Thursday, April 16, 2009

The Tanner Thesis

Lindsay Tanner has outlined a thesis in The Age today (with a longer version in what is claimed to be a blog but to me looks just like on line content).

It is a wide ranging thesis that esentially says that just because we've had a crash following globalisation doesn't mean we should try to turn back from globalisation. Instead we need to look forward to ways to make the global economy work better. There is a sense at times that Tanner wishes it could be otherwise, rather than recognising there really is no alternative to globalisation and the changes to financial markets and trade followed the developments in transportation (the container and the jet airline) and communications (most importantly fibre optic submarine cable and IP networks).

In one sense Tanner is pointing out the fallacy known as post hoc ergo proctor hoc, just because one event follows another event does not mean the first event caused the second.

Tanner claims that "mainstream economics is in crisis", and extols behavioural economics and notes that Eric Beinhocker in The Origin of Wealth promtes the idea that the economy is better framed through a biological rather than a mathematical frame.

These are perhaps valid insights, but the attack on mathematics needs to be tempered. Let's look to the valid parts. I haven't read the Beinhocker book yet, but judging by the contents (I own it) it does exactly what Tanner describes, with one chapter in particular noting that the economy is a complex system but not chaotic.

The underlying issues, the real challenges for classical (or neo-classical) economics, are three-fold. The first is the insights of behavioural economics (for an good review see Advances in Behavioural Economics), these insights are that individuals aren't the rational models of behaviour we expect. Particular deviations are that people prefer something sooner rather than deferred, they act on impulse, they value fairness, and they value something they have more than something they don't have.

The other area, not mentioned by Tanner, is the area of institutional economics which focusses on the social norms and rules that exist to underpin the economy. There are three separate strands of these, the oriinal institutional economists (Veblen and Galbraith) and then there are both the new institutional economists and the neo-institutional economists. The former (I think) are the group who following Douglas North identify the importance of property rights and the rule of law in the development of the economy, a very useful theory in development economics but attracts some strange fellow travellrs. The other group pursues a sub-strand of industrial organisation focussing on the theory of the firm and transaction cost theory.

The final area is the one that is generally called evolutionary economics and is often a fellow traveller of institutional economics. This area takes as its focus the idea that economic systems have the same evolutionary mechanism as biological systems, including the idea of a generation process and a selection process. At the level of the economy as a whole it has a link to institutional economics because the institutions are recognised as having primarily evolved rather than having been designed. At the level of the firm this gets married with the observations of Joseph Schumpeter of the process of creative destruction, that some firms succeed and others fail. In this way it has a strong link to behavioural economics because the observation is that the successful firms don't necessarily make the rational profit maximising decisions, but as a consequence of the selection process those firms that did make profit maximising decisions were successful (survived).

(That is the assumption that firms are conciously profit maximising is an example of our earlier fallacy, the fact that successful firms are the ones who make the most profit doesn't mean they are the firms who acted most rationally to do so. Indeed there is a very strong strand in strategy theory that emphasises the impossibility of being correct about the prediction of the future and hence developing strategies that optimise outcomes across the range of possible futures).

Evolution is a bit more advanced than simple trial and error but it does acknowledge the importance of chance.

The ultimate conclusion of all these alternative theories is, as Tanner states, that "markets are imperfect human artifices". More importantly markets can take many different forms, (see Reinventing the Bazaar: a natural history of markets), the rules of the markets usually evolve to meet the needs of market participants.

A good example of this is stock exchanges. When there were multiple stock exchanges in a typical country the exchanges determined their own rules. The exchanges that developed rules that built confidence in buyers and sellers attracted more custom, more custom meant more funds in the market and so more new listings on the market. The evolutionary process works so that the exchanges that survive are those with the market rules (institutions) to meet customer needs. One of the rules that evolved was about market disclosure and the need to provide reports to investors.

Over time the consolidation of the exchanges (to often one) means the competition between markets dissipates and the rules become included in legislation. Many of the major institutions evolved before legislative approaches, one particular example being the whole law of contract.

The current economic crisis has its genesis in a particular market, the market for money. Tanner rightly points out the number of international structures in place to make this market work. One of these is a thing known as the Basel convention which specified a means for determiing the capital adequacy of financial institutions. Capital adequacy refers to how much capital (equity and retained earnings) a bank (or more generally a deposit taking institution) has in relation to the loans it has made, to measure how resiliant the institution would be to the default on all those loans.

In the calculation different assets are assigned different weights reflecting the position the bank would be in if the loan did default. Because mortagage backed housing loans are - well - "as safe as houses" they are rated at 50%, the bank doesn't need to have much capital to back the loan because the assumption is that the bank gets the house and can sell it. Basel II changed the ratio of capital to risk weighted loan portfolio depending on market and operational risks, whereas the original Basel agreement specifed a single ratio of 8%. Basel II also introduced the ability to assess the risk weighting of assets, one of which was according to ratings agencies. For a full non-technical explanation see this article. (Note these are all rules to do with capital adequacy, not with liquidity. They were designed to ensure that depositors money was protected. But ultimately if the bank did have to shut its doors due to a liquidity crisis at least its net position should be positive.)

But we then face the problem of an asset price bubble as was recently seen in the US (and the rest of the world) for houses, or as was seen in the US in 1929 with equities. The central bankers can't choke off the bubble by raising interest rates generally because that prices productive investments out of the market. One solution that would be available under Basel I was to vary the risk-weighting of individual asset classes based on excessive price movements - that is, if asset values are rapidly increasing then the risk-weighting should be increased.

This isn't possible under Basel II. It also isn't possible for some securities which were taken off balance sheet, that is not included in capital adequacy calculations. That was what happened with the securitisation of mortgages. Mortgage originators were no longer DTIs (or banks) so they wouldn't have been directly affected by a decision to change capital adequacy rules. The assets that entered the banking system were the securities issued against a group of mortgages, and here the Basel II rules were seen to fail as ultimatel the ratings agencies got it wrong.

But the really important lesson is how the sophisticated financial markets actually work. A good read is A House of Cards which in its opening chapter details the ten days of the collapse of Bear Stearns. he reality is that this sophisticated market works just the same as a group of mum and dad investors at a suburban bank. In reality the supposedly knowledgable investors have no knowledge at all, so they followed a market up and rushed out when it failed.

This is encompassed well in the book Animal Spirits (which I haven't read yet) but this precis. Ultimately these markets depend on simple human factors like rust, as Shiller says "The trust in the innovative lending practices was excessive; now that trust is replaced by deep mistrust."

The first step in fixing this mess is to get everyone to agree that all markets have rules, that "laissez-faire" never really applies. It is not whether there are or aren't rules, it is how those rules are designed and what the forces are for their enforcement that count.

This would be an appropriate segue into Tanner's conclusion about the new political battle and the distinction between the left and the right - but that is another blog post.

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