Tag Archives: financial crisis

Liberty and reality

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Five years ago, as the financial crisis looked like taking down the banking system, I took out as much money as my card was permitted to get from ATMs, and stashed it in various books on my shelves. Whenever I find myself short of cash I can still browse through a few titles on the off-chance of finding a couple of tenners.

So it was that this morning I picked up a 2008 reissue of Walter Lippmann’s classic 1920 essay [amazon_link id=”B007S7H448″ target=”_blank” ]Liberty and the News[/amazon_link].

[amazon_image id=”B007S7H448″ link=”true” target=”_blank” size=”medium” ](LIBERTY AND THE NEWS) BY Lippmann, Walter(Author)Paperback Oct-2007[/amazon_image]

There is great merit in reading old books because you find that current preoccupations are always echoes of past debates, although of course the context changes. Lippmann’s essay is full of insight and seems particularly timely again now. Here is one conclusion:

“The cardinal fact is always the loss of contact with objective information. Public as well as private reason depends on it. Not what somebody says, not what somebody wishes were true, but what is so beyond all our opining, constitutes the touchstone of our sanity. … Liberty is the name we give to measures by which we protect and increase the veracity of the information upon which we act.”

[amazon_link id=”1440047510″ target=”_blank” ]Liberty and the News[/amazon_link] – my edition has a foreword by Ronald Steel and an afterword by Sidney Blumnethal – is well worth a read. Members of the reality-based community will find it uplifting, although of course other copies will not have £20 stashed inside the front cover. (And if I’m meeting you today, I’ll now be able to pay for the coffee.)

Mortgages, mayhem and murder

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As I admitted yesterday, the books I took on holiday were non-economics related. Some were even thrillers. One of those, however, drew its plot from the financial crisis – or rather, the avalanche of foreclosures that have been taking place around the US. It was Michael Connolly’s [amazon_link id=”B004TL0J5M” target=”_blank” ]The Fifth Witness[/amazon_link], a terrific page turner. The frauds that took place during the housing boom, and the unconscionable attitude of some banks since the crash, provide the backdrop to this book – and apparently the motive for murder.

[amazon_image id=”B004TL0J5M” link=”true” target=”_blank” size=”medium” ]The Fifth Witness[/amazon_image]

Coincidentally, as I was reading it, I spotted this FT story about US bankers suing to prevent a new initiative, Mortgage Resolution Partners, from helping financially troubled home-buyers reduce their mortgage payments. The reason for the suit is that the plan gets municipal authorities to use eminent domain law to take over the collateral underpinning the mortgages. The anxiety of the financial industry about this tool is understandable – but as a member of the City Council of Richmond, California, said to the FT: “The banks caused the whole financial meltdown that resulted in the Great Recession …. They all got bailed out by the government. For them to come back and try to attack a very well thought out and very creative scheme to try to bail out some of the people who were their victims is extremely cynical and extremely hypocritical.”

After all, it’s not as if the banks are falling over themselves to help troubled borrowers avoid foreclosure any other way. Thankfully, foreclosure-related murder is fictional, but the emotional and financial mayhem caused by the continuing after-effects of the housing boom is all too real.

 

Political bubbles

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The Adelman biography of Albert Hirschman, [amazon_link id=”0691155674″ target=”_blank” ]Worldly Philosopher[/amazon_link], is great but too big to carry around so I’m reading it at home, and on the tube I’m reading [amazon_link id=”0691145016″ target=”_blank” ]Political Bubbles[/amazon_link] by Nolan McCarty, Keith Poole and Howard Rosenthal, & have almost finished.

[amazon_image id=”0691145016″ link=”true” target=”_blank” size=”medium” ]Political Bubbles: Financial Crises and the Failure of American Democracy[/amazon_image]

It’s long been my view that history is over-determined, looked at from today (under-determined of course, if you’re trying to predict events.) These three political scientists have another causal explanation to add to the list of explanatory factors for the Great Crash of 2008. As well as greed and fraud, toxic financial innovation, global imbalances, fiscal irresponsibility, gigantism in banking and all the other contributors, there is the political dimension.

The charge is that a combination of three political factors created the conditions for all those other contributors to financial meltdown to develop. The first is ideology, the pure belief that markets are good and government regulation bad; the second is the array of special interests hoping for an endless boom, especially in housing – the lenders, the realtors, the people getting cheap loans; the third is the American institutional framework, expressly designed to stop things happening rapidly, in the context of ultra-rapid developments in financial markets. The three interact in a pro-cyclical way, the book argues, hence the terminology of the ‘political bubble’.

Nobody in the political elite, on the executive or the legislative side, comes out of this book well. The authors even trace some of the rot as far back as the now-saintly-seeming Jimmy Carter – after all, the savings and loan debacle of the early 1980s had its root in his presidency. The book is equally scathing about the ideologically free market Republicans, Reagan and the two Bushes, and the differently ideologically free market economics team of the Bill Clinton years.

The focus is solely on the United States. This means there is more political detail than many non-American readers will either want or be fully able to interpret.

With that caveat, I found the argument persuasive. After all, there are plenty of other mature democracies that have experienced that combination of housing bubbles, Franken-finance, and political incapacity. The US financial markets have also hugely influenced global markets. It would be interesting to work through the same kind of argument in other countries. One might even add another layer of political sclerosis in the international context, adding a fourth ‘i’ for ‘international incompetence’ to the three ‘i’s making up the book’s hypothesis.

Does economics need *more* physics envy?

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It’s often said by critics of economics that the problem is economists have physics envy: they want to describe the economy using models that are over-complicated in the mathematics, mimicking classical physics, and under-sophisticated in its understanding of how humans actually make choices. But in [amazon_link id=”1408827379″ target=”_blank” ]Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics[/amazon_link] by Mark Buchanan argues that economists haven’t been paying enough attention to physical.

[amazon_image id=”1408827379″ link=”true” target=”_blank” size=”medium” ]Forecast: What Physics, Meteorology, and the Natural Sciences Can Teach Us About Economics[/amazon_image]

He makes the argument in the context of financial economics and its discrediting by the financial crisis. I find it a wholly persuasive thesis. Rational choice theorising just cannot account for the data on financial markets – the numerous self-reinforcing large price movements without specific causes, the long persistence in the absolute size of price movements, the fractal character of the movements on annual, monthly, daily, hourly, nano-secondly timescales. However, models from statistical physics can do so. The empirics of financial markets are similar to those of earthquakes, for example, well described by power laws. Economists should be using these tools as their starting point for theorising rather than starting with theories that fit the data about as well as Cinderella’s glass slipper fits the feet of the Ugly Sisters. It astonishes me that so many economists are so resistant to believing the evidence of the data – as I wrote describing here last autumn’s ESRC symposium on macroeconomics and the reception physicist J.P.Bouchaud got from some of the other participants.

Forecast is a useful and very accessible guide to the physics models, although this is not untrodden territory in pop science. For example, Philip Ball’s [amazon_link id=”0099457865″ target=”_blank” ]Critical Mass[/amazon_link] covers it too. There were a few points when I felt it over-claimed. For example, Mr Buchanan compares events in California’s electricity market in summer 2000 to the financial market events of 1998 or 2008, when it turned out later that Enron traders were manipulating the market. From this he concludes: “Blind faith in the benefits of privatization has had negative social consequences, including the deterioration of overall social trust, the dissolution of traditional non-market relations based on social norms and the replacement of cultural incentives to ‘do a good job’ with purely monetary incentives.” This is a perfectly valid line of argument, made by many other people – [amazon_link id=”0374533652″ target=”_blank” ]Michael Sandel[/amazon_link] most prominently of late – but it is a different argument entirely from the rest of the book, and I think isn’t supported here. There are one or two other points where the book canters through a separate area – such as behavioural economics and fast versus slow thinking – interesting but not related to the main argument.

For the main point here is about the prevalence of disequilibrium in economies, and the consequent inappropriateness of equilibrium as the starting point for economic modelling; the inadequacy of comparative statics in a dynamic world; and the role of social influence in markets. There is a very interesting section on the way the ‘wisdom of crowds’ is valid for independent decisions but destroyed when people know what others think, when it is replaced by the ‘unwarranted confidence of crowds’.

The most intriguing point the book raised for me concerned the predictability of financial market prices. Markets seem to have two phases of behaviour, like water versus ice, and the transition from one to the other is particularly interesting. “When the number of participants is smaller than a certain threshold… the market always has some predictability in its movements,” Buchanan writes of some experimental research (by Yi-Cheng Zhang and Damian Challet, written up in the book [amazon_link id=”0198566409″ target=”_blank” ]Minority Games: Interacting Agents In Financial Systems[/amazon_link]). Beyond a threshold number of people, the predictability vanishes. The number is related to the amount of history participants take into account in their expectations of the future – beyond that “the space of strategies becomes effectively covered or crowded.” There will be somebody in the market who will pounce on any predictable pattern to arbitrage it, and any predictability vanishes.

Economists who have already read about complexity economics – say in Paul Ormerod’s [amazon_link id=”0571279201″ target=”_blank” ]Positive Linking[/amazon_link] or his older [amazon_link id=”0465053564″ target=”_blank” ]Butterfly Economics[/amazon_link], or Alan Kirman’s [amazon_link id=”0415594243″ target=”_blank” ]Complex Economics[/amazon_link] or Benoit Mandelbrot’s [amazon_link id=”1846682622″ target=”_blank” ]The Misbehaviour of Markets[/amazon_link] – will find much of the material in Forecast familiar. But even they will find some new insights. Economists who haven’t paid much attention to these areas should read this book and apply some of our profession’s (supposed) newly-found humility to its argument. And this is a very accessible book for non-economists (and indeed for non-physicists), who will find it interesting and wonder why on earth some economists resist learning across the disciplinary boundary.

What *is* the cost of inequality?

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Anybody who is concerned about the gap between top and bottom incomes in our society will enjoy reading Stewart Lansley’s [amazon_link id=”1908096292″ target=”_blank” ]The Cost of Inequality: Why Economic Equality is Essential for Recovery.[/amazon_link] The book does a good job of joining the dots between different pre-crisis trends – the divergence of incomes and the ‘disappearing middle’ in the jobs market, the growing debt burden as people borrowed to consume as well as buy houses, the housing bubble itself, banking deregulation, the worship of shareholder value, mega-bonuses. While little of this is wholly new, it is assembled here in a way that makes it obvious why the pre-crisis economy was unsustainable.

Along the way are some thoroughly attention-grabbing points. For example, I knew that income inequality in the US and UK had returned to close to 1920s or 30s levels. Lansley adds this has occurred: “….despite much more mature democracies and regulated economies.” (p22) He’s quite right to raise the implicit question about how on earth this was able to happen. The book is also strong on the links between the emergence of the global mega-rich and the bubbles in asset markets and dysfunctional financial sector activity, and on the feedback effects between inequality and finance – not least the growth in household debt that Raghuram Rajan put centre stage in [amazon_link id=”0691152632″ target=”_blank” ]Fault Lines[/amazon_link].

[amazon_image id=”0691152632″ link=”true” target=”_blank” size=”medium” ]Fault Lines: How Hidden Fractures Still Threaten the World Economy (New in Paper)[/amazon_image]

I would disagree with Lansley’s assertion (p27) that economic orthodoxy says inequality is essential for growth. Conventional economics says there are two countervailing effects of inequality. To quote myself (ahem) in my Joseph Rowntree Foundation Lecture of last year: “Inequality could imply a large pool of savings to finance investment, entrepreneurship or a tax system that is not too progressive and so does not discourage work effort. These would boost growth. Alternatively, inequality could reduce the incentive of poor people to acquire education, or might increase social and political instability, either of which will reduce growth.”

I was surprised to read that in 1998 there had been a City debate on inequality, with George Cox of LIFFE arguing that rich City workers were good for the economy because of their spending, and Andrew Winckler, former CEO of the Securities and Investment Board, arguing that the City had become “smug and complacent” and that “the current bonus system encourages a degree of speculation that is not warranted and is rewarding failure.” (p78) Winckler was proved right. As the book points out, the original ‘robber barons’ at least built businesses; the current lot speculate and consume. They are rentiers.

The book’s main theme is the deathly, damaging embrace of inequality and finance, and Lansley’s solutions lie in the realm of financial regulation. Without a prosperous middle class, he argues, the economy can not recover. He will surely welcome the EU’s bonus cap, even if bankers are shocked (as the caption on a Banx cartoon had one banker saying to another: “Cap our bonuses? After everything we’ve done for the world?”).

However, I think this book –  although far, far better argued than the famous/notorious [amazon_link id=”0241954290″ target=”_blank” ]The Spirit Level: Why Equality is Better for Everyone[/amazon_link] in terms of establishing causality from inequality to wider economic damage – will also speak mainly to readers who already believe that argument before they start reading. This is partly just style, as it’s written in a colourful, polemical way that’s bound to have the converted cheering in the aisles. But it is also partly that there is a more complicated story. Inequality has many interacting causes; capping bank bonuses alone won’t fix it, welcome and essential as the cap is (even Martin Wolf in the FT says so!)

I’m certain there is also a strong argument to be made about the way high incomes are parlayed into political power which rigs regulation in favour of incumbents; they are then able to block competition and entry, which, over time, reduces the economy’s potential growth. The financial sector plays a central role in this too, through both its own oligopoly power and its encouragement of M&A through the economy, but the power grab extends to other sectors too. I just haven’t seen the argument set out anywhere in exactly this way.

Having said that, [amazon_link id=”1908096292″ target=”_blank” ]The Cost of Inequality[/amazon_link] gives an excellent birds-eye view of the malign consequences of the financial sector-driven, unsustainable increase in inequality, and of the damage that has caused the US and UK economies. The book concludes: “Allowing the fruits of growth to be so unevenly shared is the real cause of this crisis. If the distribution of national income had been maintained at its level of three decades ago, idle surpluses would now be being spent, and we would be well on our way out of this economic deadlock.”