Tag Archive for 'financial crisis'

Ken Arrow - Financial turmoil is a challenge to economic theory

Published by Garry Peterson on November 15, 2008 in General. 1 Comment

On Comment is Free, economist Kenneth Arrow writes that The financial turmoil is a challenge to economic theory

The current financial crisis, the loss of asset values, the refusal to extend normally-given credit and the great increase in defaults on obligations ranging from individual mortgages to the debts of great investment banks presents, of course, a pressing challenge to the fiscal authorities and central banks to take measures to minimise the consequences. But they also present a challenge to standard economic theory, a challenge all the more important since the development of policies to prevent future financial crises will depend on a deeper understanding of the processes at work.

That economic decisions are made without certain knowledge of the consequences is pretty self-evident. But, although many economists were aware of this elementary fact, there was no systematic analysis of economic uncertainty until about 1950. There have been two developments in the economic theory of uncertainty in the last 60 years, which have had opposite implications for the radical changes in the financial system. One has made explicit and understandable a long tradition that spreading risks among many bearers improves the functioning of the economy. The second is that there are large differences of information among market participants and that these differences are not well handled by market forces. The first point of view tends to argue for the expansion of markets, the second for recognising that they may fail to exist and, if they do come into being, may fail to work for the benefit of the general economic situation.
…
There is obviously much more to the full understanding of the current financial crisis, but the root is this conflict between the genuine social value of increased variety and spread of risk-bearing securities and the limits imposed by the growing difficulty of understanding the underlying risks imposed by growing complexity.

Don Ludwig on the Black Swan

Published by Garry Peterson on November 14, 2008 in Regime Shifts. 2 Comments

The applied mathematician and scholar of uncertainty Don Ludwig reflects on the financial crisis, resilience, and The Black Swan:

This is a sort of book review. By now you may have heard of The Black Swan: the impact of the highly inprobable by Nassim Nicholas Taleb published by Random House (2007).

Taleb is from Lebanon, but he prefers to be called a Levantine. He worked as a trader in currencies, and maybe also derivatives. He claims that nothing of importance in finance can be predicted, except its unpredictability. His book will undoubtedly attract attention for its claim of an inevitable financial collapse, like the one we are experiencing.

He writes on p. 225:
I spoke about globalization in Chapter 3; it is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans [events that are extremely rare and important]. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are now interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks (often Gaussianized [assuming normal deviations] in their risk measurement) — when one falls, they all fall. [lengthy footnote here, which includes the statement that "Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite"] The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we have fewer failures, but when they occur … [no deletion here] I shiver at  the thought. I rephrase here: we will have fewer but more severe crises. The rarer the event, the less we know about its odds. It mean[s] that we know less and less about the possibility of a crisis.

Taleb goes on to mention the power blackout of 2003 as an example of what happens when things are tied too closely together.  Taleb points out that all the experts use Gaussian assumptions for risk analysis, which delivers precisely the wrong answer. Hence I think that it is extremely likely that the favored solution to the world financial crisis will be to tie the financial system even more tightly together, thus ensuring an even bigger collapse next time. It seems to be happening already. There is no sign that Obama has twigged to the hazards of greater financial integration. There is no sign that the experts can learn from collapses: they don’t seem to have learned from past collapses, as Taleb points out.

I think we can learn from Taleb: he writes very forcefully, but exaggerates his points too much. It may be that if we confine ourselves to financial situations, then his statements are valid, even though they are extreme. Taleb seems to have been treated very nastily by the financial establishment: Scholes, Merton & Co. He seems to be both hurt and angry. Perhaps this causes his arrogance as well. I had to grit my teeth to get through to the later chapters, which have most of the substance.

Taleb offers some financial advice:
1. Above all try to protect yourself from the big drops that are coming (have already come). This implies investing a very high percentage in lower risk securities such as government bonds.

2. Try to participate in the big booms that are also sure to come. Taleb advises spreading some stuff in venture capital. In view of the behavior of the Vancouver stock exchange, I should think that it would be necessary to try to avoid scams. See David Baines in the Vancouver Sun for details (e.g.).

What has this to do with ecology?

Buzz Holling has been talking for years about “surprise”, which is just another name for Black Swans. Anyone who has ever looked at ecological data knows that deviations are not Gaussian. Of course, if we drop the Gaussian or some similar assumption, we lose most of statistics, and we lose all of “risk analysis”. So we lose just about all theory. Experts can’t function without theory, so they make unrealistic assumptions, and come up with the wrong answers in Black Swan situations.

Since Black Swans are rare, ordinary experience doesn’t show any, and the experts are confirmed in their misleading assumptions, until the next time.

We can use analogies instead of theory. I recall the raft analogy we used years ago to illustrate resilience: in order to survive on rough seas, we use loose coupling rather than strong coupling. Likewise, we guard against overconfidence: another of Buzz’ favorite themes. Managing for resilience involves guarding against collapses, even though they might be rare: it implies a precautionary principle. In light of the recent financial collapse, this latter point might finally be accepted for ecological management.

Financial crisis: bad models or bad modellers

Published by Garry Peterson on November 12, 2008 in Reorganization. 0 Comments

Australian economist, John Quiggin writes on Crooked Timber about the contribution of models to the financial crisis:

The idea that bad mathematical models used to evaluate investments are at least partially to blame for the financial crisis has plenty of appeal, and perhaps some validity, but it doesn’t justify a lot of the anti-intellectual responses we are seeing. That includes this NY Times headline In Modeling Risk, the Human Factor Was Left Out. What becomes clear from the story is that a model that left human factors out would have worked quite well. The elements of the required model are

  1. in the long run, house prices move in line with employment, incomes and migration patterns
  2. if prices move more than 20 per cent out of line with long run value they will in due course fall at least 20 per cent
  3. when this happens, large classes of financial assets will go into default either directly or because they are derived from assets that can’t pay out if house prices fall

It was not the disregard of human factors but the attempt to second-guess human behavioral responses to a period of rising prices, so as to reproduce the behavior of housing markets in the bubble period, that led many to disaster. A more naive version of the same error is to assume that particular observed behavior (say, not defaulting on home loans) will be sustained even when the conditions that made that behavior sensible no longer apply.

…More generally, in most cases, the headline result from a large and complex model can usually be reproduced with a much simpler model embodying the same key assumptions. If those assumptions are right (wrong) the model results will be the same. The extra detail usually serves to produce more detailed results rather than to produce significant changes in the headline results.

James K. Galbraith economics and the financial crisis

Published by Garry Peterson on November 2, 2008 in General. 0 Comments

An interview with economist James Galbraith in the NYTimes.com

..There are at least 15,000 professional economists in this country, and you’re saying only two or three of them foresaw the mortgage crisis? Ten or 12 would be closer than two or three.

What does that say about the field of economics, which claims to be a science? It’s an enormous blot on the reputation of the profession. There are thousands of economists. Most of them teach. And most of them teach a theoretical framework that has been shown to be fundamentally useless.

And a review of the impact of the crisis.

During the go-go investing years, school districts, transit agencies and other government entities were quick to jump into the global economy, hoping for fast gains to cover growing pension costs and budgets without raising taxes. Deals were arranged by armies of persuasive financiers who received big paydays.

But now, hundreds of cities and government agencies are facing economic turmoil. Far from being isolated examples, the Wisconsin schools and New York’s transportation system are among the many players in a financial fiasco that has ricocheted globally.

Björk discusses Iceland’s response to financial crisis

Published by Garry Peterson on October 24, 2008 in Adaptation and Reorganization. 0 Comments

From Pitchfork - the Icelandic musician and star Björk, on the Icelandic response to the financial crisis (which locked up Iceland’s imports as massive bank failures lead to a currency crash):

… the Náttúra Campaign, the Icelandic environmental movement co-founded by Björk. Náttúra’s original mission was to protest the construction of foreign-backed aluminum factories in Iceland, but in recent weeks, the movement has taken a dramatic turn. ….

Björk: For the last two weeks, Icelanders are getting a crash course in economics. I mean, I didn’t know about these things two weeks ago. The news is full of right-wing guys saying, “Stop the environmental value stuff! We should just build factories everywhere now, because that’s where the money is!” …

These aluminum smelters, nobody wants to build them in Europe, because there’s so much pollution. So it’s like, “Oh, just go dump them in Iceland.” We are getting them energy for so cheap that they are saving so much money by doing all this here.

Instead, what we are saying is, we’ve got three aluminum factories, let’s work with that, we cannot change that. Why not have the Icelandic people who are educated in high-tech and work already in those factories in the higher paid jobs, why not let them build little companies who are totally Icelandic with the knowledge they have? Then they get the money and it stays in the country. Then we can support the biotech companies and the food companies and all these clusters. I think that if you want to be an environmentalist in Iceland, these are the things you’ve got to be putting your energy into.

A lot of investors [are] coming, and I’m hoping they will want to invest in the high-tech cluster. There are money people here that did not lose a lot of money. For example, here is one investment company in Iceland only run by women. They are doing fine. [laughs] They aren’t risk junkies. They just made slow moves. The people who are crashing, they took a huge loan and then another huge loan, and so on. And it’s all just air. But these women didn’t build on air.

…

I’ve also been trying to get someone to Iceland to suggest green industries to Icelanders and introduce us to the companies that haven’t even been built yet in the world. This man Paul Hawken, who is famous in the States, he has agreed to come here in November. He’s supposed to be a green capitalist. He’s a functionalist, not just an idealist. I’m hoping he can unite these two polarized groups in Iceland. I’m setting up a meeting with him and the people in power. Because I think private money people can put money into those seed companies, but most of all, the government has to do it. It has to be a mixture of two things. It cannot just be visionary money people.

Turbulence and Finance: Taleb and Mandelbrot

Published by Garry Peterson on October 24, 2008 in General. 0 Comments

On PBS’s NewsHour, Paul Solman interviewed Nassim Nicholas Taleb and Benoit Mandelbrot about how strongly coupled systems can produce unpredictable turbulence.  They strike very resilience oriented themes - narrow over-optimization leading to a loss of resilience.

PAUL SOLMAN: In the [Black Swan], Taleb wrote, “The increased concentration among banks seems to have the effect of making financial crises less likely. But when they happen, they are more global in scale and hit us very hard. True, we now have fewer failures, but, when they occur, I shiver at the thought.”

NASSIM NICHOLAS TALEB: The banking system, the way we have it, is a monstrous giant built on feet of clay. And if that topples, we’re gone.

Never in the history of the world have we faced so much complexity combined with so much incompetence and understanding of its properties.

PAUL SOLMAN: But there’s been complexity before. There has been overextension of credit before. We’ve had crashes in American history many times before. We’re a resilient system. Won’t we pull out of it?

NASSIM NICHOLAS TALEB: Let me tell you why it’s not like before. Look at what’s happening. The world is getting so fragile that a small shortage of oil — small — can lead to the price going from $25 to $150.

PAUL SOLMAN: A barrel.

NASSIM NICHOLAS TALEB: A barrel. A small excess demand in an agricultural product can lead to an explosion in price.

We live in a world that is way too complicated for our traditional economic structure. It’s not as resilient as it used to be. We don’t have slack. It’s over-optimized.

PAUL SOLMAN: What do you mean by “over-optimized”?

NASSIM NICHOLAS TALEB: Let me tell you what is happening in the ecology of the banking system. They’re swelling to large banks, OK, because it’s vastly more optimal to have one large bank than 10 small banks. It’s more efficient.

PAUL SOLMAN: Well, we’ve certainly seen the consolidation of the industry.

NASSIM NICHOLAS TALEB: Exactly. And that consolidation is what’s putting us at risk, because we are — when one bank, large bank makes a mistake, OK, it’s 10 times worse than a small bank making a mistake.

…

PAUL SOLMAN: So, getting back to your fundamental work and insight, this is a system that can become turbulent or is inherently turbulent, that doesn’t have enough of a buffer, and that’s the danger?BENOIT MANDELBROT: That is not well-understood. In fact, that is misunderstood for which tools have been developed which assume that changes are always very small.

If one of them comes, nothing bad happens. If several of them come together, very bad things have happened. And the theory does not take account of that, and the theory doesn’t take account of very large and sudden changes in anything.

The theory thinks that things move slowly, gradually, and can be corrected as they change, whereas, in fact, they may change extremely brutally.

NASSIM NICHOLAS TALEB: Now you understand why I’m worried. I hope I’m wrong. I wake up every morning — actually, I don’t wake up every morning now. I start to wake up at night the last couple of weeks hoping that I’m wrong, begging to be wrong.

I think that we may be experiencing something that is vastly worse than we think it is.

PAUL SOLMAN: And we think it’s pretty bad.

NASSIM NICHOLAS TALEB: It’s worse. Of all the books you read on globalization, they talk about efficiency, all that stuff. They don’t get the point. The network effect of that globalization, OK, means that a shock in the system can have much larger consequences.

via Global Guerrillas

Assorted financial crisis news and analysis

Published by Garry Peterson on October 9, 2008 in General. 0 Comments

The US radio show This American Life has an informative show on how non-transparent couplings between credit default swaps allowed caused the contagion that was critical to the financial crisis - Another Frightening Show About the Economy. You can listen to their show online or download an MP3 file.

Also see economist Paul Krugman on the financial crisis here and with a longer analysis here. He also posts a revealing graph which shows the how the strength of the coupling between the US and the rest of the world’s (ROW) economies has increased over the past thirty years.

The US TV show 60 Minutes has a 12 min. segment on the “Shadow Financial System“. The segment charges the managers of investment banks with criminal incompetence.


Watch CBS Videos Online

Also, the New York Times, a critical look at the deregulation of financial markets under the US Federal Reserve chairmanship of Alan Greenspan. Taking Hard New Look at a Greenspan Legacy

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan in 2004

And in the UK’s Financial Times, columnist Martin Wolf writes that is is now time for a comprehenisive plan to rescue the financial system:

As John Maynard Keynes is alleged to have said: “When the facts change, I change my mind. What do you do, sir?” I have changed my mind, as the panic has grown. Investors and lenders have moved from trusting anybody to trusting nobody. The fear driving today’s breakdown in financial markets is as exaggerated as the greed that drove the opposite behaviour a little while ago. But unjustified panic also causes devastation. It must be halted, not next week, but right now.
The time for a higgledy-piggledy, institution-by-institution and country-by-country approach is over. It took me a while – arguably, too long – to realise the full dangers. Maybe it was errors at the US Treasury, particularly the decision to let Lehman fail, that triggered today’s panic. So what should be done? In a word, “everything”. The affected economies account for more than half of global output. This makes the crisis much the most significant since the 1930s.

Herman Daly on the Financial Crisis

Published by Garry Peterson on October 9, 2008 in Ecological Economics. 0 Comments

The Oil Drum has an article by the ecological economist Herman Daly on the Credit Crisis, Financial Assets, and Real Wealth. Daly writes:

The current financial debacle is really not a “liquidity” crisis as it is often euphemistically called. It is a crisis of overgrowth of financial assets relative to growth of real wealth—pretty much the opposite of too little liquidity. Financial assets have grown by a large multiple of the real economy—paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities. It should be no surprise that the relative value of the vastly more abundant financial assets has fallen in terms of real assets. Real wealth is concrete; financial assets are abstractions—existing real wealth carries a lien on it in the amount of future debt. The value of present real wealth is no longer sufficient to serve as a lien to guarantee the exploding debt. Consequently the debt is being devalued in terms of existing wealth. No one any longer is eager to trade real present wealth for debt even at high interest rates. This is because the debt is worth much less, not because there is not enough money or credit, or because “banks are not lending to each other” as commentators often say.

Can the economy grow fast enough in real terms to redeem the massive increase in debt? In a word, no. As Frederick Soddy (1926 Nobel Laureate chemist and underground economist) pointed out long ago, “you cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest] against the natural law of the spontaneous decrement of wealth [entropy]”. The population of “negative pigs” (debt) can grow without limit since it is merely a number; the population of “positive pigs” (real wealth) faces severe physical constraints. The dawning realization that Soddy’s common sense was right, even though no one publicly admits it, is what underlies the crisis. The problem is not too little liquidity, but too many negative pigs growing too fast relative to the limited number of positive pigs whose growth is constrained by their digestive tracts, their gestation period, and places to put pigpens. Also there are too many two‐legged Wall Street pigs, but that is another matter.

Growth in US real wealth is restrained by increasing scarcity of natural resources, both at the source end (oil depletion), and the sink end (absorptive capacity of the atmosphere for CO2). Further, spatial displacement of old stuff to make room for new stuff is increasingly costly as the world becomes more full, and increasing inequality of distribution of income prevents most people from buying much of the new stuff—except on credit (more debt). Marginal costs of growth now likely exceed marginal benefits, so that real physical growth makes us poorer, not richer (the cost of feeding and caring for the extra pigs is greater than the extra benefit). To keep up the illusion that growth is making us richer we deferred costs by issuing financial assets almost without limit, conveniently forgetting that these so‐called assets are, for society as a whole, debts to be paid back out of future real growth. That future real growth is very doubtful and consequently claims on it are devalued, regardless of liquidity.

Systemic risk reflections

Published by Garry Peterson on September 29, 2008 in General and Reorganization. 1 Comment

TED spreadSome recent reflections on systemic risk and the financial markets - ranging from details to the big picture.

First, Gretchen Morgenson in the New York Times writes Behind Insurer’s Crisis, Blind Eye to a Web of Risk:

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”— Joseph J. Cassano, a former A.I.G. executive, August 2007

…Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.

In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

Second, America’s National Public Radio’s Planet Money has a lot of recent indepth coverage of the financial crisis in this vein available of podcasts.  Including a recent one called the day America’s economy almost died.

Looking a more the big economic picture,  Predicting Crisis in the United States Economy a profile of Nouriel Roubini discusses the selective vision of models and the biases against discontinuities or nonlinear change.

Recessions are signal events in any modern economy. And yet remarkably, the profession of economics is quite bad at predicting them. A recent study looked at “consensus forecasts” (the predictions of large groups of economists) that were made in advance of 60 different national recessions that hit around the world in the ’90s: in 97 percent of the cases, the study found, the economists failed to predict the coming contraction a year in advance. On those rare occasions when economists did successfully predict recessions, they significantly underestimated the severity of the downturns. Worse, many of the economists failed to anticipate recessions that occurred as soon as two months later.

The dismal science, it seems, is an optimistic profession. Many economists, Roubini among them, argue that some of the optimism is built into the very machinery, the mathematics, of modern economic theory. Econometric models typically rely on the assumption that the near future is likely to be similar to the recent past, and thus it is rare that the models anticipate breaks in the economy. And if the models can’t foresee a relatively minor break like a recession, they have even more trouble modeling and predicting a major rupture like a full-blown financial crisis. Only a handful of 20th-century economists have even bothered to study financial panics. (The most notable example is probably the late economist Hyman Minksy, of whom Roubini is an avid reader.) “These are things most economists barely understand,” Roubini told me. “We’re in uncharted territory where standard economic theory isn’t helpful.”

Finally, Science Fiction writer Charlie Stross writes about the increasing difficulty of projecting the near future at all:

We are living in interesting times; in fact, they’re so interesting that it is not currently possible to write near-future SF.

… Put yourself in the shoes of an SF author trying to construct an accurate (or at least believable) scenario for the USA in 2019. Imagine you are constructing your future-USA in 2006, then again in 2007, and finally now, with talk of $700Bn bailouts and nationalization of banks in the background. Each of those projections is going to come out looking different. Back in 2006 the sub-prime crisis wasn’t even on the horizon but the big scandal was FEMA’s response (or lack thereof) to Hurricane Katrina. In 2007, the sub-prime ARM bubble began to burst and the markets were beginning to turn bearish. (Oh, and it looked as if the 2008 presidential election would probably be down to a fight between Hilary Clinton and Rudy Giuliani.) Now, in late 2008 the fiscal sky is falling; things may not end as badly as they did for the USSR, but it’s definitely an epochal, historic crisis.

Now extend the thought-experiment back to 1996 and 1986. Your future-USA in the 1986 scenario almost certainly faced a strong USSR in 2019, because the idea that a 70 year old Adversary could fall apart in a matter of months, like a paper tiger left out in a rain storm, simply boggles the mind. It’s preposterous; it doesn’t fit with our outlook on the way history works. (And besides, we SF writers are lazy and we find it convenient to rely on clichés — for example, good guys in white hats facing off against bad guys in black hats. Which is silly — in their own head, nobody is a bad guy — but it makes life easy for lazy writers.) The future-USA you dreamed up in 1996 probably had the internet (it had been around in 1986, in embryonic form, the stomping ground of academics and computer industry specialists, but few SF writers had even heard of it, much less used it) and no cold war; it would in many ways be more accurate than the future-USA predicted in 1986. But would it have a monumental fiscal collapse, on the same scale as 1929? Would it have Taikonauts space-walking overhead while the chairman of the Federal Reserve is on his knees? Would it have more mobile phones than people, a revenant remilitarized Russia, and global warming?

There’s a graph I’d love to plot, but I don’t have the tools for. The X-axis would plot years since, say, 1950. The Y-axis would be a scatter plot with error bars showing the deviation from observed outcomes of a series of rolling ten-year projections modeling the near future. Think of it as a meta-analysis of the accuracy of projections spanning a fixed period, to determine whether the future is becoming easier or harder to get right. I’m pretty sure that the error bars grow over time, so that the closer to our present you get, the wider the deviation from the projected future would be. Right now the error bars are gigantic.