Tuesday, November 03, 2009

Geanakoplos' Theory is No Paradigm Shift

The WSJ has a Malcom Gladwellesque article on John Geanakoplos as an iconoclastic genius who topples staid conventional wisdom. These are popular because we like the idea, but alas, what makes for a good read is often not true, not that most readers really care (who goes back to check which alarmist Time Magazine cover stories turn out accurate?).

A good way to assess someone's philosophy is to see what it implies. If you read John Geanakoplos's "Solving the Present Crisis" paper, we see the following insights and proposals:

First, he notes financial crises are typified by periods of easy lending, followed by periods of hard lending. The boom is manifested by easier terms (less collateral required for the lender as a percentage of the loan amount) and lower rates. This is hardly revolutionary. There would have to be some greater specificity on that mechanism to be useful.

The fact that banks offer greater leniency via two factors--the loan rate, and the amount of collateral required--is not really that radical. Many goods and services are multidimensional, such as when coffee is served in a nice cup or with free half&half. If you then say, if you give more leverage to 'natural buyers', they will push equilibrium prices above their 'true value', you need some metric of identifying this deviation ex ante. Everyone knows all things housing related pre 2007 were overpriced, and I don't remember Geanakoplos ringing the bell that some metric of overpricing was happening in real time. I don't see any metric here one can use to identify these situations, which makes sense because it implies an absence of arbitrage (there are no  $20 bills on the ground).

But consider his solution to our crisis last year, his paper had three prongs.

1) Put a floor under housing prices.

His mechanism is unimportant, but highlights he is a true macroeconomist: he looks at aggregate prices, not relative prices. The problem, he notes, is that too much lending for housing occurred, so I don't see how keeping prices out of line fixes anything but the symptom, and delays the inevitable adjustment.

2) Provide easier lending for mortgage backed securities.

I don't have a problem with this. As I argued in the April about the PPIP Treasury plan that Stiglitz said was a massive give-away, but was eventually shelved for a total lack of interest: if you allow modest financing, the 'put option' you write is not so valuable, and so it is not a give-away. But, given all the extra obligations that come with having Uncle Sam as your investing partner, it probably is not worth it. The plan won't help, but it won't hurt.

3) Put equity into financial organizations, and have the government get involved in management decisions, and getting banks to lend more.

This is a disaster. Look at which financial institutions are pegged to have the largest losses: Fannie and Freddie. They have the dual objective of doing good, as defined by politicians, and making money. Those objectives don't work well together. Note how once they took over IndyMac they immediately stopped foreclosure, a classic populist approach to banking that is not viable long term.

For what is presented as a new paradigm, it sounds a lot like a standard Democratic talking points on the crisis. Not that this is necessarily bad, just that there's nothing really interesting there that's new or clever.


Anonymous said...

A floor under housing prices assures that most people will be priced out of a home without a huge loan. So far as I can see the whole thing is a scheme to keep people surfs working to pay off debt on massively inflated home values.. payments made to banks that have almost zero cost of capital that has never been truly earned and does not represent accumulated wealth, all backed... All backed by the state to favor certain groups over others. Macro Economists are the witch doctors of our age.

Anonymous said...

NB this footnote:

“The reader should know that I am also a Partner in the hedge fund Ellington Capital Management, which trades primarily in mortgage securities.”

Anonymous said...

Geanakoplos is not a macroeconomist. He's a hard-core mathematical GE theorist (check out his cv sometime). Now obviously in the real world everyone knows that interest rates and collateral matters, but in academia you would have been hard pressed to find any theoretical model of collateral and default at all. In macro models - well, in most cases, borrowing and lending don't even take place, to say nothing of defaults.

So from a strictly academia inside-baseball point of view, yes, this could actually be a big shift.

Eric Falkenstein said...

A GE theorist who recommends targeting one relative price, with little mention about the indirect effects on total welfare, strikes me as someone who has had a very parochial focus within GE theory.

Anonymous said...

A foolish economist espouses what basic econ refutes ... the media then declares them a genius and stupidity is institutionalized

The Rioja Kid said...

I don't see any metric here one can use to identify these situations

the rental yield? (specifically, the spread between the rental yield and the average cost of financing - when this turns negative, a real estate project has become "speculative" in Minsky's sense, and when the negative spread is greater than the collateral margin, the project is "ponzi" in that the monthly rental payment does not cover the interest cost).