What's wrong with finance

http://www.economist.com/blogs/buttonwood/2015/05/finance-and-economics

by akg_67 • 11 years ago

75 68 11 years ago

economist.com

thret• 11 years ago

Spellcheckers should really detect repeated sentence fragments. Also 'theiw'.

25 standard deviations has to be an exaggeration? I fail to see how any model could ever be that far off the mark.

formulaT• 11 years ago

It's just a blog post. Regular economist articles are better edited, but mainstream economics doesn't make the HN front page.

25 standard deviations has to be an exaggeration? I fail to see how any model could ever be that far off the mark.

It's easy to be that far off the mark. E.g. assume a normal distribution for a fat-tailed distribution.

akg_672• 11 years ago

25 SD is exaggeration only for people who believe everything is normal distribution. I will suggest reading Nassim Nicholas Taleb's work specially The Black Swan and Fooled by Randomness.

rvn1045• 11 years ago

It's 25 standard deviations because they only take like a year's data into account. So anything that happens and seems out of the ordinary for that particle date range will show up as 25 standard deviations. If you've read about the LTCM crash, they keep citing absurd standard deviations. Basically they didn't have any historical datasets that they were basing their models off of. It's completey ridiculous that they talk about such absurd numbers.

crdoconnor7• 11 years ago

This is where academic theory comes in. The finance sector damages the economy because it does not function as well as the models contend.

This is rather an understatement. Most neoclassical models (the dominant strain of economics, despite its demonstrated failure to predict crises) basically assume that the financial sector doesn't exist.

This is why most economists' reaction was "nobody could see it coming" and their policy recommendation response to the crisis was "even more of the same, please" (deregulation, desupervision and de-facto decriminalization).

Then they wonder why people don't respect them any more.

"Hope", as such, does not come from the school of behavioral economics. That was getting trendy even before the crisis hit and did not help at all. Personally, I can think of only one economist who is making models that accurately model the behavior of financial institutions in the macro-economy - Steve Keen, who is resurrecting and extending upon Hyman Minsky's instability hypothesis.

TheOtherHobbes• 11 years ago

A lot of "uneducated" people could see 2008 coming. I had many conversations with people with no economic training who were all thinking "Uh oh..."

The rational conclusion from this is that mainstream academic theory - i.e. not people like Keen - is a source of collective stupidity.

See e.g.

http://www.telegraph.co.uk/finance/economics/8089832/We-cant...

When untrained people can predict the future more accurately than trained experts, the training of those experts has negative social value.

ghostberry• 11 years ago

There are always people thinking "Uh oh..."

Sometimes they are right.

Ollinson• 11 years ago

To paraphrase Nobel prize winning economist Paul Samuelson, everyone has predicted 9 of the last 5 recessions.

akg_672• 11 years ago

“HFM: But he’s the expert, right? It’s a tough thing. If you have somebody who’s really trained in the mortgage business, he’s been in the mortgage business for fifteen years, in equilibrium he’ll do a great job. He’ll be able to pick, of the mortgage pools out there, which is the good one, which is the bad one. He did a very good job of that, because the ones that he picked were better than the market. But in terms of detecting the paradigm shift, the guy who’s just buried in the forest…he’s not going to see the big picture, he’s not going to catch the paradigm shift.”

Excerpt From: Anonymous Hedge Fund Manager, n+1and Keith Gessen. “Diary of a Very Bad Year.” HarperCollins, 2010.

TheCowboy• 11 years ago

It depends on people's definition of mainstream academic economists, because in general, there has been strong predictive power in the models they use in how the effects of the financial crisis played out over time. There are surveys of academic economists out there that can back this up.

This in contrast to mainstream people who talk about economics, who have been predicting hyperinflation for years now.

There were many academics who warned that austerity policies would be a drag on the economy for years. There were people in academics warning about a possible housing bubble.

jeffreyrogers• 11 years ago

This is why most economists' reaction was "nobody could see it coming" and their policy recommendation response to the crisis was "even more of the same, please" (deregulation, desupervision and de-facto decriminalization).

The aftermath of the financial crisis seems to have been handled remarkably well though, don't you think? At least in the US the economy is doing fairly well and the deleveraging was handled admirably.

caseysoftware• 11 years ago

I think the metrics are doing well in that unemployment is down, the stock markets are up, and housing prices have mostly stabilized.

Unfortunately, that ignores: - the labor participation rate is dropping steadily.. because long term unemployment is up. - the Fed has pumped $1T (yes, trillion) into the market each of the last 5 (6?) years. - wages have been stagnant and have only now reached 1998 levels. - education - previously a ticket into the middle class and beyond - has been devalued by poor standards but simultaneously the price tag has increased dramatically.

ggchappell• 11 years ago

This seems to be true from a short-term perspective. From a more long-term perspective, factors that led to the crisis have not really been dealt with at all. Dodd-Frank is hardly Glass-Steagall. The revolving door between finance and government is still spinning. Regulatory capture is in full swing.

And that means -- if I might be prophetic for a moment -- that it's all going to happen again.

crdoconnor7• 11 years ago

The aftermath of the financial crisis seems to have been handled remarkably well though, don't you think?

Hell no. It was used as an excuse to shovel money into the pockets of the ultrawealthy.

At least in the US the economy is doing fairly well

By what measure?

Because if you're going to count employment, you should factor out the people who used to have decent middle class jobs and are now scraping by working at walmart.

contingencies• 11 years ago

Original @ http://faculty.chicagobooth.edu/luigi.zingales/papers/resear... includes an interesting list of Fines paid by financial institutions to US enforcement agencies 2012-14.

goodmachine• 11 years ago

Great paper indeed, tackles all players in the problem (financiers, theorists, regulators) unsparingly. Well worth reading.

lscore720• 11 years ago

Awesome, thank you very much for sharing!

huac• 11 years ago

Some of the biggest problems in academia (especially in marketing) now revolve around similar phenomena of 'momentum' or 'clustering.' It's incredibly difficult to predict or model this kind of behavior, and even more difficult to take advantage of these trends. We see the same kind of "well, if we ignore this difficult-to-model process, then the equations look good" in physics, so where's the outcry over the Navier-Stokes theorems?

I don't think you can call this a failure of academics, it seems more like next on a long bucket list of questions to answer.

As an aside -- some of the explanations of M-M and CAPM are wrong, which is straight up first semester finance.

makomk• 11 years ago

Physics has one major advantage over economics - in physics, the system you're modelling is not sentient and actively trying to exploit flaws in your model, whereas we see this time and time again in economics.

cm21872• 11 years ago

I think people like to listen to economists because they see them as some kind of scientists and because when facing uncertainty, most people like someone who confidently predicts the future, whether it is an economist or a fortune teller. The reality is that one can't reduce our complex human societies to an excel formula, and economists are not scientists: they have no way to absolutely prove or refute any theory. They can only express an opinion in which one can believe or or not, and which are most of the time based on a massive over-simplification.

I don't think bubbles need a complex financial system to form (the famous example of the tulips). And a society can sustain any bubble. A bubble only really hurts if it is combined with high leverage, as it was in 1929 and as it was in 2007.

The mechanism by which this leverage is achieved doesn't really matter, it is the over-reliance on debt we should focus on. That people leveraged themselves through mortgages financed by CDO^2, by a shadow banking system (p2p loans) like in China, or by good old banking loans is a technicality.

One can blame the financial industry but the problem is really the addiction of society to leverage. Banks are merely the drug dealer.

I live in the UK and I am always perplex when I see how natural it is for people here to mobilise all their financial resources, bury themselves into debt through all the means possible in order to bid as much as they physically can on a house. And this is encouraged by the government who pushes for 100% LTV loans. And when confronted they always respond "it is fine, the property market only goes up, we just need to get on the ladder". Sure...

Governments are doing exactly the same. The rise of public debt since the 60s should be absolutely alarming. We have reached war time levels of indebtedness. How will this not result in a financial collapse?

One can blame bankers and speculators but I think this is missing the big picture here.

crdoconnor7• 11 years ago

I don't think bubbles need a complex financial system to form (the famous example of the tulips). And a society can sustain any bubble.

The tulip bubble was small and did not have knock on effects for the Dutch economy, and for what it's worth, there was a futures market for tulips in 1637. Complex financial systems are not new.

I live in the UK and I am always perplex when I see how natural it is for people here to mobilise all their financial resources, bury themselves into debt through all the means possible in order to bid as much as they physically can on a house. And this is encouraged by the government who pushes for 100% LTV loans.

Guess who gets the government to push loans on people?

People take loans and buy a house because they're told by those above them that it's "the responsible thing to do". This message is echoed around the media as well.

One can blame bankers and speculators but I think this is missing the big picture here.

No, that is the big picture. They are the ones who benefit from an over-leveraged economy and they are the ones who are pushing for it.

Ordinary people certainly aren't dying to drown themselves in debt, just as they weren't the ones pushing for student loans. In five years time they won't be the ones pushing for the student loan book to be privatized either, but guess what? Someone out there is salivating over it.

walshemj2• 11 years ago

Because they see that paying a similar amount of money to a landlord plus all the extra fees renting requires - is not a sensible use of income/capital

notahacker2• 11 years ago

Ordinary people certainly are the ones pushing for home ownership, for the simple reason that when homes are in a serious shortage, it makes a lot of economic sense to own them if you can commit to the mortgage payments. It's the same reason as people with no connection to the UK whatsoever and piles of their own cash to spend think that London property is a good place to park it.

The government is buying electoral support with Help to Buy schemes and Right to Buy extensions; the fact the banks also like it is incidental.

learnstats22• 11 years ago

Ordinary people are pushing to own their own homes; not only for financial reasons. Rental agreements in the UK greatly favour landlords and typically don't allow you to own a cat or paint your own walls.

Renters have limited security of tenure in a sense which can be very apparent: even if you meet all the conditions of rental, you can be kicked out of your own home when the landlord decides their interests lie elsewhere.

spiritplumber• 11 years ago

If the economy is a power plant, the financial sector is supposed to be its control system.

The problem is that the control system is now using a non-negligible amount of the power generated by the plant.

Most economic models make the basic assumption that this is not the case. This makes them not very useful.

However, they have a lot of social inertia when it comes to getting listened to.

digi_owl5• 11 years ago

Try this instead:

Economy, circulatory system.

Finance, bone marrow.

Htsthbjig• 11 years ago

"BOTH financiers and economists still get the blame for the 2007-2009 financial crisis: the first group for causing it and the second for not predicting it"

Economist worth their name had predicted the crisis and way more. There are good serious economist out there, but do not look for them in the media, including the Economist.

It is economists in the media and power institutions who failed to predict the crisis, on record, because most of them are not as stupid as the look when they talk.

That is, if you get to chat with them personally, you realize they know pretty well what is happening. They have the biggest amount of intelligence resources in the world, and again they use to be very smart. But they can't say what they know in public as a word for them could bankrupt entire nations.

In the inner circles in meetings in Switzerland cities they are really worried about what is happening, but then in public they say everything is ok.

Keynesianism had become the non sense dogma of today economist on media and Universities. If Keynes were alive he would not approve what is being called Keynesianism today, as you can see if you read Keynes.

FeepingCreature3• 11 years ago

If they predicted the crisis, why aren't they rich?

Economics has the remarkable property that if you can see the future coming better than your peers, you can profit off it. So conversely, whenever somebody claims in retrospect that they saw the future coming it should be asked why they didn't profit.

slavik81• 11 years ago

The market can stay irrational longer than you can stay solvent.

Even if you can easily see the inevitable correction coming, it's difficult to say when it will happen. A powder keg still needs a spark to take.

eli_gottlieb• 11 years ago

If they predicted the crisis, why aren't they rich?

Who says they're not?

Nimitz14• 11 years ago

lol

tezza3• 11 years ago

It's convenient to blame the finance peeps. But wrong.

It is a face saving measure by the people actually responsible, namely Pension Funds and Government Policy makers in that order.

Pension Funds were chasing returns... and finance types depend on Pension funding at many levels. Pension funds own 95+ percent of the stockmarket shares overall and in some cases closer to 100%. Shareholders elect the board who appoint the staff. Further Hedge Funds do not hedge their own money exclusively. They sell to outside people, ultimately again mostly coming from Pension Funds.

Government agencies like Alan Greenspan had the option to use their blunt tools to control matters via interest rates and perhaps policy changes. They chose not to do so.

To me it is like a Railway Tycoon shouting "faster faster.." to the train drivers and then blaming the driver of the day when a massive accident happens. Even if the driver is reckless... who hired they guy and gave guidance to ignore the warning signals ??

crdoconnor7• 11 years ago

It's convenient to blame the pension funds. But wrong.

Pension funds only started chasing returns after the crisis.

Why did they do that? Because the government made a policy decision to drop interest rates like a stone.

Why did they do that? Because the too big to fail banks were sitting on a pile of mortgages without sufficient collateral because of a popping bubble that they created and they couldn't withstand the potential onslaught of defaults.

They were exposed and insolvent and in danger of being destroyed unless quick political action was taken.

Fortunately, for them, quick political action was taken and they were saved from facing the consequences of their actions. We had to deal with them instead.

tezza3• 11 years ago

Dude, they've always chased returns... It didn't magically start happening post 2008

The sub funds that Pensions invest in get rewarded according to Alpha... the amount the sub fund exceeded the main stock price movement.

How is that not chasing returns??

http://www.investopedia.com/terms/a/alpha.asp

cm21872• 11 years ago

That's not correct. Spreads before the crisis were at records lows and asset managers had to buy credit they would have preferred not to in order to get a little bit of value. This is really what fuelled the whole subprime story.

davidmr• 11 years ago

Your point in general that public pension funds have investigated in riskier assets over time is correct, but your claim that the 2008 crisis had any significant uptick after the 2008 crisis is quite simply false. Honestly, to make a claim like that and present no data to back it up is... unhelpful

http://www.pewtrusts.org/~/media/Assets/2014/06/PensionInves...

By far, the largest uptick in the shift from low risk bonds to higher risk assets like equities was in the 80s, but it's been happening longer than that. You could make a claim that there has been an increased shift to alternative assets since the crisis, but you didn't, and the uptick isn't massive anyway.

rwmj• 11 years ago

Genuine question for behavioural economists: Has anyone tried to simulate an entire population's financial transactions yet? Computers are surely getting fast enough to simulate millions of people interacting. It would let you do "what if" scenarios without needing an underlying theory (I often suspect the "theories" around macroeconomics are nonsense).

steve19• 11 years ago

that essentially means simulating a populations wants and desires, and the things that drive those wants and desires.... so The Sims with an accounts ledger. if it could be done you can be sure it would not be modeled correctly.

sten• 11 years ago

You're either underestimating social complexity or over estimating computer power. That's the same level of problem as simulating weather.

digi_owl5• 11 years ago

I think the closest you are getting are Steve Keen's work with a new dynamic modelling program called Minsky.

http://www.debtdeflation.com/blogs/minsky/

But frankly trying to model every damn individual is a fools errand. Keen limits himself to "classes", like workers, bankers and business owners.

bawana• 11 years ago

are the comments in that article written by humans or spambots?

lotsofmangos• 11 years ago

In his new book “Misbehaving: The Making of Behavioural Economics”, Richard Thaler uses a different term: econs. He writes that “compared to this fictional world of econs, humans do a lot of misbehaving, and that means that economic models make a lot of bad predictions.”

I wonder if he's been reading "Life among The Econ" by Axel Leijonhufvud. http://www.econ.ucla.edu/alleras/teaching/life_among_the_eco...

PaulHoule4• 11 years ago

Lotsa issues.

If financing (of some kind or another) is available for housing, education or health care, prices go up. In the case of housing nobody saw this as a problem: the house my parents built appreciated 10x before we sold it, and even people who were stuck buying a postage stamp sized house in California for $1M believed they were going to sell it for $5M.

At some point you have to starve the beast, that's the one thing that works.

It is astonishing how much capital is kicking around doing nothing. There is this continuous drumbeat that we can't upgrade rural America to optic fiber for instance, although Apple has the cash to do it and surely it has to be a better investment than negative interest rate bonds.

There are lots of reason why it doesn't happen and it is not that "fiber is too expensive", rather it is that Frontier can make $135 a month already selling me two phone lines and two 1.2 Mbps DSL connections and that Apple has cozy relations with wireless carriers who wouldn't want any competition for their $10 a GB money party.

seanmcdirmid3• 11 years ago

Fiber to non-dense rural locations would almost certainly cost more than you are willing to pay, which is part of the reason you pay that much for the little you are getting now (the other being a lack of competition since the market is too small to support much diversity). There are plenty of bridges to nowhere that we can apply capital too, but they won't be good investments.

PaulHoule4• 11 years ago

If we'd had that attitude 80 years ago there would be no electricity or phone service in rural areas.

So far as the cost, when you consider the effect on property values, income and stuff, the eye-popping numbers for what it costs to wire a house really are not that much, particularly when you realize services can be offered over them for 50+ years.

Often those eye-popping numbers are offered as a bluff by providers who don't want to serve an area. If you work in the IT field, $20,000 to get cable at your house pays itself back and you can put it on your HELOC if you don't have it an cash.

The problem here is not just a lack of competition but it is the competition for capital against bling-bling LTE phones and harvesting old copper wires and other things that make money quicker.

It is generally the case that government redistributes money from urban areas to rural, largely because rural areas subsidize urban areas in other ways. For instance, Silicon Valley would not have the stream of young labor that it has if there weren't places where people could afford to raise children.

prostoalex2• 11 years ago

If financing (of some kind or another) is available for housing, education or health care, prices go up.

But if there's no financing for housing, builders are realistic about their chances of selling something that's that expensive, stop building, and prices go up due to the lack of supply.

pas• 11 years ago

Yes, of course. The technical way is to say that financing pushes the equilibrium price upward. (Because it's just pure inflation, since it's new money created by the bank, and now people have more money to buy houses. The housing market then of course tries to correct, so the price goes up.) What you wrote is a hypothetical overcorrection when financing suddenly stops, the price crashes. (Sound familiar?) And then the supply of new houses reacts eventually, which then sets a new equilibrium.

pcurve• 11 years ago

I think these are symptoms.

I truly believe the root of all of these problems is over investing in financial instruments like equities, which in turn give power to financial industry, economists, and CEOs.

What's wrong with finance

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