The Anarchist dog: Inspiring http://glipho.com/socritik/the-anarchist-dog-inspiring
Things are not going so good for Francois Hollande, Paul Krugman’s recently declared hero. After S&P’s downgrade of France’s credit rating, his authority is contested in nearly every social body, from peasants to entrepreneurs. Even within the French socialist party, and the governing coalition, concerns are being raised over the strategy of prudence and lack of political courage developed by Francois Hollande.
Hollande has been elected on a platform of serious budget management, revival of France’s industry, an overall war against the wealthy and the financial sector, and a concern of social justice in every decision he vowed to take. Almost two years into his presidency, and by all accounts, the debacle has been obvious.
Now members of his own governing coalition are resisting his authority, from voting against Presidency approved texts in the French Senate to asking him to change the head of the government in a desperate move to calm public opinion. This is how bad the situation is for Hollande.
A recent poll conducted by the BVA institute showed that Hollande suffers from the lowest approval rating in the history of the 5th Republic. During the Armistice ceremony, his convoy was booed by participants proudly wearing the bonnets rouge, a symbol of revolt that originated in Brittany against the levy of an environmental tax on road transport. This incident is unique in its nature, given that the Armistice is historically a day of national unity and paying due respect to elders that scarified their life for the good of this country. This year, people had other things in mind.
In this short report from RT, attention is drawn to the increasing rate of suicide among French farmers. Tragic working conditions are also the sad fate of policemen, prison guards, hospital staff, and a lot of small and medium business owners.
One of the main reasons for this situation is the difficult budgetary position France is in right now. Hollande finds himself having to manage a tight budget, combined with a promise of an increase in public spending and inability to reform. And when he actually accomplishes a reform, like the CICE, a credit mechanism for businesses that allows them to deduct social costs from their taxes, the reform fails to deliver results. A reform aiming at increasing the competitiveness of french export enterprises has benefited companies like the SNCF that have mainly internal activities. Unlucky?
France’s difficult budgetary position does not benefit from Hollande’s inability or unwillingness to decide between two ideological camps, an leftist Marxist ideology and a pro Europe liberal ideology, that are coexisting within his government. Ingredients for smooth political management of crises.
A majority of the French people has grown hostile to all forms of taxation, especially small businesses, who are facing a record number of bankruptcy cases (more than 20 percent yearly increase). Faced with a tight budget, the French government has adopted a strategy of increased taxation and maintaining the social safety net at an acceptable level politically. Taxes are being chased in every corner of the French administration. Economists like Paul Krugman hailed France for this prudent policy stance, spending need not to be controlled, but increased, to ease the economic depression. Except that Krugman and Hollande underestimated the taxpayer’s patience and docility.
Solutions and Illusions
Thinking that he can maintain the economy afloat, while undergoing mini reforms and waiting for growth from dear old Uncle Sam, Francois Hollande underestimated the level of tolerance people have towards taxation.
Social movements have been multiplying, the latest being small business and shop owners movement against the increase in V.A.T. This movement was preceded by many, others, the “bonnets rouges”, “les pigeons”, the “French Spring”, and revolt movements designed to undermine the authority of the President. Perhaps the most caricaturist and symbolic signal was the decision to tax saving accounts of million of French people retroactively.
How amateurish can a politician be in imagining solutions for problems is beyond me. The first reflex is; Tax, and think later. Changing the rules of savings account during the course of their maturity is one negative signal no politician wants to send to markets, and the socialist French government managed to do that.
This comes after a series of delicate situations faced by the French president, including the Leonarda affair, where he appeared hesitant and unable to uphold the law. A bad situation just became worse.
On the employment level, Hollande’s promise to stop the increase in the unemployment rate at the end of 2013 seems attainable, but with nearly 10 million French people on social benefits, a halt in the unemployment rate increase is not what he was elected for. The most optimistic response Hollande had to the unemployment problem was thousands of state sponsored contracts, old socialist recipes for a deep economic problem. And people are seeing just that.
The limits of taxation
Polls measuring people’s acceptance of taxation decisions, their hostility to tax agents, the decrease of the volume of the wealth tax collected in 2012, and the multiplication of fiscal procedures for bad declarations are an indicator of a very hostile environment for public policy.
Record number of young French people leaving to the Gulf in search of a better future, or London to open up their businesses.
Another indicator of how bad things are is the hike in thefts of basic food products. Food is becoming expensive for the middle class french, so imagine how expensive it is for 10 million people living on social aid. Criminality is not just showing itself on a low level, the whole of the French society is victim to a climate of increased criminality and theft. With the price of some commodities hitting record highs, any mean is legitimate to survive.
To complete the negative scene, and reach the peak of irony, French football clubs threatened the country with a strike to protest the 75 percent tax on player wages exceeding 1 million euro. This exceptional tax has been the only decision Francois Hollande has enjoyed popular support for, but the increasing revolt from social bodies around the country is a fact that cannot be neglected. Even if the situation of French football clubs is critical, and the tax proposed is just symbolic as the socialists themselves acknowledged, no opportunity is missed to add another tax to the trophy collection.
Hollande’s allies, the Left Front, are organizing a subsequent march towards Bercy, the ministry of finance building, in a sign of revolt against central government taxation. Now these people are the president’s allies, the people that are supposed to have his back in times of political difficulties, like now.
If revolt and popular discontent with fiscal policy are so evident, S&P’s degradation of France’s credit worthiness is not surprising. It is hard to imagine how reforms are going to be implemented, and the tax level be sustained at that high a level. Krugman’s defense of France and Hollande seems funny, from a French citizen’s perspective.
Thank You De Gaulle
One of the reasons Francois Hollande should not worry for the rest of his presidency is the nature of the French 5th Republic institutions. A strong presidential regime designed by Charles De Gaulle makes it very difficult for a president to fail in completing his mandate. He might need to change his government, under pressure, or even call for early parliamentary elections, but his political future is secured by the solidity of the institutions designed by same political figure French socialism despises. How ironic.
A systemic risk exists however, and the French society is boiling. This is a factor academic models do not take into account.
I’m no pro-German. The German boom does not impress me more than the average success story, and the German economic model based on a strong public sector along with strong market fundamentals is not one I particularly appreciate or long to live under. But times are different today.
German bashing going on in media and institutional elite is one step too far, to be honest. Germans are being accused of modern-day mercantilism and building a war chest of external trade surplus. They are accused of building that surplus on the backs of their southern European counterparts, after proceeding to an internal devaluation other countries are just now undertaking. Reviving old German Southern European hostilities by blaming the Germans for the southerners’ misery, a lame and dangerous intellectual exercise.
Austerity vs. Government Spending
The German debate is always revolving around Austerity vs. Government spending. The attacks on the German trade surplus are actually an indirect attack on the austerity measures Germany is imposing on the rest of its European counterparts. Paul Krugman et al., joined by all liberal leftist media, and the U.S Treasury department (not a surprise) are pointing out to policies involving budgetary discipline, (i.e refusal to increase public spending, run temporary deficits) as bad for growth, and the cause of Europe’s current problems.
The case is compelling indeed. Since the Troika flew to rescue Greece from default, all policies made up of austerity measures have failed in delivering any results on GDP or European Employment. On a macro level, one cannot contest the diagnosis of Paul Krugman and Keynesians. The results are not there. Except for Germany. As you can (hardly, sorry) see, the figure below shows that public spending has actually more or less increased in European crisis, meaning that anyone analyzing the issue seriously cannot assert that any European country apart from Germany and Sweden has applied austerity effectively.
Germany underwent deep reforms that were equivalent to an internal devaluation counter-cyclically; meaning, in a time where all other European countries were increasing their public spending, Germany was working on its terms of trade and cost structure. While other countries enjoyed growth stimulated by the increase in public expenditure they underwent, Germany was experiencing moderate growth and taking care of its savings. While Southern Europe was looking for ways to enlarge its welfare state, not caring for the low GDP figures of the last 30 years, Germany was adapting to a world with low growth, and cutting on its spending. While Southern Europe has a culture of inflation and price rigging, Germany has a culture of financial puritanism.
The creation of the euro was followed by the emergence of huge imbalances, with vast amounts of capital flowing from the core to the periphery. Then came a “sudden stop” of private capital flows, forcing the peripheral nations to eliminate their current account deficits, albeit with the process slowed by the provision of official loans, mainly through loans among central banks. The really bad news for the periphery is that so far the adjustment has taken place mainly through depressed economies rather than regained competitiveness; so the counterpart of that “improvement” for Spain is 25 percent unemployment.
Normally you would and should expect the adjustment to be more or less symmetrical, with surplus countries reducing their surpluses as deficit countries reduced their deficits. But that hasn’t happened. Germany hasn’t adjusted at all; all of the rise in peripheral European current accounts has taken place at the expense of the rest of the world.
Technically, and given that the Euro is not an optimal monetary union, exchange rate adjustments were not possible to counter trade surpluses and deficits, and every country had to improvise to adjust to imbalances. During a time where the southern European countries are cutting on their deficits, Keynesians and the left expect Germany to significantly increasing its public spending, to stimulate demand by opening its markets to those southern countries. Germans are refusing to do that.
Does this mean that what Germany is inflicting to the Irish, Spaniards, Italians, Greeks, is fair? No it ain’t.
This situation however is not the German’s fault, and this is what I will try to explain below.
Turning the austerity debate upside down
Even though I agree on the macro diagnosis of the state of the European economy, the reasons we are in front of such drastic policy choices is not austerity.
Austerity is a result, and not the cause, of low growth, big spending policies, and replicating those policies will not cure the European economic debacle.
Lorenzo Bini Smaghi, a visting professor at Harvard, dismisses the Krugman argument that “politicians are stupid, academicians get it all” as a not that solid an argument. It is easy according to Smaghi to assert that European leaders applied austerity measures solely under the recommendations of the Troika and German leadership. He looks for answers to why austerity measures were applied in the financial health of individual European states.
Smaghi puts it this way
European policy makers are not stupid because they pursue austerity, but they pursue austerity because they are stupid, or – to put it more diplomatically – they are short-sighted and have ignored other alternatives and were ultimately left with only one option, austerity. In other words, they implemented austerity because they arrived at a point where they had no alternative.
He takes a sample of Eurozone countries, excluding Greece, and attempts to draw relationships between growth and factors influencing it, including austerity measures. His findings contrast with Krugman’s theory: European politicians have been stupid and ill-advised in applying austerity polices.
It may mean that relationship between austerity and growth is more complicated than many economists think. In looking at growth performance during the crisis, macro-economists are inclined to look at the specific policies which have been implemented, without asking why such policies were followed. The hypothesis that policy makers were ill-advised or irrational may seem appealing to academics who tend to despise politicians. However, there may be alternative hypotheses, which the above simple statistical analysis does not seem to reject.
- It’s not austerity which caused low growth, but low growth which ultimately caused austerity.
Put it in other terms, the countries which experienced low potential growth, because of fundamental structural problems such as literacy or low productivity growth, accumulated an excess of public and private debt before the crisis to try to sustain their standards of living and their welfare systems, which turned out to be unsustainable and required a sharp adjustment when the crisis broke out.
When I was an economics student, something that represented the alpha and omega in this social sciences is that public debt is SAFE. The EURO crisis proved that a monetary zone so badly designed as the EU could shake this economic dogma.
While all economists acknowledge the bad consequences of austerity based economic policies, one has to look at the financial conditions European countries were going into the 2009 crisis and the Great Depression. This is the essence of Ken Rogoff’s piece in the FT, where he takes the U.K example to highlight the importance of financial stability and a country’s credit solvency as preconditions to having a mere possibility of exiting a strong depression.
To summarize Ken Rogoff’s argument, austerity was an insurance policy against financial market risks, like a debt crisis:
The argument here is all about insurance. The financial markets are unpredictable beasts, and who knows what they might have done if – in particular – the Euro had collapsed. As Rogoff acknowledges, they might have run for cover into UK government debt, but I also agree that they might have done the opposite. His article is all about saying the UK is not immune from the possibility of a debt crisis, so we needed to take out insurance against that possibility, and that insurance was austerity.
A lot has been written on the Eurozone’s optimal monetary union, especially the absence of exchange mechanisms on a federal level to counter imbalances. Markets have not failed at spotting the Eurozone’s financial turbulence, large deficits, and welfare states that were built on GDP growth figures dating from the 1970′s. Austerity was a sequence that will continue until all Eurozone areas find a sort of financial security that can ensure that the monetary union can go forward. As explained by Smaghi below, there is a strong correlation between growth and credit conditions, and any future hope for growth needs those conditions to be restored.
Figure 4 shows the correlation between growth and credit conditions, reflected by spreads on lending rates charged by banks; the correlation is quite strong.
It suggests that firms’ financing conditions have been an important factor in explaining cross-country growth differentials in the Eurozone.
EZ countries which had increasing difficulties in financing their public debt during the crisis suffered from both a credit crunch – as reflected by more expensive bank credit – and the impact of the fiscal adjustment. In other words they experienced both restrictive monetary and fiscal policies.
Figure 4 Credit conditions and growth
Critical time for the Union
A strategic decision has to be taken soon, and I am guessing after the European elections in 2014. Europe has one of two choices; take a step towards more economic and political integration, and that means federalism, or go back to an inter governmental platform of cooperation. Both choices involve deep cooperation in order for internal adjustments to go smoothly on European populations already undergoing a deep social crisis coupled with historic levels of unemployment.
If Europe needs to advance, blaming Germany for clairvoyance, being strategic, and playing the game while taking advantage fully of the rules is not an option. Germany did not cheat more than the French who ran a generous retirement system, or the Spaniards who inflated a horrible housing bubble, or the Greek who were unable to sustain a taxation system worthy of a 21 st century country. Everyone in the European Union took advantage of the generous situation a single monetary union gave them, and now it’s time to pay.
It is easier to pay and go forward however, with the Germans, and not against them.
There are few fights less dramatic than one launched over the drab subject of macroeconomic policy. But even if the latest infighting and backbiting between rival camps at the European Central Bank isn't all that thrilling, it is significant.
The public snipes come on the heels of a surprise rate cut at the ECB last week, to which a sizable minority of the central bank's interest rate-setting committee voted no.
Retail sales in Eurozone point to recession, having lost in September a part of their volume. According to Eurostat, “In September 2013 compared with August 2013, “Food, drinks and tobacco” fell by 0.6% in the euro area and by 0.5% in the EU28. The non-food sector decreased by 0.1% in the euro area, but rose by 0.3% in the EU28”.
The famous liberal political economist Paul Krugman published a series of blog posts accusing S&P French downgrade to be a political step.
Last week, S&P downgraded the French solvency rating from AA+ to AA, a relatively solid notation, but not as good as France’s historical role as the locomotive of the European Union Economy.
I am deeply skeptical about rating agencies. Moreover, I fundamentally believe they are one of the biggest problem in the financial system. Their fallacious modeling and conflict of interest often minimize risk factors in the overall economy, leading the rest of the economic actors to downplay the systemic risk following these recommendations. Rating agencies are bad, Krugman is right. But not in France’s case.
Actually, in France’s case, they are seriously too late with their evaluation.
The Hollande presidency is turning into a catastrophe. His approval ratings are the lowest in the 5th Republic history. Brittany, a French region, is seeing popular fiscal upheavals that are uniting political parties from the far right to the far left. The message?
This is one argument in Krugman’s three papers that is fallacious, arrogant, and amateurish. He is practically saying, S&P downgraded France because of its Welfare state. He is saying that France’s biggest sin, in S&P’s eyes, is that it relies on taxing benefits of the wealthy instead of slashing spending. And this is the reason of the downgrade. Ideological. The economic situation has nothing to do with it. Thus turning the whole issue into austerity vs. big spending fruitless debate.
The future in France will tell Paul Krugman exactly what the people, small businesses, farmers, and the whole french society think about his stupid opinions: There is a threshold of popular acceptance of taxation that you should not exceed, or the revolution will hit you hard.
But does a NYT op-ed elitist arrogant columnist care how much the farmer, small business owner, or student pays in taxes?
No sir, his fiscal lawyer takes care of these issues.
Stop the Krugman political fallacy, get back to talking economics.
The best answer to Krugman might be Professor Melvyn Krauss’s response published by Bloomberg:
That the U.S. Treasury secretary is on the same wavelength as Krugman, a Nobel-winning economist who has descended to shrill Germany-bashing, suggests he isn’t listening to his own highly professional staff, and it’s evidence of how politicized Treasury has become duringJack Lew ’s short tenure. If anything deserves the label “beggar-thy-neighbor” that Krugman used for German policies in his column, it is the Treasury’s attack on Germany’s export surplus and its concomitant obsession with increasing German domestic demand.
One of the world’s biggest financial institutions, JPMorgan Chase, has allegedly agreed to pay a fine that settles its civil cases facing its actions prior and during the financial crisis of 2009.
The deal, brokered between the U.S Department of Justice through American Attorney General Eric Holder Jr, and JP Morgan CEO Jamie Dimon (which apparently was spurred by a phone-call) shows the Obama administration in a heroic posture, trying to save the real economy from the gangster bankers, or the “banksters”, as know in the economic blogosphere.
Am I seeing a political play being performed here? We have the good politician, Barack Obama, through the Department of Justice, the bad bankers from JPMorgan, and 13 billion being distributed to poor mortgage investing public. The hero, the bad guy, and the poor victim, all in one scene.
Obama, like all he has been doing since he has been in office, is more interested in his own image and polls describing his “oh Great Politician, modern 21st century legend” posture, than in finding real solutions for a financial industry in a deep chaos.
The answer is not regulation, the answer is not bribery, in the form of paying fines that technically barely make you itch if you’re JPMorgan. The answer is reform, and not regulation. The answer is criminal, and not public, indictment.
Why is JPMorgan paying: Bear Stearns and Washington Mutual activities
In the case per se, JPMorgan is not guilty, in the traditional sense of the word . The illegal mortgage practices that the penalty is trying to counter are the proud property of two JPMorgan acquisitions, Bear Stearns and Washington Mutual.
And JPMorgan can pay, don’t feel sorry for them. Two things are worth mentioning here, again: JPMorgan CAN PAY. And Second, enormous amounts of alleged abuses has been reported concerning JPMorgan and the industry as a whole, and a lot of people (including the taxpayer) want their money back (listen to audio).
In JPMorgan’s defense:
Some defense lawyers also question whether the government is going too far. A $13 billion penalty would be more than half of JPMorgan’s profit last year. And some of the mortgage securities in question are not JPMorgan’s. Rather, the bank inherited the liabilities when it bought Bear Stearns and Washington Mutual in 2008, at the height of the financial crisis.
So to resume, in the midst of the financial turmoil of 2008, JPMorgan acquires Bear Stearns and Washington Mutual, which are both involved in fraud and investor deception while trading mortgage-backed securities, and is now settling the legal problems they inherited with this deal.
Why all of this is not serious regulation
You would think that after a long and global reach crisis, regulators would learn their lesson. No Sir.
The issue with JPMorgan, Goldman, and a lot of the financial planet is leverage and risk management.
Leverage, as in the system is too big to manage without cutting back on its size (balance sheets when talking about banks) (see Jim Rickards, Currency Wars). Too much money is being traded and risk dissipated without anyone knowing where the hell is it being hid.
Risk management, is as simple as asking how the hell did Bear Stearns and Washington Mutual, and a lot of the financial planet, engage in subprime products. Financial engineering and maneuvering will never change the fact that a bad debt is a bad debt, no matter how you shape it and in what bundle you sell it. But they did…
Did the regulators deal with these issues by fining JPMorgan?
No. Why? Because of incentives.
Even though JPMorgan is finding it hard to take the hit for Bear Stearns and Washington Mutual, acquiring these two companies at a discounted price, helped by the American government, outweighs any fine you can imagine. See the collusion in the system here? We have the same people trying to police JPMorgan, at the same time facilitating its business operations. You cannot be serious! (cc John McEnroe)
The real issue: Politics
So bottom line for me: even if this deal goes through, it’s nothing close to efficient financial industry regulation, the point is this industry cost the American taxpayer some $ 600 billion in a rescue package in 2009 (some say it is closer to $ 2 trillion), and $ 13 billion is not just gonna do. It may offer relief to some home-owners, which the same government regulations led them to invest in housing and go broke in the first place, but that’s so much it. It may offer some politician a populist rhetoric and a pool of potential voters, but it will not curb the fraud and bribery happening in the financial industry.
In order to achieve that you must create incentives, curb irrational behavior by setting up incentives throughout the whole system.
What has the Fed been doing since the beginning of the recession? Free Money for all, 0 % interest rates. Now anyone with an economic vision of things would tell you that this isn’t creating an incentive. Let us face it, the banking system is not in a great shape, and regulators are doing a bad job creating the incentives to fix the problem by keeping the same bad financial products and low rate policies on the table.
So are regulators doing the job?
Who’s Barack Obama’s Treasury Secretary? A certain Jack Lew is the answer. When this man was appointed in the beginning of the year the American president’s chief of staff, Bill Moyers wrote the following:
The story behind it is that Jack Lew is President Obama’s new chief of staff — arguably the most powerful office in the White House that isn’t shaped like an oval. He used to work for the giant banking conglomerate Citigroup. His predecessor as chief of staff is Bill Daley, who used to work at the giant banking conglomerate JPMorgan Chase, where he was maestro of the bank’s global lobbying and chief liaison to the White House. Daley replaced Obama’s first chief of staff, Rahm Emanuel, who once worked as a rainmaker for the investment bank now known as Wasserstein & Company, where in less than three years he was paid a reported eighteen and a half million dollars.
So the current secretary of the treasury is a former Citigroup lobbyist. What has a former Citigroup lobbyist have, as an incentive, to change the way the financial industry functions, fraud and deceit, if he himself is only in position for a given legislature, and going back to the SAME business he is regulating in a couple of years when the president is out of office? My humble guess, NONE.
To illustrate my thought of how not serious Obama is about curbing the problem, I will quote Moyes again:
President Obama may call bankers “fat cats” and stir the rabble against them with populist rhetoric when it serves his interest, but after the fiscal fiasco, he allowed the culprits to escape virtually scot-free. When he’s in New York he dines with them frequently and eagerly accepts their big contributions. Like his predecessors, his administration also has provided them with billions of taxpayer dollars – low-cost money that they used for high-yielding investments to make big profits. The largest banks are bigger than they were when he took office and earned more in the first two-and-a-half years of his term than they did during the entire eight years of the Bush administration. That’s confirmed by industry data.
I can go on and on citing practical examples of how the financial industry, the majority of it, is engaged in activities that any free market economist would call: RIGGING, but that’s a known fact now. The challenge is how to regulate this industry in a smart and self-correcting manner.
Keeping government in deep collusion with the financial industry by keeping the doors open between the two entities will lead no results whatsoever, and the next crisis in preparation will show us just that.
Some Fun:Jamie Dimon handled by Max Keiser
So, Conde Nast has published its Readers' Choice awards and Beirut has made it as one of the world's 25 best cities, tied with Seville in Spain and ahead of the traditional cities Lebanese people adore: Venice, Paris and of course, Barcelona.
Here's what the small caption said, and I couldn't help but shake my head in silence at the "Paris of the Middle East" bit…
Today, Eugene Fama, Robert Shiller and Lars Peter Hansen were awarded the Nobel Prize in Economics* for their research into how financial markets price the things they sell.
A typical reaction, courtesy Belgian economist Paul de Grauwe:
He's not wrong! After all, Shiller warned people about a housing bubble in 2007, while Fama still denies it even existed. (Pity poor Hansen, whose econometric innovations help better measure asset prices and advanced Shiller's theories but are…
A great day for behavioral economics, psychology, and the individual in the study of economics. And farewell rationality.
For most people the attribution of the 2013 Nobel prize in economics is just “another piece of news”. For the academic world and financial planet (and anyone analyzing this seriously and honestly), the main debate around “are financial markets rational” is still not decided. In the midst of a Great Depression, it seems hard to believe.
First of all let me be honest with you. If i wanted to be dogmatic, i should be opening a bottle of Moët for our friend Fama and all the Chicago school of economics and market fundamentalists. But economics today is not about markets and modeling anymore. And this is what the attribution of the 2013 Nobel in economics really teaches us.
The Prize was attributed to Eugene Fama, Robert Shiller and Lars Peter Hansen. Their bio and work are largely shared on the web these two days. To resume, here is what is the bulk of their contribution to economic theory:
Fama: main contribution is the ‘efficient market theory’ (EFH) that mainly says
Markets are efficient. They are accurate. They take into account all available information at all times. Whatever investors know about a stock or bond is already reflected in its price, and prices respond instantly to newly available information. As a consequence, no one will consistently beat the market.
Shiller: that basically contradicts Fama in asserting
Shiller’s work, dating to the early 1980s, showing that stock prices are not as tightly linked to future dividends as the previous theory had held, but can become rapidly inflated. However, Shiller found, such swings in the market also lend themselves to a level of long-term predictability, since market corrections tend to ensue.
worked on a statistical method that tests the theories of asset pricing. His macroeconomic research has focused on pinpointing linkages between financial and real sectors of the economy.
The Funny part
The funny part of this Nobel episode is that it resumes the whole state of the union of the economics science nowadays. We have two leading financial markets academicians, that pretty much go from the same starting point to arrive to fundamentally different conclusions. And the third is a guy who is practically giving them the statistical tools to resolve their differences by linking the financial side to the real economy side of the equation.
The Nobel committee is pretty much saying: “We don’t understand you (weird economic creatures), we think you are crazy, but you’re all cool people, and we’re sure you can all work it out for the good of society as a whole”.
Rationality vs. Irrational behavior
In a previous post, I paid tribute to Milton Friedman and the Chicago school of economics. Perhaps one of the most important hypothesis Friedman has taken in his work is rationality. Fama has built his work on rationality. His Efficient Markets Hypothesis follows this logic, and tons of empirical work and asset price monitoring, to clearly state that all information are processed in prices. At any moment in time, the price of an asset and its future path incorporate all the information available to the market, so in fine, you cannot beat the market. You can get lucky from time to time, but beating the market is impossible.
This theory is highly controversial. You know why? Just read the work of the other Noble Laureate.
For Shiller, the predictor of the dot-com bubble, and precursor in behavioral economics, there is so much irrationality in financial markets that they cannot be consistently correct. The formation of bubbles and recent financial history has proved him right, as it is commonly acknowledged in academic economics.
Grasping the contradiction between the two schools of thought here? While both schools of thought differ in their academic approaches in tackling the question of financial markets efficiency, their findings diverge on a substantial scale.
“More Money Than God”
For once these last 4 years I agree with Paul Krugman in his post. Fama’s Nobel is just an acknowledgment of years of work, a sound basis of reflection, but a failure to understand his theory’s limits facing real world experience:
So, all good — and you actually have to admire the prize committee for finding a way to give Fama the long-expected honor without seeming as if they are completely out of touch with everything going on around them.
Shiller however, has totally grasped Fama’s EMH, and tested it to real world experiments, including the housing market assets, and produced a reliable number of findings on financial markets far more consistent with Fama’s theoretical work.
In a bestseller titled “More Money Than God”, Sebastian Mallaby documents the history of the hedge fund industry. To synthesize the findings of Mallaby, Hedge Funds are the living proof that markets are inefficient. As he writes, with a bit of irony:
Meanwhile, other researchers acknowledged that markets were not perfectly liquid, as Steinhardt had discovered long before, and that investors were not perfectly rational, a truism to hedge-fund traders. The crash of 1987 underlined these doubts: When the market’s valuation of corporate America changed by a fifth in a single trading day, it was hard to believe that the valuation deserved much deference. “If the efficient markets hypothesis was a publicly traded security, its price would be enormously volatile” the Harvard economists Andrei Shleifer and Lawrence Summers wrote mockingly in 1990. “But the stock in the efficient markets hypothesis-at least as it has traditionally been formulated-crashed along with the rest of the market on October 19, 1987. (More Money than God, Introduction: The Alpha Game, p7)
The efficient markets hypothesis is a critical advancement in the science of economics and understanding what drives movements in asset prices, don’t get me wrong. But economic history has shown it’s validity is limited, and itself depends on factors it cannot possible think of. Human, and hence investor nature is so unforeseeable, that any theory that assumes predicting it is presumptuous.
Mallaby’s documentation of the history of the hedge fund industry is maybe the biggest criticism of the EFH. We learn throughout the book that in 1988, Fama was “leading the revisionist charge: Along with a younger colleague, Keneth French, Fama discovered non random patterns in markets that could be lucrative for traders. ” So it started in 1988. Fama was already doubting his EMH, which let’s keep in mind, is being honored by the Nobel Committee. This preceded years and years of the hedge fund industry moving the fundamentals of the EMH.
As Mallaby states in his book, concluding on the October 1987 crash,one of the lessons was that (More Money than God, The Alchemist, p104)
Wall Street’s gyrations administered a crippling blow to the efficient market theories that Soros had long criticized. Over the course of a week, the value of corporate America had bounced around like a pachinko ball; there was nothing efficient about this, nor was there any sign of equilibrium. “The theory of reflexivity can explain such bubbles, while the efficient market hypothesis cannot,” Soros wrote later, and broadly he was right. It was surely no coincidence that efficient market thinking had originated on American university campuses in the 1950′s and 1960′s-the most stable enclaves within the most stable country in the most stable era in memory.
Fama might be a wonderful academician, a strong believer in efficient markets, but experience and data do not back him up anymore (he does not even acknowledge bubbles exist):
Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst.
I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.
I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.
That’s what I would think it is, but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.
Are you saying that bubbles can’t exist?
They have to be predictable phenomena. I don’t think any of this was particularly predictable.
Shiller has been more of an inspiration to a lot of economists, especially by linking academics to the monitoring of the real economy, as the Case-Shiller home price index he created helps achieve daily.
This Nobel Prize is pretty bizarre. Fama’s work is academicly flawless, but it’s testing failed. Shiller questioned the academic work of Fama and derived a new way of understanding asset price movement through human behavior. Hansen produced econometric modeling too complex for me to explain to you, but helped both Fama and Shiller test their theories in a more realistic and close to the real economy way.
In Summary, it is like telling Obama he is sharing the Nobel Peace prize with Kim Jung Un and Mother Teresa. A strange pick, right?