Arnold Kling  

Justin Fox, Fischer Black, Tyler Cowen

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Fox, The Curious Capitalist, has a new book, called The Myth of the Rational Market. He spent a lot of time trying to piece together the history of the theory of efficient financial markets--random walks, capital asset pricing model, option pricing formula, on the one hand, and noise trading and behavioral finance on the other. I'll excerpt a few paragraphs below.

One of the characters in Fox's book is Fischer Black, who often wrote for the Financial Analysts Journal. Tyler Cowen has an article in that journal, in which he claims to be using Black's ideas to explain the financial crisis.

You have to read the whole thing. I get the sense that Tyler had this tremendous stream of thoughts, but he only wrote down a few excerpts. To quote from the paper is to take an excerpt of an excerpt, as it were. For example,


As investors pull their resources out of risky assets, the prices of those assets reflect less and less market information and markets become less efficient.

He just tosses that in there, and I am not sure (a) whether it is right or (b) whether it is important to his central thesis.

His central thesis, as I see it, is this:

1. A lot of wealth was created in the 1990's, particularly in rapidly developing countries.
2. People felt inclined to take risks with this new wealth, and they felt inclined to trust others to select the risks to take.
3. The risk-taking became excessive, and we had a crash.
4. Now, there is a big mess, and there is not much anyone can do about it.

I am trying to sort out the issue of operating leverage vs. financial leverage. I always thought that Fischer Black's story of the business cycle was one of operating leverage. People acquired too much human capital and physical capital, which in an efficient market has a high beta, meaning that its value depends on a common factor driving the economy.

Think of an agricultural economy in which investments will pay off really well if there is good weather, but lose badly if there is bad weather. If people are cautious, they will not invest a lot and instead will hold safer assets (maybe just grain stored in silos). If they are less cautious, they will buy lots of tractors and get degrees in agronomy. If the weather turns out bad, they would have been better off just storing grain.

Financial leverage means that financial institutions take on a fragile financial structure. Our farmers don't necessarily overinvest in tractors and agronomy degrees. But when they do invest, they take on debts, and the banks that lend to them hold very little capital.

Clearly, it is easier to get overinvestment if there is a lot of financial leverage. And if the financial sector is deleveraging, then it is easy to get underinvestment. But my recollection of Fischer Black is that he was more focused on what I call operating leverage, not financial leverage.

Here is an excerpt from the conclusion of Fox's book (p. 307):


For figuring out what your portfolio should look like, Harry Markowitz's model of balancing risk and reward--and looking for investments that aren't correlated with each other--remains an excellent starting point. The complication is that it's not past volatility and past correlations that determine investing success, but future volatility and correlations. That future can only be guessed...

A popular concept in recent years has been the "wisdom of crowds"--the notion that groups can often make better-informed decisions than individuals. It's a valid enough idea, and the title of an excellent book by James Surowiecke, but the wording is misleading. Crowds--and markets--possess many useful traits. Wisdom is not one of them...

Markets, as Friedrich Hayek argued, are the best aggregators of information known to ma. Yet mixed up amid the information in security prices is an awful lot of emotion, error, and noise.


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COMMENTS (7 to date)
emerson writes:

Tyler: "As investors pull their resources out of risky assets, the prices of those assets reflect less and less market information and markets become less efficient."

So when everyone puts their money into risky assets, that results in a wealth of information for potential investors? Isn't the fact that people AREN'T investing in a certain risky asset valuable information itself?

fundamentalist writes:

How does a large part of the economy become overleveraged if the feds don't pump new money into the economy. All of this makes good sense, except that it doesn't just happen at random or by "animal spirits". Either the feds accomodate growing demand for loans by keeping interest rates low, or the feds stimulate the economy with below market rates and keep them low for too long.

It's amazing to me the gymnastics guys like Cowen will perform just to avoid the monetary theory of cycles. But if he thought about it for just a minute, he would see that none of the other explanations can work without the feds accommodating them with monetary pumping. The crash comes when a shortage of capital goods causes a massive breakdown in market coordination. In other words, everyone's plans can't succeed because there are too few capital goods to meet everyone's plans.


The Political Dictionary

wisdom of crowds n. The fabled effect where the combined judgment of many people is better than any one individual. The successful experiments asked crowds to estimate the number of jelly beans in a jar, or the butchered weight of an ox. The averaged estimates came closer to the exact answer than any one guess.

Unfortunately, we routinely see the awful result of applying crowd-wisdom to electing politicians. Possibly, this is because the crowd is smarter than any jelly bean or ox, and the beans and ox are incapable of making promises.

George Carlin expressed this well: "Just think how stupid the average person is, and then realize that half of them are even stupider!"

Justin Ross writes:

I shudder to think the Curious Mercantilist has written a book. His column made TIME Magazine a very easy gift subscription not to renew.

Bill Woolsey writes:

Overinvestment = underconsumption.

Underinvestment = overconsumption.

Right?

fundamentalist writes:

Bill, not necessarily. As Hayek liked to say, money is the loose joint in those equations. For short periods we can have overinvestment and overconsumption as well as underinvestment and underconsumption, all because of the way money works, especially fractional reserve banking.

David Merkel writes:

Two notes: 1) All assets, risky and otherwise, are 100% owned all the time. Aside from IPOs, new capital projects, acquisitions for cash, etc., money doesn't go into and out of assets. Movements in secondary markets only indicate the levels at which people are willing to exchange safe assets for risky ones.

2) It's not operating leverage for the business cycle -- it's total leverage, financial and operating together. Economies that are more heavily debt-financed are more cyclical and given toward financial panics.

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