Category: Commentary

What Is the Efficient Market Hypothesis?

Brad DeLong cites Underbelly citing The Economist quoting Richard Thaler:

The [Efficient Capital Markets] hypothesis has two parts, he says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.

I think this is exactly right. Ever since graduate school I have said that I believe in efficient markets, by which I mean the “no-free-lunch part.” The idea that some people might think that “no free lunch” implied that “prices are right” didn’t even occur to me at the time. My thinking was basically like this: yes there are bubbles, but it’s hard to tell if you are in one, and even if you can tell, you can’t tell how long it will last so you can lose a lot of money betting against it, and even if you have a very long time horizon, who’s to say you won’t be in another bubble when you finally want to sell? Put another way, you may be “right” about an asset price, but if the market is composed of lots and lots of people who are “wrong,” and those people are never going away, what does that get you?

More fundamentally, for an interesting asset like a share of stock (or a house), what does it even mean for a price to be “right?” Sure, ten years later you can see what the dividends have been for ten years and what the stock price is on that date, but that price is no more “right” than any other price; it’s still a collective, irrationality-tainted guess about the future. Future states of the world are not only unknowable right now, they dont’ exist right now, so questions of right and wrong don’t even apply to them. There are just better and worse estimates, and there will never be any way to determine which estimate was better. (Just because things work out a certain way doesn’t imply that that was the most likely outcome.)

I think I’ve beaten this question into the ground recently, so I’ll stop there.

By James Kwak

More and Better

After the wholesale discrediting of the strong form of the efficient markets hypothesis, Robert Shiller may be the most respected financial economist in the world at the moment. This is what he has to say on the last page of Justin Fox’s The Myth of the Rational Market:

Finance is a huge net positive for the economy. The countries that have better-developed financial markets really do better. . . . I think that we’re less than halfway through the development of financial markets. Maybe there’s no end to it.

I think Shiller’s first and second sentences are almost certainly true. There is a strong correlation between having a high material standard of living and having a relatively sophisticated financial system; think of the United States, Japan, and Germany as opposed to Zimbabwe, for example.  But you can’t infer that more financial market “development” is always better. (I’m not saying that Shiller necessarily believes that, but most of the defenders of financial innovation take it for granted.)

Just because something is good, it doesn’t necessarily follow that more of it is better. Take food, for example. It’s pretty obvious that over a wide range – say from 0 to 1500 calories per day – more food is better for you. For most people that range probably extends up to 2000 calories or a little more. After that, not so much.

Continue reading “More and Better” →

The Rise and Rise of Jamie Dimon

As Simon pointed out earlier, Jamie Dimon has been getting a lot of good press recently. The New York Times portrayed his recent rise to prominence as not only the CEO of American’s number one bank (at least, the number one bank that has not recently been compared to a vampire squid), but as a player in Washington and, according to at least one quip, the man Barack Obama turns to on financial questions:

Now that Mr. Obama is in the White House, Mr. Dimon has been prominent when the president wants to talk to big business.

During one such meeting in late March, as Citigroup’s chairman, Richard D. Parsons, was trying to explain banks and lending, the president interrupted with a quip: “All right, I’ll talk to Jamie.”

Continue reading “The Rise and Rise of Jamie Dimon” →

Jamie Dimon v. Larry Summers

Jamie Dimon has won big.  JP Morgan Chase now stands alone, both in financial position and political clout – including special access to the White House and, as explained in today’s NYT, Rahm Emanuel’s likely attendance at his next board meeting tomorrow. 

Dimon’s semiotics have been brilliant throughout the crisis – it wasn’t his fault, he was forced to take TARP money, and – in phrasing that will make the history books – bankers should not be “vilified”.  But now he has a problem.

Larry Summers forcefully stated Friday that high recent profit levels for big banks (i.e., JPMorgan and Goldman) are based on the support they received and still receive from the government (listen to his answer to the second question, from about the 6:10 to 10:30 mark).  At that level of generality, in a period of financial stabilization and consequent reduction in executive branch discretion, this statement does not threaten Dimon or anyone else.

And Summers’ statement on the dangers of “too big to fail” was “too vague to succeed”.  Dimon saw this one coming and is very much aligned with Tim Geithner on the technocratic fixes that will supposedly take care of this – the mythical “resolution authority”, which will not actually achieve anything because it has no cross-border component, so the next time a major multinational bank (e.g., JP Morgan) fails, the choice again will be “collapse or bailout” (as Summers put it in the same Q&A Friday).  Yes, I know the G20 is supposedly working on this; no, I don’t think they are making progress.

But Summers also drew a line in the sand on consumer protection. Continue reading “Jamie Dimon v. Larry Summers” →

More on Spotting Bubbles

In comments on my previous post on bubbles, John McGowan and others point out that you can use the price-to-rent ratio (or price-to-income) as an indicator of a housing bubble. I think this is a partial but not a perfect solution.

The value of a thing should be the net present value of the future cash flows from the thing. In experimental economics, they use securities with absolutely certain cash flow profiles, so when a bubble in prices appears, you have an objective measure of value to compare it to. With individual stocks, on the other hand, the P/E ratio could go up to 100, and you can back an implied growth rate of earnings out of that, but who’s to say the company won’t hit that growth rate? At that point it’s just your opinion against the market’s.

Continue reading “More on Spotting Bubbles” →

Who Nationalized Whom?

Hank Paulson’s testimony yesterday was informative, if only because it illustrated that he himself still understands little about the origins and nature of the global crisis over which he presided.  Perhaps his book, out this fall, will redeem his reputation.

A fundamental principle in any emerging market crisis is that not all of the oligarchs can be saved.  There is an adding up constraint – the state cannot access enough resources to bail out all the big players.

The people who control the state can decide who is out of business and who stays in, but this is never an overnight decision written on a single piece of paper.  Instead, there is a process – and a struggle by competing oligarchs – to influence, persuade, or in some way push the “policymakers” towards the view:

  1. My private firm must be saved, for the good of the country.
  2. It must remain private, otherwise this will prevent an economic recovery.
  3. I should be allowed to acquire other assets, opportunities, or simply market share, as a way to speed recovery for the nation.

Who won this argument in the US and on what basis?  And have the winners perhaps done a bit too well – thinking just about their own political futures?

Continue reading “Who Nationalized Whom?” →

CIT Down

At the end of the day, CIT had nothing.  Their asset quality was poor, their systemic risk implications seemed limited, Sheila Bair dug in her heels, and Jeffrey Peek (CEO) didn’t have sufficiently strong connections to get her overruled.

CIT had friends, but not enough – and maybe this tells us something about the shifting political sands.  The Financial Services Roundtable (top financial CEOs) came out in force, the House Committee on Small Business reportedly made worried noises, and Barney Frank sounded supportive.  But the American Bankers Association (the broader mass of bankers) publicly stood on the sidelines and Senate Banking – and prominent senators – seemed otherwise engaged.  Continue reading “CIT Down” →

The AEI Versus the Real World

Peter Wallison of the American Enterprise Institute accuses the Consumer Financial Protection Agency of being a liberal plot to restrict good financial products to sophisticated elites. Mike at Rortybomb does a point-by-point takedown complete with actual data, so I can stick to the high level (not to be confused with the high road).

Wallison’s op-ed reads like a caricature of conservative ideology – all supposed moral principle and no real-world implications. His argument is basically that by imposing restrictions on complex products (Option ARM mortgages) that are not imposed on plain vanilla products (30-year fixed-rate mortgages), the CFPA is limiting choice for the poor and unsophisticated and preserving choice for the rich and sophisticated; since according to conservative ideology choice is always good in principle, the CFPA is discriminatory.

Where do we start?

Continue reading “The AEI Versus the Real World” →

Is It Possible to Detect Bubbles?

On the one hand, it seems obvious; didn’t we all know there was a housing bubble back in 2006? On the other hand, if it’s that easy, why aren’t we all as rich as John Paulson?

A while back I suggested that the Fed could spot a housing bubble by treating housing prices the same way if treats the prices that make up the CPI. If there is high inflation in the core CPI, you don’t stop and ask if there is a fundamental reason for higher inflation; you tighten monetary policy (raise interest rates). The Fed could do the same thing for housing prices, since housing is an asset that people need to consume. But that’s probably a simplistic view.

Leigh Caldwell thinks that behavioral approaches may be able to separate out irrational overvaluation from changes in fundamental values. I believe his argument is that you can measure the degree of irrational overvaluation for certain types of assets, and you can extrapolate from there to see if there is a bubble:

Outside of the laboratory, precise knowledge of the returns of some assets does become available at times, and it would be possible to measure investors’ behaviour with regard to those assets. If investors, in aggregate, become overconfident about returns it will be possible to spot this from certain types of price change.

Continue reading “Is It Possible to Detect Bubbles?” →

The Man Who Crashed the World?

Back in November, Michael Lewis wrote a great story in Portfolio on the financial crisis, focusing on the traders who saw that the housing bubble was going to crash, bringing mortgage-backed securities down with it – and made lots of money betting on it. Now Lewis is back with his article in Vanity Fair on AIG Financial Products (FP) and its last head, Joseph Cassano. This time, though, it feels like it’s missing the usual Lewis magic.

Lewis sets out to tell the untold story of FP, based on extensive interviews with people who actually worked there. He starts by laying out the conventional wisdom about FP, which presumably he is going to debunk. The conventional wisdom, according to Lewis, is that the problem lay in credit default swaps: “The public explanation of A.I.G.’s failure focused on the credit-default swaps sold by traders at A.I.G. F.P., when A.I.G.’s problems were clearly much broader.” Indeed, Lewis implies that the government essentially framed FP: “Why were officials, both public and private, so intent on leading others to believe all the losses at A.I.G. had been caused by a few dozen traders in this fringe unit in London and Connecticut?

Continue reading “The Man Who Crashed the World?” →

CIT Battlelines

The issue of the day is obviously CIT.  It’s hard to sort out the real news from clever PR/planted stories in this situation, but it looks like the FDIC is coming out strongly against being involved in a rescue package.  Given Sheila Bair’s successful political positioning and strong popular appeal, it’s hard to see how – once dug in – the FDIC can be moved.

The lobbying frenzy has concentrated on CIT’s role in financing small and medium-sized business; “the recession will be deeper if CIT fails” is the refrain.  This is a weak argument – it would be straightforward to refinance this part of CIT’s business without bailing out CIT’s creditors, and definitely without keeping top CIT executives in place; this is the essence of “negotiated conservatorship,” which is a proven model in the US.

More plausible is the concern that given Treasury’s generous handouts to date for financial firms, if they are now tough on CIT’s creditors, this will send a new signal about how they may treat other firms – and maybe raise fears of Hank Paulson-like flipflopping.   Citigroup’s CDS spread is still at worrying levels, and Treasury/National Economic Council watches this closely – for both organizational and personal reasons. Continue reading “CIT Battlelines” →

Will CIT Go Bankrupt?

CIT Group is apparently in trouble and now negotiating with Treasury, the Fed, and the FDIC for some sort of “bailout”, e.g., in the form of a guarantee for its debt.

Traditionally, CIT provided vanilla loans to small and medium-sized business. “But under its current chief executive, Jeffrey M. Peek, a well-liked Wall Street veteran who lost out several years ago in a race to run Merrill Lynch, CIT made an ill-timed expansion into sub-prime mortgage and student lending” (NYT today).

What happens to CIT will help define exactly where we are with regard to “too big to fail.”  Continue reading “Will CIT Go Bankrupt?” →

The Problem with Software

Phillip Longman has an article on health care information systems with the provocative title, “Code Red: How software companies could screw up Obama’s health care reform” (hat tip Ezra Klein). The argument of the article goes something like this. One, the health care cost problem is largely caused by overtreatment. Two, the answer is software: “Almost all experts agree that in order to begin to deal with these problems, the health care industry must step into the twenty-first century and become computerized.” Three, software implementation projects can go horribly, horribly wrong. Four, the solution is open-source software.

I have no argument with point one. And I agree wholeheartedly with point three. Anecdotally (but I have seen a lot of anecdotes), the median large-scale corporate software project goes way over budget, is delivered years late, is just barely functional enough to allow the executives involved to claim they delivered something, and is hated by everyone involved. But I’m not sold on points two and four.

Continue reading “The Problem with Software” →

How to Back Up the Shadow Banking System

Mike from Rortybomb has an interview with Perry Mehrling on the shadow banking system. I was going to try to put this in some context, but Mark Thoma (who played an important role in this saga) beat me to it.

Merhling’s takeaway point is that there needs to be a “credit insurer of last resort,” who will insure any asset against a fall in value – for a sufficiently high premium. This would make it possible for financial institutions to unload the risk of their asset portfolios in a crisis, if they are willing to pay enough to do so. The only institution that would have the credibility to play this role in a real crisis would be the federal government; as we saw, AIG – the world’s largest insurance company, remember – was not up to the task. Still, though, I’m not sure this would do the trick. If I’m a large bank with a balance sheet full of toxic assets, and I don’t want to pay the premium that the insurer of last resort is charging, then I go to the government, say the price is too high, and ask for a bailout. The credit insurer of last resort would need to be coupled with a commitment not to provide an alternative form of government support, or we would end up where we are today.

By James Kwak