment. As a result, a fundamental aspect of the school’s mandate was compromised (Svangren 1998). Though they would be rare exceptions, (as experience in Denmark demonstrates) schools established for the academically gifted or those for a particular learning disability are impossible in this environment. It is a loss to Sweden that its politicians prohibit families from choosing a specialized education for their children and prohibit schools from making such educational alternatives available for them.


Are we serious about regulating banking?

When the sub-prime crisis hit in 2007, we were all bombarded with stories about how this showed the effects of deregulation run amok.  Never mind that the housing and banking industries are heavily regulated, the crisis showed we had the wrong kind of regulation.  Or perhaps it showed that the Bush administration never had their heart in regulation, so they let the banks get away with murder.  I think it’s a bit more complicated than that (Bush did try to rein in Fannie and Freddie) but obviously Bush wasn’t keen on discouraging banks from making housing loans.  Just the opposite, he wanted to create an “ownership society.” 
Den ganzen Beitrag lesen…

Dude, Where’s my New Deal?

Ever since the economic meltdown began last year we have heard lots of voices on the left gleefully predicting the end of “laissez-faire capitalism” (when did we ever have it?) and the dawning of a new New Deal.  I’ll get to the US eventually, but first let’s take a quick look around the world:

1.  In the most important election since the crisis hit, Indian voters decisively ousted the communist party from the coalition government, opening the door to further economic reforms by the Singh government.

2.  In EU elections voters swung to the right in all 5 of the biggest countries.

3.  And now for the election in Argentina.  To set the scene, recall that Argentina since 1998 is the closet parallel to the US of the 1930s to be found anywhere in the world.  Just to review:

Argentina started the decade with a right wing government foolishly pegging its currency to an asset whose real value was appreciating in world markets.  (Remember Hoover?)  It was memories of 1980s hyperinflation that made the government reluctant to devalue.  (In the US memories of the 1920s German hyperinflation made everyone fear fiat money.)  Eventually the pain got so bad (in the form of high unemployment) that voters threw out the right wing government and replaced it with a left wing government.  The left wing government blamed the crisis not on a deflationary monetary policy, but rather on laissez-faire capitalism (now termed “neoliberalism.”)  The left wing government sharply devalued its currency, leading to an immediate surge in economic growth.  The left wing government renounced contracts that promised to pay debts in the reserve asset (gold in the US, dollars in Argentina.)  In both cases the decision was contested all the way to the Supreme Court, and in both cases the government eventually got their way.  Over time, their statist policies gradually took a toll on the economy.

Den ganzen Beitrag lesen…