All the best,
M Brandl

Point of clarification: Geithner’s four pillars are: IMF, World Bank, WTO and now the FSB

View the video on YouTube at: http://www.youtube.com/watch?v=ihnUKAHjD34

Tell me your thoughts…

All the best,
M Brandl

The Chinese Minister of Commerce blasted the move as “a grave act of trade protectionism.”  Beijing was so upset that they filed a complaint with the WTO and said they will launch an investigation into US “dumping”of auto parts and chickens in China.

Critics in the US called it “capitulation to trade unions.”

Watch the video on YouTube: http://www.youtube.com/watch?v=b0bxZ_PFypM

All the best,

M Brandl

In usual Krugman form, he twists the history of economic thought to suit his politically motivated  arguments.  Before pointing out where he goes wrong, let me point out where I agree with Krugman.

First, I think Krugman is correct in lambasting modern day macroeconomists for their obsessive love affair with formal economic modeling.  So much intellectual capital has been wasted over the last 50 years in developing mathematically sophisticated economic models that have added absolutely nothing to our understanding of how the economy functions.  Economic departments, both freshwater and saltwater, are stuffed to the gills with mathematical geniuses claiming to be economists, who impress each other with things like their newest stochastic dynamic processes.

I cannot tell you the endless hours I have spent pouring over working papers and published academic articles, solving a multitude of equations only at the end to arrive having gained absolutely no insight into how and why economic outcomes are they way they are.

But such is the life of an academic economist these days:  you must learn to pray at the quantitative alter if you are to be “accepted” by the tenured high priests of our profession.  Never mind that these mathematically gifted soothsayers have no idea how to get us out of the current mess in which we find ourselves.

Second, I think Krugman is correct to point out the advancement made by behavioral economists.  The field of behavioral finance in particular has much to offer in giving us a better understanding of how markets actually function.  Behavioral economics, experimental economics, behavioral finance, etc. start with observations of what actually happens in markets and/or what people actually DO as opposed to how our elegant mathematical models suggest they should act.  More economists should be encouraged to observe how markets, societies and people actually do function and how they have functioned in the past.  Let us be more like the natural scientists that start with observations and then move to develop theory and models of behavior, not the other way around.

Next, Krugman is also correct in pointing out the disconnect between finance and macroeconomics.  I think The Economist did a much better job of describing this disconnect than does Krugman (I think that is where Krugman got the idea for his most recent op-ed, but that’s beside the point).  The Economist correctly described the “silos” macroeconomists and financial economists find themselves.  That is, the macroeconomists basically exclude financial interactions in their description of the overall economy, and financial economists basically ignore the total impact of financial market instability.

This siloization (if that is word) has come about because to uber-specialization of our fields.  Multi-disciplinary approaches to economic issues are shunned by both macro and financial economists.  In a recent meeting with colleagues when it was suggested that financial economists actually consider a multi-disciplinary approach to their subject, a leading “scholar” in the field snapped “none of the cross-discipline research that is being done is any good.”  What my esteemed colleague failed to recognize is that he and his ilk are the ones who decides what is “good” or not by determining what gets published in the leading academic journals.  Thus, since inter-disciplinary work is not “valued” by the quantitative high priests, very little of it actually gets done.

This leads to where I disagree with Krugman and/or where I find fault with his arguments.

First, Krugman misrepresents the Chicago School’s approach to business cycle fluctuations.   What he leaves out is that idea that government policies, while well intentioned, can actually prolong recessions by creating distortions in a variety of input markets.  Thus, it is not that markets work perfectly all of the time, as Krugman claims the Chicago models suggest, rather it is that excessive government rules and regulation keep markets from achieving equilibrium.

And so it is with the recent crisis.  Krugman completely leaves out how government policies were major contributors to this current economic crisis.  Nowhere does he mention how the defacto government guarantees of Fannie Mae and Freddie Mac lead to a misallocation of capital.  He also fails to mention how past government bailouts of our banking system created a massive moral hazard problem that contributed to this current crisis.  No, instead in Krugman’s view, government policies only seem to react perfectly in stimulating demand reversing the economy’s slide into recession that was brought about by “the casinos” that are financial markets.  And then he wonders why people snicker at the Keynesian simplistic explanations.

Next, Krugman’s argument of what went wrong in financial markets completely leaves out the role of incentives.  Because of past government bailouts, large financial institutions and the traders within them, realized that their institutions were “too big to fail.”  And yet, they also realized that if excessive risks they were taking paid off, they would be rewarded with huge financial bonuses.  Thus, the incentives within the financial markets were completely misaligned.  It was a replay of the savings & loan crisis of the 1980s:  heads I win, tails the government loses.

The massive Treasury/Fed bailout, supported by Larry Summers, Greg Mankiw and other leading Neo-Keynesians does little to address these misaligned incentives. At least the Europeans are looking at some type of restructuring of incentives within their financial markets to ensure a disaster like the current one does not occur again.  Where are the American Keynesians to suggest real world policies to correct the structural problems that exist?  Oh that’s right, they are too busy pointing the finger of blame at Chicago to be bothered with “reality.”

Which gets me to my final point:  yes, we need to rethink what economists do and how we do it.  Krugman is right that we need to learn from the past, but I think it is more John Hicks we should learn from as opposed to John Maynard Keynes.  About 20 years, Will Baumol wrote an excellent piece on Hicks entitled “Sir John Versus the Hicksians or Theorist Malgre Lui?” which appeared in the December 1990 issue of The Journal of Economic Literature.  In it Baumol described how Hicks, creator of the IS-LM model among other things, wanted to be known for his work on economic history.  In fact it was Hicks’ wish that he was awarded the Nobel Prize for that as opposed to his work on labor theory, money or value for which he is better know.  To quote Baumol:

“Hicks simply remained a product of the time of his training, when economic analysts were expected to derive understanding from explicit study of institutions and history, and when there was no doubt that real economic phenomena were the central preoccupation of economists.”

Let us return to that.

All the best,

MBrandl

But, when these economist sounded this warning in the mid 1990’s they were ignored by the business press and non-economists.  The screams went out “how can these pencil-headed economists question what is happening in the Tiger economies?  We are making money so everything is fine.”

No it wasn’t.  U.S. banks poured money into Southeast Asia, feeding the asset bubble that ultimately imploded.

Fast forward 15 years to today.  A recent report from John Makin at the American Enterprise Institute is questioning China’s recent economic “rebound.”  For a nice quick summary see Jim Jubak’s 8/11/2009 Jubak’s Journal article on msn’s moneycentral.  Basically Makin argues that the Chinese government statistics about their economic growth do not really reflect what is going on in the economy.  Essentially, the Chinese government maybe destroying a great deal of resources/wealth in an attempt to make their GDP numbers look good.

If this is true (and it looks as though it is) remember what happened in Southeast Asia 15 years ago.

But…I can hear the pundits in business press and the non-economists already:  “China is different!  You economists don’t know what you are talking about - we are making money there, so don’t question what is going on.”

Hmmm…mispricing of risk…not understanding data…where have I heard that before???

All the best,

MBrandl

I started to think more about this mentality that we are developing of “them” versus “us.” We seem to have a growing intolerance of those we consider not to be “us.” And it seems who we define as “us” is getting more narrow and more extreme.

Here is what I mean: in policymaking it used to be that Republicans and Democrats would debate, argue and reach some type of compromise. In business, firms would compete in many markets but would also co-operate with each other in other settings.

But we see this less and less now it seems. Democrats refuse to consult Republicans in the drafting of legislation. Republican talk show hosts wish for the collapse of the economy simply because the Democrats are in power. Management sees it as their responsibility to destroy the competition at every turn.

And the behavior doesn’t seem to end with these broad definitions. Within the Republican Party we see Rush Limbaugh and Dick Cheney seeking to kick people like Colin Powell out of the party because they see Powell as not a “true” Republican. It seems only the true-believers; those who don’t question the elite are welcome in the Republican Party today.

So too it seems with the Democrats. Anyone who dares to question the rising level of government debt is shunned into the intellectual corner as “not understanding” the current economic situation. Even the President claims there was “no disagreement” among economists that his stimulus package was needed.

Really?

So disagreeing with those you support or agreeing with and working with those on the other side is no longer “allowed?” That seems to be the accepted behavior.

So what happens is Conservative Christian Republicans only talk to other Conservative Christian Republicans. Progressive Well Educated Democrats only hang out with other Progressive Well Educated Democrats. As a result the Conservatives become more conservative and the Progressives become more liberal.

This is dangerous.

We learn from people who are different from us and think differently than us. By talking to those who think differently than we do we broaden our insight and sometimes we even change our minds.

Think about this: Ronald Reagan started off as a Democrat in the 1940s. He didn’t talk only to Truman Democrats of the time, and as a result his views evolved. That did not mean, however, he simply repeated everything other conservative Republicans said. Reagan and the great conservative intellectual William F. Buckley, Jr. had a nationally covered debate on the issue of the Panama Canal Treaty in 1978. Could you imagine the leaders of the (so-called) conservative movement debating and disagreeing with each other in public today? No, they aren’t that deep. We need another William F. Buckley.

Great leaders don’t tell us what to think, they teach us how to think. This is true in policymaking, in leading businesses and in raising & educating our young.

Maybe college sports really are a window into the rest of our society. What a pity.

All the best,

M. Brandl

• an attempt to hold loan originators to be more accountable by requiring them to hold 5% of the credit risk of the loans they secure
• give the Federal Reserve additional responsibility of being a “systemic risk” regulator
• create a new regulator over consumer financial products and minor reforms to bond rating agencies

Reports in the business press tell us that the Administration has caved into pressure from the banking lobby and thus abandoned any attempt to undertake far reaching financial market reforms.  Reports in the popular press tell us the Administration also gave into political pressure from those in Washington who would loose power if financial markets were truly reformed.

Instead of preparing our financial markets for the world of the 21^st century, Congress and the Administration will slap yet another patch on the system that has not been restructured in over 70 years. Thus, it seems, little will change. Yet another patchwork solution will be put forward, instead of an attempt to truly reform our financial markets.

What a shame.

What would true reform of the financial markets look like?  It would start with a realization that the world has changed since the 1930s.  While commercial banks are very important to the functioning of our system, these banks can (and should) come in a variety of forms.  In addition, there are now many important non-bank financial institutions that need to be considered.

One way to think about this new landscape is in terms of deposit insurance and the amount of federal oversight and regulation that is truly needed.  Imagine a world where financial entities would be classified into a five-star risk/return/regulation framework.  It might look something like this:

Five Star Institutions:  Extremely Safe - Low Returns.  These institutions would have 100% deposit insurance, be required to fully disclose their financial statements in real time every day, face bank examinations monthly and pay shareholder very low returns.  Many of them might opt for a non-profit status.

Four Star Institutions:  Relative Safe - Relative Low Returns. These institutions would have deposit insurance on the first $50,000 of deposits with the ability to purchase private deposit insurance if desired, fully disclose financial statements every six months, face bank examinations yearly and pay shareholders low returns.

Three Star Institutions:  Moderately Safe - Moderate Returns.  These institutions would have deposit insurance on the first $5,000 of deposits with the ability to purchase more private deposit insurance, fully disclose financial statements every year, face examinations every two years and pay shareholders moderate returns.  These institutions could invest deposits in equities as well as debt instruments, much like mutual funds.

Two Star Institutions: Risky - Potential Significant Returns.  .  These institutions would have deposit insurance on the first $5,000 of deposits only by paying a fee to the FDIC, fully disclose financial statements every year, face examinations every two years and pay shareholders higher returns.  These institutions could invest deposits in a wide range of financial instruments.  Many of the accounts the offer would be illiquid.

One Star Institutions: High Risk - Potential High Returns.  These institutions would offer no deposits insurance, would agree to standardization in the reporting of returns, face bi-annual audits, subject to systemic risk regulation.  These institutions would undertake private equity (especially venture capital) investments and some hedge funds investments along with other asset purchases.  Most of the accounts they offer would be illiquid.

This type of system would offer the banking public (both savers and borrowers) a variety of choices. Underlying the system would be a level of safety and security, notice even one star institutions are subject to regulation, but competition would determine which entities succeed and which fail.

Think of this system as analogous to our restaurants.  We have a variety of restaurants that do different things:  fast food restaurants with their quick cheap food served on plastic trays all the way to high end restaurants with gourmet food and fine linen table cloths.  Are they all the same?  No.  Are we told what restaurant we must eat?  No, we choose.  When we choose we know there is a basic level of safety/regulation-someone we trust has inspected the kitchen and made sure it is clean-but we choose.

Even if a restaurant is closed by the health inspector, does that cause us to stop eating out all together?  No.

If we collectively choose not to go to a certain restaurant that restaurant does goes out of business.

And so it should be with our financial market regulation and financial market structure:  allow people to choose, force them to pay for what they want, but the regulators should also offer a level of safety to the system and close down those that are unsafe.

This would be true financial market reform.

This would be “change we could believe in.”  This is what the Obama Administration should be doing.

All the best,
MBrandl

Now that my semester is over, I’d like to shift my focus from innovating the technology to making my content the right mix for my readers. Please take the poll below and let me know what you want more of. Feel free to add your own answers and comments.

Each of these revolutions came about because the then current macro models of the day could not explain what was happening to the actual economy.  In Keynes’ day it was the failure of Classicalists to explain the prolonged economic downturn of the Great Depression.  In the Rational Expectations Revolution it was the stagflation of the 1970s.  Each revolution offered a new way of examining the macroeconomy and in doing so, could explain the past as well as the present.

Slightly oversimplifying things:  Keynes said the Classicalists were wrong because prices were sticky and planned investment might be different from actual spending and dynamic general equilibrium models (the modern incarnation of the rational expectations revolution) argued the Keynesians were wrong because they ignored microeconomics.

In dynamic general equilibrium (from now on DGE) macroeconomic models, market participants learn from their mistakes and thus input markets are in equilibrium.  This is why asset pricing is now a part of macroeconomic models.  The advantage of DGE models is that we can have the interaction of various parts of the macroeconomy all impacting each other:  households are maximizing their intertemporal utility function subject to time and budget constraints, firms are maximizing their profit function subject to technology and resource constraints, etc.  The models break away from the Keynesian ad hoc assumptions about consumption and investment and are more closely aligned with how microeconomists  view behavior.

Or…at least how microeconomists USED to view behavior.  Over the last 20 years or so the field of behavioral economics (and the closely related field of behavioral finance) has changed in the way many microeconomists think about market behavior.  Again oversimplifying things a bit, the behavioralists have raised questions about the assumption of perfectly rational economic agents.

Now…behavioral economics is not accepted by everyone…yet.  But…what if they are on to something?  Maybe if macroeconomists truly want to build models with “sound microeconomic foundations” the models should have irrationality play a bigger role.

Of course one of the major stumbling blocks is that it is rather difficult to mathematically show irrational behavior.  That is why macroeconomists have generally ignored it (among other reasons).  But…is that a good enough justification anymore?  What if this irrational behavior is The underlying driving force behind many of our modern economic problems?  Can we continue to just ignore it?

The past as a key to the future

One of the great intellectual underpinnings of the GDEs is they were based on very old idea:  Ricardian equivalence, for example.  Maybe macroeconomists need to again return to the past:  back to the days when economists used other disciplines for insight into how the overall economy functioned.  Remember the “first” macroeconomists (those before Keynes) studied “political economy.”  Maybe we need to look at how psychology, sociology, history and political science can help us better understand how the macroeconomy works.  Maybe economists have become too enslaved by our desire to formally represent relationships that we have missed key components of those relationships.

So maybe it is time for a third macroeconomic revolution;  one where we realize that not all important macroeconomic actions/relationships/behaviors can be shown mathematically.  Instead our new generation of macro models will use the insights of various fields to explain business cycles fluctuations and long run economic growth.  Only when we break from our enslavement to rigid mathematical modeling will we advance the field of macroeconomics.  Perhaps the time for that change is now.

All the best,

M Brandl

Please let me know what you think about my perspective, the video posts, or anything you’d like to see more or less of. Your feedback is greatly appreciated.

All the best,
M. Brandl

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