Thursday, July 23, 2009

The Failings of Financial Economics… or Financial Economists??

The Economist magazine this week published an editorial plus two supporting articles assessing the state of the art in economics -  that is macro and micro – the latter with an emphasis on finance. As usual it is thoughtful and worth a read and has their on going paranoia about bubbles and asset pricing (what is a bubble?).

In the economics school I come from we used to only partially joke that there was no such discipline as macro economics (you can imagine what we thought of sociology). Even leaving our physics envy to one side there are a couple of fairly obvious problems which I think the Economist misses but the recent recession provides abundant evidence of.

Problems with macro and the policy prescription, cut to their bone seem to me to be:

Macro

1.   a simple fallacy of composition. It is highly unlikely that any model which simply “sums up” the aggregate behaviour of individuals into a “lump” which is seen as not a lot different to the parts is going to provide good explanations let alone predictions. So the idea that aggregate economic behaviour could be summed up then reduced to the simple, single target of monetary policy was ever flawed.

You don’t have to be of the left to recognise that quantitative change is often accompanied by qualitative change – water is H2O whether in the form of ice, steam or potable drinking stuff…. but the chemical model is downright useless for describing the difference between the three.

So too economic behaviour. Doris and her chequebook are not a good proxy for the nation – champagne or no champagne Mr Keynes.

2.   The policy problem. Economist Steven Landsburg calls it the greatest temptation. Hayek called it the Fatal Conceit. The Economist thinks its business as usual and is in awe (for some odd possibly very English deference related reason) of central banks.

Simply put even if macro delivered plausible explanations, nay descriptions would be a start, of aggregate behaviour, the idea that a monopoly of the currency vested in an institution characterised by coercive powers could influence – to a material extent and in a desired direction – the behaviour of individuals is flawed. Fatally flawed.

So macro – and the policy prescription arising there from is not worth barking at. It was never going to get you there. The Greenspan years reflect damn good luck confused with “I did it” ego. Listening to those who disagreed with Greenspan would have produced no better outcome – so no point blaming him.

If there is blame to be laid it goes to the very base… the epistemological assumptions of macro. Very unsexy but think… what are the flaws of reductionism, what is the fallacy of composition, what is an over identified model, how does quantitative change beget qualitative? It is in the bowels of the philosophy of science that the weaknesses lie.

Meantime – since there is simply far too much tenure at stake for anyone to tackle these issues soon – best to place no faith in central bank fiddling, eschew the macro endeavour as much as possible and try desperately not, not to rely on monetary or any other central bank based policy (Keynesian central bank stuff suffers the same problem while killing society with pretended free lunches as well) for trips to higher, greener pastures.

In a classic piece of understatement the NZ Business Roundtable’s Roger Kerr – an grossly under rated economist who is regularly misrepresented as a lobbyist – has it that “monetary policy needs mates”.  As is clear above – I would say, “yes… but better give it away totally thanks.”

Micro

To the credit of the Economist they open their micro salvo by stating very clearly that simply saying “the market is not efficient” is woeful as critique. And so it is – a pathetic  attempt to underwrite the jobs of security analysts without adding much at all.

Even with the greatest investors of our time – Buffett and Munger – we see Charlie M in his wonderful “The Almanac of Poor Charlie” time and again be oh so very careful to say  “the strongest form of market efficiency” does not hold. Wonderful Warren advocates index based investment as likely to be best for 80% of investors.

So – they are saying strong form doesn’t hold. Strong form efficiency was ever only the logical outcome of thinking clearly. That, for goodness sake, is why Eugene Fama allowed of semi strong and weak form efficiency. So the left who would grab at every crash, jump and short run inconsistency whereby an apparent inefficient outcome might be bent into a call for intervention, the securities analysts with job protection uppermost in mind and the fund managers afraid of index investment proving them valueless ought – 40 years on - to go home and have a re think.

We know that there is a kind of triple curse on all investment which works roughly as follows:

1. the market is efficient enough that few, if any, pickings are to be had net of costs

2. to find the pickings you have to look in places where assets are valued inefficiently. In those places there is, by definition, little liquidity – so liquidity risk gets you.

3. to get the returns of the hard to find and illiquid assets up to a respectable level requires leverage – worse its likely leverage in an illiquid market.

So there you have it. No escape. Inefficiencies? For sure – if you look in illiquid places. Returns? For sure if you take enough leverage risk. You want more efficiency – fine – but the pickings will be ever slimmer. People are ever chasing though – the temptation to search is high and so is the risk.

One is tempted to say – pretty much an MM world. Exactly as predicted circa 1958. The closest financial economics ever came to physics – no free lunch is another way of expressing the laws of thermodynamics.

No need for behavioural quirks or irrational humans.

So is micro… at least in financial economics a failure? Far from it. The description and the explanations bear up well. The major, if general predictions are borne out:

Markets are generally too efficient over the long run for people, or the institutions which claim to act faithfully on their behalf, to consistently beat risk and become unjustifiably rich.

The last 18 months have seen unparalleled evidence that this is indeed the case.

The failure for micro has been the same failures physics and the “hard sciences” have suffered. Physics in general and Newton in particular has not, to this writing, made a strong enough case for gravity that the vanity industry which sells anti sagging crèmes, pills and machinery has gone out of business.

None of the quantum physicists has put astrologers out of business. Nor has Einstein – Nobel prize and undoubted genius - got any real traction for the notion that Neil Armstrong got back from the moon younger than he left earth.

What path is the most promising?

Is there a best way ahead and what is it?

There may be. A key reason for the failures of micro and macro to advance has been a singular inability to come to terms with what economists Harold Demsetz and Armen Alchian so long ago called “imperfect worlds”. The world is not perfect. So perfection is the wrong benchmark – especially for expectations of “how things ought to be” and even more dangerously prescriptions of what to do to achieve perfection.

Ronald Coase – in the 1930s produced one way of conceiving of this issue. There are, he noted, always transaction costs… just as in physics the world of assumed vacuums is just that – an assumed world – so the world of economic transactions without haggling, politicking, rent seeking, selfish behaviour and constant costly bickering does not exist outside the economists laboratory.

The Austrians – in the main F.A. Hayek – conceived of it as a “costly information” problem. The costs of gaining enough information – and brilliant teacher of this stuff the late Paul Heyne crystallised the line of thought with his pithy “what’s the point of disclosure if no one is paying attention” – are formidable, and in some cases – like the Central Bank – insurmountable.

To understand more we might focus harder on these issues. To prescribe less and less uselessly economics the discipline might focus on costly information and transaction costs – and how to explain that to more people.

The jury has yet to be assembled on the conclusions for policy if we knew more and if, as a wider society, we had a better understanding of the issue – meantime, and certainly a more than defensible policy in all arenas would be …. less is more – or in the words the Economist is so fond of quoting – First do no harm.

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