Will the CDS really reflect well what Hart and Zingales say it will?

Hart and Zingales write:

In our mechanism, when the CDS [Credit Default Swap] price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI [Large Financial Institution] to issue equity until the CDS price and risk of failure back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.

But what about this criticism:

The CDS may be a poor measure of the large financial institution's probability of failure absent government assistance, because the market will price the CDS to include the substantial likelihood that the government will pump in taxpayer money if the large financial institution (LFI) would otherwise go under.

Even if the LFI were being run in an extremely risky way (because management was taking advantage of the "heads I win, tails you lose" taxpayer backup likelihood), the CDS could still be very low priced, if the market knows the government is likely to bail the LFI out.

Even if the LFI would almost surely go bankrupt without government assistance, the CDS might not be particularly low priced if investors think it hardly matters; the tax payers will almost surely give the LFI billions to keep it from bankruptcy.

If instead you had a highly skilled team of regulators, with complete authority to see any and all of the LFI's records, they might be able to – using high-level, flexible, ultra-high-dimensional intelligence, not just simple mathematical formulas – estimate the probability of default much better than from the price of the CDS, if the CDS's signal is extremely blunted and noisy from investor perceptions of the probability of a government bailout to the tune of billions, tens of billions, or even hundreds of billions. I should make very clear, though, that I do support having some strong smart "objective" limits on shadow banks, of any size, LFI or SFI, things like leverage limits. Clearly we've seen that Republican regulators, or "regulators" can't be trusted with complete discretion.

I've looked through Hart and Zingales' working paper on this. Although I haven't read it very patiently and carefully, word for word, as I like to for academic papers, what I found that responds to my criticism is this:

Our mechanism is similar in spirit to the “market-based” regulation underlying Basel 2. The main difference, however, is that we rely on market prices and not on credit rating agencies...Would our mechanism have worked better?...In answering this question, it is important to appreciate that the CDS prices are endogenous with respect to the default rule we choose. On the one hand, this endogeneity implies that there is no guarantee that CDS prices will perform in the same way as in the past under our proposed rule. On the other hand, the continuous government interventions, which led to the rescue of Bear Stearns, AIG, Citigroup, and Bank of America, have certainly affected the reliability of CDS prices as an indicator of the probability of financial insolvency. To minimize this latter effect we look at CDS prices before 10/14/2008 (i.e., the Paulson rescue of all the major US Banks). (pages 17-18)

But this appears suspect, at least in claims (or implied claims) about how well their idea would work in the short run (as well as perhaps the medium run, and perhaps for decades). Because their idea would be put into effect after the information in the CDS became less reliable due to the government bailouts of Bear Stearns, AIG, etc. That's the world we're living in now, one where investors saw in 2008-9 a demonstration of the great lengths the government would go to to keep LFI's from failing, especially when they are so interlinked. This may strongly increase investors' confidence that the government would do it again in the future.

The authors claim that their CDS idea would work well only by looking at CDS prices in the world before the recent spate of hundreds of billions of dollars of bailouts.

So, I have my doubts about this. I'm not sure how accurate CDS's will be, and how overfitted the rule for using them that Hart and Zingales devised might be to past data, especially pre-recent-crisis past data. If their rule is used at all, it might be best to use it as a guide for flexible, intelligent, skilled regulators, who would have the final say, on a case by case basis, after going deep into the books of the LFI. In addition, it may easily be best to greatly limit the choices of LFIs of the kind of difficult to price, complicated assets and liabilities that H&Z say are a reason for using the CDS as a measure of default probability.

Update, 4/15/10: I added the line in the sixth paragraph, 'I should make clear, though, that I do support having some strong smart "objective" limits on shadow banks, of any size, LFI or SFI, things like leverage limits. Clearly we've seen that Republican regulators, or "regulators" can't be trusted with complete discretion.'

Problems with Clarke's Student Debt Post, Part I: Lifetime Consumption Issues

There are serious and very important problems with Conor Clarke's post, "Let College Students Get Into Debt". In part 1 of this series I discuss his statement, "…if the the point of credit-based consumption is to bring lifetime consumption more in line with lifetime income – as I believe it is – then college students more than anyone else should be getting into debt."

How in line does Clarke mean? In the real world, unlike in the simple classical lifetime consumption models, it is not optimizing to have consumption (spending) exactly equal throughout life. It's far from it. Did Clarke mean that it was optimal to perfectly even-out spending? I don't know, but a reader could interpret it this way. This is a misconception that comes from the all too common problem in economics of taking models with grossly simplifying assumptions literally, or overly literally.

First, spending usually just gets a lot more valuable with age – and non-spending gets a lot more costly and consequential. As you get older and your health, energy, and durability decrease you need a lot more spending on medical care and conveniences. At age 19 you can sleep like a baby on a beat up old discount futon or mattress. At age 45 or 60 or 75, this may lead to serious chronic back pain, and sleep/rest deprivation. And obviously at age 19 you need to spend far less on medical and dental care to avoid severe, or even deadly, consequences than you do at age 45, 60, or 75.

You can have the vacation of your life at age 19 sleeping at dirt cheap youth hostels, down and dirty motels, and campgrounds. It's going to probably be a lot less fun, and a lot more painful and risky, at age 50 or 70 (and this includes the fact that prestige externalities – that pink elephant of economics – get much greater with age). There's just a whole wealth of cheap or free activities that are great fun at 19, but are typically less fun, and less do-able, at 50 or 70. Examples include soccer, surfing, and even, how shall I put this, intimate activities.

And let's talk food. At 19, you can have a great time stuffing yourself with cheap and delicious Entenmann's and Whoppers, with relatively little or no weight gain. At 50 or 60, with a far lower metabolism, eating like that may preclude walking very well, or at all.

Now, even at 19, or 3 for that matter, there are, in fact, serious long-term risks to eating these things. The risks of cancer and heart disease drop much more, to extremely low levels, if a healthy, 80%+ little or unprocessed plant food diet is started in childhood (for the strong scientific case, see the books "Eat to Live" and "Disease-Proof Your Child", by Joel Fuhrman, M.D.)

But even eating healthy at age 19, you can still stuff yourself with delicious and fattening, but otherwise healthy and cheap foods like nuts, juices, 100% whole grain pasta, fresh backed whole grain breads smothered in zero trans-fat all vegetable margarine, 100% whole grain waffles swimming in 100% maple syrup, etc. At age 40 or 70, if you want to get as much taste pleasure in your life, or anything close, without ballooning up, you're going to have to spend a lot more for expensive ingredients and restaurants that can give you the same taste with far less calories.

And do you really think it's optimal to spend the same amount of money as a single 19 or 25 year old as when you're a 35 or 45 year old with three kids?

Of course eventually it can go in the other direction. By the time you're 100, you may not be in a condition to get much pleasure out of your money, at least with current medical and rejuvenation/restoration technology. But even there, it may be very important to you to help your children and grandchildren, or to leave a legacy with your wealth.

On top of this, as I've mentioned, positional/context/prestige externalities are far greater at 50 than at 19. If you're like the vast majority of people, you're going to get a lot less pleasure out of driving around in a beat-up 20 year old Honda Civic (with a great stereo), and being seen in it, (and trying to attract the opposite sex), when you're 19 than when your 50. Positional/context/prestige externalities are an extremely important factor in individual and societal utility maximization. The costs to society of academic economics treating them like a pink elephant are monumental.

I could go on; to put it in economics terms, the marginal utility function of money, despite the common simplifying implied assumption, is far from constant throughout life.

There are also some crucial behavioral factors that are ignored by simple lifetime consumption models. First, I've talked about positional/context/prestige externalities, where the utility you get from consumption depends on the level (and type) of consumption of others. It is also the case that the utility that you get out of current consumption is dependent on your own past levels of consumption; in fact it's highly dependent.

A typical person will get far more utility from $100,000 per year in consumption if his past consumption was $50,000 per year or less, than if it was $500,000 per year or more. This makes it so that a forced large decrease in consumption is especially utility decreasing. It can be devastating to be forced to experience a large and lasting drop in consumption (including its associated prestige – very much including this).

As a result, it's usually well worth it for people to play it relatively safe with their consumption, to try to decrease the odds of having to lower their spending greatly from what they've grown accustomed to, to try to insure against this. Taking out debt goes in the exact opposite direction, it increases the odds that you will grow accustomed to a certain consumption (and prestige) level and then have to go substantially below that due to something going wrong, or not as you had hoped.

The simple lifetime consumption models that conclude you should borrow extensively if necessary in an attempt to keep your consumption exactly the same throughout life don't take this into account. They assume a world with no risk.

In addition, people really enjoy constantly improving, or improving their circumstances. This is an important part of human nature. Thus, one might expect that a typical person would prefer, all other things equal, to have constantly increasing consumption throughout life over always having exactly the same consumption throughout life, if the total amount of consumption is equivalent. In fact, Andrew E. Clark, writes in his 1999 Journal of Economic Behavior & Organization article:

Recent years have seen the admission of a new member to the battery of explanations of increasing wage profiles. Commonly known as the Forced Saving Hypothesis, it states that workers prefer wages that rise over time. It has two components:

1. Workers make inter-temporal comparisons over their level of consumption. An increasing consumption stream is preferred to a flat consumption profile with the same present discounted value.

2. It is possible to create increasing consumption profiles from a flat or downward-sloping wage profile by saving appropriately. Agents, due to a lack of self-control, cannot do so. Increasing wage profiles are one way of giving some external actor the power to ensure that the agent’s consumption rises over time.

The basic classical lifetime consumption model, with its grossly simple utility function, is good for teaching the lesson that the phenomena of diminishing marginal returns for money makes it desirable to smooth consumption, all other things equal. This is a valuable lesson, but it's not the whole story. It's not all of the phenomena, or factors.

Like all models, the basic classical lifetime consumption model is only as good as its interpretation. It's not reality. It teaches some lessons, but not all. There are many additional important factors in lifetime consumption decisions than just what's best, all other things equal, when the marginal utility of money is decreasing.

And it's not always decreasing. The Law of Diminishing Returns does not say that marginal return is always decreasing. It just says that eventually you reach a point where the marginal return is decreasing. That point can be extremely far out (if it even exists. This is not a physics law. What's called, or what has been called, a "law" in economics can have many exceptions), and you may never get near it. This is why we often see the opposite of diminishing returns – economies of scale.

Upcoming:

Part 2: um, the interest rate does matter

Part 3: Very Asymmetric Information, Very Imperfect Decision Making

Part 4: Costs to Productive Risk Taking, Innovation, and Flexibility

Part 5: Consumption Smoothing through Taxes, Transfers, and Social Insurance

McHongKong?

From Michael Perelman:

Paul Romer [one of the world's foremost growth economists] proposes that developing countries could invite instant Hong Kongs---new cities in new locations run by experienced governments such as Canada or Finland. They would enrich the country where they are built as special economic zones while also rewarding the distant government that makes the investment of building the new city state and installing a set of fair and productive rules.

This reminds me a lot of franchising in business, where a small entrepreneur gets often badly needed aid in the form of a well established and successful system and ingredients, training, and a vast and sophisticated support network, but the motivated and energetic entrepreneur provides the bulk of the work on the ground. The entrepreneur is also restricted to following many of the rules of the franchiser that are for the purpose of ensuring quality control, efficiency, and success.

This has been an extremely beneficial relationship for a great number of entrepreneurs. It's a powerfully synergystic and successful concept, or model.

Given the great logic and success of franchising, Romer's idea certainly appears to have potential, but you need to be very smart and careful in structuring the details so as not to cause strong opposition due to sovereignty and nationalism issues.

Rodrik's post on governance has substantial potential to mislead

It's important to be careful in discussing the link between good governance and economic growth because it's easy to mislead. First, there's what you define as "good governance", and second there's the issue of whether you're talking about direct effects, indirect effects, or total effects.

For example, Harvard economist Dani Rodrik talk's about how a good industrial policy can be very helpful. The government makes the decision whether to implement a good industrial policy, so you could say that how good you call governance is based in part on this.

Likewise, the policies and ingredients for moving out of poverty that Rodrik describes in his book, "One Economics, Many Recipes", are highly dependent on government actions. Certainly a government which pursues those things aggressively and intelligently (and you could certainly think this is an important part of what's called "good governance") greatly increases the odds of the country quickly moving out of poverty, especially as opposed a government which does the opposite – very harmful things to development.

Rodrik might say that he defines good governance not this way, but as democratic, transparent, non-corrupt, etc., but it looks like you could make a good case that even with these things, usually, or often, depending on other particulars, the more you have, the better the policies and environment will be for moving out of poverty.

I especially think Rodrik's apparent claim that the U.S. in the 2000s is an example of how a country can have terrible economic results with good governance, and so good governance can be a non strongly positive factor, is dead wrong (or at least has great potential to mislead about very important things).

The example actually shows the exact opposite. It shows the great impact good governance (as I think most people would interpret the term) can have on economic growth and wealth.

The quality of governance plummeted astoundingly with the take over of Bush and the Republicans from Clinton and a more balanced mix of power in the rest of government – and the drop in wealth, efficiency, and growth that resulted from this was amazing over a period as short as eight years. They brought us from an overall sound economy and record surpluses to record deficits and the brink of a depression in a mere eight years, and if we had just a few more years of their governance, we probably would have had a depression.

The Bush years were just the opposite of what Rodrik apparently claimed; they were an amazing example of the how much bad governance can hurt economic growth.

And the Clinton and Obama periods are an amazing example of how much good governance can help economic growth, especially if you don't want all of the growth (and more) going to the rich.

And even if you call good governance just democraticness, lack of corruption, transparancy, etc., it was not having enough of those things that allowed Bush and the Republicans to seize power in the 2000 election; it was not having enough of those things that greatly aided them in doing so much harm. And I'm not talking about just the corrupt Supreme Court decision; I'm talking about the Electoral College; I'm talking about the fact that there are no run-off elections so that a Nader can cause the more popular of the two top candidates to lose; I'm talking about the fact that Wyoming has the same voting power in the Senate as California, and the District of Columbia, which has more people than Wyoming, gets zero voting power in the senate; I'm talking about how corporations can donate enormous sums to help politicians, and more.

But, it was having enough democraticness, lack of corruption, transparency, etc. which allowed us to make the amazingly positive change in 2008, in economics and so many other areas, of going from Republican control to Democratic.

Now, that was a roaring place to end, but my primary purpose of writing this blog is to teach, and discuss for important understanding. This takes a priority far higher than "good writing style". So I will continue with two statements by Dani that I think it's important to respond to:

"Johnson argues that U.S. economic policies have been captured by a (financial) oligarchy, in much the same way that business elites corrupt policy-making in much poorer countries such as Russia. The U.S., it turns out, is not that different."

Even in the darkest depths of Republican control, the U.S. was still far better than Russia in this regard. Plus, look at how quickly the U.S. Democratically pulled out of corrupt and incompetent control by electing the Democrats. It's far harder and takes far longer for Russians to identify and expel corrupt and incompetent administrations than Americans precisely because Americans have much better democraticness, lack of corruption, transparency, etc.

"After all, no-one can deny that the United States, for all its financial follies, is a rich country. It turns out that it is possible to be corrupt in a fundamental way and still be rich."

Not if you continue that way. Not if the U.S. had stayed that way. If the U.S. had kept Republican control, there would have been a depression lasting many years, and after that a long-term descent towards banana republic status. After a few generations, other first world countries would have left us far behind. But again, that's where good governance, as defined by democraticness, lack of corruption, transparency, etc., can be so valuable. It can allow a nation to kick out a really harmful, corrupt, and incompetent administration relatively quickly and easily.