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10 Years After Lehman: Hubris

Pride and fall.

Pride and fall.
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6 comments on “10 Years After Lehman: Hubris

  1. The failures of modern economics and banking policy are the failures to slay dogma. The present dogma has all manner of fancy mathematical formulae but there are akin to using dinosaur bones to prove dragons exist. Start from the premise there are dragons then assemble the bones to look like dragons… ergo dragons. Rather than starting from neuroscience and physics and building up from those cornerstones. We will continue to be stupefied when policy fails just as the men jumping from cliffs with wings strapped to their arms could not grasp why the birds flew but they plummet, until such time as we begin to examine the actual science of supply, demand, production and consumption and rebuild economics as a scientific field instead of a cult.

    • well, see, that’s the thing. there is no hard “science” of supply, demand, production and consumption. It makes no sense to talk about those things in terms of hard sciences. Economists are doing the best they can do. There will never, ever, ever, ever be a time when economics is a “hard” science. Because as soon as, for instance, you think you’ve discovered the foundational building blocks and physics of my demand function and consumption habits on the way to predicting I’m going to buy peanut butter today, I may decide to go to the strip club on a whim instead.

      • Haha, yes of course but then you cannot predict the explicit location of an electron only the probability distribution of it’s locations but the probability distribution is reflective of observed reality. I cannot tell you whether your next dollar will go to peanut butter or a strip club but I suspect neuroscience can build a predictive algorithm with high fidelity that tells the probability you do either at any given time. Meteorology is not as precise as 2+2 is four but it is highly science based and the predictive power grows with time and rarely does a storm predicted to have strong winds in summer instead produce sunshine and a light breeze. It is ultimately the unwillingness to be forthright and examine the experiments that limits its development.

  2. Our entire monetary system is a construct imposed onto us via force. On top of that the construct is run with the idea that those running it can model macro behavior. Reality is they cannot model macro behavior (because… humans) and no one asked for this construct to begin with. This means the construct is inherently going to fail as it already has multiple times in the past.

  3. Thomas Higgins

    How do we know if something is a hard science? First, it employs the scientific method: observation, theorization, experimentation, and formulation of the laws that govern a particular field of study. Second, practitioners of that field should be able to apply those laws to predict the outcome of a particular set of circumstances. Finally, if that field does have laws and if the practitioners do indeed understand what they are, it should be possible to use those laws to create a desired outcome. To borrow an example from the field of chemistry, Carrier used his knowledge of how gases operate to invent the air conditioner.

    Assuming that economies do indeed operate in accordance with certain laws and that economists have a thorough knowledge of what those laws are, one would imagine that these economic engineers would be able to create desired outcomes, that they would be able to counter the effects of economic crises. Has this been our experience?

    Did they, for example, immediately apply the lever necessary to end the GFC? In fact, despite protestations to the contrary, the crisis never ended. Not immediately nor even now, though ten years have passed. Otherwise, the markets wouldn’t threaten to have a heart attack at the mere suggestion that rates might rise above historically low levels.

    What actually happened was an exercise in trial and error. In an attempt to find some measure to deal with the crisis, the FED tried the Twist, numerous rounds of QE, near-zero interest rates, buying at par “assets” that could not otherwise be sold except at a steep discount, and various other stratagems.

    Nor is it just our economists who are not up to the challenge. For about 20 years the Bank of Japan has employed similar measures in an unsuccessful attempt to solve the crisis in their country. The record of the ECB of Europe since the GFC is no better.

    In short, economies do not operate in accordance with what a scientist would call laws, or if they do those laws are not discoverable through the scientific method. (An economy has so many inputs, many of which are unknown and possibly unknowable, that it would be impossible to control for all variables except for the one being tested.) Not surprisingly, economists lack the understanding necessary to bring about a desired economic outcome.

    As you rightly observed, Mr. Heisenberg, economists realize the limitations of their field of study. (If they hadn’t before, the unsuccessful decade-long attempt to bridle market forces has certainly taught them that fact.) This explains current Fed policy, but an elaboration on that theme is peripheral to the question at hand: Whether economics is a hard science with laws that economists might have used to predict and prevent the GFC.

    We know what Bernanke would have us believe: that the GFC was a bolt out of the blue, that neither the Fed nor anyone else could have seen it coming.

    There is a sense in which that is true. Economics is not a hard science, and it does not in the strict sense of the word have laws that economists might have used to anticipate the GFC. Just as economists are limited in their ability to positively affect an economy, their ability to make accurate predictions regarding the future of the economy is also severely constrained.

    Nevertheless, anyone with even a moderate amount of common sense could anticipate that trouble was brewing. Recall that the Fed had slashed rates in an attempt to limit the fallout from the implosion of the dot.com bubble some years earlier. The resulting flood of liquidity inflated a new bubble, this time in housing.

    One characteristic of bubbles is that they must either grow or die. And so it was here. The time came when pretty much everyone who could buy a house had already done so. In the natural course of things, the housing bubble would have collapsed.

    Obviously, that would never do. Various banks (Washington Mutual most prominently, though there were many others) decided to give house loans to “subprime borrowers,” the elderly (some more than 100 years old), illegal aliens, people without jobs or assets — all of the types of people who for legitimate reasons had been denied loans up until that time. To enable the borrowers to make the payments, banks issued “exploding ARM loans.” The payments would be small at first but within a few years they would rise as much as three times.

    “Of course,” the bankers said to themselves, “when the payments increase the borrowers will default and we will be left holding the bag. That would never do. Ah, I know! I’ll just ship the loans off to the big Wall Street houses. They will package them up as mortgage-backed securities and sell them to unwitting dupes. I’ll collect the origination fees, and when the borrowers default the MBS buyers — not my bank — will take the fall.”

    It should have been obvious to everyone with even a remote understanding of how the financial system works (and that certainly includes the Fed) that this would not end well. The subprime borrowers would default, and the owners of the mortgage-backed securities would go down (pension funds, chiefly, but a number of investment banks also).

    It should have been equally obvious that the fallout would not end there. Fannie Mae and Freddie Mac had insured a great many of these subprime loans. If, as proved to be the case, the defaults were sufficiently widespread, those institutions might well buckle under the financial strain. The mortgage-backed securities had also been insured with credit default swaps, and the issuers of these CDS’s (chiefly, the giant insurer AIG) would experience a great deal of pain. Widespread defaults would lower the value of real estate, harming real estate investment entities (not just REITs but also the large investment banking house Lehman Brothers, which had effectively transformed itself into a real estate hedge fund).

    There is much more on the subject that I might say, but this response is already overly long. The point is that the danger was quite obvious, even to those without a background in economics. And, indeed, during the three years preceding the crisis Shiller, Roubini, Taleb and a great many others warned of the danger resulting from an imminent real estate collapse.

    Yet, Bernanke claims that the GFC came as a total surprise. Let’s just say that I find that excuse less than compelling.

  4. One big difference between meteorology and economics is clear. If you predict rain, and people change their plans accordingly, the validity of the weather prediction remains unchanged. With economics, a prediction can have behavioral consequences that can change the economy and skew reality away from the prediction.

    Nevertheless, I do think economic science could make better predictions if its practice were not affected by the dogma of economic religion. For example, I remember arguing with a business prof who strenuously but not convincingly argued for the complete efficiency of the stock market. Such assumptions make for well-behaved models and may provide an interesting comparison, but are completely untenable for predicting reality. (One of H’s favorite themes is the lack of price discovery in modern markets, intimately relared to market inefficiency.)

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