Monday, January 04, 2010

Cassandra or sage?

How can one ever tell the difference between a Cassandra and a sage? At any point in time there is a plethora of nay-sayers on any particular topic, and they are usually rubbished. They are typified as Cassandras - which is a funny misuse - because Cassandra was really a person who could foretell doom but not be believed, whereas the usage refers to people who always see the negative.

One favourite example of mine was during the phase where WorldCom convinced the world that the capacity of the internet was doubling ever hundred days. Andrew Odlyzko did a detailed study to show it wasn't, but every telco manager believed it was even though their own data didn't support the proposition.

The recent example came to me by reading a book called How Markets Fail: The logic of market calamities. It refers to a 2005 symposium held by the Federal Reserve Bank of Kansas City in 2005, and in particular a paper by Raghuram Rajan.

Rajan's paper is a perfect description of exactly how the liquidity crisis in American finance unfolded - given before the event. He neatly describes the two sources of instability as the incentive on fund managers to take risks that are concealed from ivestors and the incentive to herd with other fund managers on investment choices. The first is drive by the compensation scheme that rewards short term return. The second is driven by the need to perform as well as the next guy.

Ultimately these were the two underlying causes of the continued growth of the securitised mortgage market. Raja even describes in detail the nature of the heightened risk profile of banks and how a liquidity shock would spread like a ontagion through the system.

More interesting than Rajan's paper itself is the discussion that is also available on the symposium site - of great economic thinkers dismissing the argument. The dismissal comes down to little more than "but to fix this you want us to intervene in the market and the market is (almost) perfect so we won't.

The tragedy of what happened in 2007/08 is not that economists didn't expect it - it is that they were told and chose to ignore it.

That said, I'm not actually sure the solution necessarily works. If I have a system of very small "vibrating" agents and I connect them all together to dampen the overall vibration, I just make the size of the eventual instability greater. Would changing incentives and pridential requirements have stopped people adding more elements to the system or is it just adding yet more springs?

And more importantly how do you tell the difference btween a Rajan and all the other forecasters of doom?

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