A Research Question

We are told, usually by financiers, that 'sophisticated financial instruments' like CDSs and CDOs are essential to the functioning of the economy. Yet the economy seems to have been doing quite alright before they were invented.

The chart above is a log plot of the Dow Jones industrial Average since 1928; '2' is the Dow at 100, '3' is 1,000, and '4' is 10,000.

The trend line sits quite nicely in the data. The R-squared for the trend line is 0.926; in other words a simple exponential growth function accounts for over 92% of the variance in the Dow. Of course high R-squared are normal in this kind of time series data. I also appreciate that small changes at the margin may be worth considerable sums of money. Nonetheless, intuitively the economy as a whole does seem to have been growing at a relatively steady pace for almost a century.

"Ahh" say the financiers, "but just look at the growth they generated in the last 15 years". Suppose we do that:

We do indeed see a sharp increase in the rate of growth. Of course this sharp increase in growth corresponds to the Internet bubble. It's followed by something of a correction. Over a longer period of course is the growth in the use of consumer credit and then, beginning at the turn of the century, the housing bubble. With the collapse of the banking sector and the shrinking availability of credit, the economy has retracted and the Dow has dipped well below its historic trend line.

Of course this is vastly oversimplifies things and, as they say in the advertisements, "the past is not necessarily a guide to the future". Nonetheless there is something rather compelling to the thought that "plus ca change...".

My rather simple view of economics suggest that GDP growth can come from two things: more people, and greater productivity. GDP per capita therefore can only change if productivity changes. I lump two things into productivity: gains from trade and specialization and technology. Leaving trade aside, this upswing in the last 15 years might reflect improvements in productivity from new technology; and new 'sophisticated financial instruments' might be seen as an example of a new 'financial technology'.

We should be wary of this explanation, however, on two counts. First a McKinsey study a few years ago suggested that the gains in productivity from new technology have been vastly overstated. Second, new sophisticated financial instruments might possibly be better thought of as bets or gambles than as technologies.

If they are bets, not useful technologies, then there will be no change to the trend line with their adoption, only movement around that trend over time. If so, the correction (which may be a little overdone) brings us back close to where we should be. More importantly, in the long run the impact of these 'sophisticated financial instruments' may be a wash.

So that's the research question for any budding macro-economists: are these instruments technologies or gambles? So to those who say these instruments are an essential part of the modern economy I would say "show me the data". Demonstrate their contribution to GDP; that is how much smaller, if at all, would the economy be were we not to have these instruments available to us? Some empirical evidence is needed, since all we have at the moment is hype and unsubstantiated assertions from interested parties. And that's never as good as real evidence.

More on AIG

Like many people I am concerned that employees and managers in the Financial Products Division of AIG, the arm of the company that wrote the under-priced CDSs, are receiving large bonuses. It is more all the more irksome because they are now being paid by US tax payers, many of whom are struggling with the fall out of AIG's bad decisions.

However, I am opposed to some of the suggestions being floated in Washington to recover that money, for example that of Charles Schumer, who is advocating new completely ad-hoc tax laws. This is the kind of response that makes people wary, indeed suspicious, of government. Such ad-hocary increases uncertainty and makes the Government look weak and capricious.

The time to argue about bonuses was before the money was handed over, not after the fact. Of course, as was I'm sure clear to many at AIG, they had the government over a barrel and the government would have found it enormously difficult to make the surrendering of bonuses a pre-condition of the bailout.

While AIG took excessive risks that have contributed the crisis, it did so because we (regulators, government and the electorate) allowed them to do so. Blaming a few fat cats is easy - they make wonderful scapegoats, but not all of the blame is theirs.

Stewart vs. Cramer

First let me declare my bias: I enjoy Jon Stewart’s show (sorry Dominie). Having watched it pretty regularly for 8 years, I think he does a better job pointing out inconsistency and illogicality in public figures than 90% of the serious television so called journalists (a reflection on the regrettable state of the broadcast media). And that was really his point last week.

Conspiracy theorists and Fox News junkies may impute to Stewart “a hidden agenda”; in some ways they are probably right - I imagine that his “agenda” includes such subversive ideas as a belief that hypocrisy, and unethical behavior in public figures should be called out. Is he “Fair and Balanced”? Probably not. Is Fox News? Of course not.

But this is all quite irrelevant. To dismiss Stewart because he is a comedian or because he probably votes Democrat is a superficial and misguided heuristic, because his substantive points have not been answered.

Cramer was shown explicitly encouraging ethically dubious market manipulation in his internet show; as an insider was may reasonably assume he had more knowledge than most about CDOs and CDSs; given is background and access to insider information, his advice on Lehman stock seems more to reflect the interests of his industry associates than those of the people his show claims to represent.

Stewart’s understandable outrage stems perhaps from seeing his mother’s 401k fall in value while those whose actions contributed to the collapse take home very large bonuses, something to which he alluded on the show.

Of course, some will argue that the problem was not just on Wall Street and I agree. Politicians of both sides contributed to relaxation of oversight regulation the evisceration of the agencies that should have been carrying out that oversight. And many people (encouraged I’m sure by unscrupulous real estate agents) made very foolish decisions that left them overextended. Yet someone who made a bad decision on their choice of mortgage looses their home; they don’t get a six or seven figure bonus (paid for by us, the tax-payers) as a reward for their poor choices.

AIG

AIG needs more tax payer money. While this seems a little like throwing good money after bad, what happens if we don’t? Here’s my lay-person’s take.

If AIG goes under, presumably it will not make good on its credit default swaps (CDS), the insurance-like products it sold to the banks. These CDSs were bought by the banks to protect the mortgage-backed securities they had written; in the event that the collateral (the properties against which the mortgages were written) turned out to be worth less than the mortgages themselves, their mortgage-backed securities (or collateralized debt obligations, CDOs) still had something behind them. If AIG doesn’t make good on its CDSs commitments, the banks’ CDOs are worth less than they currently and those banks will likely fail their ’stress tests’. Consequently, they will be forced into bankruptcy as well.

Some think this is a good idea (and perhaps in some ways they’re right), yet the cost to many could be horrendous. Without the banks to lend to business and consumers the economy will contract further, more people will loose their jobs, their houses, their 401k savings. Property prices will fall further, personal credit will be more difficult to obtain, consumption will decline, and the recession will deepen.

Of course, though keeping the banks alive may lessen the severity of the recession, we will have preserved the very system that was in no small measure to blame for getting us into the mess in the first place…