Part of the blame rests with the influence of three persistent, flawed ideas about markets. First is the "microfoundations critique": Truths about aggregates must be ground in truths about individuals. As such, the financial system has no identity apart from the sum of its parts. Second is the "efficient-market hypothesis": Prices of publicly traded assets like stocks reflect all known information -- a theory mistakenly treated as a rule. Third is the proposition that investors have "rational expectations": That is, investors use information efficiently so that while individual investors may make mistakes, the market as a whole tends to an optimum. Thus, the market price is by definition right. * * *Macroeconomics was pretty much invented by Keynes, so when Blyth writes, "there was no macro to worry about," that meant pretty much ignoring macroeconomics, including Keynes and those who enlarged upon his work.
Before Lehman collapsed, microprudential regulation ruled. Each bank used a variety of internal risk models to measure exposure and obeyed requirements to keep a certain amount of capital on hand to cover losses. At the end of each day, each bank thus calculated its "value at risk" and hedged. The problem was that the banks used similar models, meaning they produced common positions with common hedges across enormous, disparate portfolios. So though any one bank was diversified, the system as a whole was not -- exposing the whole system to far greater risk than anyone could have foreseen when staring at their own models.
We had built a system around the assumption that if you look after the micro then there is no macro to worry about. A year ago, that world ended. The U.S. government had to guarantee payrolls a week after Lehman collapsed. Iceland, an OECD country, went bust. Asian exports collapsed. The doctrines of Keynes replaced the doctrine of "there is no alternative."
Wednesday, September 16, 2009
Remember TBA noting Paul Krugman's claim that the Chicago-School economists not only disagreed with Keynes, but didn't even read him? Mark Blyth's analysis of the Wall Street collapse corroborates Krugman:
Thus blogged Anderson ... on or about Wednesday, September 16, 2009