The Economist’s article on the state of economics is rather good. But there’s one good point it makes which needs developing, namely its criticism of modern macroeconomics for having “too little interest in the inner workings of the financial system.”
This failure, though, is part of a wider and longer omission - it is not a mere quirk of DSGE models. Macroeconomics has traditionally ignored the inner workings of all companies. It has seen non-financial firms as mere production functions, transforming inputs into output in a stable (and smoothly differentiable) way. Regarding banks as black boxes for converting savings into loans is a natural consequence of paying insufficient heed to institutions.
However, we can only understand this crisis by looking inside the black boxes. We can do so from two perspectives.
One is the Austrian angle, which stresses the role of entrepreneurship, of discontinuous innovation. But this played a crucial role in the crisis. Banks used new mortgage derivatives as collateral to raise wholesale funds. This had the effect - we now know! - of increasing the riskiness of that funding. Macroeconomists’ natural tendency to assume stable production functions distracted them (us) from the consequences of this innovation.
The second perspective is that of principal-agent problems.
It is only in this context that criticisms about banks’ handling of risk makes sense. Intellectually, everyone has known about tail risk, correlation risk, liquidity risk and counterparty risk for years; the crash of 1987 and the collapse of LTCM in 1998 taught us all about them.
The problem is, though, that agency problems within banks militated against understanding these risks.
For example, who is most likely to keep his job as risk manager - the guy who tells his board “our value at risk today is £112.5m” or the guy who says “we dunno the default risk on our CDOs because we haven’t enough data. It’s really hard to quantify correlation risk or counterparty risk and the maths of non-Gaussian copulas is really tricky”?
The fact is that people in power very often want precise answers, not true ones - especially when it‘s only other people‘s money they are managing. Offering precision rather than truth is therefore a trick one can use to climb up the greasy pole.
Or take another example. Which trader is going to get more capital and more autonomy from his bosses - the one who says “these assets are mis-priced: we can make a fortune here”, or the one who says: “these look cheap, but they carry all sorts of liquidity, tail, correlation and counterparty risks”?
It’s agency problems, then, that help us understand why banks behaved as if they were really moronic.
Again, mainstream macro’s “black box” mentality led it astray. Economists listened to Taleb railing against the risk management and said - rightly - “no-one’s that stupid.” But they (we) failed to consider that institutions can be structured so as to filter out intelligence.
In other words, macroeconomics failed in this crisis because it has for ages under-rated the importance of the stuff we (might) learn in industrial organization classes.
Herein, though, lies a quirk of history. There’s one significant figure who cautioned against this error - Marx. In Capital (ch 6) he criticized orthodox economists for ignoring “the hidden abode of production.”
But mainstream economists - including Keynes - ignored him. They did so, in large part, because they were not especially interested in Marx’s question of how income was distributed between profits and wages.
So, could it be that a by-product of a lack of interest in this question has been “black box” thinking that’s proven very costly for mainstream economics? The amazing thing is that macroeconomics managed so well for so long with this omission.
This failure, though, is part of a wider and longer omission - it is not a mere quirk of DSGE models. Macroeconomics has traditionally ignored the inner workings of all companies. It has seen non-financial firms as mere production functions, transforming inputs into output in a stable (and smoothly differentiable) way. Regarding banks as black boxes for converting savings into loans is a natural consequence of paying insufficient heed to institutions.
However, we can only understand this crisis by looking inside the black boxes. We can do so from two perspectives.
One is the Austrian angle, which stresses the role of entrepreneurship, of discontinuous innovation. But this played a crucial role in the crisis. Banks used new mortgage derivatives as collateral to raise wholesale funds. This had the effect - we now know! - of increasing the riskiness of that funding. Macroeconomists’ natural tendency to assume stable production functions distracted them (us) from the consequences of this innovation.
The second perspective is that of principal-agent problems.
It is only in this context that criticisms about banks’ handling of risk makes sense. Intellectually, everyone has known about tail risk, correlation risk, liquidity risk and counterparty risk for years; the crash of 1987 and the collapse of LTCM in 1998 taught us all about them.
The problem is, though, that agency problems within banks militated against understanding these risks.
For example, who is most likely to keep his job as risk manager - the guy who tells his board “our value at risk today is £112.5m” or the guy who says “we dunno the default risk on our CDOs because we haven’t enough data. It’s really hard to quantify correlation risk or counterparty risk and the maths of non-Gaussian copulas is really tricky”?
The fact is that people in power very often want precise answers, not true ones - especially when it‘s only other people‘s money they are managing. Offering precision rather than truth is therefore a trick one can use to climb up the greasy pole.
Or take another example. Which trader is going to get more capital and more autonomy from his bosses - the one who says “these assets are mis-priced: we can make a fortune here”, or the one who says: “these look cheap, but they carry all sorts of liquidity, tail, correlation and counterparty risks”?
It’s agency problems, then, that help us understand why banks behaved as if they were really moronic.
Again, mainstream macro’s “black box” mentality led it astray. Economists listened to Taleb railing against the risk management and said - rightly - “no-one’s that stupid.” But they (we) failed to consider that institutions can be structured so as to filter out intelligence.
In other words, macroeconomics failed in this crisis because it has for ages under-rated the importance of the stuff we (might) learn in industrial organization classes.
Herein, though, lies a quirk of history. There’s one significant figure who cautioned against this error - Marx. In Capital (ch 6) he criticized orthodox economists for ignoring “the hidden abode of production.”
But mainstream economists - including Keynes - ignored him. They did so, in large part, because they were not especially interested in Marx’s question of how income was distributed between profits and wages.
So, could it be that a by-product of a lack of interest in this question has been “black box” thinking that’s proven very costly for mainstream economics? The amazing thing is that macroeconomics managed so well for so long with this omission.
trivial point, but some blank lines between paragraphs would help me read. and they're free.
Posted by: o | July 19, 2009 at 01:23 PM
The best person I have ever heard on finance and organisations has been a little published man called John Darlington.
I have yet to hear anything useful from economists on economies of flow and systems thinking. John Darlington and John Seddon come the closest.
See the implications of systems thinking in public sector organisations and then rethink your financial and economic models!
http://www.thesystemsthinkingreview.co.uk/
Also check out Ecomomies of Scale: It's a myth! (available on ITunes - the systems thinking review as a video podcast.
Posted by: [email protected] | July 19, 2009 at 02:32 PM
"But they (we) failed to consider that institutions can be structured so as to filter out intelligence."
Was the FSA one of those institutions?
Posted by: ad | July 19, 2009 at 05:25 PM
One is the Austrian angle, which stresses the role of entrepreneurship, of discontinuous innovation. But this played a crucial role in the crisis.
How? Banks using new mortgage derivatives as collateral is hardly entrepeneurship, as meant by the Austrian school. It's arrogance.
Posted by: jameshigham | July 20, 2009 at 09:22 AM
Yes. As ever, it all depends on what kinds of question you are trying to answer - the black box approach might be OK for some macro questions, but some of the questions macroeconomists should have been tackling do require the opening of black boxes, I agree. Broadly speaking, one of these questions was "what are the sources of the 'shocks' that cause recessions?".
You write that macroeconomics has been led astray, and the accusation that macro was looking in the wrong places, (possibly) constrained by methodological blinkers, obviously has weight. However, I can't help doubting that some of its critics are as familiar with the last decade of macroeconomic research as they think they are. For example, one black box to open might be to replace "expectations are always correct" behavior with rule-of-thumb "learning" by economic agents, which can lead to herd behavior etc. There's a chapter on learning dynamics in the mainstream bible Handbook of Macroeconomics (1999). And a Shiller chapter on irrational behavior. Perhaps the failure lay more in not having got these ideas into the mainstream, and not having transmitted them to policymakers.
What is it that with retrospect we wish macroeconomists had warned us of? If the standard macro model in 2005 had been one of endogenous booms & busts, housing price bubbles etc., would the existence of a "deflate bubbles" macro policy have been sufficient to dodge the crisis?. Would such a macro model have warned us that falling housing prices would cause the financial system to implode? What would have stopped the banks tying themselves up in knots? I don't know.
In some respects bickering over who should have done what is academic in the bad sense - the big picture is that "economics" didn't prevent the crisis (although it's just as well to think clearly about who to blame for what). With the benefit of hindsight, if "the system" (regulatory or otherwise) had taken on board the lessons of principal-agent problems, and really understood how the actions of banks can cause the build up of systemic risk, how in hindsight do you we think that could have been achieved? Why didn't the all the economists who study principal-agent problems ensure policy makers listened to them, for instance?
And while everybody is giving macroeconomists a good kicking, wasn't there a group of people who specialise in the black box of financial markets ... "Financial Economists"? Everybody is focused on narrow risk modeling, but didn't financial economists also study herd behaviour, principal-agent problems, and systemic risk? I'm not familiar with that field, but I know some financial economists were worried about the stability of the system (as in that oft quoted 2005 speech by Rajan).
Previously when making such arguments I have been accused of trying to divert the discussion onto obscure theoretical controversies; on the contrary, I think it's weird how 'economics' has been reduced to 'DSGE + Gaussian copulas'. There's a lot more to economics than that, and a lot more to the story of how we came to be in this situation.
Incidentally, if you are interested in opening the black box of production, you could look at Ricardo Caballero's work on relationship specificity between factors of production, which addresses some of the short comings you mention. Journals like the AER and QJE have been publishing that stuff since the mid-nineties. The now mainstream approach to income distribution of "bargaining over match surplus" in presence of frictions is one I think Marx might have liked, too.
[It's an interesting side question - if somebody asserts "the problem with economics is that it ignores X", how many citations of economists writing about X does it take to change somebody's mind?]
Posted by: Luis Enrique | July 20, 2009 at 11:26 AM
Yes, but even without the micro insights, macro should have seen it coming:
http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf
(From Steve Kenns blog -)
http://www.debtdeflation.com/blogs/2009/07/15/no-one-saw-this-coming-balderdash
Posted by: reason | July 21, 2009 at 09:37 AM
reason,
seen what coming?
1. a recession
2. a recession caused by unwinding of global macroeconomic unbalances
3. a recession caused by falling house prices
4. a recession caused by "too much debt"
5. the implosion of the global financial system caused by banks having got themselves in a position whereby something as commonplace as falling house prices could start a sequence of events that wipes out all their capital and more.
I'm not sure how much credit you get for 1-4. All of those were reasonable positions to hold, but at the same time, during "good times" forecasting "bad times" ahead is always a reasonable bet and at any point in time a reasonable group of people are always forecasting it. A great many people saw 2, 3 & 4 on the horizon, including lots of macroeconomists (mainly 2 some 3).
Posted by: Luis Enrique | July 21, 2009 at 11:55 AM
Since my days as an undergrad I have wondered how the concept of operating leverage and the supply part of a S&D curve could exist in the same building. The black box is often desirous of selling more units evan at a lower price per unit(increased ROI), thus giving the supply curve the same downward shape as the demand curve. Additionally, the black box's sr. mangement would rather manage a company twice as big in sales with half the profit margin %(same ROI in both cases, but way closer to a private jet in the bigger sales case.) I always thought it would all get too interdepartmental for anyone trying to bridge the gaps between household behavior (property of the Marketing dept.), company behavior (property of the Finance dept.), and macro-econ's tools.
Posted by: Frank the sales forecaster | July 21, 2009 at 04:49 PM
Refreshing thoughts. Getting your take on it has really given me some insight I didn’t have before.
Posted by: Peter Luke | July 29, 2009 at 02:17 AM
And a lot of it reflects a switch from bank deposits to securities; foreigners “other investments” in the UK, http://www.watchgy.com/ mostly bank deposits, fell by £143.2bn in Q1. And of course there’s no guarantee such buying will continue.
http://www.watchgy.com/tag-heuer-c-24.html
http://www.watchgy.com/rolex-submariner-c-8.html
Posted by: rolex submariner | December 27, 2009 at 04:57 PM