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  • Frydman and Goldberg's 'Beyond Mechanical Markets'
    May 24, 2011
    BeyondMechanical125.jpgHow wrong were we? After several years of commentary on the causes of the financial crisis, we still struggle to plumb the full depths of the event. We have tossed up, like so much confetti, a variety of culprits, both human and systemic, many of which undoubtedly played some role and had some complicity: from executive compensation to lack of transparency to Alan Greenspan to Congress to credit default swaps. Journalists have been excoriated for missing what was apparently obvious; homeowners blamed; Wall Street pilloried; economists accused of intellectual dishonesty. We have chewed over questions of structure, size, capital, leverage, risk. We have put the Zeitgeist (blame the '60s!) in the chair, probed trade imbalances, decried the presence of greed and taken refuge in irrational impulses. And yet, there is a strong sense that we are just swirling pieces of a jigsaw puzzle across the table. There remains a feeling that perhaps we were wrong in some deeper way.

    Enter "Beyond Mechanical Markets: Asset Price Swings, Risk and the Role of the State," a book published earlier this year by two economics professors, New York University's Roman Frydman and the University of New Hampshire's Michael D. Goldberg, that has elicited remarkably little discussion in the U.S. (it's done better in Europe, but that's another story). "Beyond Mechanical Markets" is a serious piece of work that's based on research the pair has been doing for some time; while it's "about" the financial crisis, its core ideas transcend that episode. It takes aim at a dominant macroeconomic impulse that, in popular terms (if anything seriously economic can be "popular") encompasses the rational-expectations hypothesis. There have been several popular books that have taken aim at that set of ideas, from Justin Fox's "The Myth of the Rational Market," to Yves Smith's "Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism." And Tuft's Amar Bhidé's recent "A Call for Judgment: Sensible Finance for a Dynamic Economy" touches on many aspects of this critique, but looks at it more from an organizational perspective: How rational expectations and efficient markets became embodied in deeply flawed risk management techniques like the Black-Scholes options-pricing model and value-at-risk tools.
    Frydman and Goldberg's thesis deals with more fundamental macroeconomic matters: To what extent can we predict the future? Is there a mechanical causal link that we can ever truly identify and quantify between past and future? They gather and deploy their intellectual confederates: Frank Knight, John Maynard Keynes, Friedrich Hayek, Karl Popper. They argue that rational expectations is one method, certainly a ubiquitous one, based on what they call a "fully predetermined model," in which market players act as robots and markets operate as a kind of machine; another predetermined approach, they argue, is the New Keynesian school, that is the formalization into mathematical models of Keynes' "General Theory" of 1936; a third includes some of the more mechanical tendencies of the behavioral school. "To portray individuals as robots and markets as machines," they write, "contemporary economists must select one overarching rule that relates asset prices and risk to a set of fundamental factors such as corporate earnings, interest rates and overall economic activity, in all time periods. Only then can participants' decision-making process 'be put on a computer and run.' " These models assume individuals possess "perfect" knowledge of how available information will affect future prices and risk. The causal factors need never change.
    Once an economist assumes market participants have equal access to information, the rational-market model implies that prices reflect the "true" prospects of the underlying assets nearly perfectly. "Economists and many others thought that the theory of the rational market provides the scientific underpinning for their belief that markets populated by rational individuals set asset prices correctly on average. In fact, the theory is a proverbial castle in the air: it rests on demonstrably false premises that the future unfolds mechanically from the past, and that market participants believe this as well."
    From this base the pair argues a number of related points. Again, the rational-expectations hypothesis posits mechanical, fully predetermined, Newtonian markets. But many players in the markets are, in fact, rational, in the sense that act in "reasonable" ways. Rational players do not just automatically use one model (and investors, in the real world, differ in approach, self-interest and interpretative emphasis); they recognize that their information is imperfect and that they are constantly buffeted by what Frydman and Goldberg call "nonroutine" change, such as innovations, perturbations of the Zeitgeist or, for that matter, revolutions and earthquakes. One of the great challenges for believers in mechanical markets is what the pair call "long-lasting asset swings" and what we often loosely and promiscuously characterize as bubbles. Ironically, to explain asset swings, many economists end up arguing that investors have been seized by bouts of irrationalism, crowd psychology and momentum trading or fooled by "informational problems, poor incentives, and inadequate competition," allowing assets to diverge from intrinsic values, as determined by the model. The market, from a predetermined perspective, loses its moorings and has to eventually be reeled back by harsh reality. That belief that outside factors have marred the perfect operation of the market machine has been buttressed by some adherents of behavioral economics (which ironically helped undermine rational expectations in the first place) who replace predetermined market relations with predetermined psychological factors. The result is the same: The market, in a sense, loses its mind until its painful return to rationality.
    To be sure, they note, lack of transparency, lousy incentives and psychological factors contribute to market problems and to the destructive result, a misallocation of capital and a painful correction. But even if they did not exist, they argue, assets would still swing because of the inevitability of imperfect knowledge. Participants know prices are growing excessive; but Frydman and Goldberg are arguing for a kind of middle way between two extremes and opposing tendencies in economics: the first, that markets allocate capital nearly perfectly; the second, that markets and participants are irrational, grossly inefficient at allocating capital and prone to a succession of bubbles. Each demands a different role for the state: In the first, a hands-off attitude to upswings in asset prices; the second, a readiness to massively intervene. Getting your mind around where Frydman and Goldberg are going requires a sensitivity to terms and definitions. They are not arguing that prediction, for example, is impossible, but that "precise" prediction is. Forecasting can be successful, particularly over the short term and, over the longer term, by understanding what they call "qualitative and contingent" regulatories or trends "in driving price swings."   
    Both their market diagnosis and remedy sail a course between these extremes. Frydman and Goldberg dedicate much of the heart of this book to refuting the notion that asset swings represent a departure from reality. True, they argue, psychological factors such as confidence and optimism play a role in driving the market throughout the cycle, underpinned by fundamental considerations. The difference is that their notion of what is fundamental shifts over time as they react to nonroutine change. In the late '90s when the great upswing in prices of tech stocks was forming, there were good reasons for investors (and the pair discuss at some length the interaction of short-term speculators and longer-term value speculators) to be optimistic, even as they exceeded historical market benchmarks: There was great optimism about technology; interest rates, inflation and unemployment were low; productivity was high; and despite some disturbing episodes (the Mexican default, the Asia Crisis, the Russian default, Long-Term Capital's failure), America and the liberal West emerged relatively unscathed and seemingly in control. Similarly, a host of economic fundamentals -- low-interest rates, low unemployment, low inflation -- fed the rise of housing prices. And in both cases, belief in rational markets -- that any action to flatten those swings, or to prick a hypothetical bubble, would produce "distortions" worse than letting them play out -- demanded a passive role from regulators. Frydman and Goldberg believe that long-lasting asset swings are inherent in how assets markets allocate capital. However, because market participants must base their trading decisions on imperfect knowledge, asset price swings can sometime become excessive and lead to misallocations of capital.  
    How might that be done? This brings us to what they call "restoring the market-state imbalance." They lay out a scheme in which regulators, such as the Federal Reserve or the Financial Stability Oversight Council, monitor markets and carefully and discretely employ a variety of techniques -- based on what they call Imperfect Knowledge Economics, or IKE -- to try to dampen asset swings that exceed, either on the high end or low, a wide range of values based on historical benchmarks. This is a kind of economics analogue to regulation by principle, seeking to reach beneficial outcomes through flexible, empirical response to dynamic conditions. Although they lay out a number of ways this kind of equity analogue to monetary policy might be done (much of their earlier work on IKE focused on foreign exchange markets), this sometimes seems sketchy. It downplays the difficult technical and political task of regulators going into the markets to deflate what may, or may not be, dangerous swinging assets. They agree with Ben Bernanke that regulators can easily move too soon, thus stifling, say, useful technological innovations. But they admit that more analysis needs to be done to give regulators better tools to pinpoint the best moment to act. And they generally ignore the regulatory-capture problem, which extends well beyond the fact that regulators embraced the orthodoxy of rational expectations over the past few decades. Rational expectations may have seemed to regulators to be true -- it certainly was a seductive idea -- but it also feeds regulatory desires to lead a peaceful life, to preside over prosperous times and to attain a comfortable retirement.
    "Beyond Mechanical Markets" is not an economics text heavy with math (the approach of their earlier book on IKE, "Imperfect Knowledge Economics: Exchange Rates and Risk," was); it hearkens back to the narrative method of economics that arguably reached its apex with Keynes. Unfortunately, Frydman and Goldberg lack the elegance of Keynes, though they're hardly alone. The book demands some sweat equity in readers and it assumes a more-than-passing familiarity with the substance of economic ideas and history; it has a circular quality, pounding home points, then shifting the perspective, and pounding them again. That said, it marshals a powerful argument that's bolstered by empirical reality: the eternal failures of mechanical forecasting; the sheer difficulty of beating the market with consistency; the unforeseeable ways that history unfolds. The belief in precise prediction resembles a kind of utopian project, a tower of economic Babel. At bottom, the pair makes a philosophical point that Knight, Keynes and Hayek (ironic, they comment, given that rational expectations came out of Chicago, where Hayek taught) offered many decades ago: the combination of men and events, particularly in these manmade constructs called markets, certainly improves our ability to price assets (and to forecast) over that of an individual or bureaucracy. But that inclusion of freely determined humanity (or humanity that believes it has free will, which is the same thing) conspires to erode any simple, mechanical or guaranteed relation between past and future. They quote Popper: "Quite apart from the fact that we do not know the future, the future is objectively not fixed. The future is open: objectively opened." At bottom, they're trying to thread the needle in the ancient free will versus determinism argument.
    Will they succeed? Will anything change? Not quickly. As they admit, the power of fully predetermined models may have actually increased because of the crisis. Economic pundits continue to speak with great certainty, and these issues are complex, nuanced and often hidden. Besides, the insurrection Frydman and Goldberg argue for is far greater than just an overthrow of rational expectations; it's an entire economic world view that claims the power to accurately predict, forecast and capture market reality. Generally, the classic response of an orthodoxy (or what Thomas Kuhn famously called a paradigm) is to ignore any threat, not only out of fear of what might be lost (tenure, prizes, careers), but out of incomprehension; to the predetermined model builders, Frydman and Goldberg's argument must literally seem like babble. That may well be the best explanation for the fact that these issues and this book can barely generate a debate in the United States. - Robert Teitelman

    May 24 9:32 AM | Link | Comment!
  • Peter Temin on natural economics
    May 16, 2011 Peter Temin125x100.jpgThe Straddler has posted a fascinating conversation with MIT's economic historian Peter Temin conducted back in February (hat tip: The Baseline Scenario). Temin argues that macroeconomics has embraced a metaphor of a "natural" market that stems from the belief in a maximally efficient, general-equilibrium model. Any deviation from that ideal is described as unnatural, and thus an efficiency-destroying "distortion." Temin:

    "In my opinion macroeconomics has lost its way. The kind of models that many people use -- general equilibrium models -- start from an assumption of perfect competition, omniscient consumers, and various like things that give rise to the an efficient economy. As far as I know, there has never been an economy that looked like that -- it's an intellectual construct. But many people claim that the outcomes of that economy are natural outcomes. When you say 'natural,' you already have an emotionally laden term. Deviations from the 'natural' -- say, like minimum wage laws, or unions, or governments that give food stamps, or earned income tax credits -- are interference with the natural order and are therefore 'unnatural.' "
    There's a wonderful recent example that comes immediately to mind: Alan Greenspan's now-notorious recantation of "mistakes" in the Financial Times in late March, in which he decried "regulatory inconsistencies [stemming from Dodd-Frank] whose consequences cannot be readily anticipated." Greenspan went on to add, "The act may create the largest regulatory-induced market distortion since America's ill-fated imposition of wage-and-price controls in 1971." And in fact, Greenspan argued that the financial system was so complex and dynamic that no one -- neither regulator nor trader this side of the Godhead Himself -- could comprehend what was going on. This, in fact, is a classic articulation of the argument from nature that Temin picks up on, and that resembles a kind of radical environmentalism for money: Because it's beyond our ken, we shouldn't mess with it and create distortions.
    The biggest problem here, which I touched on with the Greenspan column and that Temin points out far more elegantly, is that a free and perfect market is as much a myth as the state of nature: Markets are created, regulated and manned by homo sapiens. As Temin says: "In work Frank Levy and I did, we talked about a period we called the Treaty of Detroit (1945-1970s), where you had a lot of government intervention, and then this later period we nicknamed The Washington Consensus (1970s-present), where there was minimal government intervention. At first our tendency was to say that the later period was natural competition and the earlier period was unnatural government intervention. But then we had to say, no, the government is involved in all of these things, it's just that government policy is different in one period than in another period. It's not that one is natural and one is unnatural. It's that one does something, and the other does something else."
    Temin's deeper argument then is that "general equilibrium tends to lend support" to those who favor minimal government. And the success of this point of view over the past three decades has created a feedback loop. "As people have gotten richer, conservative people have funded organizations which generate economic research promoting their political views," he writes.
    Temin goes on to offer considerable more detail on how this affects economic matters. But this is larger than just economics. The argument about nature has a long pedigree historically, going back at least to the Enlightenment and reaching a kind of feverish apotheosis in the Romantic period. It's been with us ever since, with such phenomenon as "the noble savage" that extends from Rousseau to Margaret Mead to the Playboy Philosophy. And we have the current mania for "organic," which is so prone to distortion, but which is based on the notion that "natural" is "healthier" and morally better. The theme also pops up in healthcare, where "natural healing" or alternative medicine has long had a following because it is, well, natural (see the history of Christian Science). Indeed, biological advances that used the body's own immune system to battle diseases like cancer were long promoted as a way to avoid the side effects of chemically based therapeutics, without real clinical efficacy. The reality is that the side effects of so-called immune products from the interferons to the interleukins to a hundred other complex and intricately designed (by evolution or God, depending on your point of view) molecules could be just as devastating and just as baffling as organic compounds cobbled together by chemists or discovered on the bark of some tree in the Amazon.
    The truth is "natural" can kill you or save you, feed you or starve you, offer darkest evil or moral uplift, represent a social good or a social disaster. Indeed, the quest for the truly "natural" is a road into ambiguity and relativism. Nature becomes whatever we claim it to be. Are the animals in the farmyard any less "natural" than the birds in the trees and the denizens of the woods? Are the only truly "natural" situations those where an ecosystem returns to a general equilibrium uncontaminated by man? We are, obviously, part of nature, bipedal animals with a unique self-consciousness and talent for abstraction. What does it mean to banish us from evolution?
    What's interesting here to see is how this powerful and deeply rooted metaphor has been adopted by conservative, hardheaded, empirically minded, economic technicians who would probably resist the company of nature freaks, environmentalists, alternative medicine gurus and health-food apostles. But it's a metaphor with great power within this culture with a protean fungibility, even if it is one that, when it falls into the hands of economists and free marketers, has a tendency to run roughshod over all other claims, even those also held up as natural. And as we know, the perfectly free market is an aggressive force that eventually will overstep its bounds and, quite naturally, implode. - Robert Teitelman

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    May 16 3:05 PM | Link | Comment!
  • Bell, Buffett, Graham and the markets
    May 5, 2011 belltake2125x100.jpgIn wandering the wilds of the Web recently, I stumbled across an interview on with the late Harvard sociologist Daniel Bell, who died in January at 92. Bell, of course, was the author of a number of important books, all with titles that have lasted longer than the arguments that shaped them: "The End of Ideology," "The Cultural Contradictions of Capitalism" and "The Coming of Post-Industrial Society." Bell was always a lively, even combative, raconteur, and this interview, a few months before he died, is worth reading in its entirety. But several answers by Bell sent me wandering down obscure biographical byways and odd intellectual confluences. It began when Bell offered a personal aside in a discussion of the financial crisis, including a few thoughts on Goldman, Sachs & Co. (very smart people who, he argues, failed to get the timing right and "got trapped"), when he suddenly veered to reminiscence: "I have a former father-in-law, through a previous marriage, who wanted me to come into the family business. His name is Benjamin Graham. Benjamin Graham, you probably know, was the founder of value analysis. He said: 'I have a bright young man here, named Warren Buffett. I'll pair you with Warren Buffett!' And I said, Ben, the problem is, I have no stomach for the 'timing,' and that's crucial in this business. Well, anyhow, I worked for Ben, and I made some money with it. I do understand the markets."
    Bell, Graham, Buffett? You sense worlds colliding. Bell has a fascinating background, evocative of a particularly fertile time and place in American intellectual history. He was born and raised to Jewish immigrant parents on New York's Lower East Side -- his description of the tenement life is pungent, sad and funny. His father died when he was young, but he ended up like many of his peers at City College in the '30s arguing schismatic left politics in the famous cafeteria. He became a sociologist, an editor of intellectual journals (The New Leader and later, with Irving Kristol, The Public Interest), and he even he spent a decade -- 1948 to 1958 -- as the labor editor at, of all things, Henry Luce's Fortune magazine, which captures his reach as a public intellectual. (Fortune in those decades had employed a number of intellectuals: John Kenneth Galbraith, Peter Drucker, William Whyte and Bell. The times, not to say Time Inc. and the magazine business, were very different. )
    How did Bell come into contact with Graham? Probably through his daughter, although given the varied circles of both men, it could be the other way around. Graham had long connections with Columbia University's Business School. He taught his famous advanced securities analysis course from 1928 to 1954. Bell had attended a year of post-graduate studies at Columbia in 1939, then taught there from 1959 to 1969. The much-married and peripatetic Graham wrote an eccentric and entertaining partial memoir, "The Memoirs of the Dean of Wall Street," that never mentions Bell, though it does make reference to "my second daughter [who] was to become Elaine Graham Bell, PhD, and later the wife of Cyril Sofer." Graham then wanders off to other subjects. Indeed, the memoir never reaches the '50s, when Buffett shows up at Columbia and becomes Graham's greatest student, then, in 1954, his employee at his investment firm Graham-Newman. (There is a chronology at the end that includes everything from "hires Buffett" to "falls in love with Malou" to, in 1959, "gives up tennis.")
    A digression (we're wandering a bit like Graham) may suggest how Elaine Graham and Bell met. Both Bell and Elaine Graham were sociologists -- note that proud reference to "PhD." It is interesting that Graham fails to identify Bell, but implies we should all know Cyril Sofer. Who is Sofer? Well, he was a British organizational and management theorist -- that is, like Bell, a sociologist -- and author ("Men in Mid-Career: A Study of British Managers and Technical Specialists" and "Organizations in Theory and Practice") who taught at Cambridge University. Elaine Graham Bell, then Sofer, wrote about many of the ideas of David Riesman, whose "The Lonely Crowd" may have been the most famous sociological text of the '50s. Sofer's first wife, South African-born Rhona Sofer, was a sociologist and psychoanalyst who went on, after divorcing Sofer in the '50s, to marry cultural anthropologist Robert Rapoport. This was a little nest of social scientists operating in a kind of golden age of the discipline. It's likely then that Bell met Graham through his daughter. It's also probable that when Bell talks about Graham and Buffett it's taking place around 1954, when Buffett left Omaha to work for Graham and Bell was at Fortune.  
    What about Bell, Buffett and Graham? What did Bell do for Graham? More importantly, how would that troika have worked out? All three had, at one point or the other, pretensions to higher thought. Bell came closest: He got his start in radical '30s politics (although he negotiated ideological politics of the day with great skill, abandoning the Marxist left of his youth but avoiding the neoconservatism of Kristol and so many of his old colleagues: He famously claimed to be socialist in economics, liberal in politics and conservative in culture). He was, like so many of the postwar New York Jewish intellectuals, formidably conversant in a variety of fields. Graham viewed himself as a Renaissance figure, mastering not only value investing, but claiming to be the only person asked to teach in three departments, literature, philosophy and mathematics; he was also involved in the theater. As for Buffett, he raised Graham's theories to a kind of folk-philosophy, although he has never displayed the intellectual ambitions, or pretensions, of his mentor. An entire industry has grown up around Buffett to explain and extrapolate his ideas, not unlike that which surrounded the late management thinker Peter Drucker.
    However, in the interview, Bell touches on issues that suggest he may have had deeper problems with Graham and Buffett than just "timing" and a career dedicated to making money. After all, Graham's notion of intrinsic value lies beyond the daily mutterings of Mr. Market. Intrinsic suggests that there is a sort of ideal value out there in any given corporate asset. Discover that, through the kind of hard, commonsensical analysis that Graham pioneered, and eventually the market would come around to recognize it. In a Graham world, you didn't need necessarily to time; you simply required rigorous analysis and patience; it's the Protestant work ethic of investing. Although Buffett operates in a far more complex way these days, he still preaches these Grahamian basics.
    The Graham approach thus operates as if there's a causal link between the past and the future. Indeed, the future can be predicted by knowledge of the past that is the intrinsic value of the asset in question. (In the Buffett industry, this link between past and future takes on a moral quality: True value will reveal itself in time.) But Bell in the interview raises grave doubts about that link -- echoing ideas that economists have increasingly articulated. Bell was asked about whether he thought of himself, because his books dealt with broad social change, to be a "futurist." He dismissed the idea, laughing about a project he worked on in the late '90s designed to rebut Alvin Toffler of "Future Shock" (or as Bell quips, "Future Schlock") fame. Then he turned more serious:
    "There are two problems with futurology. One is that no one can do prediction. Why? Because predictions are point events, and you never know the internal dynamics. I think of my erstwhile colleague Zbigniew Brzezinski, with whom I taught at Columbia. During a debate on television he was asked: 'Professor Brzezinski, are you a Kremlinologist?' And he said: 'Well, if you like, though it is an ugly word.' 'So you are someone who studies the Soviet Union? If so, Professor Brzezinski, how come you failed to predict the ouster of Khrushchev?' And Zbig said: 'Tell me: if Khrushchev couldn't predict his own ouster, how do you expect me to do it?!'

    "So you can't predict. What you can do is deal with structural change. If you move from an agricultural to an industrial economy then there are obvious changes you have to make in the educational system, and various other places. That's why I make a distinction between prediction and forecasting. The other problem is that we weren't interested in the future, per se. We were interested in the fact that once you make a decision it becomes binding and lays out the lines for the next time period. If you build a city, and build it on a grid pattern, then it becomes a constraint on how you build in the future. Whether you build in a circular pattern or a grid pattern affects the lives of people in the future. So we're not only interested in forecasting the future, but in saying: let's pay attention to how we make decisions now, because they are going to affect our legacy in the future."

    You can make too much of this, of course. Bell was a relatively young man in 1954; he developed his ideas about prediction and forecasting much later. Indeed, it's a parlor game to contemplate the new path Bell might have launched himself upon had he taken up Graham's offer; maybe he could have been Charlie Munger. At the same time, Bell inadvertently puts his finger on one of the underlying weaknesses of the Graham-Buffett approach: That is, to make value investing work effectively, as both men have (joined by relatively few others), you need to do a lot more than calculate intrinsic values; you have to be a forecaster of genius, working through a vast number of factors that will shape and reshape that intrinsic value as time weaves its wayward, perhaps even its random, path. (This is one reason that Buffett stays away from high-tech plays: Innovation may be the hardest phenomenon to predict.)

    This takes us to a current debate that's slowly unfolding in economics, one captured in a book on my reading pile by NYU economist Roman Frydman and the University of New Hampshire's Michael D. Goldberg: "Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State." The pair argues that economies are shot through by "nonroutine" events that cannot simply be banished by rational or behavioral models. This is oversimplifying, but a key conclusion they draw is that modern macroeconomics, not just the efficient-market school but the New Keynesians as well, is based on a powerful belief in mechanical causality that, given the inescapable human element of economics, rarely turns out as predicted. Others such as Tufts' Amar Bhidé in "A Call for Judgment" which we reviewed here, have made similar arguments about the mechanization of financial judgment, though coming from very different angles.

    This is a long way from a partnership between the three men -- a sociologist and two investing geniuses -- that never came to pass. But it does suggest that Bell was right about one thing. He knew something about the markets. And what he knew may well be worth revisiting. - Robert Teitelman

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    May 16 2:41 PM | Link | Comment!
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