a herd of economists

January 6, 2009

Now that everyone [economist or not] is throwing a shoe at Alan Greenspan, it is certainly worth remembering how they were herding behind the man a few years back.

The Wall Street Journal blog [which I reached via Paul Krugman’s] has a series of very interesting links.

In 2005 there was a conference [pretty much a celebration towards the achievements of Alan the Great] at Jackson Hole, where R Rajan gave a paper which was titled “Has Financial Developement Made the World Riskier?”, to which the paper answered “Yes”.

The responses by D Kohn [the vice-president of the Fed], and other participants are clear as spring water.

Rajan argues that the general “dis-intermediation” trend has produced as a byproduct a management layer between the investor and the investment. He claims that if the incentives are not carefully aligned, then the management will be directed towards riskier investments. He contrasts the bygone era where a bank manager was paid a fixed salary, with the current environment where performance incentives typically dwarf the fixed portion.

Rajan mentions two kinds of risk:
* Risks arising from “rare” events, which offer a stream of income until catastrophe strikes. Rajan calls them “tail” risks, but I would find the notion of “skewness” or “asymmetry” more precise.
* Risks arising from the market structure, where compensation is linked to the performance versus a group of peers. This encourages “herding” behaviour, which in turn produces and pops asset bubbles.

In this competitive environment banks are not isolated. They are under pressure to serve as originators of more risky produsts, and will typically sustain the first portion of losses. As they hedge on liquid markets to hedge their exposure, a lack of liquidity when the “rare” events materialize will be detrimental to their solvency.

When read today, Rajan’s paper looks prophetic. He points out that regulators and policymakers will have a hard time getting ahead of this complex system where the impact of large shocks can travel through channels that are not well understood. The same system that spreads and diversifies small shocks, will also transmit and possibly larger shocks that can lead to a meltdown.

What do the discussants have to say about Rajan’s thoughts? Perhaps unsuprisingly, D Kohn reiterates the Chairman Greenspan doctrine, which he appears to hold as gospel. He goes on about letting the markets do their business, and the <<iron law of unintended consequences>>, getting a bit rude towards the end where he critisizes Rajan’s <<nostalgia>> for old-style finance.

But for me, the coup de grâce is his comment on the Japanese experience: <<I think we would all agree the industrial economy that has suffered the greatest systemic strains from problems in the financial sector in the past 15 years is that of Japan, which remained tied to the commercial bank model that Raghu finds safest.>> The Japanese experiments are the topics of my entry here.

Kohn’s response is expected, but what is interesting is they way the other discussants [with the exception of Blinder] align with Chairman Greenspan’s doctrine. And in particular the response of L Summers, who is the brain working on Obama’s measures to rescue the US economy. He takes Kohn’s position on the Japanese banking setup, and its reliance on products that are not too exotic. And the coup de grâce follows: <<[Rajan’s] tendency toward restriction […] seems to me quite problematic. It seems to me to support a wide variety of misguided policy impulses in many countries.>>

Now presumably L Summers will be the architect of these misguided policies. And economists are herding rapidly towards this new Jerusalem, where money is free with the risk-free rate at zero and where governments borrow and spend like there is no tomorrow. The herd got lost last time they left the pen, can we trust them to find their way now?



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