Arnold Kling  

More on the Fischer Black Model

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Some more thoughts on Fischer Black's model of business cycles, following up on my earlier post on Tyler Cowen's piece.

1. Black thinks of us as living in a CAPM world. There is no reward for idiosyncratic risk (risk that could be diversified away). Instead, there is a diversified market portfolio, and there is a risk-free asset. When we have an appetite for risk, we hold more of the market portfolio and less of the risk-free asset. Good times are when we hold a lot of the market portfolio and conditions are right. (In my example, in an agricultural society we make large investments and the weather turns out to be good.) Bad times are when we hold a lot of the market portfolio and conditions are bad. (The weather is bad, and we wish we had just stored grain rather than making risky investments.)

2. The financial crisis appears to be idiosyncratic, rather than general. That is, it looks as if people did not buy the market portfolio. Instead, some people over-invested in houses, and some institutions over-invested in risky mortgage loans. One could argue that the risk was spread ex post by the government, with all the bailouts.

3. Cowen's argument, however, is that this apparently idiosyncratic nature of the risk is deceptive. In fact, you should think of the crisis as, to a first approximation, bad times for the market portfolio. Everybody wishes, ex post, that they had put more into safe assets and less into the market portfolio.

I have a number of problems accepting this as a story for the current crisis. Among the problems I have is that I cannot pinpoint the real shock at work--the shock that would be analogous to bad weather in an agricultural economy.

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COMMENTS (10 to date)
Bill Woolsey writes:

A "riskless" asset may be an appropriate assumption for a partial analysis of financial markets, but there is no such thing as a riskless asset for the economy as a whole. All there can exist is methods of shifting risk. That includes goverment-issued fiat currency. If its value is stabilized, then risk is being shifted to taxpapers. If its value flucatuates, then it is a risk asset too.

Mitch Oliver writes:

I've come to the conclusion that the "bad weather" event for our economy was the spike in oil prices. I freely admit that I have no data to back this up, only a suspicion.

I think one of the difficulties with this idea is that I'm not personally convinced that the response is justified for the actual rise in energy prices. I speculate (wildly, of course) that seeing the rise in prices with no end in sight, and facing the prospect of those prices reaching those same levels again, people reordered their priorities.

But again, no data only guesses.

paul writes:

I don't think you necessarily have to have a "shock." It can be simply a wrong decision. I chose to build an extra house, you chose to manage my money. now we have to correct our allocation and decide again what should we do for the next period. Black's paper "Noise" 1986 J of F is a better explanation of the financial crisis as it relates to macro causes. S#@t happens...

stephen writes:

Perhaps the "market portfolio" is too diverified for single shock to matter. Perhaps there was a confluence of shocks.

Perhaps there was a series of shocks over a longer period of time and the time series needs to start alot earlier. Perhaps the bad weather started with the tech bubble, then 9/11, then the oil price shock.....

Perhaps we live in an "inovation economy" and the shock was simply a lack of enough new and "meaningful" inovation. Perhaps the 80's and 90's produced so much new technology that we all got fooled, not realizing the low hanging fruit had been picked.

Perhaps the world is still more malthusian than we think and we are just returning to a more natural growth equilibrium and investor expectations are lagging behind a little bit.

Obviously I have no idea what I am talking about but it is fun to pretend every now and then!

fundamentalist writes:

Cowen: “If monetary policy had been the primary driver of the credit boom, investment would have gone up and consumption would have fallen. After all, without an increase in real resources (the global savings glut), an economy cannot expand on all fronts at the same time. But consumption was highly robust during the boom, especially in the United States.”

Cowen assumes that because consumption and investment increased together then the cause of the boom cannot be monetary. As Bill Woolsey wrote on the other post, overinvestment = under consumption and vice versa. So if both increased at the same time, then it must be due to the rapid increase in real wealth in the world which led to a glut of savings.

But Cowen is making Keynes’ mistake of assuming unlimited resources. If the world economy is at full employment, then it’s impossible for investment and consumption to increase at the same time, given a fixed supply of money. The only way that investment can increase is for consumption to decrease. After sufficient time has passed to allow for the production of more goods, then consumption will increase as a result of the earlier increased investment.

However, Cowen is right that investment and consumption increased rapidly at the same time over the past decade. How is that possible? The answer lies in the monetary theory of cycles. First, booms grow out of depressions which leave unused resources. So when the recovery begins, monetary pumping by the Feds makes it possible to have increasing consumption and increasing investment at the same time. Without the monetary pumping that would be impossible.

Second, once the unused resources are gone, businesses will consume capital in order to keep the pace of production going. This is a major insight from Austrian econ, but anyone who has worked in the real world has seen this happen in practice. Hayek does a good job of describing it in several articles. Finally, businesses will switch to the use of more labor as capital goods shortages increase. The crash comes when shortages of capital goods and labor cause businesses to fail.

Failing businesses are the “shock” that change investor psychology from being risk embracing to risk averse.

Cowen: “Investors systematically overestimated how much they could trust the judgment of other investors.”

Cowen drops Black’s name into the conversation to bolster his argument, thereby drawing upon Black’s reputation, but his theory is hardly different from the psychological theories of business cycles that Hayek demolished in “A Monetary Theory of Trade Cycles” back in 1939 and which Wilhelm Roepke destroyed in “Crises and Cycles” about the same time.

The problem with psychological explanations is that they are true as far as they go; they psychology of investors does change throughout the cycle. But that begs the question of why the psychology changes. What is the catalyst? Cowen falls back on Taleb’s explanation: crap happens! Sometimes a black swan is born and we have no idea why. That’s supposed to be economics?

shayne writes:


I suspect you may be trying to identify a single, triggering event ("... I cannot pinpoint the real shock at work ...) as an overall causal factor for this phenomena. What Tyler seems to be saying is that there is no single causal event, but instead a slightly more gradual realization on the part of markets that out-sized investment return expectations will not be realized.

To equate that with your "bad weather" in agriculture analogy, consider that "bad weather" could take the form of a single triggering event such as a hail storm (wiping out a crop) OR it could just as likely be a more gradually occurring sub-optimal combination of rain/sunshine, or even sub-optimal timing of rain/sunshine that results in a (gradual realization of) low crop yield. Both would be considered "bad weather" by the informed farm investor, but only the hail storm event would be recognized as such by the less sophisticated investor.

Greg Ransom writes:

Weren't houses supposed to be like grain storage?

Greg Ransom writes:

Cowen says that trust grew and people felt less risk because there was growing trust.

Cowen also says there was a growing appetite for risk ..

Cowen wants to eat everything in the buffet at Hometown Buffet and tell us he's serving up a tight explanatory story.

He isn't.

fundamentalist writes:

An important point to keep in mind, when analyzing the current crisis, is that not all businesses failed. In fact, very few businesses have failed. 90% of those employed before the crisis still have their jobs. What distinguishes those businesses that failed from those that didn’t? Leverage. What did most of those businesses that failed have in common? High leverage.

Cowen gives four incentives for CEO’s to take risks. But what he doesn’t answer is why those incentives worked on only a few CEO’s who took enormous risks while the same incentives didn’t influence the majority. The four reasons for risk taking that Cowen provides applies to all CEO’s. So why didn’t all CEO’s respond I the same way to the same incentives?

Austrian economics provides the answer. At a given interest rate, say 5%, all businesses that can profitably borrow money at that rate have done so. Those businesses that could operate profitably only at lower interest rates will not borrow at 5%. But when the Fed lowers interest rates to 1%, a lot more business ventures appear profitable. Which ventures will appear more profitable at a lower interest rate than a higher one? The riskiest ventures!

What traditional risk analysis ignores is the reward part of the risk/reward tradeoff. Risk is just the frequency of failure of particular types of ventures and that frequency remains relatively constant. But the rewards attainable by those risky ventures changes with the interest rate. At high interest rates, the reward is smaller for the same amount of risk. At low interest rates, the reward is much higher for the same amount of risk.

The Feds depend upon this shift in rewards relative to risk in order to persuade entrepreneurs to borrow money during bad times. In the midst of depressions, the rewards for risk taking appear to be too small compared to the losses, so the Feds adjust the ratio by lowering interest rates. It signals to entrepreneurs with risky projects that the reward can be much higher, in the same way that a spider lures its prey to its web. But the ventures it finances with low interest rates are the riskiest ones.

Mike Rulle writes:

The CAPM never stuck me as something that was meant to be fully explanatory. But as a first approximation (i.e., investors should hold a diversified portfolio of stocks in some combination with risk free assets), it still makes enormous sense.

But the world, as a whole, has other assets. There is residential real estate, credit risk (which one could call the "senior" portion of profit before taxes--i.e., really part of the equity asset class), commodities, insurance and probably much more.

Looking at the Fed's classification of "household" assets; "tangible" assets (houses, cars, and other durables) represent 37% of total assets (the last 6 years this number has been between 37%-39%). I am pretty sure this was not part of the CAPM.

I am one who views the last 2 years as just another random set of events without any particular significance. My one exception to that statement is the amount of significance that has been given to it by analysts, and more importantly, the Federal Government. We have insisted on calling this "the worst economy since the great depression", which has to be a record for exaggeration. We happened to have a confluence of economic and political decisions which has led us to where we are.

We have had a spate of unusual events: a bubble in California housing (plus Vegas and Phoenix); panic by regulators (for example, AIG has not had a single default on its CDS yet looked what it caused), the accident of a presidential election causing both candidates, but Obama in particular, to over state the negative; the non-stop uncoordinated and disorganized tinkering or threatened tinkering by Paulson (now Geithner) and Bernanke; the unnecessary confusion which created the auto industry bailout (started by Bush); and the remarkable left wing big government agenda being proposed by the Democrats.

Most of the above list is Government's reaction to a pretty localized real estate bubble. We have had lots of bubbles and crises in the last 25 years---there was nothing this time around that was inherently more striking than the others--with the exception of the Government's reaction--which as bad as its been, is as much noise as action.

Paulson, Bernanke, Obama, and Pelosi are my 4 horsemen of the apocalypse. Except it really isn't an apocalypse--yet. Anything is possible I suppose---but I cannot believe the projected spending budgets will happen. I think investors are getting used to the new floating rules--we are more adaptable than we thought. We also will stop the energy and health proposals. The TARP will be paid back, GM will eventually unwind into oblivion etc.

Perhaps I am unrealistic--but I think all the government actions of the last 10 months will eventually get unwound.

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