Keynes-Hayek Smackdown

Here's a new video from Russ Roberts explaining the differences between the ideas of J.M. Keynes and F.A. Hayek... in a manner the kids can understand.

Zombie Economics (John Quiggin)

Economist John Quiggin has a new book (in progress) entitled Zombie Economics. Now, don't think its about a microeconomic analysis of the undead's behavior or the costs and benefits of eating brains. Rather,

Before the global financial crisis ideas like the Efficient Markets Hypothesis and the Great Moderation were very much alive. Their advocates dominated mainstream economics and their influence, acknowledged or not, guided the thinking of the practical men and women whose decisions created a financial system in which tens of trillions of dollars of interlinked obligations were built on a foundation of speculative, or entirely spurious investments, and a global economy in which both households and nations lived far beyond their means.

Today these ideas appear to be defunct. Commentators who were proclaiming, a year or two ago, that the business cycle had been tamed, and replaced by a Great Moderation in economic activity, have admitted their error or, more commonly, moved on to talk of other things. The claim that financial markets make the best possible use of economic information, and can never be subject to irrational bubbles, is rarely made, and usually hedged with all kinds of qualifications and escape clauses.

But habits of mind and thought are hard to change, especially when there is no ready-made alternative. The ideas that brought the global financial system to the brink of meltdown, and have already caused thousands of firms to fail and cost millions of workers their jobs, still underlie the thinking of those who are trying to respond to the crisis and, to a large extent, of the commentators and analysts who assess those responses. These ideas are neither alive nor dead; rather, they are undead, or zombie ideas. Hence the title of this book.

Its worth reading. His analysis and the resulting implications of the efficient market hypothesis (and other theories) are insightful and well-written.

Alberta Puts Forth New Rules for Pay Day Loans

I wrote previously about the ways in which pay-day loans result in individuals paying more for financial services. Now Alberta has put forth a new set of rule for pay-day lenders. Some highlights:

Starting in September, businesses will be prohibited from charging more than $23 in fees and interest for each $100 borrowed.

Giving customers a two-day cooling-off period in which they can return the money and cancel the loan without paying any costs.

Ordering companies to use plain language in contracts.

Requiring them to post their costs prominently in outlets.

Rollover loans — where people with more than one loan pay extra charges — will be banned.

The province will also license any companies that wish to operate in Alberta.

Robert Engel on Volatility

Robert Engel has a new article in the Financial Times on volatility in financial markets. The crux is on what determines volatility and what we can expect in the current crisis:

Volatility is not yet back to normal primarily because macroeconomic uncertainty is not yet resolved. When the end of the recession becomes more predictable and the recovery is in sight without excessive inflation fears, then volatility should finally return to its normal level just below 20 per cent.

Canadain Versus U.S. Banking Systems

Canadian banks have weathered the current economic crisis much better than their U.S. counterparts. Nick Rowe has suggests the following:

But it doesn’t seem to be as simple as “Canadian banks are more tightly-regulated”.

1. We never had restrictions on interstate banking, so Canadian banks spread their assets and liabilities across Canada. (So it doesn’t matter if a local housing market goes bust).

2. We don’t have Glass-Steagal. The investment banks joined the retail banks some years ago.

3. We don’t have mortgage interest deductibility from taxes. So paying down your mortgage is a tax-free investment. So most people want to pay down their mortgages.

4. (Except in Alberta), mortgages are fully recourse. You can’t just walk away from a negative equity home and hand the keys to the bank; the bank will come after you for the difference.

I wouldn’t describe those differences as “Canada is more regulated”.

But we do have higher capital requirements. And mortgages over 80% must be insured (mostly by the government-owned CMHC).

For more information, see the direct blog post here and the discussion here.

Robert Merton on the Science of Finance

Here's a video of a lecture given by Robert Merton entitled "Observations on the Science of Finance in the Practice of Finance." This is part of the video series put out by MIT.

Career Advice from Obama and Bernanke

Here's something from the Wall Street Journal blog that undergraduates may want to consider, particularly those in business schools at their respective universities:

Both President Barack Obama and Federal Reserve Chairman Ben Bernanke talked Tuesday about the recent attraction of finance as a profession for some of the nation’s brightest young people.

Obama, speaking at Georgetown University in Washington, D.C., appeared to welcome the changing economy that means fewer people will be going into Wall Street jobs: “One of the changes that I would like to see — and I’m going to be talking about in this in weeks to come — is seeing our best and our brightest commit themselves to making things — engineers, scientists, innovators. For so long, we have placed at the top of our pinnacle folks who can manipulate numbers and engage in complex financial calculations. And — and that’s good. We need some of that. But you know what we can really use is some more scientists and some more engineers who are building and making things that we can export to other countries.”

At Morehouse College in Atlanta, Bernanke was asked by a panel of students about job prospects in finance. He answered by emphasizing the value of finance to an economy, mentioning, for instance, venture capital, but made clear that he thought too many recent graduates were lured to Wall Street by outsized salaries.

“It’s clear that some of the compensation and some of the risk taking was excessive and as we go forward there’s going to be a more vigilant regulatory system to make sure compensation systems don’t incentive risky behavior,” he said. “I think that in one way this is healthy…People ought to go into a profession based on what they enjoy” as well as what is valuable to them and valuable to society, he added, urging the students not to seek only “the highest possible income.”

”I’m not saying that smart people, talented people shouldn’t go into finance,” Bernanke said, “but you ought to follow your interest and the direction that you think will give you the most personal satisfaction.”

Economics Photo of the Week (March 23)

I'm out of town next week so I thought I would make this post a little early. This is a photo of Eugene R. Black Sr. (and his wife). Black was president of the World Bank from 1949-1963 and head of the Brookings Institution from 1963-1968. Black is known for his writings on economic prosperity being a prerequisite for political freedom.

His father (also named Eugene Black) was a governor of the Federal Reserve Bank of Atlanta and head of the Board of Governors in 1933 during the Great Depression. While in Atlanta, he was known for having provided easy and fast credit to banks experiencing bank runs. This is largely thought to have kept these banks open.

More on Music and Economics

I've written on the subject (I guess), but here's a new piece for those building a portfolio of papers on music and economics.

Music and the Market: Song and Stock Volatility

Abstract:
I compare the annual average beat variance of the songs in the US Billboard Top 100 since its inception in 1958 through 2007 to the standard deviation of returns of the S&P 500 for the same year and find that they are significantly negatively correlated. With the recent high stock volatility, people should now prefer less volatile music. Furthermore, the beat variance appears able to predict future market volatility, producing 2.5 volatility points of profit per year on average.

Keywords: music, trading strategy, billboard, variance, volatility

Arrow on the Financial Crisis

I'm currently teaching Arrow's work on risk and uncertainty in a graduate course. Here's an editorial from the Guardian by Kenneth Arrow, winner of the 1972 Nobel prize in economics and truly one of the ground-breakers in modern economics. Here's he provides his insights on the current financial crisis.

The current financial crisis, the loss of asset values, the refusal to extend normally-given credit and the great increase in defaults on obligations ranging from individual mortgages to the debts of great investment banks presents, of course, a pressing challenge to the fiscal authorities and central banks to take measures to minimise the consequences. But they also present a challenge to standard economic theory, a challenge all the more important since the development of policies to prevent future financial crises will depend on a deeper understanding of the processes at work.

That economic decisions are made without certain knowledge of the consequences is pretty self-evident. But, although many economists were aware of this elementary fact, there was no systematic analysis of economic uncertainty until about 1950. There have been two developments in the economic theory of uncertainty in the last 60 years, which have had opposite implications for the radical changes in the financial system. One has made explicit and understandable a long tradition that spreading risks among many bearers improves the functioning of the economy. The second is that there are large differences of information among market participants and that these differences are not well handled by market forces. The first point of view tends to argue for the expansion of markets, the second for recognising that they may fail to exist and, if they do come into being, may fail to work for the benefit of the general economic situation.

The value of spreading risks has, of course, been recognized as the basis of conventional insurance as well as the issue of company shares that spread corporate risks widely. The central element of standard economic analysis since the 1870s has been the concept of general economic equilibrium, which, under competitive conditions, leads to an optimal allocation of resources. In the 1950s, it was shown how to incorporate uncertainty into general equilibrium, which suggests, at least, that increasing the number and coverage of risk-bearing instruments would improve the running of the economy. Not only would risks be more efficiently borne, but, more importantly, additional socially valuable risky enterprises would be undertaken. Research showed how derivative securities should be priced, how individuals should choose portfolios to minimise their variability, and how individual contracts, such as mortgages, could be bundled so as to distribute the risks for different parts of the market with different risk tolerances.

The second strand of analysis was a growing recognition of the importance of information in governing reactions to uncertainties. If individuals in the market have different degrees of information, the ability to create securities or engage in other forms of contracts becomes limited; the less informed understand that the more informed will take advantage and react accordingly. This situation was long recognized by insurance companies under such terms as, "moral hazard" (when the insurer cannot tell how well the insured is avoiding risks) and "adverse selection" (when the insurer cannot distinguish among differentially risky insured, so that, at any given premium, the more risky insure themselves most extensively). Economists began to realise that "asymmetric" information was the key to understanding the limits of health insurance and the incentive problems of socialism and then that these concepts found their most important application in financial markets, precisely in the complex securities that the first strand of analysis had called for.

There is obviously much more to the full understanding of the current financial crisis, but the root is this conflict between the genuine social value of increased variety and spread of risk-bearing securities and the limits imposed by the growing difficulty of understanding the underlying risks imposed by growing complexity.

Understanding the Financial Crisis in the U.S.

I've been asked by a number of people about the current financial crisis in the U.S. I've been struggling to find a simple way to explain it, but now have some resources.

First, Roger Congleton has put together a good set of notes explaining the credit crisis. (HT to Tyler Cowen)

Secondly, Joesph Stiglitz was on Democracy Now today (October 2nd). He gave an easy to understand presentation of the crisis, its causes, and its relation to the current war in Iraq.

Washington Mutual

Here's ago, my wife and set up our first joint bank account with Washington Mutual in Sacramento California. Now that bank is on the verge of failure and federal take-over in the states. This would be (in nominal terms at least) the larges bank failure in U.S. history and will have effects across the entire economy.

We still have $209.34 in our account. I hope it's safe.