Author: James Kwak

Fatal Sensitivity

By James Kwak

One more post on Reinhart-Rogoff, following one on Excel and one on interpretation of results.

While the spreadsheet problems in Reinhart and Rogoff’s analysis are the most most obvious mistake, they are not as economically significant as the two other issues identified by Herndon, Ash, and Pollin: country weighting (weighting average GDP for each country equally, rather than weighting country-year observations equally) and data exclusion (the exclusion of certain years of data for Australia, Canada, and New Zealand). According to Table 3 in Herndon et al., those two factors alone reduced average GDP in the high-debt category from 2.2% (as Herndon et al. measure it) to 0.3%.*

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Are Reinhart and Rogoff Right Anyway?

By James Kwak

One more thought: In their response, Reinhart and Rogoff make much of the fact that Herndon et al. end up with apparently similar results, at least to the medians reported in the original paper:

So the relationship between debt and GDP growth seems to be somewhat downward-sloping. But look at this, from Herndon et al.:

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More Bad Excel

By James Kwak

In 1975, Isaac Ehrlich published an empirical study purporting to show that the death penalty saved lives, since each execution deterred eight murders. The next year, Solicitor General Robert Bork cited this study to the Supreme Court, which upheld the new versions of the death penalty that several states had written following the Court’s 1973 decision nullifying all existing death penalty statutes. Ehrlich’s results, it turned out, depended entirely on a seven-year period in the 1960s. More recently, a number of studies have attempted to show that the death penalty deters murder, leading such notables as Cass Sunstein and Richard Posner to argue for the maintenance of the death penalty.

In 2006, John Donohue and Justin Wolfers wrote a paper essentially demolishing the empirical studies that claimed to justify the death penalty on deterrence grounds. Donohue and Wolfers attempted to replicate the results of those studies and found that they were all fatally infected by some combination of incorrect controls, poorly specified variables, fragile specifications (i.e., if you change the model in minor ways that should make little difference, the results disappear), and dubious instrumental variables. In the end, they found little evidence either that the death penalty reduces or increases murders.

Now the macroeconomic world has its version of the death penalty debate, in the famous paper by Carmen Reinhart and Ken Rogoff, “Growth in a Time of Debt.” Thomas Herndon, Michael Ash, and Robert Pollin released a paper earlier this week in which they tried to replicate Reinhart and Rogoff. They found two spreadsheet errors, a questionable choice about excluding data, and a dubious weighting methodology, which together undermine Reinhart and Rogoff’s most widely-cited claim: that national debt levels above 90 percent of GDP tend to reduce economic growth.

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“Gut Instinct Doesn’t Matter”

By James Kwak

I’m no fan of the genre of CEO interviews published in the Sunday Times. But this past Sunday’s CEO-of-the-week column featured Marcus Ryu, a good friend and someone I’ve worked with at three different companies.

Marcus is not only very smart and someone who really knows what it’s like to build a company from the ground up, but he’s also someone who has thought very hard about what it takes to succeed as a company and what a company needs in its CEO. Unlike many CEOs, he doesn’t believe in gut instinct or the magical ability to judge character. He believes that success in business is hard and, as I’ve heard him say many times, there never is a day when suddenly everything becomes easy. If you are or want to be a CEO someday, I recommend it.

Memo to Employers: Stop Wasting Your Employees’ Money

By James Kwak

Now that I’m a law professor, people expect me to write law review articles. There are some problems with the genre—not least its absurd citation formatting system and all the fetishism surrounding it—but it’s not a bad way to make arguments about how and why the law should change in ways that might actually help people.

That was my goal in my first law review article, “Improving Retirement Options for Employees, which recently came out in the University of Pennsylvania Journal of Business Law. The general problem is one I’ve touched on several times: many Americans are woefully underprepared for retirement, in part because of a deeply flawed “system” of employment-based retirement plans that shifts risk onto individuals and brings out the worse of everyone’s behavioral irrationalities. The specific problem I address in the article is the fact that most defined-contribution retirement plans (of which the 401(k) is the most prominent example) are stocked with expensive, actively managed mutual funds that, depending on your viewpoint, either (a) logically cannot beat the market on an expected, risk-adjusted basis or (b) overwhelmingly fail to beat the market on a risk-adjusted basis.

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The Value of “Top Talent”

By James Kwak

From a Wall Street Journal article about The Children’s Investment Fund:

“[The fund] lost 43% in 2008, among the worst losses by a hedge-fund that year.”

“Both investors and employees defected during the crisis, with top talent leaving to start hedge funds of their own.”

“But with a 30% return in 2012 and a 14% gain this year, TCI has crossed its high-water mark.”

Makes you think.

Moving the Goalposts

By James Kwak

Ezra Klein yesterday highlighted one of the underlying problems with even apparently informed discussions of deficits and the national debt: the CBO’s “alternative fiscal scenario.” As opposed to the (extended) baseline scenario, which simply projects the future based on existing law, the alternative scenario is supposed to be more realistic. And it is more realistic in some ways: for example, it assumes that spending on Afghanistan will follow current drawdown plans, not a simple extrapolation of the current year’s spending. But the problem is that it has become excessively conservative in recent years—to the point where, as Klein says, “Policy makers, pundits and others almost exclusively use this model to stoke Washington’s deficit anxieties.”

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Lessons of the Sequester

By James Kwak

The automatic sequester—the across-the-board cuts to discretionary programs that President Obama said “will not happen”—happened. The reason is simple and predictable: Republicans insist that the sequester be replaced entirely by spending cuts, while Democrats insist that tax increases must be part of the bargain.

One of the more controversial positions that I have taken, on several occasions over the past two years, was that the Bush tax cuts should have been allowed to expire completely. Now we see why.

In White House Burning, Simon and I calculated that the Bush tax cuts would be worth 2.5 percent of GDP in the long term. In other words, extending the tax cuts would mean that, in order to stabilize the debt-to-GDP ratio in the long term, we would have to come up with other tax increases or spending cuts equivalent to 2.5 percent of GDP—in today’s terms, about $400 billion per year.

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Maybe It Was Apple

By James Kwak

A little over a year ago, iconic but fading department store J.C. Penney hired Ron Johnson as CEO. Johnson was head of retail operations at Apple—which, in case you didn’t know it, is just about the most successful retailer in the world by a bevy of metrics.

According to today’s Wall Street Journal article, Johnson quickly eliminated coupons and most sales at J.C. Penney.

“Johnson bristled when a colleague suggested that he test his new no-discounts strategy at a few stores. . . . ‘We didn’t test at Apple,’ the executive recalled Mr. Johnson . . . saying.”

Well, yeah. Apple doesn’t discount because they sell stuff that people really, really want and that they can’t get anyplace else. And they don’t test because Steve Jobs refused to. At Penney? Sales have fallen by about 30 percent.

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The Importance of Excel

By James Kwak

I spent the past two days at a financial regulation conference in Washington (where I saw more BlackBerries than I have seen in years—can’t lawyers and lobbyists afford decent phones?). In his remarks on the final panel, Frank Partnoy mentioned something I missed when it came out a few weeks ago: the role of Microsoft Excel in the “London Whale” trading debacle.

The issue is described in the appendix to JPMorgan’s internal investigative task force’s report. To summarize: JPMorgan’s Chief Investment Office needed a new value-at-risk (VaR) model for the synthetic credit portfolio (the one that blew up) and assigned a quantitative whiz (“a London-based quantitative expert, mathematician and model developer” who previously worked at a company that built analytical models) to create it. The new model “operated through a series of Excel spreadsheets, which had to be completed manually, by a process of copying and pasting data from one spreadsheet to another.” The internal Model Review Group identified this problem as well as a few others, but approved the model, while saying that it should be automated and another significant flaw should be fixed.** After the London Whale trade blew up, the Model Review Group discovered that the model had not been automated and found several other errors. Most spectacularly,

“After subtracting the old rate from the new rate, the spreadsheet divided by their sum instead of their average, as the modeler had intended. This error likely had the effect of muting volatility by a factor of two and of lowering the VaR . . .”

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Michael Lewis!

By James Kwak

On the title page of my copy of The Big Short, in black ink, it says:

“For James Kwak

With admiration”

And then a scrawl that I take to be Michael Lewis’s signature. (Christopher Lydon got the book signed for me, since Lewis was on his radio show a few days before I was.) It may be the only book I’ve ever bothered to get autographed.

So I was especially happy to read that Lewis also wants to break up the big banks (hat tip Ezra Klein):

“Along with the other too-big-to-fail firms, Goldman needs to be busted up into smaller pieces. The ultimate goal should be to create institutions so dull and easy to understand that, when a young man who works for one of them walks into a publisher’s office and offers to write up his experiences, the publisher looks at him blankly and asks, ‘Why would anyone want to read that?'”

When Simon and I made that the centerpiece of the last chapter of 13 Bankers, I thought our chances were slim. When we wrote, in the epilogue to the paperback edition, that a proposal to do exactly that had been voted down, 61 to 33, in the Senate, I thought they had changed from slim to none. It’s still a long shot, but the issue hasn’t died, and if anything is getting more attention now, what with people like George Osborne threatening to break up banks if they don’t reform themselves. Perhaps it isn’t impossible.

Tobin Project Book on Regulatory Capture

By James Kwak

One of the last things I did in law school was write a paper about the concept of “cultural capture,” which Simon and I discussed briefly in 13 Bankers as one of the elements of the “Wall Street takeover.” The basic idea was that you can observe the same outcomes that you get with traditional regulatory capture without there being any actual corruption. The hard part in writing the paper was distinguishing cultural capture from plain old ideology—regulators making decisions because of their views about the world.

Anyway, the result is being included in a collection of papers on regulatory capture organized by the Tobin Project. It will be published by Cambridge sometime this year, but for now you can download the various chapters here. It features a lineup including many authors far more distinguished than I, including Richard Posner, Luigi Zingales, Tino Cuéllar, Richard Revesz, David Moss, Dan Carpenter, Nolan McCarty, and others. Enjoy.

Another Perspective on Bad Software

By James Kwak

Last summer, Lawrence Baxter wrote these two posts about the toxic combination of bad software—actually, software in general, since no software system is perfect—and too-big-to-fail banks. Baxter knows whereof he speaks, as he was previously a technology executive at a very large bank. Here’s what he has to say about it:

I don’t care what a CIO or even a CEO might say: if they claim that they can eliminate the real risk of such missteps, they just don’t know what they are talking about no matter how good they are. And if such missteps are inevitable, then we simply cannot avoid the question whether the dangers posed by large, complex financial institutions and systems could outweigh their benefits.

Think about that the next time you hear some CEO talking about his company’s state-of-the-art technology.