Risk Models

Sorry to say this but the speed of the recovery looks as if it will be very slow. There are a number of reasons for this, but right at the top comes the state of our banking system. Which is something we have not fixed. A second factor is the state of economics itself. As Paul Krugman said earlier this week most of the work in economics during the past thirty years has been useless in both diagnosing and curing this crisis. Much of it has been harmful. So the trajectory we follow over the next few years rests largely on these two obscure problems.

Banking remains a mess. The administration has taken a passive attitude towards the causes of the recession, preferring to focus on short term bail out and fire dowsing. No one can reasonably object to the triage of the last few months. Looking back to the origins of the economy’s downfall and the actions of both the Bush and Obama administrations since the bottom fell out of the real estate market I think it is correct to conclude that most of what was done has helped. Most of it could have been done better of more transparently, but that observation comes with the benefit of hindsight: at the time there was a very real feeling of impending catastrophe.

“The industry thought it was modeling its way to safety. In fact it modeled its way to oblivion.”

From my perspective one of the aspects of the crisis that is most illuminating, and one that will shape our thinking deep into the future, was the extraordinarily slow reaction of the Bush regime.

This slack response as the crisis gathered speed centered on the Treasury and other parts of the administration. The Federal Reserve Board cannot be accused of similar lethargy. The fault was not one of lack of interest, except for Bush himself who turns out to have been remarkably uninterested in the economy’s nose dive, nor was it lack of analysis. There were plenty of people involved in digging out the facts. That a bubble was bursting was well known and obvious. It was the reaction to that well known set of facts that established our course.

Government policy was built around two catastrophically incorrect premises:

That the banks were the staid, dull, and conservative institutions we all imagines them to be. And that the economy would benefit from the magical power of the ‘market’ to correct itself.

Either false premise would have caused damage. Together they led to crisis.

Banks, it turns out, had long ago given up all pretense to conservatism. They had become gambling houses. Their balance sheets were full of assets whose economic value was tenuous at best and powerfully destructive at worst. They had had totally lost control of their risk. This was even as they implemented ever more sophisticated risk management models. Executive managers at most of the large banks appear to have had no idea of the true consequences of the business practices they were employing. This is an astonishing indictment of a class of people who are still arrogantly self-assured and extraordinarily well paid for their apparent stupidity.

And let’s be honest: they were stupid.

There is no other way to explain the horrific destruction of wealth that the banks brought about. Whatever they thought they were doing was obviously totally disconnected from what they were actually doing. That managers, boards of directors and regulators failed to notice this is one of the great mysteries of the crisis.

Banks were being willfully ignorant as they pursued returns that any first year finance student could have queried. Somehow banks imagined that they had severed the link between risk and return. They could manufacture endlessly higher returns at ever lower risks.

This was Ponzi banking.

The economist Hyman Minsky long ago described the situation w found ourselves in. His argument was that stability, long periods of strong economic growth and profitable business, inevitably leads to chaos. Stability breeds instability. His hypothesis was that certain markets, and in particular financial markets, are inherently unstable. Stability breeds confidence. Confidence breeds disregard for history. Disregard for history breeds hubris. All of this leads to a willingness to accumulate absurd amounts of debt and to justify it all with equally absurd nouveaux theories built upon ludicrously small sample sizes and self-supporting critiques of the facts.

Banking failed miserably because it believed its own hype.

It became infested with quasi-scientific rationales that allowed it to ‘model’ its risk capacity. The industry thought it was modeling its way to safety. In fact it modeled its way to oblivion. And everyone involved was culpable: managers turned away at any sign of doubt because the bonus stream generated by the false belief were compelling; regulators turned away because they could not compete with the intellectual horsepower arrayed against them and those profits seemed secure; and politicians turned away because the profits from the false beliefs enabled cash to flow in torrents into campaign war chests. The banks captured the legislative and regulatory process. So society lost its bulwark against the steamrolling it was about to get from the exposure of the error.

I mention all of this because nothing has changed.

You would think that in the light of the epic destruction of wealth that the false methods brought about that few, if any, of those responsible would still be employed. Instead we find them all there. Complaining that they are misunderstood. Complaining that restrictions on bonuses will rob them of ‘talent’. Complaining that government intervention subverts the power of the ‘market’ to find solutions. And, even more absurdly, getting indignant that the public should care or be involved in the creation of those solutions.

Moreover, the world view upon which the false belief was built: that of ‘market superiority’ or ‘market efficiency’ still pervades and still undermines our ability to fix the economy.

At the beginning I mentioned that one of the oddities of this crisis was the tardiness of response. That tardiness resulted from the belief system into which our elites have invested themselves. They honestly believe in market magic. Which like the tooth fairy is responsible for all the good things in an economy. All the bad things? Well they result from non-market forces that create ‘market failures’. So as the economy imploded the policy response, at first, was to employ the standard markets-are-wonderful toolkit. When you believe in market magic all you need to do is to sit back and watch after you have cleared away all the impediments to its ability to work.

It was only when the bottom had completely fallen out, when the abyss beckoned, and the standard policy cupboard was both bare and exposed as useless that a few people recalled Minsky. They thus recalled Keynes, because Minsky was a true Keynesian.

Then we could employ the proper defense.

The success of all the policies since this great awakening is evident. We have arrested the fall. Things have a strong chance of improving. The economy may yet be saved.

But.

We have not fixed the banks. They are still using those false models. They used them to build their responses to the ‘stress tests’. Which is why I am highly skeptical of the test results. The regulators still condone their existence. Managers still rely on their output. We are still flying blind. Its as if we were using astrological tables to fly to the moon. This stuff needs to be tossed overboard before it gets us back into a new bubble.

Already the infighting as begun over the shape of the ‘reform’ of the banking industry. We have been promised that they will be fixed. But there is very little evidence that the politicians and regulators who will shape that reform will succeed. They still advocate market magic. They still fail to understand that the events of the past year have falsified the claim that markets are efficient. They still have faith in the mathematics of the risk modelers. A mathematics now proven to be in error. It was the mathematics of textbook economics where market magic made everything nice and neat. There were no messy outlier events lurking to trash the system. Market magic sprinkled over the data always leads to erroneous results.

Until we expunge market magic from our belief systems we will fail to construct a stable banking system. We will also fail to institute policies that set us on a course for sustainable recovery. Already the leaders of the big economies are bragging about their successes in dodging a catastrophe. Complacency is setting in. The moment for learning appears to be slipping away. The banks are getting back to ‘normal’. And that market magic still lingers in the air. That old stability is returning.

From which instability will inevitably result.

There’s a bubble in our future.

Go read Minsky. Now.