Tag Archives: financial markets

Exuberance, animal spirits and identity

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The arrival this week of Robert Shiller’s revised edition of his wonderful book [amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] was timely, because it came in the wake of Aditya Chakrabortty’s radio programme about the teaching of economics. One of the the bizarre claims made in the programme is that mainstream economics is fixated on rational choice models. Shiller’s work on finance, for which he received the Nobel Prize of course, serves as Exhibit One in showing this claim to be incorrect. (Tony Yates blogged about this and other issues with the programme.)

[amazon_image id=”0691166269″ link=”true” target=”_blank” size=”medium” ]Irrational Exuberance[/amazon_image]

The new preface to [amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] begins: “One might think that years after the bursting of the speculative bubbles that led to the 2007-9 world financial crisis, we should be living in a distinctly different post-bubble world. One might think that people had learned their lesson, and would not again pile into expanding markets.” But no. Although the situation isn’t as fragile now as in 2000 (ahead of the 1st edition) or 2005 (2nd edition), Prof Shiller clearly thinks there is renewed potential for a crash somewhere. The bond market is clearly a leading candidate. One substantial addition to the book is a chapter on the bond market, which he believes has a high probability of currently being in a bubble, vulnerable to bursting. But it isn’t just bond markets that could be bubbly, but also equities: the ratio of real share prices divided by the ten-year average of real earnings in the US is higher than it has been at any time except 1929, 2000 and 2007.

Interestingly, the book suggests that the psychology of bubbles is not one of firm belief that a crash cannot happen, but rather one of inattention to evidence that it might or will do. This is in line with work Paul Seabright at the Toulouse School of Economics has beein doing on attention – or its lack. A second kind of addition to this 3rd edition is the integration of Shiller’s thinking on psychology since his book [amazon_link id=”069114592X” target=”_blank” ]Animal Spirits[/amazon_link] co-authored with George Akerlof. Akerlof has continued to work on this too, including his very interesting work with Rachel Kranton on the role of identity in economic choices, in [amazon_link id=”0691146489″ target=”_blank” ]Identity Economics[/amazon_link].

[amazon_image id=”069114592X” link=”true” target=”_blank” size=”medium” ]Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism[/amazon_image]   [amazon_image id=”0691146489″ link=”true” target=”_blank” size=”medium” ]Identity Economics: How Our Identities Shape Our Work, Wages, and Well-Being[/amazon_image]

[amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] is a classic and it is essential reading on economics and financial markets; for anyone who hasn’t yet read it, this 3rd edition brings the contextual information up to date and expands on the psychological insight of the original. I should add, Robert Shiller is the most prominent exemplar of economists using decision assumptions and frameworks other than ‘rational choice’ but he has plenty of company in the profession – in fact, it’s pretty mainstream nowadays.

Investment and values

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Normally I don’t read books about investment, but I know and like Guy Spier, author of [amazon_link id=”1137278811″ target=”_blank” ]The Education of a Value Investor[/amazon_link], so obviously I was going to buy it. And, once I started, I devoured the book in a couple of train journeys. It is a thoroughly enjoyable and enlightening read.

[amazon_image id=”1137278811″ link=”true” target=”_blank” size=”medium” ]The Education of a Value Investor[/amazon_image]

The investment advice is actually pretty straightforward: be a value investor. Guy is a *huge* admirer of Warren Buffett.

What’s far more interesting, and perhaps even practically useful, in the book is the advice about how to build into your life the capability to be a value investor. Guy does this through recounting his own career, intellectual and psychological trajectory, from ambitious ex-Oxford and HBS financier living the high life in New York to well-grounded, Zurich-based investment fund manager and family man. The personal story carries the underlying message about the psychology and morality of investing in a very appealing narrative.

For the difficulty in actually being a value investor, as Guy explains it, is human psychology – the strength of social pressure, of ‘everybody’s doing it’, the buzz of responding to the latest information, the imperatives created by rivalry and status. He cites the literature on behavioural economics and finance, and also explains how he has put it into practice in his own life. For example, he checks Bloomberg screens and stock prices only occasionally and has the terminal in a separate room from the place he reads and thinks; never places orders during trading hours; has an investment checklist before acting on a decision; has a group of like-minded people to discuss issues with; moved out of New York to run his fund, Aquamarine – whose returns look impressive. I’m not an investor but made a few notes about habits that seem very sensible.

One very interesting chapter is an early one in which he describes his first job at a cut-throat and unscrupulous New York investment bank, D.H.Blair. He had ignored warnings about its reputation on joining the bank as a ‘vice president’, but quickly found that the only way to survive in the Wall Street game was to play by the rules of the game, unpalatable as they are. It reinforced my view that the problem with so much of finance is not that there are some ‘bad apples’ but that it’s systemic – the structure of the barrel turns all the apples bad. So punishing some individuals, or working on bankers’ ethics, will make no difference at all.

Maybe it’s because he and I had the same intellectual formation, having been first taught economics by the wonderful and brilliant Peter Sinclair at Brasenose College, Oxford (albeit some years apart, as Guy is younger than me) that I find the philosophy behind [amazon_link id=”1137278811″ target=”_blank” ]The Education of a Value Investor[/amazon_link] so appealing. Guy & I met and became friends relatively recently, but a teacher who catches you at the right stage of your life is of course a uniquely powerful influence on your life. Interestingly, Guy questions his elite education, though, suggesting it was a good grounding for conventional, worldly success but taught the habits of reductionism and intellectual arrogance. However, in his case at least, a modest and wise man seems to have been forged by it.

High-speed predators

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There have apparently been some reviews sniping at [amazon_link id=”0241003636″ target=”_blank” ]Flash Boys[/amazon_link], the latest book by Michael Lewis on the financial markets, not that he will care given how well it’s selling. The grumpy reviews are wrong. It’s an excellent book. Lewis writes like a dream, and brings characters to life as well as any novelist. There are laugh out loud moments. And he explains as clearly as it is possible for a general reader the way today’s super-super-fast US equity market functions, or rather malfunctions.This is a great achievement, as it is very complicated.

[amazon_image id=”0241003636″ link=”true” target=”_blank” size=”medium” ]Flash Boys[/amazon_image]

I’ve not read other reviews of the book, but I gather from Twitter that some people accuse Lewis of exaggerating and making out all high frequency trading to be bad when it has cut commissions and increased liquidity. They’re wrong. Maybe there are one or two good guys doing HFT. But when there are frequent crashes and spikes in prices, and when the HFT firms do not make losses on any day, these traders are not taking on risk and enhancing liquidity; they are tax farming and increasing volatility through massive amounts of ultra-fast trading activity.

I got interested in HFT early in 2012 when I was preparing for my Tanner Lectures. It seemed the most extraordinary example of performativity, the shaping of reality by economic theory, as the options pricing formula devised by Black, Scholes and Merton had ended up causing a tunnel to be drilled through the Allegheny Mountains so a new fibre optic cable from Chicago to New Jersey could send information at something closer to the speed of light. [amazon_link id=”0241003636″ target=”_blank” ]Flash Boys [/amazon_link]starts with the same new line, built by Spread Networks. Lewis writes about the contract Spread Networks offered the Wall Street banks, whereby they could use the line for their own proprietary trading but not for their brokerage customers: “The whole point of  the line was to create inside the public markets a private space.”

The HFT markets serve the HFT firms and the big banks, which operate “dark pools”, or private markets in which they execute customers’ trades. Even giant hedge funds get a worse deal than the proprietary traders. Indeed, HFT firms pay Wall Street firms for access to their dark pools – to prey on the orders in there. No matter how big the investor, they would know nothing about how their orders were routed or when executed once they had issued the buy or sell order.

The market dysfunction had come about because of Regulation NMS, a stock exchange rule issued by the SEC with the intention of making sure investors got the best prices but with the unintended consequence that it created a spaghetti junction of orders moving around exchanges, with delays that HFT firms could use to their advantage. It isn’t just Lewis who says the rule backfired: here is a Wall Street Journal write-up questioning the benefits of the regulation. The regulation created short-term profit opportunities from gaming it, and the proliferation of exchanges it encouraged. As one character says, “It’s hard to be forward thinking when the whole of corporate America is about next quarter’s earnings.” High frequency traders, including those in big Wall Street banks, give themselves an information advantage over investors (including the funds looking after your money and mine); once an investor asks its broker to buy or sell shares, the information about the order belongs to the broker.

The solution to complexity that can be gamed and privileged information lies in simplicity and transparency, and the narrative thrust of [amazon_link id=”0241003636″ target=”_blank” ]Flash Boys[/amazon_link] is the creation of a simple, transparent exchange, IEX, by good cowboy Brad Katsuyama, who left Royal Bank of Canada to found it once he started to uncover the absolute scandal of the way high frequency trading was operating. Unexpectedly, Goldman Sachs emerges heroically, being the first major institution to route large volumes of orders through IEX. Lewis speculates that its senior people had come to realise: (a) Goldman is not very good at HFT because it has an old computer system; (b) one day, the highly complex and unstable equities market created by HFT will cause a huge, but huge, market crisis and they don’t want Goldman to get the blame. Goldman Sachs also emerges as villain for getting the FBI to arrest a Russian programmer, Sergey Aleynikov, for “stealing” some of their computer code – although found guilty and imprisoned, he had sent himself – openly – some mainly open source code when he quit the firm.

The book ends with a puzzle: the FCC license number 1215095, fixed to a microwave tower in Pennsylvania. The license application was filed in July 2012. Follow the lead, Lewis says, and you will find “another incredible but true Wall Street story, of hypocrisy and secrecy and the endless quest by human beings to gain a certain edge in an uncertain world.” Naturally, a lot of people have already done so.

As this ending suggests, he doesn’t argue that high frequency traders are evil. But the book does make a powerful case that the financial system is a dangerously complex system that creates damaging incentives. Like all complex systems, there will be a straw that breaks the camel’s back, a grain of sand that causes the whole pile to collapse. The world is uncertain in the sense that the specific straw or grain – which one, when –  is unpredictable, but the collapse is inevitable. There is an interesting question as to why innovation in finance – unlike in any other sector of the economy – so often works against the interests of consumers, not in their favour.

Lewis cites some others who have written about HFT: Sal Arnuk and Jospeh Saluzzi in [amazon_link id=”0132875241″ target=”_blank” ]Broken Markets[/amazon_link]; Eric Hunsader, founder of Nanex, a stock market data company; researcher Adam Clark-Joseph (pdf), whose work on HFT led the CFTC to shut its programme giving researchers access to data. There is also a book, [amazon_link id=”1847940986″ target=”_blank” ]Dark Pools[/amazon_link], by journalist Scott Patterson. Publications like Automated Trader are well worth a look too.

[amazon_image id=”0132875241″ link=”true” target=”_blank” size=”medium” ]Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio[/amazon_image]

Anyway, [amazon_link id=”0241003636″ target=”_blank” ]Flash Boys[/amazon_link] joins Lewis’s earlier book on the 2008 crisis, [amazon_link id=”0141043539″ target=”_blank” ]The Big Short[/amazon_link], and John Lanchester’s [amazon_link id=”014104571X” target=”_blank” ]Whoops[/amazon_link] as must-read guides to the insanity of modern finance.

Robert Shiller, Dr Jekyll and Mr Hyde, and Karl Marx

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I’ve been lucky enough to have met two of this year’s three economics Nobel winners, Gene Fama and Bob Shiller – my only contact with Lars Peter Hansen was the excitement of learning about Generalized Method of Moments estimates in their early days, while I was mid-way through my PhD. Both Profs Fama and Shiller were a pleasure to meet.

I interviewed the former for The Times in the relatively early days of the financial crisis (I can’t find the archived article but it was linked to his Onassis Prize lecture at the Cass Business School), and he was unmoved in defending the efficient market hypothesis, as the lecture shows.

Prof Shiller is somebody I’ve met a few times, and you couldn’t hope to meet a kinder or more charming person, or one who lives up better to the absent-minded academic label. His best-known book is of course [amazon_link id=”0691123357″ target=”_blank” ]Irrational Exuberance[/amazon_link], perfectly timed before the (first) crash of 2001, followed by [amazon_link id=”069114592X” target=”_blank” ]Animal Spirits[/amazon_link] co-authored with George Akerlof. Both books are appreciated by those who believe financial markets to have become a dangerous excrescence of capitalism and illustration of the dangers of markets in general.

However, Shiller has also in between written [amazon_link id=”0691120110″ target=”_blank” ]The New Financial Order[/amazon_link], [amazon_link id=”0691154880″ target=”_blank” ]Finance and the Good Society[/amazon_link] and [amazon_link id=”0691139296″ target=”_blank” ]The Subprime Solution[/amazon_link], books promoting the greater use of financial markets, or extending markets to areas where there are currently none – such as sovereign insurance against natural disasters. Many commentators have pointed out the apparent paradox of the Nobel committee rewarding both Shiller and Fama for their work on financial markets, but fewer the apparent [amazon_link id=”149228856X” target=”_blank” ]Jekyll and Hyde[/amazon_link] character of Prof Shiller’s own work.

[amazon_image id=”0691123357″ link=”true” target=”_blank” size=”medium” ]Irrational Exuberance: (Second Edition)[/amazon_image]

Speaking of anti-capitalism, this article about the 2008 crash leading to a revival of Marxism among the young reminded me of this 1997 John Cassidy article on – The Return of Karl Marx – sixteen years ago this week. [amazon_link id=”0199535701″ target=”_blank” ]Capital[/amazon_link] is pretty unreadable in my view, but Marx wrote about technology, inequality, power struggles and the disequilibrium dynamism of the economy, and will always look attractive as long as mainstream economics ignores these un-ignorable aspects of the world.

[amazon_image id=”1840226994″ link=”true” target=”_blank” size=”medium” ]Capital: Volumes One and Two (Wordsworth Classics of World Literature)[/amazon_image]

Finance fact and finance fiction

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I had a delightful weekend at the Pordenonelegge book festival, speaking about the new Italian edition of [amazon_link id=”0691145180″ target=”_blank” ]The Economics of Enough[/amazon_link]. The life of an author is indeed tough.

Reading in Pordenone

As my reading matter, I took a book (recommended by Brett Christophers, whose Banking Across Boundaries is out next year) that might be tough to get through in everyday life. It’s [amazon_link id=”0226675335″ target=”_blank” ]Genres of the Credit Economy: Mediating Value in 18th and 19th century Britain[/amazon_link] by Mary Poovey. The author is an English and Humanities professor at NYU, so this isn’t a natural title for me to have picked up. But, a bit over half way through, I’m finding it fascinating.

[amazon_image id=”0226675335″ link=”true” target=”_blank” size=”medium” ]Genres of the Credit Economy: Mediating Value in Eighteenth- and Nineteenth-Century Britain[/amazon_image]

The book traces the creation of a distinction between writing about value that became money – bills of exchange and bank notes – writing about value that became formal, ‘expert’ economic writing, and writing about value that became literary writing. What we now understand to be totally distinct genres were created so by the development of the credit-based economy in 18th and 19th century Britain and the sociological evolution of the economics profession on the one hand and literary writers on the other. A split between ‘factual’ writing about monetary or market value based on the forms of writing about natural science and ‘fictional’ writing about non-market value in literary fiction and poetry now seems natural and inevitable, but it was not always so. Once one sees this, it becomes immediately obvious that some ‘factual’ forms of writing about markets are entirely ‘fictional’. Without even going to the metaphorical character of many economic models, this statement obviously applies to the multi-hundred pages long prospectuses issued for complex securities in the run up to the Crisis (and for that matter still being issued). Nobody could possibly have read and understood these. Not that this mattered – they might as well have been tales of unicorns and dragons, containing less insight about value and values than, say, my next read, which will be [amazon_link id=”1849904936″ target=”_blank” ]Parade’s End[/amazon_link].

[amazon_image id=”1849904936″ link=”true” target=”_blank” size=”medium” ]Parade’s End[/amazon_image]

Meanwhile I’ll write a full review of Prof Poovey’s book when I’ve finished tit.