Saturday, March 7, 2009

Seven must read links

1. Dani Rodrik draws attention to a brilliant expose of modern financial markets by Michael Lewis on Vanity Fair, who chronicles the spectacular story of Iceland's experiments with financial market de-regulation which resulted in the de-facto bankruptcy of the country as it ran up a staggering debt of 850% of GDP. (Update: Freakonomics compares the financial market crisis in Iceland with how government intervention regulated the exploitation of common property resources in fishing)

2. Felix Salmon has this fascinating account of the Gaussian Cupola function, developed by David X Li, which held the attraction, for many years leading upto the sub-prime meltdown, of appearing to model hugely complex bond market risks with more ease and accuracy than ever before.

3. Keynes is not the only economist making a comeback. The Economist has this nice article on Irving Fisher who famously declared in October 1929, just a week before the markets crashed, that stocks had reached a "permanently high plateau". Fisher's major contribution is his analysis of the serious consequences of de-leveraging induced deflationary spiral in the aftermath of debt-driven asset bubbles, which ends up increasing the real debt burden and worsening the economic downturn. He described "debt deflation as a sequence of distress-selling, falling asset prices, rising real interest rates, more distress-selling, falling velocity, declining net worth, rising bankruptcies, bank runs, curtailment of credit, dumping of assets by banks, growing distrust and hoarding".

Fisher felt that it was "always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted". In other words, create inflation and thereby bring down real home prices while allowing nominal home prices to stabilise, and reduce real debt burdens. But creating inflation, as Japan found out in nineties and US may find out over the next few years, is easier said than done.

4. Another economist making a comeback is James Tobin. Bloomberg has this nice summary of the increasing influence of Tobin in policy making, especially his salience in the Obama administration's $787 bn stimulus plan. Like Kenynes, Tobin was an advocate for the role of government in maintaining full employment through stimulus spending and using quantitative easing to unfreeze the credit markets when faced with zero lower bound interest rates.

Paul Krugman's tribute to Tobin on his death is another excellent piece. Articles on Tobin Q (ratio of a company's total market capitalization to the replacement value of that company's total assets) here and here.

5. Amartya Sen has this brilliant essay (FT version here) in the New York Review of Books where he advocates a "new understanding of older ideas" espoused by the likes of Adam Smith and Arthur Cecil Pigou, as opposed to blind faith in the powers of the market and its invisible hand. He calls attention to the "importance of non-market institutions and non-profit values" in constructing "an economic system that is not monolithic, draws on a variety of institutions chosen pragmatically, and is based on social values that we can defend ethically".

About Adam Smith, Sen writes, "The most immediate failure of the market mechanism lies in the things that the market leaves undone. Smith's economic analysis went well beyond leaving everything to the invisible hand of the market mechanism. He was not only a defender of the role of the state in providing public services, such as education, and in poverty relief (along with demanding greater freedom for the indigents who received support than the Poor Laws of his day provided), he was also deeply concerned about the inequality and poverty that might survive in an otherwise successful market economy."

On Pigou, who attributed economic fluctuations partly to "psychological causes" and "infectious pessimism", Sen draws attention to his pioneering studies on public good externalities and the measurement of economic inequality as a major indicator for economic assessment and policy.

6. William Buiter argues in a Vox article (and Maverecon post) that "standard macroeconomic theory did not help foresee the crisis, nor has it helped understand it or craft solutions... both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow the key questions about insolvency and illiquidity to be answered. They did not allow such questions to be asked".

7. Joseph Stiglitz lays out his plan for "A Bank Bailout That Works" in an article in The Nation. He argues that any bank bailout plan would need "to be transparent, cost the taxpayer as little as possible, focus on getting the banks to start lending again to sectors that create jobs, and should make it less likely, not more likely, that we will have problems in the future". Stiglitz claims that the only way to unfreeze the credit markets, while meeting all these aforementioned objectives, is to take over the failed bank, restructure it, shut down many of the branches and lending departments with particularly bad track records, and then sell it. He describes this "temporary nationalization".

Update 1
Good article in the NYT that chronicles the rise of quants in the financial markets over the past three decades.

Update 2
Mark Thoma points to an excellent article by Anatole Kaletsky which blames the academic economists and the economics profession in general for the crisis, and feels that if economics is to become useful again "it must undergo an intellectual revolution — becoming both broader and more modest".

Mark Thoma offers his comments here. He draws the distinction between academic economists and business economists - the former uses economic and econometric models to understand how economy works and whuy an event took place, whereas the latter uses these models to make forecasts. He also draws attention to the perils of forecasting given the problems associated with the relevance and accuracy of data.

Update 3
Anatomy of a financial crisis by John Cassidy.

Update 4
Niall Ferguson (full here) chronicles the emergence of Planet Finance, where "mathematical models ignored both history and human nature, and value had no meaning".

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