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

Waiting For The Big Push: Selling The Consumer Protection Agency For Financial Products

In mid-March, the administration proposed that toxic assets could and would be safely removed from banks balance sheets.  We were skeptical, and the the PPIP now seems to have slipped into irrelevance (loans; securities).  But the administration still put an impressive effort into persuading independent analysts, and broader public opinion, that they should do something clearly beneficial for banks.  This was “all hands on deck,” and it definitely had an impact on the debate, at least for a while.

Now, the administration’s major remaining initiative is its version of a Financial Product Safety Commission – something that would be clearly beneficial for the public.  And the skepticism – and outright opposition – comes from the banking sector.

How does the administration’s effort compare, then vs. now? Continue reading “Waiting For The Big Push: Selling The Consumer Protection Agency For Financial Products” →

Who Is Upton Sinclair? (Weekend Comment Competition)

By 1906, it was obvious to many people that the industrialization of food production in the United States had brought with it some unpleasant and even unsafe practices.  Consumers were definitely not getting exactly what they thought they were getting.

But efforts to reform the industry – and to protect consumers – were mired in the power of this lobby (with strong political power based on its great economic power), the resilience of laissez-faire ideas, and the intransigence of powerful individuals in the Senate.  There were legislative proposals, but the overall reform agenda was not really going anywhere fast.

Then Upton Sinclair published The Jungle.  No one could look at meat packing or its products in the same way again, and this directly and immediately helped produce stronger federal legislation regulating the industry.

So who is our Upton Sinclair and when will they write the definitive piece that captures imaginations and changes the terms of the debate?  Is it about how consumers were mistreated, politicians captured, or the public treasury ransacked?  Will it be a novel or nonfiction? 

Or perhaps it is a movie, with all the modern Hollywood marketing techniques and tie-ins? 

By Simon Johnson

How to Win Friends and Influence People

An old friend of mine asked me for some advice about how to increase readership for his blog. I was going to write him a long email, but I thought if I put it here other people can chime in as well.

The conventional wisdom about how to make your blog successful is “write great content.” Of course, that’s very self-serving for established bloggers to say, since it implies that they write great content. I think Felix Salmon is more accurate: write a lot of content.

Should you write more, with lower quality, or less, with higher quality? Fortunately, the blogosphere has been around for long enough that we have a simple empirical answer to this question: given the choice, go for quantity over quality. You might not like it — I certainly don’t — but I defy you to name a really good blogger who doesn’t blog frequently. . . .

Mostly, blogging is a lottery on the individual-blog-entry level — and if you want to win the lottery, your best chance of doing so is to maximize the number of lottery tickets you buy.

(Of course, we at The Baseline Scenario don’t follow this rule, but if I had more time I would.) I recommend Felix’s whole post, most of which I agree with. But I’ll add a few thoughts of my own.

Continue reading “How to Win Friends and Influence People” →

Larry Summers’ New Model: Details, Contradictions, And Odd Assumptions

Larry Summers had “lunch with the FT” (p.3 in the Life and Arts section today) – although unfortunately the paper does not report when this happened; a week or two makes quite a difference these days.

Putting this next to his April speech to the IDB, Summers’ view of the way forward has a few problems. Continue reading “Larry Summers’ New Model: Details, Contradictions, And Odd Assumptions” →

The Future of Computing?

Google announced the Google Chrome “Operating System” a few days ago, and the world I used to live in is abuzz with people talking about the earthquake this represents for the computing industry. TechCrunch says, “Google Drops a Nuclear Bomb on Microsoft.” Leo Babauta of Zen Habits has a more thoughtful response, but also subscribes to the “future of computing” theme: “Google is moving everything online, and I really believe this is the future of computing. The desktop model of computing — the Microsoft era — is coming to an end. It’ll take a few years, but it will happen.”

Continue reading “The Future of Computing?” →

Speculators ‘R’ Us: The G8 And Energy Prices

The G8 summit was obviously disappointing, even for those with low expectations.  Usually, the substance is lacking but the public relations are well managed.  This year even the messaging was messed up – they said some new things on climate change but not what we were told they could say, the food aid/development package was lamer than advertized, etc.  So the whole thing looks like an expensive flop.

But actually it was much worse. Continue reading “Speculators ‘R’ Us: The G8 And Energy Prices” →

People Who Think Taxes Will Have to Go Up

David Leonhardt has started a new club, which has already attracted some additional members.

Count me in, in spirit at least (there must be dozens of more prominent people for the Times to bother with). Because, ultimately, I think we Americans are a decent people (or at least a squeamish people), and we will not be able to endure the sight of millions of seniors being thrown onto the streets or deprived of medical care. And so the looming combined shortfall of Medicare, public pensions, private pensions,  and individual savings will at some point motivate us to raise taxes on ourselves.

By James Kwak

The Limits of Economics

In honor of Mark Sanford and that other guy from Nevada, the fun-loving crowd over at Planet Money has been talking about the economics of adultery, and even got Simon to comment for them. I’m all in favor of a cute model, but I think this is as much a sign of the over-expansion of economic reason as anything else.

Chana Joffe-Walt’s post asks this question of the typical cheating politician: “Didn’t he know he’ll get caught, put his family through hell, exhaust all of us with the details and jeopardize his career? The costs are so great, how could the affair possibly be worth it?”

Well, that assumes that he was going to get caught, and the odds of being caught in an affair are one of those things that are inherently very difficult to measure (and that cheaters are likely to underestimate, because of selection bias). We can see the numerator, but we can’t see the denominator. It also assumes that trading your political career for a steamy affair is a bad outcome. On some level, don’t you suspect that a lot of male politicians do it because they want to impress women, and that affairs are part of the payoff of politics? And what sane person would really want to be in electoral politics anyway?

More generally, the motivations that drive people to want to have sex with people they are not married to, or otherwise live secret lives other than the one they are supposed to live, seem to me not only too complex for a Chicago-school rational-actor model, but even perhaps too complex for a behavioral model. That is, I suspect that this type of behavior involves multiple actors inside the same person: one person who combines the ambitious, values-touting politician; the typical middle-aged man going through a midlife crisis and hoping for someone to validate his self-image; and, of course, the lout who thinks with something other than his brain. I think combining those sides of the psyche into a single utility model and maximizing it subject to a budget constraint (be it money or time) is basically a fantasy. But economists these days wil stop at nothing.

By James Kwak