Thursday, February 26, 2009

Commanding Heights

I've been watching Commanding Heights, a PBS historical account of Hayek's struggle to be heard (vis a vis Keynes) and his ultimate success in old age (suggested by mark miller). Part one covers a lot of history in broad and bold sweep. I like the historical approach.

My current hypothesis is that the human race doesn't understand economics. We understand what doesn't work, even though not even that is clear:
  • Capitalism without Unions (too hard on the workers, they revolt)
  • Soviet style command economy (too hard to adapt to real demand, leads to stagnation)
  • Regulated capitalism (same sort of problem as the Soviet style command economy)
  • De regulated capitalism (has led to the current mess)
But we don't understand what does work. The suggestion, from the video (part one), that Hayek, Thatcher and Reagan had all or most of the answers seems unlikely to me. It's more likely that they were or are the latest flavour of the month, year or decade. After a while we'll discover that Hayek doesn't work either.

It's fairly easy to see now that our leaders don't know what they are talking about. It also seems obvious that they never knew what they were talking about.

1 comment:

Mark Miller said...

I think you'll like the 3rd part of the series, because it gets into the complications of globalization. It talks about the Asian financial crisis of the late 1990s, Russia defaulting on its debt, and the near collapse of LTCM, a major hedge fund that used the Black-Scholes formula in a deluded effort to totally eliminate financial risk. The situation with LTCM was rather like the collapse of AIG. It was so big it could not be allowed to collapse completely, lest it ruin the economy and risk an economic depression. The difference was the Fed was able to arrange a totally private bailout by other banks. Crisis was averted.

Whenever I think of what happened at LTCM I think of what Alan Kay said about the dangers of mathematics without science. I think it was a case in point.

The global economic crisis it describes has shades of the current one, though the negative effects were isolated to Asia and Russia.

It also gets into the politics of globalization, showing those who oppose it, and those who support it.

I think that the economy can be studied from a scientific perspective for further understanding--economics. There are computer models for different economic theories, and they are used for studying the economy and for getting a rough idea of possible outcomes from financial and policy decisions, though my understanding is they are not used to make iron-clad predictions. It's understood that they're not reliable enough for that.

I noticed by watching the 3rd part that a similar thing happened in the Asian crisis as happened with the current crisis: One player in an economic category collapses and investors get scared about the whole category (in the former case, Asia, in the current case, banks), and rather than risk capital in the category they choose to withdraw funds from that category altogether, even if the actual situation for some of the players is not serious. The withdrawal of funds creates a self-fulfilling prophecy, causing a member of the category that was otherwise healthy to become an economic/financial crisis that needs to be bailed out. A more common term for this is a "run on the bank". This is a behavior that we have not been able to ameliorate.

I just watched a Frontline documentary today talking about what happened in this financial/economic meltdown, the decisions that were made, and their results. A piece of the story I noticed was the case of Lehman Bros. Sec. Paulson decided to assert the principle of "moral hazzard", and said "You're getting no help from the government". They were allowed to fail. This is what caused the credit freeze, which then caused the Fed and Sec. Paulson to basically panic, and rush to congress to rescue the banking/credit system. Paulson underestimated the impact that Lehman would have, the kind of financial relationships that other institutions had with it. Lehman's fall caused the crisis at AIG. AIG's crisis was so huge, Paulson was forced to relent on his "moral hazzard" policy. AIG's crisis was so big precisely because of a mentality that "moral hazzard" was supposed to address. AIG had huge positions which counted on Lehman never going bankrupt. AIG assumed long before the crisis hit that Lehman would be bailed out one way or another if it ever came to that.

The reason for this whole crisis, as far as I can tell, is a) the extent of the financial obligations within each of the institutions that collapsed, and b) the fact that for whatever reason hardly anyone knows how to value the mortgage-backed securities that the institutions own. This is a type of derivative formulated by physicists and mathematicians who worked for the financial institutions that created them (I'm not sure who created them, though sometimes they were from Freddie Mac). From what I heard, institutions like AIG, Lehman Bros., Bear Stearns, etc. bought these instruments without understanding what they were getting. It was a case of incompetence. When the crisis hit, mortgage-backed securities went to $0 in value, because of the inability to value them. According to accounting regulations, the financial institutions have to take the $0 values for these securities as losses until they can be valued otherwise.

From the information I've had access to I can't tell if the reason no one can understand them is because most people in the financial industry and/or government are not mathematically literate enough to understand them, or if they were frauds to begin with, making no logical sense. I'm anxious to know which it is. Alan Greenspan said in a recent interview that he tried looking at some of these securities. He said, "I have quite a background in mathematics, and I couldn't figure them out."

There have been various solutions bandied about to try to assign a value to these assets. A problem that was identified is there's no specific market trading system for these types of assets. Some have suggested setting up such a thing, but there seems to be a lack of agreement about how to do that.

A theme I've been hearing over and over during this crisis is that markets cannot function properly without transparency, which I take to mean truthful, complete statements of assets and liabilities, and being able to establish prices for things that have value. The Asian crisis seemed to be caused by a lack of honesty (self-deception), and a lack of transparency (outward deception). In this case, the lack of transparency seemed to be caused by incompetence--not understanding a segment of an institutions assets and liabilities.

As I watched "Commanding Heights" I wondered if computers could help in such situations in the future, not in terms of predicting the economy, but helping make the complexity of financial relationships understandable, and the effects of making decisions that affect them; helping financial professionals perceive what's going on in a crisis more clearly so there's less guesswork. What I got out of the description of the current crisis was that Paulson could not see the full effects of his decisions, because he did not have a full accounting of the relationships they were affecting. Had he known that he might've made different decisions and we might've been looking at a smaller bailout, and a less severe economic crisis.

It's clear to me now that ideology played a role with Paulson, but he also showed himself to be a pragmatist when he could see that ideology was not going to fly.

As to our leaders not understanding economics, I think what you say is true. I don't know if the subject will ever be completely understood, but I think there are some things that are understood about it. Just not everything.

In addition, I would add that I think it's too bad that most common everyday people don't have a clue about economics. They understand it in their own experience, but in terms of understanding the national or global economy, it is totally beyond them. Our leaders don't totally understand it, but the citizenry of the respective countries tend to understand it far less. Larry Summers in the 3rd episode put it well: The positive effects of globalization are intangible, but they are there. It takes a knowledgeable, keen mind to see them. The negative effects are very visible, obvious. This is the reason opposition to globalization has been growing, particularly in the developed countries over the last decade.