October 27, 2013

Classic economics, models and free markets, stand no chance against arrogant intellectually sloppy regulators

In it Tett writes that “There is a profound irony here. In some senses, Greenspan remains an orthodox pillar of ultraconservative American thought… And yet he, like his left-wing critics, now seems utterly disenchanted with Wall Street and the extremities of free-market finance – never mind that he championed them for so many years.”

What free market finance is Tett referring to? That which requires banks to hold reasonable amounts of capital (equity) when lending to medium and small businesses and entrepreneurs but allowed banks to hold basically no capital when lending to those considered absolutely safe like sovereigns housing and the AAAristocracy? Is that “free-market finance”? She´s got to be joking! 

And Tett also writes “Greenspan has had a change of heart: he no longer thinks that classic orthodox economics and mathematical models can explain everything… he thought – or hoped – that Homo economicus was a rational being and that algorithms could forecast behavior”

No Tett! And no Greenspan! The problems had nothing to do with faults in classic orthodox economics or of mathematical models per se, or with “The ratings agency failed completely”, the problem is to be found entirely in the sloppiness with which these were applied.

Simple common sense should have forecasted what was going to happen, namely too much easy bank credit to what was considered as “absolutely safe”, and too little to what was ex ante perceived as “risky”. Or, what would Tett, or Greenspan, think that I could be referring to, when in the Financial Times in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds.”?

If banks used “perceived risks”, which includes of course the perception of rating agencies, then why should the regulators reuse the same perceptions for the capital requirements? What the regulators had and need to do, is of course to base the capital requirements for banks on the possibilities and implications of those ex ante risk perceptions being wrong. And in that case, since what ex post turns out riskier than the ex ante perception was, is always riskier than what turns out safer, if anything, the capital requirements should be higher the safer the ex ante perception are.

It is sad to hear Greenspan admitting: “When I was sitting there at the Fed, I would say, ‘Does anyone know what is going on? ... I couldn’t tell what was really happening”.

But, that more than five years after the crisis began, Greenspan and the Fed (and Tett of course) seemingly do still not know what happened, and is happening, well that is truly scary stuff… especially for all those unemployed young who are going to pay for it.