Black Swans and Dark Matter

by John Quiggin on December 22, 2008

There’s been a lot of talk about the idea that the GFC (the in-group shorthand for ‘global financial crisis’) is an example of a ‘black swan’, that is, an event that would be treated as impossible on the basis of induction from past experience, and hence that could not be encompassed by formal models of the kind used by risk managers. All this talk has of course been great for Nicholas Taleb who has a book with this title. It’s good in a lot of ways, but I found it ultimately insufferable in the continuous repetition of the message that only Taleb was smart enough to see all this. ( To be fair, Taleb predicted a global financial crisis, and didn’t simply claim it in retrospect as an unpredictable Black Swan).

I spend a lot of my time working on how to think about unforeseen contingencies and I’m not at all convinced that the GFC should be described in this way. Of course, the models used by the risk managers in investment banks didn’t include this as a possibility; if they had, the implication would have been that all sorts of much-desired deals should not go ahead. But as I pointed out a while ago, very simple models based on well-established principles predicted that the bubble economy would end badly.

The crisis then, involved something more like dark matter, the ‘missing’ matter in the universe that must exist if it is to work as it does, but can’t at presented be detected. Given that risk can’t easily be made to disappear*, it was obvious that the risk associated with lending of all kinds (most obviously, mortages offered to people with no capacity to repay) was being borne by someone, and probably someone who was unaware of it.

The big problem for the Cassandras (and we were certainly both correct and disregarded) was that it was easy to see that the bubble could not continue and much harder to foresee how it would end – it’s one thing to say that dark matter must exist and another to work out what it is really like. Like Brad and Brad, I expected that the problems would emerge first in the form of a run on the US dollar, given that holders of US dollar assets were receiving very little compensation for the obvious risk of large capital losses. In fact, the US dollar actually rose in the early stages of the meltdown, though it has been falling more recently.

One ‘black swan’ explanation of the mortgage crisis was that the mortgage derivatives created by Wall Street couldn’t fail except in the event of a simultaneous downturn in all major housing markets in the US, something that had never been observed, and therefore could not be included in the models. But of course the reason such a thing had never occurred was that local housing markets had been separate from each other, with their own sets of banks, S&Ls and other financial institutions. The very banks that were doing the modelling were creating the conditions under which a national bubble and bust could take place. This was both foreseeable and foreseen.

*Unlike matter, risk can be created with ease. Reducing it is more difficult, though pooling and sharing of uncorrelated risks works in many cases.

{ 96 comments }

1

dsquared 12.22.08 at 11:21 am

The thing that irritates me particularly about the “Black Swan” metaphor is that it implies that on discovering the Australian black swan, ornithologists were like “OMG! All of our previously held theories about swan colour are falsified! We will have to rewrite the history books! Previously we had believed that swans were a priori white and that a swan of any other colour was impossible!”.

And I bet they didn’t. I bet they just went “ooh, a new kind of swan, that’s interesting”. I would even slightly extend the bet to suggest that no actual ornithologist[1] ever made any universal predictions about swan colour.

[1] As opposed to amateurs like Juvenal who IIRC[2] used “black swan” as a metaphor for something rare (as opposed to actually impossible)

[2] All right, I gleaned this from Wikipedia, are you happy now?

2

John Emerson 12.22.08 at 12:18 pm

The GFC was caused by excessive optimism result from drug use.[1]

Modern pharmacology leads people to light far too goddamn many candles and forget to curse the darkness, even when the darkness desperately need cursing.

[1] I didn’t specify that the drugs may have been legally prescribed. And besides amphetamines, anti-depressants were almost certainly involved. Negative thinking can be your friend.

Breaking news: Was Rush Limbaugh the Palin family’s oxy connection, via Levi? Sarah Palin had an interview with Rush on October 15. Were Bristol and Levi with her then? Historically Wasilla has been more of meth and weed town, but they were due for an upscaling, with the next President of the US of A living there.

3

john b 12.22.08 at 12:23 pm

The surprising, not-advance-predictable thing about recession is surely not that US housing market bubble losses were borne by $someone_unexpected (that was pretty obvious by about 2005), but that losses in the $1trn order of magnitude (ie 5-10% of US GDP) – a relatively small sum compared to the size of the global financial system – have triggered its collapse…?

4

dsquared 12.22.08 at 12:38 pm

$1trn is not small relative to the capital base of the global financial system. It’s small relative to the assets of the global financial system, but that’s just because the capital of the GFS is small relative to its assets (or in other words, that it’s highly leveraged, which was the original point).

5

john b 12.22.08 at 1:06 pm

This is the bit where my head starts spinning, though. Total equity listed on the NYSE in 2005 was US$13trn, plus US$4trn on the NASDAQ and US$3trn on the LSE, meaning that a not-at-all unlikely 10%-20% fall in stock prices would have destroyed twice as much as the house-bubble-burst in pretend money.

Why does a US$1trn fall in house values make the whole system collapse, when the destruction of far greater asset values (also with leverage involved, unless I’m radically misunderstanding how investment funds work) in stock markets hasn’t had the same impact?

6

john b 12.22.08 at 1:08 pm

(or did everything get so crazily geared during 2001-07 that actually, if stock prices had collapsed before house prices this time round, this would have triggered the same magnitude of crisis we’re seeing now?)

7

A. Y. Mous 12.22.08 at 1:19 pm

John B.,

There is a very fine fault line between skating on thin ice and walking on water. So, yes. Most likely.

8

lemuel pitkin 12.22.08 at 1:28 pm

John B-

The difference is that the housing market has always involved far more leverage than the stock market. There is no stock-market equivalent of a mortgage. And even in the good old days of responsible lending, mortgages often involved loan to value ratios of 90 percent, which would be an extraordinary degree of leverage for a stock market transaction. So it’s not surprising that a fall in housing prices has much greater financial impact than a proportionate fall in stock prices.

9

dsquared 12.22.08 at 1:29 pm

Total equity listed on the NYSE in 2005 was US$13trn, plus US$4trn on the NASDAQ and US$3trn on the LSE, meaning that a not-at-all unlikely 10%-20% fall in stock prices would have destroyed twice as much as the house-bubble-burst in pretend money.

Not sure what this statistic is relevant to; this is market capitalisation of equity markets rather than shareholders’ funds of the banking system, right?

10

lemuel pitkin 12.22.08 at 1:32 pm

So no, a 10-20 percent fall in stock prices would absolutely not have had a similar effect. And indeed, stock prices actually fell quite a bit more than this in 1999-2002, without triggering anything close to a financial collapse.

11

Seth Finkelstein 12.22.08 at 1:40 pm

“Hot potato”? “Musical chairs”? “House of cards”? While a cliche, “house of cards” strikes me as very apt – it’s beautiful while the house is being built, and it’s clear it’ll all collapse at some point, but not exactly when or how – and anyone who says “it’s all going to crash” is a killjoy.

12

Alex 12.22.08 at 2:27 pm

I’ve said this before; on the way up it was all about how our intellectually pure market models proved it was different this time and anyone who disagreed was a stick-in-the-mud and a closet eurosexual socialist, on the way down it’s teh black swans and nobody ever really knows anything, so traditional authority must be respected, la la Oakeshott wibble Hayek wibble Burke.

Very simple indicators showed clearly that there was a huge housing bubble and a huge imbalance in the multilateral trading structure for years before it happened. All you needed to do was look at a chart of the price-rent ratio, for example. But we’re in Orwell Notes on Nationalism country here. “If you harbour anywhere in your mind a nationalist prejudice, some facts, though known in a sense to be true, are inadmissible.”

I would argue that conservative economics certainly qualifies as a nationalism in Orwell’s special sense. Remember, if you’re an EMH true believer you don’t believe there is such a thing as a bubble or a crash. At any and all moments, the price of an asset captures all possible information about it! You may say this is a bubble, but how do YOU know? Eh? Eh? After all, the only possible sources of error are normally distributed, so they cancel each other out and we don’t have to worry about’em! Begone, socialist calculator!

Then, of course, there is a bubble and there is a crash. Fortunately, here come teh black swans – who could have possibly known? Not being ornithologists, or aerodynamicists, the answer isn’t “Wow! A new species of swan!” or “You realise, there’s something wrong with our theory. Take bees, for example…”, but “It’s impossible to predict anything really, so therefore there is no reason to do anything differently. Can haz TARP? Thx”.

This is not an attack on Taleb, or swans, but on the cult of him.

13

peter 12.22.08 at 2:36 pm

dsquared #1: Whatever the reactions of scientific theorists surprised by the discovery of black swans, you can be certain it wasn’t anything like: ““OMG! All of our previously held theories about swan colour are falsified! We will have to rewrite the history books! Previously we had believed that swans were a priori white and that a swan of any other colour was impossible!”.

A more plausible reaction from theorists, as I think Paul Feyerabend first noted, would have been: “You call THAT a swan!? THAT bird is not a swan! For a start, it’s the wrong colour.”

14

Mrs Tilton 12.22.08 at 2:48 pm

Lemuel @8,

There is no stock-market equivalent of a mortgage

Sure there is. Buying shares on margin and buying a house with a mortgage are both a sort of hypothecation. What there’s no equivalent of in the stock-market world (and this is what I think you wanted to say) is the degree of leverage tolerated. In the US, I don’t think a margin account can be leveraged more than 3X.

15

Bob B 12.22.08 at 2:49 pm

John Q – try this recent piece in the FT on: Why policymakers should have known better, by Sushil Wadhwani:

” . . Over the past decade, while the bubbles were emerging, it was frequently argued that central bankers have neither more information nor greater expertise in valuing an asset than private market participants. This was often one of the primary explanations for why central banks were not attempting to ‘lean against the wind’ with respect to emerging bubbles.

“As I argue in my recent National Institute article, had central banks raised interest rates by more than was justified by a fixed-horizon inflation target while house prices were rising above most conventional valuation measures, it is likely that the size of the eventual bubble would have been smaller. At least as importantly, because of the fear of being seen as ‘market-unfriendly’, fiscal and regulatory policy did not lean against the wind either. Our economies would plausibly have exhibited greater stability if tax policy were used in an anti-bubble fashion (eg a counter-cyclical land tax) and if regulatory policy were more activist (eg a ceiling on loan-value ratios) and contra-cyclical (eg time-varying bank capital requirements). . .”

In Monday’s news, a deputy governor of the Bank of England, John Gieve, is saying that the Bank didn’t really understand the significance of the burgeoning consumers’ indebtedness (which has reached £1.4 trillion, about equal to Britain’s annual GDP) and the associated house-price bubble – the relating news reports can be easily retrieved by searching Google news for: Gieve

I find all that curious in the light of this news report back in 2002:

“CHARLES GOODHART, a former member of the Bank of England’s monetary policy committee, warned yesterday that the Bank is failing to take sufficient account of the house price boom in setting interest rates.

“His warning comes amid growing fears among economists that house prices, fuelled by the lowest interest rates for 38 years, are getting out of control. Yesterday, new figures showed that homeowners are borrowing record amounts against the rising value of their homes. . . “
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2002/04/06/cngood06.xml

It’s instructive to retrieve other news reports concerning commentary by Charles Goodhart so I’m very surprised that the Bank of England is now claiming it didn’t properly understand the significance of the house-price bubble.

16

Bob B 12.22.08 at 2:54 pm

Sorry – this is the missing link to the Sushil Wadhwani article:
http://www.ft.com/cms/s/0/dadc438a-cb84-11dd-ba02-000077b07658.html?nclick_check=1

17

Slocum 12.22.08 at 2:54 pm

Like Brad and Brad, I expected that the problems would emerge first in the form of a run on the US dollar…

I think you’re really stretching it to say, “We saw this coming”, since what was expected — a collapse in the dollar — didn’t happen. And DeLong, at least, didn’t even come close to grasping the potential for the systemic effects of the collapse of the housing bubble. In fact, DeLong advanced the theory that the rise in housing prices was explained in some areas by underlying value — that the desirability of living in coastal regions in the U.S. had risen and that the price increases reflected that demand.

But of course the reason such a thing had never occurred was that local housing markets had been separate from each other, with their own sets of banks, S&Ls and other financial institutions.

But it wasn’t the banking that made housing markets in the U.S. distinct, it was government and economic conditions (density, zoning laws, local economic conditions). And, actually, the housing markets remain distinct. Most of the U.S. did not participate in the housing bubble to nearly the same extent as the ‘sand states’. Most U.S. states have nothing at all comparable to, say, California’s Riverside County:

Seven hard-hit states — Arizona, California, Florida, Georgia, Michigan, Nevada and Ohio — had 64 percent of all “underwater” borrowers, but just 41 percent of U.S. mortgages.

“This is very much a regional problem, and people tend to forget that,” said David Wyss, chief economist at Standard & Poor’s, who expects home prices nationwide to fall another 10 percent before bottoming late next year.

Nevada was hardest hit, where mortgage borrowers on average owed 89 percent of what their homes were worth, and 48 percent had negative equity. Michigan was second, with an 85 percent loan-to-value ratio and 39 percent of borrowers underwater.

New York fared best, with an average 48 percent loan-to-value ratio and just 4.4 percent of mortgage borrowers with negative equity.

http://www.reuters.com/articlePrint?articleId=USTRE49S3Q520081031

That’s a huge regional variation between a state with 4% of borrowers having negative equity vs 48%. But the bad news is that even though foreclosures and negative equity are concentrated in a few states (and even counties within those states), the sum total was still big enough to precipitate the collapse of mortgage-backed securities and the banking crisis.

18

Slocum 12.22.08 at 3:13 pm

Rats — block quote in preview doesn’t match block quote in actual comments.

19

Tim Worstall 12.22.08 at 3:17 pm

“couldn’t fail except in the event of a simultaneous downturn in all major housing markets in the US, something that had never been observed, and therefore could not be included in the models. But of course the reason such a thing had never occurred was that local housing markets had been separate from each other, with their own sets of banks, S&Ls and other financial institutions. The very banks that were doing the modelling were creating the conditions under which a national bubble and bust could take place. This was both foreseeable and foreseen.”

Interesting point which I hadn’t seen before.

However, I’m rather with Slocum here. While I agree that the various local markets are more integrated than they were they’re still not all that much.

http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html

The city based Case Shiller indices have Atlanta at 125 in early 2005, peak at 136, now at 122. Dallas 117, now 121 and peak 125. Compare that to the bubble in Vegas.

So more integrated now, yes, but not very much as yet.

20

Delicious Pundit 12.22.08 at 3:24 pm

But, Slocum, isn’t it that, although the actual crappy condos are all in the same region, their equally flimsy securitized mortgages have been released into the world? I take JQ’s argument as: In previous go-rounds a collapse in the sand states housing market would have just taken down the First National Strictly Legitimate Bank of Nevada. Now, because Lehman and Co. owned pieces of all these mortgages, and had leveraged them, they take down everybody.

21

dsquared 12.22.08 at 3:29 pm

Buying shares on margin and buying a house with a mortgage are both a sort of hypothecation

More important than the leverage is the fact that margins are call money and mortgages are term finance. Margin loans have variation margin to maintain a constant level of collateralisation, whereas a mortgage can go way underwater and if it’s kept current, the lender has very limited ability to do anything about the undercollateralisation.

22

Mrs Tilton 12.22.08 at 3:30 pm

DP @19 has it right. There are any number of financial institutions here in Germany, for example, wishing very ardently that housing markets were as distinct as Slocum and Tim think they are.

23

ajay 12.22.08 at 3:33 pm

Mr Emerson: do you know about “depressive realism”?

24

lemuel pitkin 12.22.08 at 3:49 pm

What there’s no equivalent of in the stock-market world (and this is what I think you wanted to say) is the degree of leverage tolerated. In the US, I don’t think a margin account can be leveraged more than 3X.

Right, that’s my point. The existence of the morgage as a standard, accepted, eleally favored debt instrument specifally for real property means that housing is universally purchased on a margin, with ratios of 5X or 10X being considered entirely reasonable, even conservative. That’s what there is no equivalent of in the stock market.

The large majority of stock purchases are by pension funds, mutual funds, insurance companies, and the like, with no leverage at all. That’s a huge difference. Not only that, but most of these institutional investors — pension funds especially — are set up to recognize capital gains or losses only over an extended period — six or eight years is standard for US public sector pension funds. That has the opposite effect of margin purchases — it dampens fluctuations in value instead of amplifying them.

So on the one hand we’ve got an asset that is alwyas purchased on large margins, and ont he other an asset that is not usually purchased on margin, and with much smaller ratios where it is. A decline in value of the one, is going to have much greater financial repercussions, than of the other. That is the answer to John B.’s question.

25

lemuel pitkin 12.22.08 at 3:50 pm

legally favored, that is.

26

lemuel pitkin 12.22.08 at 3:51 pm

More important than the leverage is the fact that margins are call money and mortgages are term finance. Margin loans have variation margin to maintain a constant level of collateralisation, whereas a mortgage can go way underwater and if it’s kept current, the lender has very limited ability to do anything about the undercollateralisation.

Right. Again, there really is not a close equivalent of the mortgage for other kinds of asset.

27

Witt 12.22.08 at 4:00 pm

something that had never been observed, and therefore could not be included in the models.

Is this descriptive or sarcastic? I don’t know anything about economic modeling but from a layperson’s perspective that sounds insane. I would buy “it was hard to talk other people into including it in the models,” or “that factor includes a lot of variables and nobody included it in the modeling because they couldn’t figure out how to account for them,” maybe.

Otherwise it sounds disturbingly like “But there has never been a Category 5 hurricane followed by another hurricane in New Orleans so how could we have modeled it?”

28

John Emerson 12.22.08 at 4:53 pm

We could do with more of it, Ajay. In all seriousness. In a world where no one took “Dow 36000” seriously, I really doubt that this would have happened, but this is a world in which lots of people believed that stuff. Giddy cargo-cult magical thinking was everywhere — New Age, management handbooks, investment guides, prosperity theology, the WSJ, Tom Friedman, and apparently high levels of government and finance. The people I knew who “played the stock market” were scarcely more rational than the oes who played the lottery. My grumpy, stodgy brother spent hours trying to convince his daughter not to take a bad loan, and she went ahead with it anyway.

I understand that economists believe that the market will smooth out psychologically caused mistakes by punishing the people making the mistakes, but I don’t see how group-psychology errors will be smoothed out. And as I understand, while high theorists leave group psychology entirely out of their theories, whenever something unexpected or bad happens they often try to cover themselves by talking about other people’s feelings.

Worse than the idea that no one could have expected this, is the idea that a lot of them did, but that their various professional and financial interests prevented them from warning the rest of us. And some of us remember that when things are going well, economists are happy enough to take credit, cash in, and proclaim themselves as geniuses, and they’re usually extraordinarily effective in expressing their contempt for non-economists who dare to disagree with them.

Yours in Ludd, &c.

29

Bloix 12.22.08 at 5:00 pm

Anyone familiar with Herbert Stein’s law – “If something cannot go on forever, it will stop” – knew that there was a housing bubble that would have to end. How precisely it would end and how badly it would end were not easily predictable but anyone who claims that the bubble itself was undetectable is lying.

30

John Emerson 12.22.08 at 5:02 pm

BTW, the idea of “the black swan” is folkish. No ornithologist would be fazed by a different colored swan. There are birds like loons which seem like ducks but aren’t, and they don’t bother people either. An new insect suborder (Mantophasmatodea) was recently discovered and entomologists were delighted.

The white blackbird is a comparable concept, partly because it’s a verbal paradox good for a few thousand philosophy of language articles. No big deal for science.

Of course, economics may still be in the folkish stage.

31

John Emerson 12.22.08 at 5:09 pm

26: something that had never been observed, and therefore could not be included in the models.

Maybe it was one of the things that was left out of the model in order to get better results. Economists love counterfactual assumptions and theoretical fictions.

A friend of mine said that he went into an auto shop in [a certain third world country] and saw a bucket of miscellaneous parts in the corner of the room. He asked what it was and they told him it was the leftover parts from engines they’d reassembled. That’s how economics works. If you don’t know what to do with something, you just throw it into the anti-model.

32

Bloix 12.22.08 at 5:14 pm

According to that fount of all knowledge, Wikipedia, the black swan metaphor originated with Juvenal. Perhaps an English reader could report on whether the expression “a bird rare in the land” is a genuine proverb:

The Roman satirist Juvenal wrote in 82 AD of rara avis in terris nigroque simillima cygno (‘a rare bird in the lands, and very like a black swan’).[6] He meant something whose rarity would compare with that of a black swan, or in other words, as a black swan did not exist, neither did the supposed characteristics of the ‘rare bird’ with which it was being compared. The phrase passed into several European languages as a popular proverb, including English, in which the first four words (a rare bird in the land) are often used ironically. For some 1500 years the black swan existed in the European imagination as a metaphor for that which could not exist.
http://en.wikipedia.org/wiki/Black_Swan_emblems_and_popular_culture

33

Bloix 12.22.08 at 5:16 pm

I suppose “rare bird” is a genuine expression in the US, of the sort you see in punning newspaper headlines and nowhere else.

34

John Emerson 12.22.08 at 5:17 pm

The flying pig has replaced it. I think that we’re safe with that metaphor.

35

Giles 12.22.08 at 5:23 pm

“I bet they just went “ooh, a new kind of swan, that’s interesting”. “

Isnt that just what alot of economists are doing in relation to this crisis?

36

John Emerson 12.22.08 at 5:29 pm

A different-colored bird isn’t even interesting. Extremophiles are interesting. The Mantophasmatodea is interesting. The Gromia sphaerica is damn interesting.

37

chris y 12.22.08 at 5:41 pm

something that had never been observed, and therefore could not be included in the models.

AFAIK this was more or less standard methodology in geology until the middle of the last century. Uniformitarianism, as propounded by Lyell in 1830, was the name of the game. Nobody had ever seen a glacial lake collapse and create Scablands, so it couldn’t happen. Nobody had ever witnessed an asteroid impact big enough to create a damn great iridium spike, so the dinosaurs must have been the victims of global cooling.

So it isn’t as if the economic modellers were uniquely obtuse; just that they were 40 years out of date. And thereby hangs a tale.

38

John Emerson 12.22.08 at 5:51 pm

Uniformitarianism vs. catastrophism, IIRC. Steven Jay Gould’s “Time’s Cycle, Time’s Arrow” talks about that.

39

Steve LaBonne 12.22.08 at 6:15 pm

In a world where no one took “Dow 36000” seriously, I really doubt that this would have happened, but this is a world in which lots of people believed that stuff.

Unfortunately, I don’t think the actual kind of world where lots of people fall for that kind of thing is going to go away unless we’re replaced by a species whose brains are wired rather differently. I think there’s much reason to believe that something in human psychology makes bubbles inevitable.

40

lemuel pitkin 12.22.08 at 6:25 pm

I think there’s much reason to believe that something in human psychology makes bubbles inevitable.

Yeah? Then why are asset bubbles restricted to the last 0.1% of human history?

Maybe beacause that’s the only part that includes financial assets?

41

Steve LaBonne 12.22.08 at 6:31 pm

OK, I’ll stipulate that we can get rid of bubbles if we eliminate money. (Where’s Gene Roddenberry when you need him?) ;)

42

John Emerson 12.22.08 at 6:35 pm

We just need more grumpy, negativistic people. Bubbles are pathologies of positive thinking and the pursuit of happiness.

And free-market utopianism, in this case.

43

engels 12.22.08 at 6:36 pm

Modern bourgeois society, with its relations of production, of exchange and of property, a society that has conjured up such gigantic means of production and of exchange, is like the sorcerer who is no longer able to control the powers of the nether world whom he has called up by his spells. For many a decade past, the history of industry and commerce is but the history of the revolt of modern productive forces against modern conditions of production, against the property relations that are the conditions for the existence of the bourgeois and of its rule. It is enough to mention the commercial crises that, by their periodical return, put the existence of the entire bourgeois society on its trial, each time more threateningly. In these crises, a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed. In these crises, there breaks out an epidemic that, in all earlier epochs, would have seemed an absurdity — the epidemic of over-production. Society suddenly finds itself put back into a state of momentary barbarism; it appears as if a famine, a universal war of devastation, had cut off the supply of every means of subsistence; industry and commerce seem to be destroyed. And why? Because there is too much civilization, too much means of subsistence, too much industry, too much commerce. The productive forces at the disposal of society no longer tend to further the development of the conditions of bourgeois property; on the contrary, they have become too powerful for these conditions, by which they are fettered, and so soon as they overcome these fetters, they bring disorder into the whole of bourgeois society, endanger the existence of bourgeois property. The conditions of bourgeois society are too narrow to comprise the wealth created by them. And how does the bourgeoisie get over these crises? On the one hand, by enforced destruction of a mass of productive forces; on the other, by the conquest of new markets, and by the more thorough exploitation of the old ones. That is to say, by paving the way for more extensive and more destructive crises, and by diminishing the means whereby crises are prevented.

44

gdr 12.22.08 at 6:39 pm

Then why are asset bubbles restricted to the last 0.1% of human history?

Is that really the case? The ancient Romans had property price bubbles. (According to Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor.)

45

belle le triste 12.22.08 at 7:18 pm

to be fair, wasn’t uniformitarianism a pushback against geologists (or whoever) simply invoking convenient earthquakes or floods to explain anomalous evidence? as in “things maintain a steady state until we can prove otherwise”? steady-state was an essential jigsaw piece in the realisation that the earth wasn’t created in 4004BC, complete with convulsions that made it look older

46

John Quiggin 12.22.08 at 7:21 pm

To be clear, Slocum, I was perfectly aware of the problems with derivatives and mortgage securitization – I just thought that the dollar crisis (and similar crises in other English speaking countries) would happen sooner.

But maybe you were already on top of all this, and could judge the likely point of breakdown a bit better.

47

geo 12.22.08 at 7:26 pm

Sorry, John, Brad, and Brad, but credit where credit is due: the clearest, earliest, most persistent, and most plausible prophets of a global financial meltdown were Loren Goldner, Michael Hudson, Doug Noland, and Nouriel Roubini.

48

John Emerson 12.22.08 at 7:35 pm

Belle, originally uniformitarianism was a pushback against ad hoc Christian deus ex machina explanations, but it got hardened into a dogma drilled into geologists in training, so that at a certain point catastrophic causes were forbidden and anomalies were explained away. It was a reverse secular case of the way that religious belief can distort science. At a certain point the reasons for the dogma were forgotten, and change was more difficult since the acceptance of uniformitarianism became a required stage in the accreditation process.

49

belle le triste 12.22.08 at 7:43 pm

i remember my dad telling me how exciting it was when the wegener theory of continental drift got accepted — more or less (as he told it) overnight: there was a big conference (1965?) where everyone expected everyone else to be rubbishing it, and that they’d be the only person giving a paper in its favour — in the event there were a dozen papers arguing for it from different perspectives, and venerable greyhairs woke up to find a life’s work was suddenly nonsense

50

Kaveh Hemmat 12.22.08 at 7:51 pm

Then why are asset bubbles restricted to the last 0.1% of human history?
And the tulip mania of the 17th century. (Or does that fall in what you meant by ‘the last 0.1%?’) I’m sure there were other cases at various pounts throughout the millennium preceding the tulip craze, perhaps not quite as bad, but investment, speculation, lending and borrowing with interest, &c., were all present, and based on complicated financial instruments.

51

John Emerson 12.22.08 at 7:55 pm

Same with tectonics. My brother was trained in tectonic geology, and he was quite amused to find a pre-tectonic geology text in a used bookstore. Because they were still able to explain everything.

It’ s sort of funny that the return of geological catastrophism is type case of a paradigm shift or epistemic transition. As Foucault might have said, when gradualism disappeared, it collapsed suddenly rather than gradually dwindling away.

I’m looking forward to tectonic economics.

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John Quiggin 12.22.08 at 7:55 pm

Geo, it’s absolutely true that Roubini and Noland did a better job than I did (I linked to Noland in the post linked above) in picking the way the breakdown would play out.

I don’t know the others, and a quick Google of Hudson suggests he was focused, like most of us, on the international imbalances at least as much as their domestic counterparts

http://www.michael-hudson.com/books/super_imperialism_II_press_release.html

Similarly, Roubini (writing with Brad Setser) put plenty of weight on the dollar crisis scenario.

To restate, the fact that the system was building up large and unsustainable imbalances, global, international and domestic was obvious. The time and manner in which those imbalances would be resolved was not. Hence, the dark matter analogy.

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John Quiggin 12.22.08 at 8:00 pm

It’s my impression that, before the discovery of plate tectonics, continental drift got reasonably strong support on the eastern side of the Atlantic, much less so on the Western side.

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John Emerson 12.22.08 at 8:00 pm

A million human years. 0.1% = 1000 years.
100,000 human years. 0.1% = 100 years.
10,000 years of written history. 0.1% = 10 years.

Probably we need a little further specification.

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lemuel pitkin 12.22.08 at 8:06 pm

300,000 thousand years of human beings, 300 years of financial crises, was how I was looking at it. In retrospect 1% might be better — but on the other hand for most of thsoe alst 300 years most of the world wasn’t experiencing speculative bubbles either.

The point is that human societies have found a great many ways to organize productive activities, only a small minority of which involve financial assets of a sort suitable for bubbles.

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burritoboy 12.22.08 at 8:26 pm

The collapse of the Bardi bank in 1353?

The bankruptcy of the Peruzzi in 1374?

(though 14th century Italian mega-banks were named after the leading family in them, outsiders could and did invest extremely large sums in these institutions)

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John Emerson 12.22.08 at 8:34 pm

My Luddite feeling is that ever since 1980 the entire global economy has prioritized high return at the cost of accepting high risk.

I’d be happy to see someone argue that a boom and bust economy is a good thing if, on the net, there’s good growth. If I’m not mistaken that’s the Mellon-Hoover “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate” creative destruction strategy. It’s impossible to argue politically, but as we know politics is bad and makes the economy less efficient.

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belle le triste 12.22.08 at 8:34 pm

i think the conference i’m talking about WAS the tectonics conference — i have old dinosaur books of my dad’s when he was a kid in the 30s that have pictures of the “vegetable matter bridges” that allowed species to cross from africa and south america (ie the paleobiologists — who KNEW the landmasses must have been linked, bcz look at the fossil evidence — were basically humouring the geologists until the geologists wised up and worked out a plausible mechanism)

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lemuel pitkin 12.22.08 at 8:38 pm

The collapse of the Bardi bank in 1353?

The bankruptcy of the Peruzzi in 1374?

Dunno. Were they the result of speculative bubbles? There are lots of ways for banks to fail.

Anyway, I stand by the point that the conditions for asset bubbles are a lot narrower than the existence of human beings.

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John Emerson 12.22.08 at 8:43 pm

The story of the channeled scablands in eastern Washington is almost the same story. The man who first hypothesized that they were produced by an enormous flood (Bretz: http://en.wikipedia.org/wiki/J_Harlen_Bretz ) didn’t get credit for decades, and IIRC he couldn’t get funding to search for the source of the water, which turned out to be Lake Missoula. You can still see the water lines of various stages of the old lake above the city of Missoula.

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John Emerson 12.22.08 at 8:45 pm

“The geology establishment was resistant to a such a sweeping theory for the origin of a broad landscape for a variety of reasons, including lack of familiarity with the remote areas of the interior Pacific Northwest where the research was based, and the lack of status and reputation of Bretz in the eyes of the largely Ivy League-based geology establishment.”

In other words, they had three different bad reasons for rejecting Bretz’s theory. Uniformitarianism was actually the best of the three.

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MarkUp 12.22.08 at 8:52 pm

“Dow 36000” seriously, I really doubt that this would have happened, but this is a world in which lots of people believed that stuff.

Unfortunately, I don’t think the actual kind of world where lots of people fall for that kind of thing is going to go away unless we’re replaced by a species whose brains are wired rather differently.

Is there another species that pro-actively seeks many manner of self extinction?

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Watson Aname 12.22.08 at 9:04 pm

Anyway, I stand by the point that the conditions for asset bubbles are a lot narrower than the existence of human beings.

I can’t see how this is contentious, or particularly interesting: some aspects commonplace to lots of currently living humans haven’t existed at all for most of human history. More to the point, is there a significant period of time in human history that has both the necessary conditions for a asset bubble to exist, and no asset bubbles?

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Steve LaBonne 12.22.08 at 9:09 pm

Is there another species that pro-actively seeks many manner of self extinction?

Ironically no other species is smart enough to do that. Sadly we don’t to be quite smart enough to be very good at getting ourselves out of trouble…

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Steve LaBonne 12.22.08 at 9:11 pm

Sorry for the second straight blockquote tag screwup, I just don’t seem to be capable of typing “/” today. Which perhaps illustrates my point, at least as regards myself…

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John Emerson 12.22.08 at 9:15 pm

Is there another species that pro-actively seeks many manner of self extinction?

I suspect that Diamond’s book, while packed with interesting stuff, isn’t that good at the macro level.

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belle le triste 12.22.08 at 9:37 pm

bretz lived to see his idea vindicated, which was probably a nice feeling — wegener not so lucky (he died in a blizzard in greenland) (possibly at the feet of the mountains of madness)

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Doug 12.22.08 at 9:38 pm

Bloix (way back at 29): The corollary, of course, is that the market can stay irrational far longer than you can stay liquid. Which also relates to the discussion of Roubini et al. — how were they on the timing? Have they been consistently bearish since, say, 2002, or did they get increasingly so and get anywhere close to calling the peak?

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Aulus Gellius 12.22.08 at 9:49 pm

According to that fount of all knowledge, Wikipedia, the black swan metaphor originated with Juvenal. Perhaps an English reader could report on whether the expression “a bird rare in the land” is a genuine proverb:

This is the sort of think Wikipedia is usually wrong about, and sure enough, the black swan as an impossibile appears at least as early as Ovid:

si dubitem faveas quin his, o Maxime, dictis,
Memnonio cycnos esse colore putem
(Ex P. 3.3.95-6)

[If I doubted that you looked favorably on these words, Maximus, I could think that swans had the color of Memnon [i.e., black, since Memnon was an Ethiopian]).

And I’m pretty sure it’s not original in Ovid either, but rather comes from a Greek source, though I don’t remember what. You may now continue to discuss economics.

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Robbie 12.22.08 at 9:56 pm

“The very banks that were doing the modelling were creating the conditions under which a national bubble and bust could take place. This was both foreseeable and foreseen.”

It is never foreseeable if you only look into the past. The banks, Wall St., and many other economic entities have tied their legs to this anvil of statistical modeling, and now are having a problem with its results, or lack of them. One of these results is the “Black Swan”, which is a problem of inductive logic; which is also problem for these modelers of arcane statistics.
After a decade or two of unabashed scientism we have placed a belief in the ability of science to solve anything. Fast computers, an entire army of physicists and mathematicians working on financial problems and what has it gotten us? Well the appearance of a “Black Swan” in the world of money, shows what happens when your axioms are all wrong no matter how many scientists you got on the job. I have read blog posts where people are trying to model human behavior as an electric circuit, and yet nobody questions if human economic behavior is about or even close to this “model”. A proof by verbosity.
Economists are even more guilty of this than most others. In an academic subject dealing with human behavior, the typical economist is often in the confessional of the church of the hard sciences. Forgive-me-father for I have used a non-verifiable, non-quantitative social theory that is dubious in origin and not remotely close to the repeatable nature of Ohm’s law. Give the church twenty regression analysis for penance.
Now I am not against these models, but it is pretty obvious that few are checking if they are correct and if they are giving a true picture of the world, but this is typical of the business world, play-ball or else you are looking for work in another place.

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John Emerson 12.22.08 at 10:11 pm

Dying in a blizzard in Greenland is the geologist’s equivalent of dying with your boots on, of course. It would have been REALLY sad if he’d died crossing the street in a crosswalk or something.

Bretz arranged to live to 95 or so. Good planning.

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someguy 12.22.08 at 10:14 pm

In the examples you gave Slocum.

You hypothesized that an upward rise in long term rates would screw banks holding long term fixed mortgages at low rates.

That really doesn’t count. I would guess the banks holding those long term low fixed rates are relatively happy right now.

You pointed out the danger of derivatives especially of the securitized as opposed to interest rate swap type and noted the danger if the debt was not rated correctly. Pointing out that JP Morgan was pretty leveraged.

Which is much better but still doesn’t count before we get to

“How likely is it to happen? In view of the extent to which standards have been compromised in the financial world, some significant breakdown in derivative markets, leading to the failure of at least some players, seems more likely than not. On the other hand, the full-scale meltdown scenario, while far more plausible today than even a year ago, remains a low probability event.”

Something bad is might happen in the financial happen sooner or later really doesn’t count as seeing it coming.

(That doesn’t mean both links don’t contain a lot of good stuff it just means they don’t count as seeing it coming. )

I would like to here some of your thoughts regarding Tyler Cowen’s objections to the fiscal stimulus.

I still cannot make up my mind, if I spend a trillion today and save 500 billion in lost output, but need to repay myself 1.2 trillion, did I get a good deal?

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chris y 12.22.08 at 10:27 pm

I really didn’t mean to divert this thread into a discussion of geological theory, although I’m grateful to have learned some interesting history from Belle. My point was that there’s a real problem, whether you’re dealing in contemporary economics or Cretaceous geology, in creating models that incorporate unfamiliar mechanisms, precisely because they are unfamiliar. With the lessons of Wegener, Bretz and Alvarez before them, geologists seem to me (I’m not a geologist) to be rather more circumspect than of yore; but economists don’t – no disrespect to Professor Quiggin. What I see instead is a faction who would have been generally in favour of interventionism anyway (Krugman et al.) saying “told you so”, while the bitter end free marketers invent just so stories about how the New Deal was no big deal.

But who is extrapolating from the data to suggest how to prevent this happening again?

(Full disclosure: in my youth I was unduly influenced by serious catastophists like Andy Glyn, Bob Sutcliffe and John Harrison. I want somebody to tell me if/why they were basically wrong.)

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Slocum 12.22.08 at 11:05 pm

John Quiggin: To be clear, Slocum, I was perfectly aware of the problems with derivatives and mortgage securitization

But see there, in your post about securitization, you said:

“If US long-term interest rates rise significantly, lenders will be stuck with a lot of long-term mortgages at low rates while they have to finance their activities at the high rates. They will have to bear the difference. Thanks to the securitisation of mortgages it’s unclear who will bear this loss, but the loss is potentially massive.”

As it turned out increasing rates and lenders being stuck with long-term mortgages at low rates had nothing to do with the crisis. It seems a reasonable point — in some counterfactual world, this sort of problem might have happened. But it didn’t. In fact, what happened was the reverse — in the bubbly areas, buyers were taking out variable not fixed, mortgages, and the end of the low introductory rates caused massive defaults. Had variable-rate mortgages been unavailable, the disaster might have been avoided because 1) There would have been no resets, and 2) Prices never would have bubbled as high if borrowers had to qualify for higher-rate fixed mortgages at the initial purchase time.

But maybe you were already on top of all this, and could judge the likely point of breakdown a bit better.

Oh no — I’m skeptical of claims of prescience, but I’m not making any special ones of my own. I recognized the housing bubble as I did the stock bubble before it, but the rather minor effects of the bursting of the dot-com bubble lead me to believe that the global economy was resilient enough to handle the end of the housing bubble without too much pain also.

Delicious Pundit: But, Slocum, isn’t it that, although the actual crappy condos are all in the same region, their equally flimsy securitized mortgages have been released into the world?

Yes, fair enough, but that’s a different point. It’s not that housing markets were integrated and that housing prices crashed nationwide but rather that mortgage finance was integrated across housing markets which otherwise remained distinct. For smaller regional crashes this should have made things more robust — the regional financial institutions aren’t all wiped out by a real-estate bust in the area. But if the regional crashes are big enough (or there are several at once), they can now take down the whole system. The analogy that comes to mind is roped climbers–lower probability of a single climber accident, but a higher probability of taking down the team.

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Tom West 12.23.08 at 3:22 am

There are piles of Cassandras for every human choice. Certainly there’s a lot of people actively predicting disaster if we don’t go back to the gold standard. In fact, we’ve got a bunch stating we have to go back to an agrarian lifestyle or the whole race faces doom. Why aren’t we listening to them as well?

Mainly because, lacking any expert knowledge ourselves, we have to rely on the consensus of the community of experts. Sadly, those who predicted this crisis did not have strong enough arguments to persuade the community of economists that their view was right.

To my mind, we have three outcomes:

(1) The claim that the crisis was obviously imminent is wrong. It wasn’t obvious to the vast majority of experts in the field.

(2) The community of experts is not smart enough to be able to comprehend the complexity of the reality of the situation.

(3) The community of experts is too biased to be able to examine the facts realistically.

(1) means essentially that this was a black swan – the experts got it wrong because there was no unbiased way of distinguishing ‘good’ Cassandras from ‘bad’ ones.

(2) + (3) mean that the profession of economics is screwed up and essentially the banks should have ignored all the experts. (After all, how can non-experts tell the smart/unbiased experts from the others?) In this case, with no accurate models possible (or more accurately, no way of telling accurate models from inaccurate models) the banks might as well guess optimistically. Especially since pessimistic CEOs are going to fired after the first year or two of profits that are substantially less than their peers. (After all, if the experts couldn’t persuade people that things are too risky, what chance does a non-expert like a CEO have?)

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nnyhav 12.23.08 at 4:20 am

Doug@68: Roubini was banging the drum from ’04 on. Which was about the point at which lending standards significantly deteriorated and house price increases accelerated. But he says he was too early. And yet, too late. About the only way of having it both ways that’s valid for an economist.

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Andrew 12.23.08 at 6:16 am

As far as I can tell, no-one laid out the precise sequence, in advance, which we would go through. But that’s a bit like Condoleeza Rice asserting to the 9/11 Commission that if only, if only, someone had given her the precise number of hijackers and the actual flights they planned to commandeer then, by gum, as National Security Advisor she’d certainly have put a stop to it. But they didn’t, so what could you do? OK, a month before a PDB had been put out which had said “Bin Laden determined to strike in the US,” but it wasn’t specific, was it?

If you were reading Roubini/Setser, or Calculated Risk/Tanta (sadly missed), by mid 2006 you knew that some really nasty stresses were in the system. Mortgage Equity Withdrawal, negative savings ratios, the strains of Bretton Woods II – these pointed many people towards the notion that the catalyst would be the end of what Larry Summers referred to as “Mutually Assured Financial Destruction,” with the foreign creditors yanking the US chain.

Instead, what most of us missed, because we most of us were simply completely and thoroughly unaware of it, was the coupled dark matter/dark energy of the “shadow banking system,” the interplay between CDSs and CDOs, and the way liquidity could disappear and solvency evaporate and we wouldn’t know which came first or even which was which. Robert Rubin is said to have had to have had the term “liquidity put” explained to him: the risks his bank was running had been, to that point, literally inconceivable to him.

In the aftermath of a tragedy, cause and effect are obvious. Tufte has a fine example on the kind of graphic displays the Morton Thiokol engineers might have used to try to persuade their counterparts at Nasa not to launch the Columbia in 1986. Instead, they spoke of their fears, were heard out, and over-ridden – not by fools, but by honest people who couldn’t fit the evidence they had into their imagination in the right way. In hindsight it’s obvious, but at the time, not so much. Don’t see much erring on the side of caution, though, in 2001 or 2006-2008.

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John Quiggin 12.23.08 at 6:28 am

Actually, the problem (at least, the fact there was a big problem, if not the exact way it would turn out, or the time this would take to happen) was obvious to a fairly large number of academic economists, but
(1) Plenty of others took the opposite view based on the efficient markets hypothesis
(2) Banks and regulators ignored the first group and hired their own “economists”
The debate leading up to the Iraq war had similar characteristics.

In both cases there were, in Rumsfeld’s famous words, unknown unknowns, but I still think more like dark matter than like black swans.

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Tracy W 12.23.08 at 9:08 am

Lemuel Pitkin but on the other hand for most of thsoe alst 300 years most of the world wasn’t experiencing speculative bubbles either.

Be careful – just because something wasn’t written down doesn’t mean it didn’t happen. And particularly, just because something wasn’t written down in English doesn’t mean it didn’t happen. I am looking forward to China and India getting rich enough that they can afford to throw hordes of money at their social scientists like the Americans do (and before someone shows up grumbling about their lack of funding in the USA, my baseline is NZ ).

More scientifically, bubbles have been easily recreated in labs: http://www.theatlantic.com/doc/200812/financial-bubbles
Admittedly this is based on a study of Americans, and it may be that different cultures would show different results.

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sg 12.23.08 at 9:40 am

I like this new requirement, a la slocum et al, that to claim success in predicting a collapse you have to predict all the details of how it happened. That’s the kind of optimism which will definitely help us to avoid the next one.

I presume 100 years from now there will be a neo-slocum claiming that climate scientists didn’t predict anything, because they got the final equilibrium height of the oceans 3 cm wrong, or somesuch…

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John Quiggin 12.23.08 at 10:50 am

SG, this requirement isn’t new – the political right learnt to use it in debate with those who predicted that the Iraq War would be a disaster, but predicted the wrong kind of disaster (actually, most of the predicted disasters happened in the end, but some took a long time to emerge and some may still lie ahead).

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Tim Worstall 12.23.08 at 11:10 am

“I’d be happy to see someone argue that a boom and bust economy is a good thing if, on the net, there’s good growth.”

Isn’t this roughly the Austrian view? Perhaps someone with more economics than I (yes, I’ll make the joke first, that means any and every one) could confirm/rubbish that?

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sg 12.23.08 at 12:41 pm

Maybe John our predictions would be more defensible in hindsight if we had a get-out-of-jail-free card like the right wingers have. The Dow would be 36000 by now if government policy hadn’t enabled minorities to buy houses, you know!

We could try this. e.g. sea level rose 3cm more than predicted because govt policy enabled minorities to emit more co2 than we allowed for in our model!

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strategichamlet 12.23.08 at 1:08 pm

“Nasa not to launch the Columbia in 1986”

The Challenger disaster was in 1986, Columbia in 2003. Sadly a similar story can be told of both tragedies. More pedantically: NASA please, before we start getting Dod, Doe, Usaf, Scotus, etc.

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Slocum 12.23.08 at 2:20 pm

I like this new requirement, a la slocum et al, that to claim success in predicting a collapse you have to predict all the details of how it happened. That’s the kind of optimism which will definitely help us to avoid the next one.

But being right about the details matters — it’s not enough to have a general sense of foreboding matters. Returning to the ‘Scary Story’ that Quiggin linked to about securitization:

http://www.johnquiggin.com/archives/000186.html

In it, he specifically identifies the unusual U.S. practice of taking out fixed rate mortgages as a particular problem. But if we had acted on that belief that fixed rate mortgages were dangerous, we would have done the wrong thing, wouldn’t we? If we’d taken actions to discourage fixed rate mortgages and encourage variable rate mortgages, is there really any doubt that the problem would have been worse?

Yes, low-interest rate mortgages drop in value if interest rates rise — but so do low-interest rate bonds. So do T-bills. There are a lot of T-bills being issued and sold right now that may come to be worth much less, and investors stand to lose a lot. Twas ever thus. But, on the other side of the equation, fixed rate mortgages give buyers not only predictability but mortgage costs that decline in real terms over the life of the mortgage (because, for example, a fixed monthly payment of $1200 in 2008 dollars us significantly less than the same $1200 was in 1998 when the mortgage was taken out). With fixed rate mortgages, no borrowers are thrown into foreclosure by unexpectedly high rate resets. So which is more dangerous to the economy, losses to investors on bonds, or massive defaults by mortgage holders? Sure looks like the latter now, doesn’t it? Many proposals now involve moving homeowners from variable into fixed rate mortgages–does Quiggin still think that is a mistake?

Predictions of doom without getting the details right strike me as pretty useless.

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SamChevre 12.23.08 at 8:17 pm

I like this new requirement, a la slocum et al, that to claim success in predicting a collapse you have to predict all the details of how it happened. That’s the kind of optimism which will definitely help us to avoid the next one.

Well, my position is pretty close to Slocum’s, and here’s why.

My criterion is “your picture of what would go wrong has to have been close enough that following it would have made things go better”; else, it doesn’t add anything useful.

If the advice you are giving is “there will be a crash in the US housing market, driving consumption down, the dollar down, and interest rates up”–following your advice would have made me worse off.

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John Quiggin 12.23.08 at 8:28 pm

Slocum and SC, I didn’t realise you were looking for investment advice here. Just to be clear, I Am Not A Financial Adviser. This is a blog in which people comment on matters of interest, discuss the viability or otherwise of particular policies and ideologies and so on. No one should rely on it for investment advice.

I’m sorry you’ve been wasting your time here for so long. But, on your way out, can I suggest you go short on free market ideology.

(Another standard line of rightwing criticism is “if you’re so confident things will go badly wrong why not back your belief with your own money”. For the same reason: it’s hard to predict the details in advance, and therefore hard to profit on a large scale. Soros, Taleb and others have gone badly wrong trying, but have deeper pockets than I do).

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SamChevre 12.23.08 at 8:40 pm

JQ,

Say what? This thread is about finance, so I used a finance example. It’s the same criterion for other fields–if your “prophecy” is so vague that anything that happens will fit into it (next year, some things will get worse), or that you have to ignore most of it in favor of it’s “broad themes” to make it true, or it’s non-falsifiable (someday, you will die) I’m not putting a lot of stock in it. And if your response to the Y2K issue was to buy a year’s supply of canned goods and move into a cave, I am not admitting that “my January 2000 bank statement was wrong” proves that this was a good idea.

I use this rule mostly in talking to people more right-wing than myself. (The various crazy varieties of predicters of the end-times.)

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Tom West 12.24.08 at 4:49 am

I think Bloix in the very first post had it dead on. I don’t know of any economists who claimed it could go on forever. But that wasn’t the question, after all, pretty much nothing we do can go on forever. The question, and what had to be proven strongly by the ‘Cassandras’ was that it was going to end catastrophically.

Certainly I was reading economists around the web and I heard lots of “it’s going to end” and a fair amount of “I hope it’s going to end softly”. But I didn’t see economists debating seriously any particular evidence of a catastrophic landing. (Most seemed to think a Roubini like outcome was a possibility, but not anything like the certainty necessary to justify painful economic policy.

I honestly can’t see any way of having insulated ourselves from this catastrophe except by massively decreasing the amount of risk taken on every possible front, which would, of course, meant a massive loss of economic wealth. And in the end, probably for no reason. After all, someone *somewhere* would have taken the risk, reaped massive rewards and ended up taking out all the conservative banks and then taken everyone else with them anyway.

(Can you tell I’m Canadian? We had a moderately well behaved banking system. It didn’t help. We’ll go down the same path as everyone else, except we didn’t make out like bandits while the going was good. Well, at least while we’re eating our catfood we’ll have moral superiority . We’re good at that :-))

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Robert Waldmann 12.24.08 at 4:53 am

” the mortgage derivatives created by Wall Street couldn’t fail except in the event of a simultaneous downturn in all major housing markets in the US, something that had never been observed, and therefore could not be included in the models. But of course the reason such a thing had never occurred was that local housing markets had been separate from each other, with their own sets of banks, S&Ls and other financial institutions.”

there is discussion upthread of the text following “of course”. I actually nodded and thought “yes of course” so I feel qualified to try to explain. First and simply, there had never been such a huge nationwide increase in house prices deflated by the CPI. The upswing was new and so it was clear that old rules didn’t apply. I believe (and I think this is what John meant) that such a nationwide bubble had not been possible before the new financial instruments were invented, because, back then, mortgage initiators had to bear the risk of “froth,” that is, local bubbles bursting. This caused fear which restrained lending which prevented nationwide house price bubbles.

A way of making the argument is that financiers will risk bankruptcy. If new instruments make them invulnerable to local bubbles then they will lend until there is a national bubble.

Now the claim that a nationwide downturn couldn’t be predicted, because it had never happened happens to be false. Such a downturn had occurred during the great depression. Ah but that was just nominal prices not real prices — which fell sharply nationwide from 1918 trhough 1922. Oh and what about Japan. A nationwide fall in house prices hadn’t occurred in the post WWII USA and therefore was excluded from the models.

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John Quiggin 12.24.08 at 6:21 am

Stephen Bell and I argued in 2006 for financial reregulation that would specifically restrict financial innovation, and I’ve been putting forward similar proposals for a long time. I think that if such policies had been adopted, they would have reduced the severity of the crisis (though possibly bringing it on earlier). But such ideas were well outside the mainstream, I admit.

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sg 12.24.08 at 9:23 am

It’s all very well to talk about the recklessness of following the predictions of the so-called cassandras, but a lot of the people “predicting” the system’s future made some pretty wrong calls too, wrong calls which mostly happen to have made some rich bankers richer at the expense of a lot of lower middle class workers. And in the process that system made it harder for a whole bunch of people to achieve a basic part of the western life course, that is buying a house.

Of course Slocum and SamC don’t care because, as ever, following the predictions of their favourite ideologues only made poor people poorer, and people who care about poor people are just losers or closet commies.

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Tom West 12.24.08 at 3:35 pm

I think that if such policies had been adopted, they would have reduced the severity of the crisis (though possibly bringing it on earlier).

There’s no doubt in my mind that you’re correct on both points. The case that has to be made (and I don’t know if it really can be), is whether the gain from dampening the severity of financial crises (which, as a pessimist, I’m convinced are unavoidable) is worth the loss of wealth produced by these innovations.

Moreover, the real problem with choosing stability over wealth is that inevitably we take the stability for granted and see only the lost wealth. It’s a little like taking medicine for severe mental illness. After taking them for a while, you feel normal enough that you can’t understand why you have to take the medicine (and endure the unpleasant side effects).

Not that finance and economics is any different from any other field. Mankind is bright enough to constantly increase our efficiency, which means that the good times are much better, and when the inevitable disaster strikes, we’re much further up the creek without a paddle. To take a page from Homer Dixon, I’d rather take a jet plane than walk, but when the malfunction finally occurs, I’d rather trip over my feet than slam into the ground at 1,000 km/h.

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Tom West 12.24.08 at 3:43 pm

but a lot of the people “predicting” the system’s future made some pretty wrong calls too

Absolutely. As JQ alluded to above, the real choice is not between particular policies or economic beliefs – after all there’s not really going to be any way of positively knowing which innovations are going to be good and which are going to be bad. (Okay, being pedantic, some people might know, but they’ll be unable to persuade a sufficient number of people to make a policy difference).

The real question is simply how much innovation do we allow? And this applies to *everything*. Medicine, agriculture, AI research, nanotechnology, materials science, physics, chemistry, everything. All of these could have catastrophic long term consequences, and if they do, there will have been people speaking against the innovation who won’t be believed.

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someguy 12.24.08 at 5:45 pm

sg,

“I like this new requirement, a la slocum et al, that to claim success in predicting a collapse you have to predict all the details of how it happened. That’s the kind of optimism which will definitely help us to avoid the next one.

I presume 100 years from now there will be a neo-slocum claiming that climate scientists didn’t predict anything, because they got the final equilibrium height of the oceans 3 cm wrong, or somesuch…”

I am curious if someone a 100 years from now provided a link in which they claimed to have predicted the disastrous consequences of global warming and it looked something like this

“On the other hand, the full-scale meltdown scenario[global environmental catastrophe], while far more plausible today than even a year ago, remains a low probability event.”

“How likely is it to happen? In view of the extent to which standards have been compromised in the financial world, some significant breakdown in derivative markets, leading to the failure of at least some players, seems more likely than not. On the other hand, the full-scale meltdown scenario, while far more plausible today than even a year ago, remains a low probability event.”

and someone objected that the provided quote wasn’t really a very good example of predicting global environmental catastrophe how would you respond?

Plenty of people thought there was a real estate bubble. I thought there was bubble back in 2002 when I bought my house and if you would have asked me what would happen when the bubble burst in 2006/2007 I would have replied bad news for the economy.

Kieran Healy with all his typical charity wrote a post mocking David Bernstein for frequently writing about the real estate bubble.

Here is a link to an instance of Professor Bernstein warning about a real estate bubble back in 2005

http://volokh.com/archives/archive_2005_08_14-2005_08_20.shtml#1124513110

Professor Quiggin’s circle of Cassandras that were correct and disregarded is pretty darn large and diverse.

The group of Cassandra’s who linked housing derivatives with the housing bubble and predicted a very large banking crisis is quite a bit smaller.

Those are pretty crucial details. Not a difference’s of 3 cms in the Oceans height.

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engels 12.24.08 at 8:35 pm

James K. Galbraith interviewed in the New York Times:

Do you find it odd that so few economists foresaw the current credit disaster? Some did. The person with the most serious claim for seeing it coming is Dean Baker, the Washington economist. I saw it coming in general terms.

But there are at least 15,000 professional economists in this country, and you’re saying only two or three of them foresaw the mortgage crisis? Ten or 12 would be closer than two or three.

What does that say about the field of economics, which claims to be a science? It’s an enormous blot on the reputation of the profession. There are thousands of economists. Most of them teach. And most of them teach a theoretical framework that has been shown to be fundamentally useless.

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