Friday, January 22, 2010

EMH Funeral Oration...

EMH Funeral Oration, by Satyajit Das
Like Mark Anthony with Julius Caesar, many have now come to bury the Efficient Market Hypothesis (”EMH”) rather than praise it. Amusingly, some of the critics who have recently found their voice are those who for years made their living from financial markets that were predicated in no small measure from the intellectual dogmas that EMH was central to.

In his previous book Dot.Con, John Cassidy, a writer for the New Yorker, provided a penetrating history of the Internet bubble and its bust. In How Markets Fail, Mr. Cassidy attempts a critique of modern economics. In this regard, he covers similar ground to Justin Fox’s The Myth of the Rational Market and Pablo Triana’s Lecturing Birds on Flying.
At its best, How Markets Fail provides a vivid history of recent economic thought and its influence on events that laid the foundations of the global financial crisis. Drawing on anecdotes and interviews, Mr. Cassidy provides an accurate outline of the developmental trajectory of modern economies.

His description of a noted confrontation between Raghuram G. Rajan and orthodox economists led by Larry Summers and members of the Fed, at a Jackson Hole meeting is revealing. Rajan, then the chief economist of the International Monetary Fund, warned about the risks embedded in the financial system. His detractors blithely denigrated the concerns on ideological grounds.

Mr.Cassidy also attempts to extend the text to encompass a critical review of what he calls “Utopian Economics”. The central focus of the criticism is that society is best served by individual self-interest and free markets. Mr. Cassidy’s argument is that individual self interest does not work, markets frequently fail, price mechanisms are flawed and markets are plagued by problems of information asymmetry – different levels of knowledge between participants.

In his criticisms, How Markets Fail is perhaps a little too eager to embrace behavioural economics and the work of Hyman Minsky. Useful as both alternatives are, they are also incomplete explanations of the complex economic and financial relationships.

In the final section of the book argues that it was these failures that led to the disastrous sequence of events that caused the global financial crisis.

Well written and researched, How Markets Fail is superior to the growing list of titles that cover similar ground. Mr. Cassidy largely succeeds in his objectives although the book does not extend the debate. The book undoubtedly will introduce a new generation of readers to the debate and encourage further debate.

There are some contentious and erroneous pieces of analysis of individual technical elements of the theory. In this regard, Donald Mackenzie’s brilliant An Engine Not A Camera provides a more technical and deeper analysis of aspects of the theory.

Recent criticism of the EMH, Chicago economics and “free market idolatry” tends to gloss over some interesting anomalies. Markets are rarely entirely free and regulatory failures were a contributing factor to many of the problems that have emerged. That is not to make the case for unfettered ‘red tooth and claw’ capitalism but to point out that many proposed regulatory interventions will not necessarily have the intended effects.

All economics is deeply embedded in a political, cultural and sociological framework. In many ways, it is symptomatic of these underlying issues.

For example, the analysis of sub-prime mortgages misses several factors. Firstly, a lack of growth in real income, especially for middle and lower paid employees, made it difficult for them to achieve the material success that was daily sold to them by the media and advertising. Secondly, the rise of stated income and low or no documentation mortgage reflected the change in work practice where large parts of the work force were no longer employed full-time. Casual or part-time employment and contracting arrangements made the required proof of income difficult.

Interestingly, many problems arise from the lack of humility about the theories. They are, at best, incomplete and highly conditional models that compare unfavourably to middle-age medical and religious superstitions.

Robert Merton articulated this concept precisely. “At times we can lose sight of the ultimate purpose of the models when their mathematics become too interesting. The mathematics of models can be applied precisely, but the models are not at all precise in their application to the complex real world. Their accuracy as useful approximations to that world varies significantly across time and place. The models should be applied in practice only tentatively, with careful assessment of their limitations in each approximation.” Ironically, the speech was less than a year before the collapse of LTCM. Writing in 1995, Merton foreshadowed the events that were to unfold 3 years later at LTCM: “any virtue can become a vice if taken to extreme”.

As recent events in Copenhagen suggest, the only thing that history tells us is that mankind generally are poor learners. Mr. Cassidy quotes a recent column by Harvard’s Greg Mankiw: “despite the enormity of recent events, the principles of economics are largely unchanged.” Professor Mankiw suggested that student still needed to learn about “the efficiency properties of market outcomes.”

How Markets Fail is perhaps merely a sub-set of a wider phenomenon – How Mankind Fails.

Wednesday, January 20, 2010

Paul Davidson Comments To Posner Article...

I am pleased that Posner has read what I (Davidson) wrote. Yes P{osner is correct that I have used Keynes as the basis for my analysis of uncertainty and Post Keynesian theory. When Keynes wrote, unfortunately, the theory of stochastic probability theory [ ergodic theory] had not been developed in the English language. Thus Keynes’s uncertainty is not terchnically defined and can easily be thought to be the same of Knight’s concept of uncertainty – but they are quite different. Knight is using an epistemological definition of uncertainty, Keynes has an ontological uncertainty concept. This makes a big difference in understanding how financial institutions and money contracts, especially loan contracts i.e., leverage making contracts, affect financial crisis. What I have done was to use technical language to show Keynes’s general theory rejects several axioms that underlie classical theory. The Classical theory's ergodic axiom underlies Friedman’s monetarism, Lucas’s rational expectations, , andthe laissez-faire economic philosophy Fama’s efficient market theory. An axiom is defined as a universal truth that needs not be proven.The ergodic axiom presumes that the same probability distribution that governed past economic outcomes governs all future outcomes. Thus, given the ergodic axiom, the future is statistically predictable– and rational decision makers know (in the actuarial sense at least) what the future is when they make a decision today. Thus, a rational economic person would never sign a loan contract unless he/she “knew” they could service this debt within their known future income and budget constraints. In a classical theory, there can never be a default by optimizing rational people, there can be no foreclosures, and no insolvencies. Hence the theories based on the ergodic axiom cannot develop a useful policy to solve these financial systemic problems when they occur in the world of experience. Keynes rejected the ergodic axiom as a basis for his general theory. Thus, in his general theory, there need not exist any current objective probability distribution that decision makers “know” will govern future outcomes. Without going into details, Knight’s unique events that cause uncertainty is the equivalent of Taleb’s black swan – an occurrence that occurs in an ergodic system but that will have a very low, but still fixed probability , of occurrence. So with a big enough sample one can predict the existence of a black swan financial disaster in a Knight system. In a nonergodic system there is no probability (as Keynes stated in his 1937 article) on which to estimate future outcomes. Thus the necessity to seal economic transaction with monetary contracts that FIX payments into the future!

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-richard-posner.html#ixzz0dBN5g3Hs

Friday, January 15, 2010

Everyone Wants to Talk about Currencies...

Everyone Wants to Talk about Currencies
Michael Pettis Jan 11, 2010 4:44PM For now I suspect everyone will want to discuss currencies. One of the more interesting pieces of news for me was yesterday’s Financial Times story on President Sarkozy’s finding “unacceptable” the disordered currency markets (“disorder” means a rising euro). According to the article:

Nicolas Sarkozy on Thursday stepped up his attack on global exchange rate imbalances saying “monetary disorder” had become “unacceptable”. The French president said he would make exchange rate policy an important theme of France’s presidency of the G8 and G20 forums of advanced and developing economies in 2011.

“There cannot be financial, economic and social order until we put an end to currency disorder,” he said at a conference in Paris. Mr Sarkozy has long railed against Chinese “monetary dumping” and the dominance of the dollar, but has sharpened his criticism in recent days reflecting concern in Paris that a balanced economic recovery in the eurozone could be choked off by an overvalued currency.

With a large trade deficit and with exports that are more price-sensitive than Germany’s, France feels more susceptible to exchange-rate movements than its neighbour across the Rhine. “We can’t increase the competitiveness of our businesses in Europe and have the dollar lose 50 per cent of its value against the euro,” Mr Sarkozy said. “When we produce in the eurozone and sell in the dollar zone, are we supposed to just give up selling?”

So we are sort of stuck, aren’t we? The dollar is overvalued, and it must rebalance downwards in order to force up US savings rates relative to US GDP, but since it cannot decline against Asian currencies, whose central banks intervene heavily, it must decline against the floating currencies like the euro.

But the euro is probably already overvalued against the dollar, so European manufacturers will be forced to accept the brunt of the adjustment. This will be painful for everyone in Europe, but I suspect it will be most painful for Germany, a country that is more dependent on manufacturing than the rest of the region and so who will suffer more if there is a sharp drop in demand for European manufactured goods. The fact that President Sarkozy is nonetheless making the most noise about the euro indicates that this is going to become a very popular political topic and has great demagogic appeal.

Later in the article Sarkozy was quoted as saying “You know how close I feel to the US. But this is not possible. The world has become multipolar. We must have a multi-monetary system.” As a half-French half-American I have to say I suspect that it is not likely to be easy to convince too many Americans of the truth of the first part of his statement. I think however, that although the US and the world (except perhaps export-dependent Asian countries) would be better off with a multi-monetary system, Sarkozy may be confusing issues.

The dominance of the dollar in reserve accumulation has little to do with a lack of an alternative currency and a lot to do with the inability of any country but the US to absorb the trade deficits created by export-dependent development strategies. Trade-surplus countries buy dollars because when they buy euros, they cause angry reactions from European businessmen and politicians who are uncomfortable with the impact of a rising euro on domestic manufacturing and employment. In fact, the rise of the euro against the dollar is precisely what Sarkozy claims to oppose in the first part of his statement and to support in the second part. If Asian central banks rely less on the dollar and more on the euro for their reserve accumulation, guess what will happen. Yes, the euro will rise against the dollar.

Japan is worried too

It always surprises me how readily people believe that the status of the dollar as a reserve currency has to do with same nefarious conspiracy. As long as the US is willing and able to run large trade deficits, the dollar will be the overwhelming currency of choice for reserve accumulation. Once the US ability or willingness stops, which I suspect is likely to be the case over the next few years, central banks will stop accumulating dollars. Like it did during the period of large US deficits in the 1960s and the 1980s, the talk about dollar hegemony will once again fade away as US trade deficits decline.

Sarkozy’s comments were reinforced, in a way, by comments the same day from Naoto Kan, Japan’s finance minister. Here is what the South China Morning Post said in an article today.

Japan’s new finance minister backed off his call for a weaker yen following an apparent rebuke from the prime minister yesterday, saying currency levels should be determined by markets.

Still, Naoto Kan said the government should pay heed to the views of the country’s business community, signalling that he was sticking to the view of favouring a weaker yen to boost the competitiveness of Japanese exports. ”Currencies undoubtedly should be determined by markets,” Kan said. “But I also believe that generally speaking, it’s the finance minister’s job to act against currency moves when needed.”

…He jolted markets in his first press briefing as finance minister on Thursday, saying he hoped the yen would weaken further and that he would work with the Bank of Japan to achieve an appropriate exchange rate level.

For those who remember the 1980s, when many policymakers in Japan insisted that Japan’s trade surplus had nothing to do with the value of the currency, and everything to do with domestic competitive advantages in manufacturing, it is a little weird seeing them now worry so much about the impact of a rising yen on their manufacturing sector and on the process of economic recovery. Currencies do matter, I guess.

Currency talk is likely to be the flavor of this year. The currency issue simply will not go away, and the fighting over it is likely to get worse, not better. On that topic, a research fellow at the Institute of World Economics and Politics at CASS had an interesting proposal earlier this week. According to an article in Bloomberg:

China should consider a one-time appreciation in the yuan of 10 percent against the dollar to reduce inflows of speculative capital into China, a researcher at the Chinese Academy of Social Sciences said. The revaluation could be followed by a cap of 3 percent in annual moves up or down for the currency against the greenback, Zhang Bin, a research fellow at the Institute of World Economics and Politics at CASS, which advises the cabinet, said in an interview from Beijing today. He said he couldn’t predict whether his proposal, outlined in an essay, would be adopted by the government.

China may see “huge” inflows of so-called hot money as foreign investors step up bets on yuan gains, Zhang Xiaoqiang, deputy head of the National Development and Reform Commission, said in a statement yesterday. The government has rebuffed calls from U.S. and European officials to allow the market to set the exchange rate and has pegged the yuan at about 6.83 per dollar since July 2008 to help exporters weather a global recession.

“It’s a good strategy to protect China from the impact of short-term capital inflows,” said Zhang. “Now is a very good time. Foreign pressure will intensify this year and China should take an active strategy.”

…A 10 percent revaluation would have limited impact on exports and slow growth in overseas sales by 3.3 percent, said Zhang. Exports dropped 1.2 percent in November from a year earlier, following a 13.8 percent decline the previous month. China’s customs bureau is scheduled to report trade figures for December sometime between Jan. 12 and 14.

Zhang, who has been interviewed by Xinhua news agency on global economics previously, said the revaluation should be adopted soon. “The earlier, the better,” said Zhang. “We shouldn’t wait until after foreign capital flows into China and expectations on yuan gains increase.”

Does the value of the RMB matter for trade?

What would the impact on trade be? Strangely enough many of the opponents of RMB revaluation insist that it would have no impact on trade balances. A new “International Finance Discussion Paper” (Board of Governors of the Federal Reserve System) by Shaghil Ahmed sees it differently (“Are Chinese Exports Sensitive to Changes in the Exchange Rate?”)

The main results of the paper can be summarized as follows: First, including the latest period of greater real exchange rate variability reinforces the conclusions of some earlier studies, such as Marquez and Schindler (2007), which found that Chinese exports respond quite strongly to movements in the real exchange rate, and go against studies which fond little effect of exchange rate changes or effects that go in the opposite direction to conventional wisdom.

Second, considering the components of the real exchange rate, consistent with the theoretical model, when the source of Chinese real exchange rate appreciation is movements of the RMB against other emerging Asian countries, this does not have a significant effect on Chinese processing exports, but it does have a significant negative effect on Chinese non-processing exports. On the other hand, when the source of the renminbi appreciation is movements against the currencies of non-emerging Asian Chinese trading partners, generally both types of exports go down. Moreover, even though processed exports remain very important for China, increases in non-processed exports have recently accounted for more of the overall increase in exports. Finally, model simulations indicate that the path of total Chinese real exports would have been quite a bit lower if the renminbi had appreciated more in recent years.

Overall, the results suggest that greater exchange rate flexibility could have significant impact on China’s trade balance by restraining growth of exports, particularly non-processed exports.

…The implications of the results for global imbalances depend on what is exactly meant by global imbalances, which is not always clear-cut. If China’s large current account surplus or its bilateral current account surplus with the United States by itself contributes to global imbalances, along with the U.S. bilateral current account deficit with China, then our results suggest that greater degree of appreciation of the Chinese currency would substantially help mitigate global imbalances. If, however, the big part of global imbalances is the U.S. overall current account deficit and the current account surplus of the emerging market world taken together, then it is less clear that greater appreciation of the Chinese currency would make a significant dent to global imbalances. For example, following an adjustment of the Chinese real exchange rate one scenario could well be that the fall in exports by China is largely matched by a rise in exports by other emerging market economies, including in emerging Asia, leaving aggregate current account balances of the United States and of emerging market economies more broadly unchanged.

But the results do seem to imply that greater flexibility of the exchange rate would help China toward its stated desired goal of shifting the sources of growth more toward domestic demand with less dependence on external demand.

Regular readers of my blog might remember that from late 2006 until the beginning of 2008 I had argued that the best way for China to address the domestic (and of course external) problems caused by the undervalued exchange rate would be for a 15-20% one-off revaluation. This would both force through a rebalancing and help revive consumption growth, all the while protecting the country from the problem of hot money inflows, which had become terrible by that time.

After the onset of the crisis I backed away from such a large revaluation (not because it wouldn’t be a good idea in the long run, but rather because it would be too painful in short run) while still arguing that a one-off 10% revaluation still made sense. Needless to say I enthusiastically agree with Zhang Bin although, like him, I am doubtful that policymakers will be willing to absorb the short term cost in exchange for domestic economic benefits that probably won’t accrue until well after 2012, when the current leadership will have retired.

Hot money

My guess is that we will see a much smaller appreciation, perhaps 2-3% during the first quarter. Apparently I am not the only one who believes that appreciation pressures are mounting. That terrible bugbear, which made China’s too-little-too-late appreciation strategy from 2005 to 2008 so difficult for the PBoC, hot money inflows, seems to be rapidly becoming a problem again. Earlier this week a senior policy advisor sounded, and not for the first time, the warning. According to an article in Bloomberg:

China may see “huge” speculative inflows as overseas investors step up bets on yuan gains, making it difficult to manage liquidity, said Zhang Xiaoqiang, deputy head of the nation’s top planning agency. Loose monetary polices in developed countries, a weakening U.S. dollar and China’s economic recovery will put renewed pressure on the yuan to appreciate, Zhang, from the National Development and Reform Commission, said in a statement on its Web site today. The country is becoming more reliant on foreign economies, he said.

Already some of my students whose parents own their own businesses have been telling me that Chinese speculative money held abroad is flowing back into the country. One of my students from rich coastal city Wenzhou, the most free-wheeling and business-savvy city in China, and perhaps the world, just rolled his eyes when I asked him if his family and friends were tying to bring money into the country. “Of course,” he said. I didn’t get the impression that he thought mine was an especially astute question.

Meanwhile all the big guns in the “monetary alarmist” camp in China have been pounding the table (in the discreet way preferred of policymakers here) about the risks of monetary expansion. As everyone now knows, the PBoC yesterday sold three-month bills at a higher interest rate for the first time in 19 weeks. Long Chen, one of the students in my PBoC Shadow Committee seminar, reported to the class via email as soon as it happened: “Hey guys, the primary yield of 3M PBOC bill increased this week. Significant sign.”

Yes, although the increase was tiny, it may indeed be a significant sign that the PBoC no longer wants to wait and is starting to tighten conditions, although I can only add that conditions are so alarmingly loose that it would take an awful lot of tightening to get back just to “loose”, and it would be hard to do this without seriously undermining current growth and employment in the short term. My guess is that this may be a beginning, but it will be a very slow and tentative beginning. The PBoC has already been lambasted (unfairly, in my opinion) for jumping the gun in 2007 and 2008 and they have little political capital against which they can afford another “mistake”.

In fact much of their action tends to be signaling – what in the US we would call “jawboning”. Four days ago, for example, Governor Zhou made another attempt to warn about risks to the banking system in an interview with China Finance very similar to a speech he gave late December. According to an article in Bloomberg:

Chinese central bank Governor Zhou Xiaochuan reiterated government warnings that investment in industries with excess capacity and in redundant infrastructure projects could threaten banks’ loan quality.

The People’s Bank of China will guide credit, seeking to avoid volatility in lending, Zhou said in an interview dated yesterday on the Web site of China Finance, a central bank publication. Investment in duplicated projects or industries with overcapacity could “pose a risk to the quality of banks’ loans,” Zhou said.

China’s policy makers are seeking to contain risks from an unprecedented credit boom, in which banks extended 9.21 trillion yuan ($1.3 trillion) of new loans in the first 11 months of 2009. Liu Mingkang, chairman of the China Banking Regulatory Commission, said yesterday that lenders have “more than” enough capital, while also cautioning that asset bubbles may emerge in the world’s third-biggest economy.

It is hard to be both soothing and at the same time to raise the alarm.

To move away from currencies and monetary policy, I saw an interesting article about the US in Xinhua.

A recent New York Times/CBS News poll has found that more than half of Americans said they are spending less money in stores and online. A New York Times report available on its website Saturday quotes the poll as saying that nearly half of Americans said they were spending less time buying nonessentials.

“Some are working longer hours, but a larger proportion are spending additional time with family and friends, gardening, cooking, reading, watching television and engaging in other hobbies,” says the report. The report also quotes the U.S. Department of Labor’s time-use survey as showing that compared with 2005, Americans spent less time in 2008 buying goods and services and more time cooking or taking part in “organizational, civic and religious activities.”

Net demand from abroad

This is almost certainly good news for the US in the medium term, but if true, needless to say, it seriously undermines hopes that US net demand will revive enough to justify the overcapacity issues exacerbated by China’s fiscal and credit expansion. There has been some hope that boosting trade with developing countries, and especially with developing Asia, will result in a new source of net demand. James Kynge said something like this in the Financial Times earlier this week:

Popular narratives sometimes overshoot. One of the latest to outlast its veracity is the conventional wisdom that China’s export engines have been spiked by subsiding consumer demand in the US. This, so the argument goes, leaves Beijing with no option but to spur domestic demand to compensate for lost export revenues.

This became an ├╝ber-narrative last year. Its snowballing popular appeal was powered by two unassailable charms: it made sense and seemed largely true – but not any longer. Its potency appears set to wane in coming months not so much because of a challenge to its central plot, but by other things happening off stage.

The telling off-stage action is the recent upsurge in trade with south-east Asia and the “newly-rising economies” of Brazil, Africa and India. Although Chinese trade with these places has historically been limited, it has grown so fast in the past five years that a robust performance in 2010 may be enough to offset any moderate weakness in China’s trade with the US.

A friend wrote to me to ask what I thought of this possibility, citing Kynge’s article, and my response (with some editing) was:

The idea that net demand from developing countries can replace net demand form the US is alarmingly widespread, both in China and abroad, and mainly indicates to me a lack of familiarity with the history of developing countries. The developing world excluding China is roughly the same size as the US, so if you want them to replace the US you need the developing world to run trade deficits of roughly equal to 7% of their GDPs.

Leave aside the huge problem that most developing countries also want trade surpluses and have a stubbornly tough time understanding why they should run deficits in order to help Chinese employment, the historical evidence suggests that just a few years of trade deficits of 2% of GDP will lead to external debt crisis. For example it took the Asian Tigers just a few years of deficits after 1993-94 to run into the Asian crisis. Do Malaysia, Indonesia, Vietnam and so on really want to go through that again? Developing country demand cannot replace the US. Even Europe cannot replace the US. This is an unrealistic hope.

No, I think the rapid growth of US consumption relative to (very healthy) US GDP over the past 30 years or longer may have been a special historical circumstance whose life, if not over, is coming to a close. Except for small countries whose trade surplus can easily be accommodated, I think the days of rapid growth driven by trade-surplus policies may be over.

This is getting to be another of my very long pieces (as my friend Kaiser Kuo reminded me last night at my club), so I will stop, but not before referring to one last interesting article about another controversy in Chinese academic circles. China is trying very hard to boost the quality of its scientific and technological research, which is, with a few exceptions, of very low quality. I am skeptical about how successful they will be, in part because the educational system here, as a history teacher in the top high school in Shanxi province once told me, is a machine for stamping out critical and creative thinking, and in part because the process is not being driven by scientists but by bureaucrats. Here is what the South China Morning Post says:

The exposure of two researchers who published fake data in an international journal is the subject of heated debate in mainland scientific circles, with opinion divided on whether the blame should rest on unscrupulous individual behaviour or deep flaws in the academic system.

Zhong Hua and Liu Tao from Jinggangshan University in Jiangxi published faked datasets in specialist journal Acta Crystallographica Section E in 2007. The fraud would have gone undetected without new computer analysis, the journal said on its website.

Leading British medical journal The Lancet urged China to tighten measures against scientific fraud, otherwise it would not become the research superpower President Hu Jintao has pledged by 2020.

These kinds of problems are so commonplace that normally I wouldn’t bring it up except for two reasons. The first is that it is a measure of how complex the problem is that there is even a debate about this episode. Normally, faking research brings universal condemnation, but the researchers have earned some sympathy because they are desperately responding to a very difficult system. The second reason I cite this article, which follows the first, is because of a very perceptive quote from Professor Jiang Gaoming of the Institute of Botany under the Chinese Academy of Sciences:

“All living creatures have an instinct to survive. When a bad system determines the survival of researchers, they have to do all kinds of corrupt and unethical things to live. The outcome is inevitable,” Jiang wrote.

This is something I often tell my students, especially about the banking system. It is not because they are especially stupid or dishonest that bankers have made bad loans, but rather because they are responding intelligently to bad incentives. Any system with distorted incentives creates distorted results.


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Wednesday, January 13, 2010

Scary Statistics...

Here's the scariest statistics you'll ever see. It's the decline in global transactions since last year's numbers__C.H.I.P.S.

Global transactions have shrunk from $508,758,657,298,000 to $364,355,126,940,000 as the difference from Dec 31, 2008 to Dec. 31, 2009... That's a shrinkage of $144 trillion dollars over the year...

What do you really think the outcome is going to be...?

Global derivatives contracts also shrunk from a high of $684 trillion in June 2008 to $592 trillion in Dec. 2008, and the most recent data of June 2009 shows they were at $605 trillion...

I think it's time for the nation and the world to start taking this global financial disaster much more seriously, than they are pretending to__What do you think...?