Wednesday, March 26, 2008

Martin Wolf on Alan Greenspan

One of my favorite blogs is Martin Wolf's on the Financial Times. Wolf is the author of Why Globalization Works. What makes his blog so interesting is that he doesn't merely write about economic issues, he also induces other prominent economists to respond. It's the dialog (and disagreement) that makes it interesting. Occasionally he has another economist a blog post (or an editorial in the print edition of the FT), and he and his fellow economists respond. That's what happened on March 16, when Alan Greenspan wrote about the mortgage crisis.

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes – those belonging to builders and investors – have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will stabilise remains problematic.

Good start I guess. He acknowledges the problem and doesn't merely lay the blame on subprime mortgages, as many commentators continue to do by referring to it as a "subprime crisis." Then he moves into risk.

The crisis will leave many casualties. Particularly hard hit will be much of today’s financial risk-valuation system, significant parts of which failed under stress. Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance.

After all, counterparty surveillance and financial self-regulation worked just super this time.

Credit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems – and the models at their core – were supposed to guard against outsized losses. How did we go so wrong?

[...]

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

[...]

Negative correlations among asset classes, so evident during an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk/reward trade-offs through diversification.

If we could adequately model each phase of the cycle separately and divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. One difficult problem is that much of the dubious financial-market behaviour that chronically emerges during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share.

OK, so first he says our risk management models are wrong and need to be improved, but then he turns around and says that firms are acting badly and taking too much risk not because of bad models, but because they will be punished by investors if they don't grow as fast as their competitors, creating a kind of feedback loop of ever increasing risk-taking. Which is it, Alan? Make up your mind!

But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling – the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve. Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioural responses as non-rational. But forecasters’ concerns should be not whether human response is rational or irrational, only that it is observable and systematic.

So here he seems to be saying that models need to take into account investors' and firms' self-reinforcing irrationality--a statement that is as banal and self-evident as it is unhelpful. And he concludes this editorial with a ringing endorsement for reform, as long as it is totally meaningless and doesn't actually place financial institutions under any additional regulation.

Now what was great about this editorial was not the editorial--which was weak tea--but the responses from many other economists. Anger and stunned disbelief. Obviously you'd expect that from liberal economists like Brad DeLong (whose response, ironically, was rather more polite and prescriptive than Greenspan deserved), but from most of them, you got outrage that Greenspan failed to acknowledge the Fed's own enabling role in this crisis--or, indeed, his own boosterism of the housing bubble when housing prices were still going up.

Even Martin Wolf himself, who I take to be a more right-leaning economist, is pretty stunned by Greenspan's avoidance of his own culpability. Wolf also berates Greenspan for overlooking "overwhelming evidence of malfeasance and gross incompetence in the chain of agents, from mortgage origination to the ultimate holders, including rating agencies, banks, investment banks, and so forth. This is not just about poor risk management. It is far worse than that. This was a huge failure of regulation." It's really worth your time to read Wolf's entire response ("I would like to add nine points...") Wolf is very civilized, but I can visualize him shaking Greenspan by the lapels and screaming at him--"And, fifth, Alan, fifth, the case for treating huge asset price surges as prima facie indicators of excessively loose monetary policy is also overwhelming!!!!"

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