Knowing and Making

There's been a movement - reminiscent of the anti-short-selling campaign - against buying "naked credit default swaps". The idea of a CDS is to provide insurance against default on a corporate or national bond; and a naked CDS is one which is bought by someone who doesn't own the original bond. The objection to this is based on a kind of moral hazard argument - the idea that if I buy insurance against your house burning down, I'll have an incentive to leave piles of leaves and open cans of petrol near it. So one proposal, according to this article in the FT , is to prohibit people from buying a CDS if they don't own the underlying bond. ( Update : Felix Salmon points out Wolfgang Munchau's more in-depth article proposing the same thing) Sounds like it makes sense at first glance. But one big question arises: what if I want to sell the bond afterwards? Do you prohibit me from selling it without also selling the CDS? If so, I am suddenly left with...

There are lots of reasons why finance is different from normal markets, but I am particularly interested in why it is difficult to model economically. It's not fundamentally because "finance markets deal with money, which is essential to all other markets". On this basis, energy markets would have the same problems, as no other markets can operate without energy; equally, computer hardware or telephones. Instead, it's because finance has a special characteristic in information-theoretic terms: it creates contracts which operate on other contracts, which in turn operate on the first contract again. This is what George Soros calls reflexivity - but I will use another term: self-referential . Self-referential systems behave very differently to "normal" systems. Douglas Hofstadter has made a whole career out of analysing them. In his famous book Gödel, Escher, Bach he compares the self-referential patterns in Escher's art and Bach's music to Gödel...

The Geary behavioural blog explores some research from Garth Brooks into time discounting and uncertain preferences. Who knew he had a second career in economics? But he evidently does: Garth has proved his credentials as a behavioural economist by not writing down an actual model for his theories; instead, he just tells an anecdote and we're meant to make our own inferences. He'd fit in just fine in J.Econ.Psych. Multitaskers are bad at... multitasking, according to the BBC . In my own model of the mind, this is one of the key factors that accounts for much of the behaviour we see in experiments. In complex situations, to rationally optimise for the ideal outcome requires us to near-simultaneously adjust and monitor several different variables. In reality cognitive limits prevent us from doing this, so we either miss opportunities to optimise, or we use heuristics which combine multiple variables into one (and that can only be an approximation). In this context, heuristics m...

From a conversation with Richard Thinks yesterday: Thanks for the link today...looking back through the emails I notice we had another conversation about transparency a few months ago. I think the idea of publishing standardised information about financial products is one of the strongest part of Osborne's proposals - but the way it's sold as enabling "price comparison websites" is a bit misleading. One of the oddities about the price comparison market (and I wrote, with a colleague, the first version of confused.com so I have a bit of inside knowledge) is that they make their profits precisely because the providers do not offer their products in a standardised way. Instead, everyone (deliberately) distinguishes their products in many different dimensions so that they cannot be directly compared. Ever tried to figure out which mobile phone deal is the cheapest? This is why those sites are so popular. If everyone did publish their terms and conditions in a common mach...

Robert Peston has an interesting insight into the financial regulation debate today: In other words, what's known as micro-prudential issues dovetail with macro-prudential issues. And if that's the case, it would make sense to put the central bank, the Bank of England, in charge of both. Or so the shadow chancellor believes. Intriguing. Indeed, it's true that there is a direct causal link between micro and macro behaviour in the financial markets. There are two reasons for this. First, the trivial one that all macro outcomes are ultimately caused by individual decisions. Second and more interestingly, one of the key influences on credit and asset markets is the appetite of individuals for risk. And a key factor in the stability of markets is whether these risk appetites are governed by rational preference theory and therefore have the ability to self-correct. In the long run everything (more or less) does correct itself, but an asset bubble and a financial crisis can easil...

Robert Peston reveals a report by MPs on bankers' bonuses. Of course they are calling for reform. But what should that reform look like? Here are a couple of odd things about such bonuses: Behavioural economic theory indicates that it's not so much the absolute amount of money that acts as the reward, but the relative amount - if I get £5m to your £3m, it's just the same as me getting £500k and you £300k. The 'reward' seems to be the ego boost of being at the top of the tree. But unfortunately it's also not the amount of money that has led to the risk-taking behaviour. Even if banks had only paid their employees 1/10 of the bonuses, they would still have acted the same way. So how to change behaviour, if that's what we want to do? Certainly tying bonuses to long-term results instead of short-term is one option. But for motivational purposes, people should still receive performance bonuses relatively quickly, as this is how their mental association between a...

I have a commentary up at VoxEU, outlining how financial regulators should use results from behavioural economics to stabilise the economy. The article is here - highlights include: ...behavioural tests can give insight into accurate asset pricing. A sharp rise in house prices, for example, might originate partly in irrational buying decisions, and partly in by a genuine increase in the expected long-term return on property. While the long-term return cannot be tested today, the irrationality of consumers can, through specific experiments. Thus the change in expected returns can be deduced by subtracting the irrationality effect from the actual price rise. There are many other tools which have been experimentally tested at the micro level but not yet applied to macroeconomics. Price anchoring, framing, endowment effects, confirmation bias and various social and peer effects all demonstrably allow us to influence behaviour in the lab; they should have applications to what we might call...

Lord Turner's report " A regulatory response to the banking crisis " was released yesterday. One of the key findings is that markets, and market participants, can be irrational. This can lead to problematic outcomes such as bubbles in asset prices and massive mispricing of derivatives such as CDOs and CDSs. However, Turner's recommendations barely address this problem. There are several valid recommendations about procyclical reserves and a hint at a power to intervene in momentum trading (such as short-selling which feeds on itself). But this only dances around the edges of the problem. He also recommends technical training or qualifications for bank executives. But that's not where the irrationality is. Indeed, many bankers have been all too rational throughout this crisis - extracting rents for themselves at the expense of shareholders and creditors. Turner does recognise this principal-agent problem and some of his recommendations deal with it. However it is n...

Continuing the discussion of a few days ago , Nick Rowe joins in correcting Niall Ferguson 's "average debt" logic. Maybe we should give the guy a break - he is only a historian, not an economist. No doubt whenever a historian writes a book about the history of [X], they get brickbats from all the practitioners of [X]. But then that's the price of intellectual engagement. The comments on Nick's post set me thinking about better ways to measure the total impact of debt in the economy. One commenter (Patrick) reminded me of the issue of debt maturity mismatch, which seems to have been a major contributor to of the current financial crisis (aside from the effect on the real economy). Here's the response I posted there: It sounds attractive that there would be some meaningful measure that at least partly captures the way in which debt influences the economy. We could certainly build models where a large amount of gross debt has almost no effect at all (e.g. A owes...

I have been working recently on an exploration of bounded rationality. This post from Robert Peston gives an interesting example of the insidious overlaps between this and other problems in economic theory - in this case the agency problem. Barclays management preferred to accept a private £2.8bn investment from the Qatar and Abu Dhabi states, rather than take UK taxpayers' money, to the apparent detriment of existing shareholders. Peston suggests (in an earlier post which he links to in this one) that the reason may be that top Barclays management want to preserve their freedom to pay big salaries and bonuses to themselves (and each other). Without addressing the accuracy of this suggestion, as I have no data either way, economic theory does shed some light on how this could happen. Assume for now that the facts are as Robert Peston says. Classical theory says that firms act in their own interest (equivalently, the interests of their shareholders). In this case, that would mean t...

Imagine a simple financial system with just three institutions: A, B and C. Let's say that each has capital of $1bn, gross assets of $10bn and gross liabilities (excluding shareholder's funds) of $9bn. Half of each bank's assets are mortgages and half are interbank loans. Of the liabilities, $5bn are interbank loans and $4bn are depositors' accounts. Finally assume there's a regulatory minimum capital limit: 8% of total assets. Now imagine that A starts to offer credit insurance on the debts of B. C has lent some money to B, so it decides that it would be smart to insure it; and takes out a $5bn policy from A. As this is a competitive market, B and C soon start to offer insurance too. A buys a policy from B insuring A's lending to C, and B insures its debt to A with C. Now say there's a 10% decline in the housing market. A's gross assets are written down to $9.5bn, eliminating half of its capital base and breaching regulatory limits. This counts as a cre...

"Finance is the web of intermediation binding economic agents to one another, across both space and time." Martin Wolf in his FT column on 30th September . It's interesting to consider how bankruptcies or insolvency of financial players can cause a recession. After all, a debt has two sides - and if it is uncollectable, the money hasn't disappeared - it's just been transferred to one party at the expense of another. If Lehman Brothers goes bust because it can't collect $40bn of debts, then presumably the debtors (or their employees, or suppliers, or the people they bought their houses from) have gained $40bn; Lehman shareholders have lost $10bn and Lehman creditors have lost $30bn. At first glance, the economy is no worse off. Indeed even the creditors aren't as distraught as they appear, because some of them now have a claim to pursue against the lucky debtors. And that's true, insofar as money is an asset in itself. The total amount of money in the e...

From the FT today : "Towards the end of the week several rivals said they had dropped internal restrictions on approaching Morgan Stanley clients when it became clear how much potential custom was available." Why on earth do investment banks have "internal restrictions" on approaching each other's clients? I appreciate that they would end up spending lots of time chasing new leads and winning new clients only to lose existing business to the other banks who start poaching their clients. They would probably end up reducing fees and increasing sales budgets without expanding the market much, just pinching share from each other. Maybe not an ideal result for the banks. But in any other industry that's called a cartel. Why should investment banks be exempt from competition law? If the public is taking the opportunity to get some reforms in return for its $700bn, this could be one to throw in. p.s. As usual, Martin Wolf's take on the issue is pretty sound.

We need certainty about the future in order to do anything. It’s a basic requirement of the action-feedback cycle that intelligent beings use to achieve their goals. On the simplest level, if I want to pick up an apple to eat, I need to know that when I tense my arm muscles, my hand will move in such a way, and when I grip it and pick it up, it will weigh (more or less) how much I expect, so that I need to apply just this much pressure to bring it to my mouth. I need to know that it will be this hard to bite and that it will give me some energy and assuage my hunger. If I am missing any of this information it’s highly unlikely I’ll be able, or even want to try, to pick up and eat the apple. In a more sophisticated decision I need the same predictability. I have to know that when I hire this person, they’ll show up at work, and when I sign this contract, the customer will pay the money on time, and when I build this car, someone will buy it. If we have certainty, it lets us see clearly ...

If the leveraged financial structures supporting the operations of the world economy are unravelling, what will happen? In the short term, it's dangerous. Today, according to the FT , banks are refusing to lend to each other. Soon that will start to have knock-on effects for exporters, and soon after that for domestic business too. They can't borrow money because their banks' risk models require the loan to be laid off to other parties who will no longer play. So companies won't be able to get export finance, and won't be able to take on domestic projects that require financing either. Why is that? If the money is out there but the banks won't lend to each other, people who need it are going to have to start finding new financial suppliers. Let's say that bank A has a strength in lending foreign exchange to manufacturers, and usually finances this by swaps with banks B and C in the forex markets. The money is spent by the manufacturers and comes back into th...