Thursday, April 02, 2009

Stiglitz is an Idiot

Ok, I read on Tyler Cowen's blog that using negative words like "idiot" and "moron" increases the number of commenters, and presumably readers. Clearly my favorite flâneur, Nassim Taleb, has climbed the best-seller ranks with this rhetorical style, so, I'll give it a try. I think Stiglitz is intelligent and educated. But he is also incredibly biased in a totally predictable, simple-minded way. This is not a partisan critique, just look at his activity: he gives speeches about once every two days. Guys like that don't have time to look at the detailed data, or derive a fresh view, but rather fit it to their internal templates. They are using their position to 'make a difference', which sounds nice, but it just means you are an amoral, confabulating advocate. Think lawyer.

In that way, he is not thinking when he writes, merely advocating the best case for his big picture idea that markets should be sublimated to government control whenever there is not perfect information (no uncertainty or asymmetric information, ie always). He edited volumes 1-3 of the collected works of Paul Samuelson, with a heavy emphasis on market failures. He loves pointing out scenarios where a market equilibrium is not a Pareto Optimum or vice versa (Pareto Optimum being the idea you can't make anyone better off without making someone worse off, a rather modest definition of optimality). Government failure is not interesting to those obsessed with market failure, a common blind spot in the Marxist tradition (very little in Das Capital outlines how communism actually works, it's mainly a criticism of free markets).

Anyway, in today's NYT he rails against Geithner's plan for several dubious reasons, but fundamentally because it is a subsidy to banks and investors. It isn't clear if his distinction between banks and investors is the difference between management and equity, or equity owners and bond owners. Whatever, his Big Idea is that there is always imperfect information, therefore markets are not optimal, therefore have the politburo control it. Here's the Nobel Prize winning argumentation in block quotes:

Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets.

Where's the data? Bank leverage, as measured by common equity to total assets, did not materially change over the past 15 years for banks. Did you mean "Investment Banks"? That did change, but only for a handful (ie, Citi and Morgan Stanley). It's not true merely because you say it every other day when lecturing as Expert on Everything.
In the process, they used overly complex instruments like collateralized debt obligations.

Derivatives are the tail of the dog. If mortgage prices did not collapse, CDOs would not have collapsed. CDO's facilitated risk transfer, if anything, it prevented a worse crisis by moving the effect of the housing price collapse out of banks and into Hedge Funds and Government (ie Fannie and Freddie). This diversification is generally considered a good thing, but here it is insinuated that it was the fuel for the risk taking. Sorry, the impetus was at the other end, with $5 Trillion in Community Reinvestment Act pledges for investing in 'traditionally underserved communities'--ie, groups previously not lent to because they were bad credit risks. Mortgage innovations like low, and even no, money down, implies the greatest leverage was to the individuals, not the banks.
The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently.
Anytime a bubble collapses we can say this, but this criticism needs more flesh on it. It seems to imply that any payment scheme that is a function of revenue generated, that does not have an infinite clawback provision, encourages excessive risk taking. That's a nice bargaining position for a socialist like Stiglitz. That may seem like a partisan shot, but it's true: he's always for giving the state more control into economic activity, to the point that it always has veto power and generally sets the agenda and mission statement, compensation, etc. His ends dictate, with perfect predictability, his interpretation of events and his prescription for rectifying the situation.
Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.

Partly to be sure. But for commercial banks this was pretty small. The biggest problem was on balance sheet. Look at the data. Look at a regional bank like KeyCorp. Their stock has fallen 75%, and they lost $1B last year. Most of this was an increase in the provision for loan losses on their books. They had $1.25B in credit default swaps at the end of 2008, and noted (page 60 of 10-K) "These swaps did not have a significant effect on Key’s operating results for 2008." Banks, as opposed to Investment Banks, are not primarily hurting because of derivatives. Their exposure would have only been worse without them.

The problems of AIG and Lehman were of taking too much risk in CDOs and credit default swaps, and to this day I have not seen specifics of their balance sheet. That is, until I see what the reference assets for the swaps, I can't assess their actual solvency, or potential for insolvency (and thus a logical run by short-term debt holders). But those problems are not the problems of our banks, 7000 little companies that try to intermediate between savers and investors. Most Commercial Banks are not Investment Banks, their balance sheets are not dominated by marketable securities.

Stiglitz notes the problem of offering banks basically 6:1 leverage, and a 50% match-funding, by looking at the following scenario. Assume there is an asset with a price of $150, that will pay off $200 or $0 next period. A $12 investment by private companies, a $12 match funding by the government, and a $126 senior debt by government. The return on the 'total value' of this transaction is either +33% or -100% [$200 or $0]. Well, with 6:1 leverage and match funding, that means a 208% return in the up state, or a -100% return in the down state. The expected return: 54% {(208-100)/2}. What a deal! Meanwhile, government gets an expected -40% return on 7 times the capital.

A key here seems to be what the prices and returns really are. If you suppose such a bad transaction, clearly, it is a greater subsidy to the private sector. But given the government is trying to fix things without nationalization, presumably a subsidy is a given. The issue is, are these deals this much of a give away? I doubt it. When was the last time a pool of mortgages was worth zero. Geithner's plan refers to pools of mortgages, not mortgage tranches. A tranche of a pool of mortgages can easily go to zero, especially the mezzanine tranches, but the pool itself? If this seems possible to you, you are, well, an idiot.

It seems like you are giving money away, to fat-cats. The problem is, these are mortgages, so they are not 'idiosyncratic risk assets'. You can not buy 100 of them, with a 54% return, and lock in that return. Instead, investing through time, and I doubt any investors are willing to put up large amounts (billions) in investments with a 50% chance of a negative 100% return. Further, the auction method of selling assets implies that even if this were a case of idiosyncratic risk (say, adverse selection made it 50% of these were worth $200, 50% $0), then somehow investors would be colluding to keep the return at these insanely high (54%) levels. Ah, the deals Captains of Industry make in the back rooms. The nice thing about greed is that it implies competition, and competition abhors easy profits the way nature abhors a vacuum.

Stiglitz notes how efficient government is in nationalizing banks. Who's to say how much value was saved, or destroyed, via government's take over of IndyMac (sold at a loss of $9B last January)? But this will only be worse if they take on lots of banks because then their portfolios will be politicized to the n-th degree, as then broader considerations will be in play. Consider that once they took over IndyMac they halted foreclosure on mortgages, leaving zombie properties where 'owners' had no equity in the properties, and bank's could not resell them. That merely added to their losses, and didn't help the little guy, it just delayed the inevitable resale of that property to someone who was a viable homeowner. Do that with 100 IndyMacs and you have really depressed the market, and a larger impact on poor communities that do not need more unowned properties. When the effective owner has no money in the house, it is not maintained, managed, or re-allocated. It just serves as a place for punks to cause trouble. Indeed, the 'owner' of the house in foreclosure limbo has zero incentive to do anything with the property, just wait and pray for hyperinflation (a potential plank II of the Treasury plan).

After the Great Depression, John Kenneth Galbraith wrote 'The Great Crash', and it was a best seller. The thesis was that greed and short-sighted risk taking, especially by corporate executives, caused the Stock market crash, which then caused the Depression. This was the standard perception for decades. Today, I doubt more than 10% of economists think that greed or short-sightedness was a singular, or useful explanation for the 1929 crash and subsequent collapse, or that the Great Depression was caused by the stock market crash.

10 comments:

Anonymous said...

falken, you went off the reservation and don't want to come back.

"a few investment banks"? that's like saying "they only dropped 1 bomb on hiroshima. what impact could THAT possibly have?"

ppip competition? have you read the conditions to get in? that not competition my man.

much to the despair of "money changers" (ring a bell?) it's not proven to be good for the economy. if the public debt increases by only 20pp to gdp (de minimus i know) as a result of this adventure, and assume the "american innovation" is responsible on average for 1% extra growth a year (the other 1% is military) then you have no, nill, zero, zilch grounds to moralize others (um, europeans?) on the benefits of deregulation, because the net result of the last 20 years is 0. (20x1%=20pp i know you got it)

going further, capitalism miracle looks shaky too. every 30 years or so, the foreign lenders must be robbed through various gold schemes, going on/off standards, capital controls, appropiations (sic), and i'm betting money the mother of all reflations this time. all on the basis of winning the last big war, through, arguably, a lucky sequence of events.

it's a shame cuz free markets really make sense on paper, but, as you say, "where's the data?"

you say last decade was not really free markets and i agree. but if humans converge to socialism even under a bush regime with gop congress what's that telling you?

people like to cite socialism in extreme failure cases like russia, but mark my words: hujintao and wen look quite enlightened to me. if they manage to make the switch from fossils to electrons first, and odds are on their side, US style capitalism is T.O.A.S.T. for 1000 years. socialists lucky enough to have the right politburo might be the way to go for the descendants of those vicious chimps we see in zoos.

ps i'm not related to stiglitz in any way and have no idea why he got the nobel for. and you still owe me an answer to my inflation question a while ago.

dan said...

Dude your posts are going downhill, you are starting to sound like Taleb with these nonsense criticisms.


It's an NYT article, you probably need a Phd NOT to understand what Stiglitz is trying to say.

First, by investors he means the 'private investors' who will investing through the program. When he says 'banks' he means the employees, shareholders and debt holders of the bank.

Second, he is using the term 'banks' to refer not only to commercial banks (99% of people in the media also use the term bank rather loosely), but to large financial institutions like Citi, BAC, AIG, Goldman, etc. Btw Goldman and others are now commercial banks, not investment banks. It's an NYT article and he can't spend ten sentences explaining in detail the differences between these financial instutions. Anyone who is not a complete 'idiot' would have understood what he means by these terms. Or do you really think that STiglitz does not know that there 7000 or so commercial banks and most of them are doing OK?

Third, of course he does not think mortgage pools will go to zero. He is illustrating via a simple example how upside optionality will distort prices and cost the government quite a bit of money.

Fourth, wrt leverage you are excluding a number of things that will not show up in balance sheet. Read the former HSBC ceo's analysis on leverage.

Fifth, there is no concrete evidence that shows that CRA exclusively caused the crises. The problem is not contained to subprime and most problems relate 2003+ vintages. It's interesting that you criticize Stiglitz's analysis being colored by ideology yet you have the exact same problem: markets are perfect, government must have caused the problem, let me find bits of evidence consistent with that view.


Sixth, a liquid secondary market for credit can deteriote lending standards, allow for greater leverage and increase systemic risk...

Anonymous said...

As a blog you come highly recommended but for a first time visitor you seem to have started with the premise that stiglitz was wrong and then worked your way into a story/blog from there. You ascribe things to stiglitz that he never said and misrepresent recent history in brutal fashion. In fact at certain points I was sure if you actually read the article, or were alive for the last 15 years. When you exclude Citi, MS and presumably GS from the list of banks that saw their leverage increase I am not sure who your audience is and how stupid they are supposed to be. These were the last of the 'investment banks', who without aid would have gone the way of Bear, LEH and MER. Furthermore to call Stiglitz a socialist because he believes in a more democratic and frankly capitalist plan is inane when in the same diatribe you assume that subsidies are a good way to correct these problems. Frankly if you somehow think socializing losses and subsidies are the best way to keep a capitalist system going, then you sir are the socialist and not stiglitz. Really the socialist nonsense is beneath your reputation and I expect that from Joe the plumber types.

Anonymous said...

Eric, it's working, keep the insults coming and you'll be the next Daily Kos!

Equity Private said...

It is sadly entertaining to me to note that, on the topic of the role of the housing bubble in the present crisis/recession/depression/crash/armageddon, the more reasoned and specific the discourse used, the more mindless and biting the criticism. It is as if so many commentators have so much emotionally and mentally at stake when it comes to the premise that capitalism and "the rich" are somehow the root cause of all the present ills, that the more fact and reason one uses in opposition to this argument the stronger and more hysterical the emotional response becomes. I cannot help but think that this is deeply connected with some displaced hatred of George Bush, Jr., or perhaps some social phenomenon related to this kind of demonizing. (This finally clicked for me when I heard someone in the mainstream media call Tim Geithner a NeoCon apologist). I started off believing that this particular culture war was a fiscal liberal versus fiscal conservative conflict. I am beginning to realize that it is far more sinister than that. We are instead literally entangled in a backlash movement against logic and reason, spurred, I can only guess, by the collapse of three decades of fantasy returns to retail investors. Once viewed in this light it becomes quite simple to see why facts are irrelevant to proponents of the "anti-capitalist" movement. Why "mark-to-unicorn-who-shits-talent-weights-of-gold" is a preferable accounting methodology to mark-to-market. Why the injection of $5 trillion of risk-distorted leverage over the last ten years is ignored or claimed to have no economic impact at all to the sector it was directed at. Why banning short-selling must be the answer. Why more leverage, more government price fixing, more taxes and the largest debt boost since the last ice age seems like a good idea. It is like telling the children it is time to leave Disneyland and go back to school, except the children can vote, storm RBS, vandalize, threaten and kidnap CEOs, and rewrite property law to give the loser in an agreement a "do-over" (provided they are one of the popular kids today).

This is nothing less than a drawn out attack on legal and economic stability because it does not currently favor a mass of spoiled children who are well-armed politically. What alarms me most is that, much like the destruction of the Library of Alexandria, if it it successful, future generations may never even have a concept of what actually happened to destroy the socio-economic system that, even after the present disaster, created and maintained more wealth and human progress in under a century than in the whole of the two hundred centuries before it.

Jim Glass said...

Don't insult lawyers, good ones pay tremendous attention to facts and detail. (Bad ones have to pay attention to facts and detail too, they just can't stomach it so they aren't very good at their jobs.)

You're thinking of PR flacks who have to come up with a new story every day to sell their client's product or agenda.

As for Stiglitz, the last time I paid any real attention to him was when I read his book, "Whither Socialism?" First, who in our time would write a book lamenting the failure of socialism and trying to find a way to lead it back out of the land of the lost?

Beyond that, while everything in it was "market failure ... market failure ... market failure" there wasn't even a hint of a high-school sophomore econ student's understanding of "government failure" -- Stiglitz apparently has never yet heard the words "Coase", or "Buchanan" or "public choice"...

Stiglitz and Samuelson... Coase once said of the differences between him and Samuelson:

"My approach is to compare the alternatives. People like Samuelson like to set up a perfect world and say that the market does not bring us to this point and imply that the government should do something. They stop their analysis at that point."

http://www.reason.com/news/show/30115.html

Samuelson, Stiglitz, Krugman...

Krugman's said several times that he was inspired to become an ecomomist after reading Asimov's "Foundation" series in which Hari Seldon engineered the rise and fall of Galactic Empires, "Hey, I really can engineer a society, if I become an economist!"

I think there's a whole class of economists who enter the profession with that emotional motivation -- a hundred years ago they'd have been old-style socialists or communists out to change the world top-down "for the better". With old-style socialism and communism now being totally disreputed after having been seen in actual practice ... well, they are smart people who've seen that failure ... so they want to learn the modern technical skills required to be effective, and on an doable scale. But their emotions towards society and their objectives are the same.

Of course, other economists have other attitudes...

I don't think anyone's yet publicly kissed off Stiglitz better than Ken Rogoff in his open letter to the man.

Anonymous said...

unfortunately for frustrated female bloggers, writing in pompous syntaxes does not equal reason/focus.

'fact and focus' is the debt/gdp will be higher than ww2 levels. is that a century of wealth created?

oh, you say, "it's just a twitch. an accident. this was not supposed to happen. this is not the capitalism i know". well, the socialists have the same arguments. it was not supposed to create misery. it was the foreign agencies who did it.

it seems the capitalist utopia is worse than socialist utopia.

first anon

Anonymous said...

"very little in Das Capital outlines how communism actually works, it's mainly a criticism of free markets".

Call me picky, but it's subtitled "a critique of political economy". So your criticism is a bit like rubbishing the manual for your new TV for not telling you how to get to Hull.

Pickier still, it's "Das Kapital" in German or "Capital" in the English translation.

I'm detecting a slight lack of familiarity with the tome, Herr Doktor...

Eric Falkenstein said...

First, I want to apologize for calling Stiglitz an Idiot. As an experiment in polemics, I feel a little dirty.

But Jim, great links! And i think its funny how definitive Stiglitz and Samuelson's market suboptimality problems are, as if a selfless omniscient social planner is available.

Point taken on Das Kapital. I should have said 'collected works' of KM.

Equity Private said...

Well, "first anon," you've managed to illuminate several of my points rather adroitly. I'm half expecting future comments to accuse you of being in my employ. For example:

1. You didn't even manage three words before resorting to argumentum ad hominem and of the fourteen words in that wonderfully ironic and grammatically challenged first sentence fully four are dedicated entirely to insult.

2. You make the rather embarrassing blunder of attributing historically high debt/gdp levels (the result of runaway entitlement and military spending by government) to the free market. Oops. The fact that the debt/gdp ratio is not substantially higher is a consequence of the significant gains in GDP over the last several decades. Social Security and the other bloated entitlement programs that currently dominate the currency black hole we call a budget are as massive as they are precisely because fantastic growth made that possible.

3. You attribute to me positions I do not hold, to wit: The current balloon of federal debt was no accident. No "twitch." It was the deliberate and methodical mortgaging of future cashflows time and time again to buy the political class votes today and pass the bill to future generations. Insofar as this was design (and one need only occasionally read the Congressional Record to settle that question) there is nothing accidental about it.

4. You then try to wrap all this up in the flag of "capitalist utopia" and burn it by association with "socialist utopia."

5. Your entire discourse engages but a single fact (which you only reference obliquely and, tellingly, provide no citation for) and somehow you even managed to fuck that up. You state: "'fact and focus' is the debt/gdp will be higher than ww2 levels." This is almost certainly false unless you get very creative with the numbers and you look out beyond 2015- well past the point where the current crisis and not continual bloated entitlement spending (read: central planning) can be blamed. The President's budget has Gross Federal Debt as a percentage of GDP peaking in 2010 at 69.4%. You only need to go back to 1955 to match that ratio with 69.5%. Now, if you are a skeptic, you can hop on the CBO figures instead. Those have "Debt held by the public" peaking in 2019 at 82.4% (peaking because they stop forecasting at this point). You need only go back as far as 1950-1951 to match that figure. Pretty much the only people for whom World War II was still being fought at that point were Japanese stragglers in the Pacific. Of course, and not surprisingly, you didn't specify which debt figure you meant exactly, but none of these are "higher than ww2 levels." Perhaps you could construct a Gross Federal Debt figure from the CBO numbers that hits 100ish, but you still aren't topping 1946 and, again, you are all the way out to 2019.

In short, you would have captured rather significant efficiencies if you had simply stayed in bed yesterday instead of typing here.