Lessons from the financial crisis

 (was “Financial crisis and policy”) Regulation 32(4), 34-37. The financial crisis is mainly about too big to fail expectations. The only way out is to limit the government’s authority to bail out. Article based on a talk given at Cato, Nov 6, NY.

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Resolution Authority

This is a very short article on the “systemic resolution authority.” It’s based on testimony I gave to the House Financial Services committee. No surprise, I’m not a big fan of unlimited power and budgets and no rules.

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Portfolio Formation in the new Financial World

October 6, 8 2009. Slides for a talk on new ideas in portfolio theory.

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How did Paul Krugman get it so Wrong?

September 16 2009 

Many friends and colleagues have asked me what I think of Paul Krugman’s New York Times Magazine article, “How did Economists get it so wrong?”

Most of all, it’s sad. Imagine this weren’t economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong.  Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses.  If a scientist, he might be an AIDS-HIV disbeliever, a creationist, a stalwart that maybe continents don’t move after all.

It gets worse. Krugman hints at dark conspiracies, claiming “dissenters are marginalized.” Most of the article is just a calumnious personal attack on an ever-growing enemies list, which now includes “new Keynesians” such as Olivier Blanchard and Greg Mankiw.  Rather than source professional writing, he plays gotcha with out-of-context second-hand quotes from media interviews. He makes stuff up, boldly putting words in people’s mouths that run contrary to their written opinions.  Even this isn’t enough: he adds cartoons to try to make his “enemies” look silly, and puts them in false and embarrassing situations.  He accuses us of adopting ideas for pay, selling out for “sabbaticals at the Hoover institution” and fat “Wall street paychecks.” It sounds a bit paranoid.

It’s annoying to the victims, but we’re big boys and girls. It’s a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this attack instead. And it’s ineffective. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.

That’s the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and advice to spend like a drunken sailor are pretty superficial compared to all the fascinating things economists are writing about it these days.  

How sad.

That’s what I think, but I don’t expect you the reader to be convinced by my opinion or my reference to professional consensus.  Maybe he is right. Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I thought Keynesian economics was such a wrong turn. So let’s take a quick look at the ideas. 

Krugman’s attack has two goals. First, he thinks financial markets are “inefficient,” fundamentally due to “irrational” investors, and thus prey to excessive volatility which needs government control. Second, he likes the huge “fiscal stimulus” provided by multi-trillion dollar deficits. 

Efficiency.

It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer. And of course it makes no sense whatsoever to try to discredit efficient-markets finance because its followers didn’t see the crash coming.

Krugman writes as if the volatility of stock prices alone disproves market efficiency, and efficient marketers just ignored it all these years. This is a canard that Paul knows better than to pass on, no matter how rhetorically convenient. (I can overlook his mixing up the CAPM and Black-Scholes model, but not this.)  There is nothing about “efficiency” that promises “stability.” “Stable” growth would in fact be a major violation of efficiency.  Efficient markets did not need to wait for “the memory of 1929 … gradually receding,” nor did we fail to read the newspapers in 1987.  Data from the great depression has been included in practically all the tests. In fact, the great “equity premium puzzle” is that if efficient, stock markets don’t seem risky enough to deter more people from investing! Gene Fama’s PhD thesis was on “fat tails” in stock returns.

It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is lower in bad economic times.  As Gene Fama pointed out in 1970, these are observationally equivalent explanations. Unless you are willing to elaborate your theory to the point that it can quantitatively describe how much and when risk premiums, or waves of “optimism” and “pessimism,” can vary, you know nothing. No theory is particularly good at that right now.

Crying “bubble” is empty unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row. Krugman rightly praises Robert Shiller for his warnings over many years that house prices might fall. But advice that we should listen to Shiller, because he got the last one right, is no more useful than previous advice from many quarters to listen to Greenspan because he got several ones right.  Following the last mystic oracle until he gets one wrong, then casting him to the wolves, is not a good long-term strategy for identifying bubbles. Krugman likes Shiller because he advocates behavioral ideas, but that’s no help either. People who call themselves behavioral have just as wide a divergence of opinion as those who don’t. Are markets irrationally exuberant or irrationally depressed today? It’s hard to tell.

This difficulty is no surprise. It’s the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what “fundamental” value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism and central planning would have worked.

More deeply, the economist’s job is not to “explain” market fluctuations after the fact, to give a pleasant story on the evening news about why markets went up or down. Markets up? “A wave of positive sentiment.” Markets went down? “Irrational pessimism.” ( “The risk premium must have increased” is just as empty.) Our ancestors could do that.  Really, is that an improvement on “Zeus had a fight with Apollo?” Good serious behavioral economists know this, and they are circumspect in their explanatory claims. 

But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse.

Krugman at bottom is arguing that the government should massively intervene in financial markets, and take charge of the allocation of capital.  He can’t quite come out and say this, but he does say “Keynes considered it a very bad idea to let such markets…dictate important business decisions,” and “finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a `casino.’” Well, if markets can’t be trusted to allocate capital, we don’t have to connect too many dots to imagine who Paul has in mind.

To reach this conclusion, you need evidence, experience, or any realistic hope that the alternative will be better. Remember, the SEC couldn’t even find Bernie Madoff when he was handed to them on a silver platter. Think of the great job Fannie, Freddie, and Congress did in the mortgage market.  Is this system going to regulate Citigroup, guide financial markets to the right price, replace the stock market, and tell our society which new products are worth investment?  As David Wessel’s excellent  In Fed We Trust makes perfectly clear, government regulators failed just as abysmally as private investors and economists to see the storm coming. And not from any lack of smarts. 

In fact, the behavioral view gives us a new and stronger argument against regulation and control. Regulators are just as human and irrational as market participants.  If bankers are, in Krugman’s words, “idiots,” then so must be the typical treasury secretary, fed chairman, and regulatory staff.  They act alone or in committees, where behavioral biases are much better documented than in market settings. They are still easily captured by industries, and face politically distorted incentives.

Careful  behavioralists know this, and do not quickly run from “the market got it wrong” to “the government can put it all right.” Even my most behavioral colleagues Richard Thaler and Cass Sunstein in their book “Nudge” go only so far as a light libertarian paternalism, suggesting good default options on our 401(k) accounts. (And even here they’re not very clear on how the Federal Nudging Agency is going to steer clear of industry capture.) They don’t even think of jumping from irrational markets, which they believe in deeply, to Federal control of stock and house prices and allocation of capital. 

Stimulus

Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.” He’s not clear on what the “beauty” is that we all fell in love with, and why one should shun it, for good reason.  The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make logically inconsistent plans to consume more, invest more, and pay more taxes with the same income. The second siren is plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again.  It presumes that people don’t think about the future in making decisions today. Logical consistency and plausible foundations are indeed “beautiful” but to me they are also basic preconditions for “truth.”

In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any more effect than spending financed by raising taxes. People, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? It’s a logical connection from a set of “if” to a set of “therefores.” Not even Paul can object to the connection.

Therefore, we have to examine the “ifs.” And those ifs are, as usual, obviously not true. For example, the theorem presumes lump-sum taxes, not proportional income taxes. Alas, when you take this into account we are all made poorer by deficit spending, so the multiplier is most likely negative. The theorem (like most Keynesian economics) ignores the composition of output; but surely spending money on roads rather than cars can affect the overall level.

Economists have spent a generation tossing and turning the Ricardian equivalence theorem, and assessing the likely effects of fiscal stimulus in its light, generalizing the “ifs” and figuring out the likely “therefores.”  This is exactly the right way to do things.  The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why it is false.  Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, how much people care about their children, how many people would like to borrow more to finance today’s consumption and so on. And when you find “market failures” that might justify a multiplier, optimal-policy analysis suggests fixing the market failures, not their exploitation by fiscal  multiplier.  Most “New Keynesian” analyses that add frictions don’t produce big multipliers.

This is how real thinking about stimulus actually proceeds. Nobody ever “asserted that an increase in government spending cannot, under any circumstances, increase employment.” This is unsupportable by any serious review of professional writings, and Krugman knows it. (My own are perfectly clear on lots of possibilities for an answer that is not zero.) But thinking through this sort of thing and explaining it is much harder than just tarring your enemies with out-of-context quotes, ethical innuendo, or silly cartoons.

In fact, I propose that Krugman himself doesn’t really believe the Keynesian logic for that stimulus. I doubt he would follow that logic to its inevitable conclusions. Stimulus must have some other attraction to him.

If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it.  Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income.  The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.

If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up. 

If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.

The crash.

Krugman’s article is supposedly about how the crash and recession changed our thinking, and what economics has to say about it. The most amazing news in the whole article is that Paul Krugman has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward. He seems completely unaware of the large body of work by economists who actually do know something about the banking and financial system, and have been thinking about it productively for a generation.

Here’s all he has to say: “Irrationality” caused markets to go up and then down. “Spending” then declined, for unclear reasons, possibly “irrational” as well. The sum total of his policy recommendations is for the Federal Government to spend like a drunken sailor after the fact.

Paul, there was a financial crisis, a classic near-run on banks. The centerpiece of our crash was not the relatively free stock or real estate markets, it was the highly regulated commercial banks. A generation of economists has thought really hard about these kinds of events. Look up Diamond, Rajan, Gorton, Kashyap, Stein, and so on.  They’ve thought about why there is so much short term debt, why banks run, how deposit insurance and credit guarantees help, and how they give incentives for excessive risk taking.

If we want to think about events and policies, this seems like more than a minor detail. The hard and central policy debate over the last year was how to manage this financial crisis. Now it is how to set up the incentives of banks and other financial institutions so this mess doesn’t happen again. There’s lots of good and subtle economics here that New York Times readers might like to know about. What does Krugman have to say? Zero.

Krugman doesn’t even have anything to say about the Fed.  Ben Bernanke did a lot more last year than set the funds rate to zero and then go off on vacation and wait for fiscal policy to do its magic. Leaving aside the string of bailouts, the Fed started term lending to securities dealers. Then, rather than buy treasuries in exchange for reserves, it essentially sold treasuries in exchange for private debt. Though the funds rate was near zero, the Fed noticed huge commercial paper and securitized debt spreads, and intervened in those markets. There is no “the” interest rate anymore, the Fed is attempting to manage them all. Recently the Fed has started buying massive quantities of mortgage-backed securities and long-term treasury debt.

Monetary policy now has little to do with “money” vs. “bonds” with all the latter lumped together. Monetary policy has become wide-ranging financial policy.  Does any of this work? What are the dangers? Can the Fed stay independent in this new role? These are the questions of our time. What does Krugman have to say? Nothing.

Krugman is trying to say that a cabal of obvious crackpots bedazzled all of macroeconomics with the beauty of their mathematics, to the point of inducing policy paralysis.  Alas, that won’t stick. The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research, in particular anything with a serious intertemporal dimension.  Paul’s simple Keynesianism has dominated policy analysis for decades and continues to do so. From the CEA to the Fed to the OMB and CBO, everyone just adds up consumer, investment and government “demand” to forecast output and uses simple Phillips curves to think about inflation.  If a failure of ideas caused bad policy, it’s a simpleminded Keynesianism that failed.  

The future of economics.

How should economics change? Krugman argues for three incompatible changes.

First, he argues for a future of economics that “recognizes flaws and frictions,” and incorporates alternative assumptions about behavior, especially towards risk-taking.  To which I say, “Hello, Paul, where have you been for the last 30 years?” Macroeconomists have not spent 30 years admiring the eternal verities of Kydland and Prescott’s 1982 paper. Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviors, especially new models of attitudes to risk,  and comparing the resulting models, quantitatively, to data.  The long literature on financial crises and banking which Krugman does not mention has also been doing exactly the same. 

Second, Krugman argues that “a more or less Keynesian view is the only plausible game in town,” and “Keynesian economics remains the best framework we have for making sense of recessions and depressions.” One thing is pretty clear by now, that when economics incorporates flaws and frictions, the result will not be to rehabilitate an 80-year-old book. As Paul bemoans, the “new Keynesians” who did just what he asks, putting Keynes inspired price-stickiness into logically coherent models, ended up with something that looked a lot more like monetarism. (Actually, though this is the consensus, my own work finds that new-Keynesian economics ended up with something much different and more radical than monetarism.) A science that moves forward almost never ends up back where it started. Einstein revises Newton, but does not send you back to Aristotle.  At best you can play the fun game of hunting for inspirational quotes, but that doesn’t mean that you could have known the same thing by just reading Keynes once more.

Third, and most surprising, is Krugman’s Luddite attack on mathematics; “economists as a group, mistook beauty, clad in impressive-looking mathematics, for truth.” Models are “gussied up with fancy equations.” I’m old enough to remember when Krugman was young, working out the interactions of game theory and increasing returns in international trade for which he won the Nobel Prize, and the old guard tut-tutted “nice recreational mathematics, but not real-world at all.” He once wrote eloquently about how only math keeps your ideas straight in economics. How quickly time passes. 

Again, what is the alternative? Does Krugman really think we can make progress on his – and my – agenda for economic and financial research -- understanding frictions, imperfect markets, complex human behavior, institutional rigidities – by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavor (read “Moneyball”) is there any real hope that this will work in economics?

No, the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the “then” really does follow the “if,” which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now.    

The insults.

The level of personal attack in this article, and fudging of the facts to achieve it, is simply amazing.

As one little example (ok, I’m a bit sensitive), take my quotation about carpenters in Nevada. I didn’t write this. It’s a quote, taken out of context, from a bloomberg.com article, written by a reporter who I spent about 10 hours with patiently trying to explain some basics, and who also turned out only to be on a hunt for embarrassing quotes.  (It’s the last time I’ll do that!)  I was trying to explain how sectoral shifts contribute to unemployment. Krugman follows it by a lie -- I never asserted that “it take mass unemployment across the whole nation to get carpenters to move out of Nevada.” You can’t even dredge up a quote for that monstrosity.

What’s the point?  I don’t think Paul disagrees that sectoral shifts result in some unemployment, so the quote actually makes sense as economics. The only point is to make me, personally, seem heartless -- a  pure, personal, calumnious attack, having nothing to do with economics.

Bob Lucas has written extensively on Keynesian and monetarist economics, sensibly and even-handedly.  Krugman chooses to quote a joke, made back in 1980 at a lunch talk to some business school alumni. Really, this is on the level of the picture of Barack Obama with Bill Ayers that Sean Hannity likes to show on Fox News.

It goes on. Krugman asserts that I and others “believe” “that an increase in government spending cannot, under any circumstances, increase employment,” or that we “argued that price fluctuations and shocks to demand actually had nothing to do with the business cycle.”  These are just gross distortions, unsupported by any documentation, let alone professional writing. And Krugman knows better. All economic models are simplified to exhibit one point; we all understand the real world is more complicated; and his job is supposed to be to explain that to lay readers. It would be no different than if someone were to look up Paul’s early work which assumed away transport costs and claim “Paul Krugman believes ocean shipping is free, how stupid” in the Wall Street Journal.  

The idea that any of us do what we do because we’re paid off by fancy Wall Street salaries or cushy sabbaticals at Hoover is just ridiculous. (If Krugman knew anything about hedge funds he’d know that believing in efficient markets disqualifies you for employment. Nobody wants a guy who thinks you can’t make any money trading!)  Given Krugman’s speaking fees, it’s a surprising first stone for him to cast.

Apparently, salacious prose, innuendo, calumny, and selective quotation from media aren’t enough: Krugman added cartoons to try to make opponents look silly. The Lucas-Blanchard-Bernanke conspiratorial cocktail party celebrating the end of recessions is a silly fiction. So is their despondent gloom on reading “recession” in the paper. Nobody at a conference looks like Dr. Pangloss with wild hair and a suit from the 1800s. (OK, Randy Wright has the hair, but not the suit.)  Keynes did not reappear at the NBER to be booed as an “outsider.”  Why are you allowed to make things up in pictures that wouldn’t pass even the Times’ weak fact-checking in words?

Most of all, Krugman isn’t doing his job.  He’s supposed to read, explain, and criticize things economists write, and real professional writing, not interviews, opeds and blog posts. At a minimum, this style leads to the unavoidable conclusion that Krugman isn’t reading real economics anymore.

How did Krugman get it so wrong?

So what is Krugman up to? Why become a denier, a skeptic, an apologist for 70 year old ideas, replete with well-known logical fallacies, a pariah? Why publish an essentially personal attack on an ever-growing enemies list that now includes practically every professional economist? Why publish an incoherent vision for the future of economics?

The only explanation that makes sense to me is that Krugman isn’t trying to be an economist, he is trying to be a partisan, political opinion writer. This is not an insult. I read George Will, Charles Krauthnammer and Frank Rich with equal pleasure even when I disagree with them.  Krugman wants to be Rush Limbaugh of the Left.

Alas, to Krugman, as to far too many ex-economists in partisan debates, economics is not a quest for understanding.  It is a set of debating points to argue for policies that one has adopted for partisan political purposes. “Stimulus” is just marketing to sell Congressmen and voters on a package of government spending priorities that you want for political reasons. It’s not a proposition to be explained, understood, taken seriously to its logical limits, or reflective of market failures that should be addressed directly.

Why argue for a nonsensical future for economics? Well, again, if you don’t regard economics as a science, a discipline that ought to result in quantitative matches to data, a discipline that requires crystal-clear logical connections between the “if” and the “then,” if the point of economics is merely to provide marketing and propaganda for politically-motivated policy, then his writing does make sense. It makes sense to appeal to some future economics – not yet worked out, even verbally – to disdain quantification and comparison to data, and to appeal to the authority of ancient books as interpreted by you, their lone remaining apostle.

Most of all, this is the only reason I can come up with to understand why Krugman wants to write personal attacks on those who disagree with him. I like it when people disagree with me, and take time to read my work and criticize it. At worst I learn how to position it better. At best, I discover I was wrong and learn something. I send a polite thank you note.

Krugman wants people to swallow his arguments whole from his authority, without demanding logic, or evidence.  Those who disagree with him, alas, are pretty smart and have pretty good arguments if you bother to read them. So, he tries to discredit them with personal attacks.

This is the political sphere, not the intellectual one. Don’t argue with them, swift-boat them. Find some embarrassing quote from an old interview. Well, good luck, Paul. Let’s just not pretend this has anything to do with economics, or actual truth about how the world works or could be made a better place.

*University of Chicago Booth School of Business. Many colleagues and friends helped, but I don’t want to name them for obvious reasons. Krugman fans: Please don’t bother emailing me to tell me what a jerk I am. I will update this occasionally, so please pass on the link rather than the document, 

http://faculty.chicagobooth.edu/john.cochrane/research/Papers/#news.

Lehman and the Financial Crisis

Wall Street Journal oped with Luigi Zingales. Letting Lehman fail was not the central cause of the financial crisis.

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Why did Paul Krugman get it so wrong?

(ms-word version). Later published in Economic Affairs 31:36-40 (2011) (local pdf). A response to Paul’s New York Times Magazine article. Bloomberg TV Video interview on the post. David Levine wrote a good open letter in a similar spirit. Note: This is just a response to Krugman’s article. A number of people have criticized me for not explaining the alternative, i.e. just what does modern macro and finance have to say about the crisis, exactly what do good models of fiscal stimulus predict, and so forth. Sorry, there’s plenty to say, but that’s a much bigger essay. See the rest of this webpage! Here's the most delicious quote, I think:

"If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it.  Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income.  The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.

If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up. 

If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume."

Read More >

What to do about Preexisting Conditions

Oped for The Wall Street Journal. Health Status insurance op-ed for Investors Business Daily (local link). April 2 2009. These pieces describe my ideas on how free market health insurance can solve the portability problem and thus let us have a competitive system: People who lose their jobs lose health insurance, often with catastrophic results. Two ways to put the basic idea: 1. You can buy “premium increase insurance” so that if you get sick you can afford higher premiums.  2. You can buy the right to buy health insurance in the future, even if you get sick in the meantime.

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Financial lessons of the great depression

A panel discussion at the Council on Foreign Relations.

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Asset pricing after the crash

This is a piece based on a panel discussion titled “Rethinking asset pricing” at the Spring 2009 NBER Asset Pricing meeting. It includes skeptical views on just how important credit constraints and liquidity really are. Liquidity is the frosting on the cake of finance. There is a lot of frosting these days, but still some cake.

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Are we all Keynesians Now?

Link to Economist. The Economist had an online debate on this proposition, headlined by Luigi Zingales and Brad Delong. This was my two cents on the issue. Of course not, right? Some good Keynes quotes and a defense that economics has in fact advanced a bit in 70 years. 

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Fiscal Stimulus, Fiscal Inflation or Fiscal Fallacies?

An analysis of fiscal stimulus. Dropping money from helicopters is “fiscal stimulus,” and that will surely goose demand before it quickly leads to inflation. Usually though, “stimulus” means by debt that the government plans to pay back, and is supposed to work without inflation. Does it? Many arguments reflect classic fallacies.  Most of all, the usual arguments imply that our current troubles come from inadequate borrowing and spending!  No, our current troubles come instead from a credit crunch, and a “flight to quality” and “precautionary demand” for government debt. Fiscal stimulus could in principle help to quench that demand, but that problem can be more easily and reversibly solved by expanding the Fed and Treasury’s asset purchases.
Update: Paul Krugman and Brad Delong wrote very critical blog posts. However, neither seems to have read past the first few paragraphs. Brad says I think the velocity of money is constant. Keep reading, Brad, down to “A monetary argument for fiscal stimulus..” where it says “if money demand increases dramatically…”. Paul says I treat S=I as an identity, not an equilibrium condition. Keep reading, Paul, down to “aggregate demand has fallen.. deflationary pressure…” where nominal GDP is adjusting to equilibrate S and I.  OK, I can’t condense all of macro down to 300 word blog posts, but if you can’t read more than that, don’t write nasty comments. Greg Mankiw and Dani Rodrik had nicer things to say. Greg’s blog is the place to go for intelligent stimulus skepticism. Declan McCullagh of CBS news wrote a nice article collecting many academic stimulus skeptics.

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IGM webpage

Visit the IGM webpage for links to lots of alternatives proposed by GSB faculty and related thoughts on how to get out of this mess. The 12 days of bailout video

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Is now the time to buy stocks?

WSJ op-ed. The average investor must hold the market portfolio of stocks and bonds. How can that possibly make sense in the current environment, especially with volatility at 50% per year? I show you how. Who should be buying more, and who should be selling more? Here is the slightly longer and more detailed manuscript, along with a short summary of research -- yes, this really is the summary of 30 years of finance research, not something I made up as I wrote it -- and answers to some common questions. Here I am on CNBC explaining it all in 20 seconds or less.

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Introduction for Gene Fama

Gene gave a talk on the history of the efficient markets hypothesis for the American Finance Association history project. This is my introduction. I try in 6 minutes flat to say why the efficient markets hypothesis is important and a great intellectual achievement. Video of Gene's speech and event from the IGM website.

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The Monster Returns

My view of the credit crunch and why the Treasury asset-purchase plan won't work. I think the focus on troubled banks misses the strength of the banking system, and the catastrophic problems in credit markets. It also appeared on the Freakonomics blog.

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Mortage Bailout

A letter to Congress against the TARP plan to buy sick mortgages. Luigi Zingales and Paloa Sapienza get credit for organizing this, with help from Anil Kashyap and Rob Shimer. Disclaimer: This letter was sent to Congress on Wed Sept 24 2008 regarding the Treasury plan as outlined on that date. It does not reflect all signatories' views on subesquent plans or modifications of the bill. A nice map showing where signatories come from courtesy of Mark Stouffer. Before anyone gets as swell head, it's worth reading the petition against Smoot-Hawley signed by 1028 economists.

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Milton Friedman Institute

The proposed Milton Friedman Institute made the news, thanks to a faculty protest letter. The letter is an interesting insight into academia, even here, with its talk of the “neoliberal global order,” “service of globalized capital,” “substitution of monetization for democratization.” I wrote a set of critical comments that got some press and amused my friends.

The protesters created a website (2014: alas apparently defunct, too bad, it was fun), and there is now a new website FriedmanFacts.com debunking them (2014: now hijacked to some nefarious marketing company). Gary Becker wrote an insightful blog post. In October 11 2008 I wrote a response to a new petition (2014: alas, now also seems to have vanished from the internet) against MFI.

All this is ancient history. The Institute, now named the Becker-Friedman institute, is up and running supporting all sorts of interesting research.

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Comments on the Milton Friedman Institute Protest letter

July 12 2008

(A group of University of Chicago faculty wrote a petition to our President opposing the foundation of a Milton Friedman Institute to support economic research. The full letter is here. These are my personal comments on that letter. I do not speak for or represent the Institute, the faculty committee, the University, or anyone else.)

As usual, academics need to waste two paragraphs before getting to the point, which starts in the first bullet. To really enjoy this delicious prose you have to first read it all in one place.

• Many colleagues are distressed by the notoriety of the Chicago School of Economics, especially throughout much of the global south, where they have often to defend the University’s reputation in the face of its negative image. The effects of the neoliberal global order that has been put in place in recent decades, strongly buttressed by the Chicago School of Economics, have by no means been unequivocally positive. Many would argue that they have been negative for much of the world's population, leading to the weakening of a number of struggling local economies in the service of globalized capital, and many would question the substitution of monetization for democratization under the banner of “market democracy.” 

Yes, there are people left on the planet who write and think this way, and no, I’m not making this up. Let’s read this more closely and try to figure out what it means.

“Many colleagues are distressed by the notoriety of the Chicago School of Economics, especially throughout much of the global south, where they have often to defend the University’s reputation in the face of its negative image.”

If you’re wondering “what’s their objection?”, “how does a MFI hurt them?” you now have the answer.  Translated, “when we go to fashionable lefty cocktail parties in Venezuela, it’s embarrassing to admit who signs our paychecks.” Interestingly, the hundred people who signed this didn’t have the guts even to say “we,” referring to some nebulous “they” as the subject of the sentence.  Let’s read this literally: “We don’t really mind at all if there’s a MFI on campus, but some of our other colleagues, who are too shy to sign this letter, find it all too embarrassing to admit where they work.” If this is the reason for organizing a big protest perhaps someone has too much time on their hands.

 “Global south”

I’ll just pick on this one as a stand-in for all the jargon in this letter.  What does this oxymoron mean, and why do the letter writers use it?  We used to say what we meant, “poor countries. ” That became unfashionable, in part because poverty is sometimes a bit of your own doing and not a state of pure victimhood.  So, it became polite to call dysfunctional backwaters “developing.” That was already a lie (or at best highly wishful thinking) since the whole point is that they aren’t developing.  But now bien-pensant circles don’t want to endorse “development” as a worthwhile goal anymore.   “South” – well, nice places like Australia, New Zealand and Chile are there too (at least from a curiously North-American and European-centric perspective).  So now it’s called “global south,” which though rather poor as directions for actually getting anywhere, identifies the speaker as the caring sort of person who always uses the politically correct word.   

“The effects of the neoliberal global order that has been put in place in recent decades….”

Notice the interesting voice of the verb. Let’s call it the “accusatory passive.” “Has been put in place...” By who, I (or any decent writer) would want to know?  Unnamed dark forces are at work.

“Many would argue that they have been negative for much of the world's population... weakening … struggling local economies”

I can think of lots of words to describe what’s going on in, say, China and India, as well as what happened previously to countries that adopted the “neoliberal global order” like Japan, Hong Kong, and South Korea. Billions of people are leading dramatically freer, healthier, longer and more prosperous lives than they were a generation ago.  “Weakening…struggling local economies” is just factually wrong about events on this planet.

Of course, we all face plenty of problems. I worry about environmental catastrophes, and their political, social and economic aftermath.  Many people are suffering, primarily in pockets of kleptocracy and anarchy.  Political oppression is still a fact of life in much too much of the world, and China in particular. Life’s pretty bleak about 5 blocks west of the University of Chicago. In my professional life, I worry about inflation, chaotic markets, and their possible death by regulation. There is a lot for thoughtful economists and social scientists to do. But honestly, do we really yearn to send a billion Chinese back to their “local economies,” trying to eke a meager living out of a quarter acre of rice paddy, under the iron grip of some local bureaucrat? I mean, the Mao caps and Che shirts are cool and all, but millions of people starved to death.

This is just the big lie theory at work. Say something often enough and people will start to believe it. It helps especially if what you say is vague and meaningless. Ok, I’ll try to be polite; a lie is deliberate and this is more like a willful disregard for the facts. Still, if you start with the premise that the last 40 or so years, including the fall of communism, and the opening of China and India are “negative for much of the world’s population,” you just don’t have any business being a social scientist. You don’t stand a chance of contributing something serious to the problems that we actually do face.  

“the service of globalized capital..”

I was wondering who the subject of all these passive sentences is. Now I’m beginning to get the idea. This view has a particularly dark history. A hint: “Globalized capital” has names like Goldman and Sachs. 

“many would question the substitution of monetization for democratization under the banner of `market democracy.’” 

What a doozy! What can this actually mean? Given the counterpoint “market democracy” (what we live in, I presume) I suspect “democratic” here means “democratic” as in “people’s democratic republic”, i.e. the government runs everything.  Monetization is democratization; it means things are accessible to anyone, not just the politically connected. That observation was, among many other things, Milton Friedman’s genius.

Once again, the awkward language and vague subjects are telling. “The substitution.” Who did this substitution? Maybe globalized capital, or the international banking conspiracy? Maybe it’s the trilateral commission.

The closing bullet point is fun as a reminder of how petty academic squabbles can be after we strip off all the big words, fancy pretentions and meaningless jargon.

 • In the interests of equity and balance, many of us feel that the University ought to reconsider contributing to the proposed Milton Friedman Institute, which will inevitably be a powerful magnet for scholars and donors who share a specific set of interests and values to the exclusion of others, whether this is openly acknowledged or not.

Translation:  we publicly charge the faculty committee who put this thing together, and promise a non-partisan non-directed research institute (me included), with lying through their teeth.  This sentence adds a – well let’s be polite and call it a “factual inaccuracy.” The whole point is not “University contribution.” The whole point is to try to get private donors who see the benefits of Milton Friedman’s legacy to support economics research here.   If the writers understood the first thing about money, that it is fungible, they might understand which side of their bread is buttered.

Still others believe that, given the influx of private contributions to the MFI, the University now has the opportunity to provide roughly equivalent resources for critical scholarly work that seeks out alternatives to recent economic, social, and political developments.  

Finally, we get to the point! We can get over our “distress” at admitting where we work, but what we want is to do some of our own “substitution of monetization for democratization.” And with none of the niceties about non-partisan, non-ideological, open-minded research in the Milton Friedman founding documents either – this money is reserved for people who can get the right answers and belong to the right clubs.  And we’re not planning to ask our sympathizers to pony up money either. Basically, we want the Friedman Institute money.  

Virtually all of us are distressed by the position the University has taken and by the process through which decisions have been made.

And we end with good old “process.”   When you can’t really complain on the merits, you can always gum up the works by complaining about “process.” Now you know why it takes so long for a university ever to do anything.

***

If it’s sad to see what 101 professionally distinguished minds at the University of Chicago think about free markets at all, it is to me sadder still how atrociously written this letter is. These people devote their lives to writing on social issues, and teaching freshmen (including mine) how to think and write clearly.  Yet it’s awful.

The letter starts with two paragraphs of meaningless throat-clearing. (“This is a question of the meaning of the University’s investments, in all senses.”  What in the world does that sentence actually mean?)  I learned to delete throat-clearing in the first day of Writing 101.  It’s all written in the passive, or with vague subjects.  “Many” should not be the subject of any sentence.  You should never write “has been put in place,” you should say who put something in place. You should take responsibility in your writing. Write “we,” not “many colleagues.”  The final paragraphs wander around without saying much of anything.  

The content of course is worse. There isn’t even an idea here, a concrete proposition about the human condition that one can disagree with, buttress or question with facts. It just slings a bunch of jargon, most of which has a real meaning opposite to the literal. “Global South,” “neoliberal global order,” “the service of globalized capital,” “substitution of monetization for democratization.” George Orwell would be proud.

I’m not a good writer. I admire great prose, and I attempt to fill the spaces between equations of my papers with comprehensible words. But even I can recognize atrocious prose when I see it.  Really, guys and gals, if a Freshman handed this in to one of your classes, could you possibly give any grade above C- and cover it with red ink?

I was quoted as saying “drivel,” and I meant it, not as an insult but as a technically correct description of a piece of prose. We can – and should – happily disagree on all sorts of matters of fact and interpretation, clearly stated, and openly discussed. But there’s nothing here to discuss, it’s just mush. The saddest aspect of this whole sorry affair is that 100 faculty at such a distinguished institution can sign their names – and with them their intellectual reputations and their sacred honor -- to such utter drivel.

***

Milton Friedman stood for freedom, social, political, and economic. He realized that they are inextricably linked. If the government controls your job or your business, dissent is impossible.  He championed economic freedom as much as a means to political freedom as for its own sake.  He favored, among other things, legalizing drugs, school choice, and volunteer army. To call him or his political legacy “right wing” is simply ignorant, and I mean that also as a technically accurate description rather than an insult.  

(Of course, Friedman also has a legacy in economics as possibly the best research economist of the 20th century, which is what the MFI will do and honor. The consumption function and the monetary foundations of inflation, are as important to 20th century economics as the discovery of DNA was to biology, quantum mechanics to physics or plate tectonics to geology.  But the letter-writers didn’t have anything to say about any of this, so neither will I, here. )   

So here’s my question: If you’re embarrassed by Milton Friedman’s legacy, if you worry that it will tarnish the University’s reputation, just what is it that you good-thinking guys and gals have against human freedom? 

Efficient Markets Today

Efficient Markets Today Talk given at the Conference on Chicago Economics. A second “discount rate” revolution has followed the first efficient-markets revolution, and dramatically changes how we think about financial markets. Alpha and beta are dead.

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Comments on the credit situation

Comments on the credit situation given at the GSB Global Financial Markets Forum, Sept 25 2007. Some good aspects of the current situation, some unheralded aspects of the Fed’s policy, some things that went wrong, and the downside of some quick fixes. Video of the event.

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