Tweet OK, now that we have the demise of Lehman, Merrill and AIG, and with HBOS teetering on the brink (and remembering that we don’t do anniversaries here), let it be noted that it’s just over a year since Northern Rock collapsed, and it’s also a year to the day since I coined the phrase […]

The Subprime SolutionHaving effectively called the top of the dotcom bubble with his first book, Irrational Exuberance, and documented the emerging US housing bubble in his second edition of the same, you’d think that Yale economist Robert Shiller would have been treated with significant reverence by our economic and financial institutions (both public and private) over the past few years. And you’d think that he would already have been asked to make a material contribution to resolving the crisis. In fact, you’d think that writing Irrational Exuberance would alone have been enough to forestall the second crisis. But then, if you thought that, you’d be me. And you’d be wrong. Again.

If you’re unfamiliar with Robert Shiller then understand that he is perhaps the most eminent and considered examiner of modern investment bubbles. It was two days after Shiller and a colleague testified before the Federal Reserve Board in December 1996 that then Fed Chairman Alan Greenspan sent stock markets into a mini-crash by coining the now legendary phrase “irrational exuberance” in the context of stock market behaviour. Influential indeed. Shiller’s book Irrational Exuberance came out in March 2000, after which the dotcom boom finally collapsed.

As Shiller tells it, the world of political and economic authority just does not work the way you might have hoped when it comes to emergent investment bubbles. And yesterday I took a look at one or two of the more popular economics websites to remind myself of how well they responded to the notion of a US housing bubble, and their level of reference to Shiller’s work. Even at the peak, these sites were looking for reasons why we were not in a bubble. It made me think that if you desperately want to sell your house these days you should do no more than find an economist or central banker and just name your price: they’ll tend to believe excessively in market efficiency and won’t even haggle with you. In fact, they really don’t seem to be very savvy at all; in the way Shiller observes Greenspan‘s ideological devotion to Ayn Rand (pp 43), they would seem to be honour-bound to reward your heroic selfishness.

Shiller’s new book, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It (publication date: September 1), is a concise attempt to elaborate in just seven short chapters the genesis of the housing bubble (a psychological carry-over from the dotcom bubble), explode its myths (“prices always go up”), explore its scale and the dangers of its deepening impact (it’s bad), assert the need to maintain confidence in our economic and financial institutions by aggressive action (comparing the US and European responses to the Great Depression), and then explore longer-term, more fundamental reforms and innovations that will create a population much more attuned to economic risk.

Case Shiller Home Prices
How the US housing bubble looked at the peak. (Source: Irrational Exuberance website)

If you were among those who’d imbibed his dotcom analysis, or just lived the visceral torment of trying to swim against the tide of this particular mania, Shiller’s narrative of the social psychology of the housing bubble is all too familiar. By the way, if you think you already paid a high enough price for being prudent and that you may now cash in, Shiller has more bad news: you’re gonna have to pay for the inevitable bailouts too.

We have to be ready for the possibility that many more tax rebates will be necessary, perhaps for years to come. These rebates may eventually have a significant negative impact on the national debt. That possibility can be accepted only if we truly recognize the seriousness of the problem.

The book describes the process of the contagion of ideas, likening the spread of bubble mentality to a disease epidemic. Like a disease, the epidemic grows as the infection rate exceeds the removal rate; in other words, positive beliefs about the market outnumber more negative perspectives. For instance, there was the irrational belief that housing always appreciates, born of the inflation-ignoring money illusion; the increasing salience of particular “new era” narratives; regional or city patriotism that implied a particular area was somehow intrinsically different — where “everyone” wanted to live — justifying the inexorable local market rise. These ideas also inform the stock of media coverage, and are woven into reports of market gains in an attempt to explain what has little or no real fundamental basis:-

Most persons can be forgiven for not seeing that the sense of economic prosperity that usually attends a major speculative bubble is actually caused by the bubble itself.

But what is particularly telling is how this infects not just the private institutions, who stand accused of complicity in creating the subprime mess, but also our public institutions: political, monetary and regulatory. For example, describing conversations with the officials from the US Office of the Comptroller of the Currency and The Federal Deposit Insurance Corporation when he was urging prompt action to curb the then excessive lending:

I had the feeling that many of them viewed me, with my argument that the bubble would burst, as an extremist who deserved a skeptical response.

The problem Shiller complains of now, though, is that he is too readily characterised as a Cassandra. Mirroring the positive feedback loop that attends market rises, Shiller describes how journalists now invite him to describe how deep and how long a recession might be, while seeming much less interested in the solutions and frameworks that he proposes as a response to the economic and market disaster that is unfolding. He argues that this negative feedback loop — the increasing salience of bad news stories — serves to undermine confidence, and deflects attention from the scale and detail of the remedies needed. And I can attest to that; I may no longer eat breakfast cereal but am obliged to consume an oversized portion of Credit Crunch every morning c/o BBC Radio 4′s The Today Programme.

More than just an academic observer, Shiller is a practitioner. He has designed institutional and market frameworks to help avoid the economic catastrophes which tend to follow bursting bubbles. For instance, discovering that there was no long-run continuous data series to analyse the activity of this most important of asset markets, he set about researching and building the now widely used (one could say “benchmark”) S&P/Case-Shiller house price index, which charts the housing market in the US back to 1890. It’s on the basis of this data, Shiller shows, that US house prices rise with inflation over the long-run and are not the one-way bet of popular imagination. With colleagues, he also devised a domestic property futures market on the Chicago Mercantile Exchange.

So, Shiller is not really in the business of I-told-you-so, nor here to knock markets. He’s passionate about understanding the individual and group psychology of investment, and designing market mechanisms that better serve us as citizens — that will enable us to take more informed risks, and so perhaps lead us toward more creative lives.

And it is worth reminding ourselves why Shiller thinks it’s important that markets send us the right signals. In this, from Irrational Exuberance, one need only substitute “dotcoms” with “new granite worktops”:-

If we exaggerate the present and future value of the stock market, then as a society we may invest too much in business start-ups and expansions, and too little in infrastructure, education and other forms of human capital.

But in The Subprime Solution, Shiller argues against those who call for a retreat to a simpler financial age. He suggests a range of options that can trickle down to the ordinary person to democratize finance, provide them with the security of home-ownership (where appropriate), and insulate them from some of the risks to their longer-term earnings profile. One interesting point he makes is that some people, lacking the means to offset their socio-economic risks, may become far too cautious in their choice of employment, thus depriving society of their more creative endeavour.

I especially liked his defence of mathematical finance as an important new technology. When we think of technology we too often think of gadgets and software rather than applied knowledge and know-how. It’s clear that some mathematical models have been erroneously applied, and I take Paul Wilmott‘s blog as my guide for insights on how that has happened. But, in simple terms, I’d venture that this is not greatly different from the misapplication of GPS: use it with common sense, and know how to navigate without it when it doesn’t work. Shiller reminds us not to throw the baby out with the bath water.

At less than 200 pages of wide-margined type, lightly annotated and with no bibliography, there is something of the emergency pamphlet about this book. And Shiller is advocating a much speedier and more deep-rooted response to the crisis, which, as of a few weeks ago, he felt was still not being taken seriously enough. I suspect the effective collapse of Fannie Mae and Freddie Mac into government support since then has helped change that, but the policy response still seems some way from the kind of discussion Shiller is trying to lead here.

Shiller notes as his inspiration John Maynard Keynes‘ 1919 best-selling critique of The Treaty of Versailles The Economic Consequences of the Peace. And there is a strong moral imperative running through Shiller’s advocacy, no doubt reflecting the increasing severity of the social consequences that can compound very quickly if the policy response is half-baked. Of Keynes’ book, Shiller says in an accompanying release:-

This says something important about human emotions and drives, and a weakness that can cause people to careen blindly into huge catastrophes. In an important sense, we see the same human weaknesses again with the subprime crisis. The resolution to this problem calls for the kind of integrated thinking involving economic, political and moral dimensions that Keynes brought to the crisis of his time. In this sense, Keynes’ great book is an inspiration to me.

There are many examples in the book of how our financial understanding can be re-framed over the long-term. One that definitely seems worthy of further examination is the unidad de fomento used in Chile and copied elsewhere in Latin America where prices are quoted in a standard inflation-indexed basket measure rather than hard currency to reveal to the individual the intrinsic value of a commodity or asset over time rather than its nominal, currency-based value. For it is the rise in nominal values over time to which Shiller attributes the recent sense that you can’t go wrong with housing. Shiller describes Chile as the most inflation-sensitive population in the world.

There are many more recommendations, but if this book has the ambition of Keynes’ earlier work, and the scale of the problem is as suggested, I’d argue that the book is as accessible as you are going to get from such a modern behavioural economics guru. It’s a book that everyone who lives in a house (and who is of reading age) should own; just don’t buy ten and try to rent them out to friends.

Shiller links

  1. The Atlantic Monthly has an exclusive feature article by Shiller, drawn from the book.
  2. You can read Shiller’s occasional New York Times pieces here.
  3. A publisher’s video interview of him is here.
  4. His Yale lectures are being made available to the public later in the year at Open Yale.
  5. the Irrational Exuberance homepage is here.

The book should also be available on Amazon’s Kindle from August 18, two weeks prior to print publication:-

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Brown Bear, Brown Bear, What Do You See?I was thinking about the geophysicist Didier Sornette the other day. The reason being that (in my counter-factual way) I wondered what the world would look like if research (or a prediction, or an analysis) by people like Sornette were avidly watched — front-page news even. And then I remembered that I’d already written that post a long time ago, in my first blog. Like the other Yogi, it was déjà vu all over again.

Every day that I wake up to more bad news about the credit crunch, I feel slightly nauseated. It’s a bit like when you’re on a boat and the weather is closing in. Or the point that night falls and you’re out of sight of land. Or both. You’ve been there before, but your night vision needs to kick in. Time to hit the chart table, fix your position, re-evaluate how much sail you are carrying. A combination of nerves and trepidation focuses the mind. The concern is not so much for yourself, but for others. You’re in a complex system. Your fear must not guide you. You need to be confident, but careful. You may be master of the ship, but not the elements nor the other seafarers. A wetted finger is not good enough to figure out which way the wind’s really blowing. You need to calculate and apply learned heuristics, the wisdom of ages, one of which is “don’t rely on electronics”.

Finance being the bad-news-of-the-day for months on end is something I’ve never experienced before. I cut my teeth as a journalist during the extended bear market in oil that ended with the First Gulf War. The build-up was virtually a private affair for those of us who were specialists; no-one cared that much that the economy was benefiting from lower oil prices. The inflection point, when it came, was very public and geopolitical. Its consequences are still being worked out. I certainly did not see the Iraqi invasion of Kuwait coming; I was convinced that Saddam Hussein was just posturing. And yet, in retrospect, I vividly remember a conversation I’d had with a wise soul from the Middle East who showed an inexplicable agitation a few weeks before the invasion that you might characterise in the same way that animals are said to become jumpy before an earthquake. What was upsetting him was that he could read the runes whereas his colleagues could not. I was 25, still working below decks, lucky that he would take my call, and lacked the experience to fully engage with what was bothering him. The build-up to the credit crunch has been different and in some ways has already engaged the entire economically active population in psychological and also very concrete ways. The fall-out looks like being just as comprehensive.

It would be helpful if one could feel some sense of vindication, but it just ain’t happening. When you see someone driving recklessly, you don’t know whether it will end in a crash; that you are on the same bit of road — to mix metaphors — means you are inescapably in the same boat.

Getting it wrong is the sine qua non of economic forecasting. As the Stand-up Economist (whose gig on Saturday night at Oxford’s OFS I’ll be attending), says:-

Micro-economists are people who are wrong about specific things, and macro-economists are wrong about things in general … macro-economists have successfully predicted 9 out of the last 5 recessions.

Weather forecasters are often pilloried for getting it wrong. But, of all specialists, behavioural studies have revealed that they are the least confident in their own predictions. Economists and stock analysts, by contrast, are the most cocksure. And yet, the same people who failed consistently to identify the scale of the danger are also asked now to explain what happened. Nice work if you can get it.

Predicting markets is a notoriously tricky business, arguably foolish, and the great criticism that bulls usually level at those bears predicting bubble-bursts is that “even a stopped clock is right twice a day”. But what’s the inverse, exactly? Can’t the same criticism be levelled at the bulls? — precisely how “right” are they the majority of the time? And what’s the consequence of the bulls being very wrong just the once? Think back to Joanna Lumley playing Purdey [sigh] in The New Avengers in the 1970s, having to shoot her way through a kind of paintball training course. She was pleased that she’d scored 99%, marked by a single red dot that represented a bullet. Her sidekick, Gambit, pointed out it’s the 1% that kills you.

But I take the stopped clock thing seriously as a criticism of scepticism because it disparagingly suggests inaction and risk-aversion — who would want to be Chicken-Licken, after all? Certainly not the Emperor With No Clothes — and it cropped up in a piece of newspaper coverage about the credit crunch recently. My James Cramer reference the other day bears some reflection too. He would maintain, I believe, that his spiel is aimed at those with spare cash to gamble. But I think, in truth, he has been a cheer-leader for an industry that has been sailing toward the storm carrying every last scrap of sail in the locker.

But then, there is a problem with consistency. It’s generally over-rated. The ability to change one’s mind without shame should be more highly prized. As should be the ability to accept, without regret, that things may turn out better than one fears. Many a fisherman decides to stay in port only to find his catch and income is lost to a storm that doesn’t quite descend. He takes risks for a living, but I’m sure has learned too that it’s better to be wise before the event when so much is at stake. By contrast, a lifeboat man will put to sea in all weathers. But you’re taught at navigation school that he’s not to be confused with the AA man who will come and fill up your tank if you run out of petrol; he should only need to put to sea for the real black swans, not your incompetence. He won’t make that judgement, of course, but will respond to your Mayday anyway.

And so I was looking back at my own adventures as a Jeremiah, thinking about questions of timing. And that’s when I remembered that old post from my earlier blog about Didier Sornette. Sornette has long been on my reading list and in my view is one of the larger anti-heroes of modern finance that comprise my anti-library of unread books. He fits into that category where the Econophysics blog sits. The jacket of his book on markets, like Mandelbrot’s, shows fractal snail-shell patterns: you get the picture. I must buy it some day.

But I did read one or two of Sornette’s papers when they came out. I found them compelling, although the maths was completely impenetrable for me. It would be hard to find a more serious analysis of how vulnerable the markets had become at that point. That was the time to take in sail, batten down the hatches, and prepare (if necessary) to trail warps, spill oil on troubled waters, consider the possibility of removing all sail — what ocean yachtsmen call “bare poles” sailing, in the case of the perfect storm. In finance, it would mean de-leveraging early, not now.

At a very small talk I attended with Nassim Taleb in London way back in 2004, Nassim was asked by a London quant whether he thought the UK property market was in a bubble. Typical of Nassim at that time, I believe, he was confessing to not reading the newspapers so had no idea. The quant persisted that Sornette thought UK housing was in a bubble. Taleb’s response, if I recall correctly was this: “If Sornette thinks there is a bubble, then there is a bubble”. These are things I tend to remember.

Interesting, because Alan Greenspan was defending himself in the financial press the other day — and has done many times before — saying that it’s not possible to identify when markets are in bubbles. It’s a view that the prediction industry likes to repeat. But my understanding of Sornette’s science is that this is just not correct; you can identify bubble conditions from within trading price data using the same approach a seismologist does to gauge the susceptibility of the fault lines between tectonic plates to a sudden shift. I think the mathematical model he applied to the housing markets goes by the name of “log-periodic oscillations”. Predicting when the quake will occur, and with what magnitude, is the problem. That is still a work in progress, but one guesses that Sornette will be at the forefront of it as it unfolds.

Anyway, this is part of what I posted way back in June 2005 in my first, rather arch attempt at blogging called “Not that I’m Biased”:

If one is looking for a truly disinterested expert, and one with the latest knowledge on bubbles, we recommend geophysicist Didier Sornette. The mathematics of Sornette’s discipline is well beyond the lay reader. The essence of it is to show how complex systems work. He is an expert in the study of earthquakes. Stock market and housing crashes are the financial equivalents.

When people think about housing they don’t tend to think of a complex system. They will first think about their own house, those in the neighbourhood, and then a national price index recently described in the press which provides a sense of overall direction. They will probably then invoke a sense of someone who made a killing on property, or whom they saw renovate and sell at a profit on some TV show. From this they will make decisions to buy or sell. There is a strong element of imitation in what motivates them.

These behaviours are definitely part of what makes up a market, but Sornette’s specialism is in analysing them mathematically through study of the price activity of markets. Sornette’s last paper on housing demonstrated that the UK housing market would peak late 2003 or mid 2004, and then be susceptible to a crash. At that time, he did not characterise the US market as a bubble, but in his latest paper he shows that, two years on, the US is in a bubble.

A bubble with a crash in the UK will be one thing, but a serious reversal in the US would be very damaging. It remains to be hoped that the pump priming that occurred in 2000-2001 has not created a greater problem from which the world economy will suffer a more severe hangover.

It is no doubt a symptom of our collective aversion and lack of understanding of mathematics that Sornette’s work is not major news.

When the Asian tsunami hit, there was much hand-wringing about why the cooperation required to create an early warning system had failed. And yet, we know that events of that size are indeed extremely rare black swans, even though they appear to live in the folk memory of some of the coast-dwellers on Africa’s eastern seaboard. Financial shocks are coming with increasing frequency, but financial institutions, governments and the regulatory authorities — let alone the critical faculties of the media, — do not seem to be prioritising really listening to the complexity folks, despite the increasing volumes of accessible literature they have been generating in the past several years. It’s something I discussed yesterday with Brooke Harrington from the Max Planck Institute after her talk at the RSA. But that may have to wait for another post.

Photo credit: BrittneyBush

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Tweet A friend sent me this story, which has Nassim eating dim sum somewhere in London with Bloomberg. For those who did not think my own coverage (almost a year ago now) contained enough finance, this more than makes up for it. But then, I think we now know that bad things happen big time […]

I don’t want to take full credit for coining the term “Magoo Finance”, because others have already attached the name to the person of former Fed Chairman Alan Greenspan well before I did (see earlier). But I wonder if it might now serve as a useful shorthand for my colleagues in Big Media to characterise the kind of blind or short-sighted risk-taking that has been a feature of the past several years.

I thought it was noteworthy that the expression Value at Risk yields no useful information when punched into the BBC news archive, The [London] Times, or Daily Telegraph. The Guardian, Independent and New York Times all make mention of it, but in no systematic way, normally simply in relation to bank earnings. (The NYT yields a review of Taleb’s second book Fooled by Randomness, that is less than complementary.)

VaR is used by the banks to determine how much the bank would lose in a given day on its assets under management given a certain fall in the markets. Banks use it to calibrate their risk management. It is a pillar of the modern banking regulatory regime. Continue reading ‘magoo finance III’

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