Knowing and Making

A couple of times recently - notably in Bill Easterly's otherwise very positive review of Daniel Kahneman's new book - I've seen the following common critique of Nudge-style approaches: "But if people are irrational, regulators are irrational too - so how can they make rules to counter citizens' irrationality?" Easterly says: But [the case for libertarian paternalism] is much too sweeping, because it overlooks everything the rest of the book says about how the experts are as prone to cognitive biases as the rest of us. Those at the top will be overly confident in their ability to predict the system-wide effects of paternalistic policy-making... While it's right for regulators to be humble about their degree of knowledge about the world, and to be cautious in creating new regulations, there are several reasons why this particular criticism is wrong. First, we are not comparing like with like. There is no claim that a regulator, when placed in the same ...

Two years later, we're still hearing about narrow banking as the solution to the problem of risky behaviour by financial institutions. In fact, most of the problems that led to the 2008 bailouts were barely related to investment banking. The primary cause of the financial crisis was a collapse in the value of mortgages extended by deposit-taking institutions. The sheer volume of mortgage lending was indeed partly enabled by investment banks, helping commercial banks to securitise the loans. But separating those from the deposit-taking banks would not have stopped this. So is there a way to stop this from happening again? What was it that led banks to take these risks, and why did they pose a problem for the whole financial system? Why did we need to bail them out? The size  of banks is a potential risk factor. And the Volcker plan to impose a tax on wholesale borrowing and a cap on the size of individual banks would help with this. But if, instead of ten huge institut...

Andrew Lo, writing in the FT , says: ...human behaviour is hardly rational, but is driven by "animal spirits" that generate market bubbles and busts, and regulation is essential for reining in misbehaviour. Regular readers won't be surprised to see me agreeing with this, and indeed I have a proposal for how that regulation could work. However I am suspicious about any theory which does not make testable predictions, and I fear that Lo's "adaptive markets hypothesis" may fall into this category. This "Adaptive Markets Hypothesis" (AMH) - essentially an evolutionary biologist's view of market dynamics - is at odds with economic orthodoxy, which has been heavily influenced by mathematics and physics...The formality of mathematics and physics, in which mainstream economics is routinely dressed, can give outsiders a false sense of precision. ...fixed rules that ignore changing environments will almost always have unintended consequences...The only ...

Pointing out a speech by William C. Dudley, president of the New York Fed, Simon Johnson says : Dudley says that the Fed can pop or prevent asset bubbles from developing. This would represent a major change in the nature of American (and G7) central banking. It’s a huge statement - throwing the Greenspan years out of the door, without ceremony. It’s also an attractive idea. But how will the Fed actually implement? Senior Fed officials in 2007 and 2008 were quite clear that there is no technology that would allow them to "sniff" bubbles accurately - and this was in the face of a housing bubble that, in retrospect, Dudley says was obvious. But is that true? If we define a bubble as "overvaluation of assets relative to their future returns" then to spot one, we would need to compare asset prices with future returns. But although asset prices are measurable, future returns are not - and this is why people generally think that bubbles are unspottable. We wouldn't...

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...

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...

Martin Wolf's article on Lord Turner's review is a good one (by which I mean, of course, that he agrees with me). He identifies irrationality as "the main analytical conclusion" of the report, but he doesn't take the next step of suggesting that it can be directly regulated. There are a range of interpretations of Turner's report. Some think his diagnosis was that banks are too thinly capitalised. Some that he condemns financial innovation. I think Martin Wolf has found the most important part: his conclusions about irrationality, both collective and individual. But while Turner has diagnosed the right disease, he doesn't propose a workable cure. To combat irrationality, he suggests a set of tools that work through rational means. Counter-cyclical capital requirements, leverage ratios, remuneration and centralised CDS clearance are perfectly sensible measures, but - like interest rates, the main tool of existing counter-cyclical policy - they work by mark...

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...