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Quoted, Not Read
When it comes to famous economists who are oft quoted but rarely read, Adam Smith jumps to the top of the list. Despite being widely considered as the father of modern economics, few people actually bother to read Smith's opus, The Wealth of Nations or its sister piece, The Theory of Moral Sentiments (including me: my copies rest largely undisturbed on the bookshelf). But this has not stopped the Scottish political economist from being quoted, mis-quoted, and generally used as a handy historical cudgel with which to beat one's ideological opponents. For example, Smith's metaphor of 'the invisible hand' is regularly used to support arguments for unconditional free markets, whereas Smith himself held a much more nuanced view. This abuse has led to, among other things, professor Gavin Kennedy devoting an entire blog to defending Adam Smith's "Lost Legacy".

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Not far behind Smith on this list you will find John Maynard Keynes. Certainly among the most famous economists of the 20th century, Keynes has had a huge impact on the policies adopted by governments in the Western world from the 1930s onward. Not only did his writings change the economic discourse, but he was also heavily involved in shaping and negotiating the Bretton Woods system that defined post-WWII international economic affairs. For all that, however, few people bother to actually read any of his writings.

This is unfortunate, for several reasons. First, it ruins the quality of the debate over economic policy. You will often find that people will argue for or against a "Keynesian" approach to dealing with the financial crisis based on a crude caricature of what that actually means. (Usually: "governments should spend lots of money" vs. "no they shouldn't").

It certainly doesn't help that an influential school of post-war economic thought calling itself "Keynesian" was a perversion of his writings. By the mid-1970s, the evident policy failures of the "Keynesians" swung the pendulum of influence towards the monetarist school of thought that begat Alan Greenspan and friends. Now, Alan Greenspan (and the rest of the world) has discovered that this ideology is flawed and the pendulum is swinging back in the other direction - at least a little. What better time to bin the caricatures and have a real debate?

Second, it's unfortunate because people are missing out on some great insight into human nature and its role in shaping political economy. Rather than being a purely mathematical sort, Keynes was a student of history, psychology, philosophy, politics and economics all rolled in together. It's therefore my impression that he developed his theories based upon what he saw around him - including the Great Depression - rather than vice versa. As a result, when you actually get around to reading what he wrote, you're left thinking: "Hey, that sounds just about right."

But don't take my word for it: I will point you to two pieces written recently by folks who "discovered" John Maynard Keynes by actually reading his flippin' book:

• The first example is by Richard Posner, a conservative lawyer, judge, lecturer and prolific writer. In his article last fall entitled "How I Became A Keynesian," Posner explains that, after reading The General Theory, he was surprised to discover that "[Keynes] is the best guide we have to the crisis."

Ah! you protest: Posner's piece is but another second-hand rehashing of Keynes' book. Doesn't that go against your advice to read the orig? Right you are, but I know that most of you are not going to bother so I offer a second-best option:

• Try reading The Epicurean Dealmaker's January piece on "Conventional Wisdom." This is a long-ish article, but if you skim further down you will find Keynes' views on financial markets and investors* quoted at length. For this anonymous blogger, Keynes' description of investor behaviour is absolutely bang on. Presumably he would know: he tells us that he is a veteran player of 20+ years in the mergers & acquisitions game on Wall Street.

Just to be clear, Keynes' views were far from perfect and his writings should be read with a critical eye. Nevertheless, some of his insights into human behaviour and political economy are just as true today as they were in the 1930s. And if you, like me, are still in the process of trying to figure out Just What The Hell Is Wrong With Our Financial System, Keynes is as good a place to start as any.

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*Keynes' The General Theory was not primarily about financial markets, but rather uncertainty and its impact on savings & the economy as a whole. I think.

- John Kay creates analogy between investors and tailgators; proceeds to beat metaphor to death.

- The New York Times to imitate the Financial Times' gated system; Felix Salmon analyzes

- Zimbabwe becomes more mobile, faces dollarization difficulties and even, um, deflation

- Why cable television is bundled. (But just because consumers prefer flat rates, it doesn't necessarily make them a good idea for most people - ditto with gym memberships).

- "If you find yourself in a suddenly resource-rich emerging market and you're interested in knowing whether revenues are being put to the proper uses, just go find the houses of the local government leaders."

- More evidence that Britain is drinking more, binging more, and being less social about it (as if we needed any)

We've seen an uptick in traffic to the site today thanks to Matt Yglesias' reference to the ketchup economics post from a while back. If anyone is interested in exploring this topic further, try reading this discussion of the efficient markets hypothesis.

The challenge for the ketchupal economists is not an abstract one: it affects business execs, government bureaucrats, and huge sections of the financial industry on a regular basis. When attempting to quantify the something as complex as the marketplace, you leave yourself vulnerable to the unquantifiable & the unforseen. For more, see this post about the pretence of knowledge.

(Alternatively, if you're more interested in all things ketchup, I'm sad to say we've got that covered as well: see here and here.)

In what amounts to a healthy rejoinder to my post from Sunday, Yves Smith challenges the notion that a con job is enough to stimulate economic recovery:

The one bit of policy, if you care to call it that, that has worked well is the Administration’s concerted campaign to talk up the stock market. Its success in using the bogus stress tests to goose bank stocks was remarkably effective, particularly since anyone who knew anything about banking and was not in on the con was highly critical of the tests. But the media played them to the max... And the Administration kept pointing to the improved tone of the markets as proof that the economy was on the mend. And some readers have noticed a cheerleading stance in news outlets that were once more evenhanded, particularly Bloomberg.

Can a con job lead to recovery? The continuing lousy news on the employment front suggests not, but as long as the stock market remains relatively buoyant, few want to challenge this thesis. I had drinks with a hedge fund manager who was recently pilloried at a buy side/sell side get together when he dared suggest that the fourth quarter might not look as robust as everyone assumed. He said the argument against him boiled down to, “We are all feeling better and spending more, so everyone else surely is too.” The fact that they are all in the top 1% of the population and beneficiaries of TARP and other government bennies means it is a huge leap to generalize from them to the other 99%, but they didn’t see it that way.

Over at The Economist, Buttonwood has an excellent piece on how we think about, and often are confused about, wealth. In particular, the article points to the dangers of confusing financial assets with real ones:

[F]inancial assets are not “wealth” but a claim on real wealth. If those claims multiply or rise in price, that does not mean aggregate wealth has increased. If a pizza is cut into eight instead of four slices, there is no more food to eat. If everyone sitting at the table is given shares in the pizza and the share price rises from $1 to $2, the meal will still be no bigger.

Which leads to further questions:

Not long ago the BBC transmitted a programme about credit-card use. One man said he felt “wealthier” because he was given a credit-card limit of £5,000 ($8,000). Of course, once he used the card he was poorer. Not only did he have to repay the £5,000, but he had to service a double-digit interest rate as well. Similarly those who buy an overvalued asset with borrowed money have not made themselves richer but poorer.

Thinking about wealth in this way is also useful when assessing rescue packages for the economy. Will these policies boost the amount of goods and services the economy produces in the long run, or will they have consequences that actually restrict economic activity? Does quantitative easing really boost wealth or simply create more claims on the same underlying pool of assets?

These are good points: there's the risk that the stimulus packages have artificially boosted the indicators of economic performance. In other words, we're being deceived into thinking the economy is recovering when in fact the resulting national debt and inflation is making us poorer in the long run. This is certainly the case at the micro level, where - as with the British man referenced above - the use of debt to fund purchases can be net negative.

But at the macro level the distinction between artificial and real wealth is not always so clear. One of the key arguments in favour of the stimulus packages was that they would foster market confidence. When market participants are more confident, they are more willing to spend - the more they spend, the more firms are willing to invest in products/services on which money can be spent. Through playing the confidence game, government spending can use the artificial sense of wealth to stimulate the production of goods and services, or "real wealth." More pizzas, if you will.

This is the theoretical argument, in any case. And it only works in the short-run, since sustained high levels of spending will not have the same impact on market confidence, and may actually reverse it. But whether this artificial-to-real wealth effect balances out the long run costs of higher debt & inflation is something which remains to be seen.

The FT reviews a new book by Justin Fox called The Myth of The Rational Market. The book tells of how the Efficient Markets Hypothesis - the theory which underpinned many dominant financial models in recent years - travelled from hypothesis to fact to myth. This is a topic our blog reviewed (in considerably less detail) a couple of months back [with addendum].

The ongoing financial kerfuffle is wreaking all sorts of havoc, but the damage has been particularly acute for the perceived legitimacy of the financial industries. The crisis has led to a torrent of criticism which accuses Big Finance of gambling with our savings, handing out bloated bonuses, and generally being a disease upon mankind. A lot of this is misdirected populist rage, but some of it is well-deserved. In fact, I think that this rage will prove useful if it leads to a greater awareness - and criticism - of the underlying logic of the tools used by Big Finance. Here's why:

Much of modern financial economics is based upon a set of assumptions that can be broadly labeled the efficient markets hypothesis (EMH). While not universal, the EMH forms the core of most financial modeling and is the foundation of a great deal of wealth creation in the last couple of decades - at least, it was. The three basic assumptions of the EMH are:

1. markets allocate resources most efficiently
2. liberalized markets will enhance the overall welfare of society, and
3. given the opportunity, market actors will converge on the "correct" economic outcome

As Tyler Cowen explains in an essay on economists and rationality, the EMH comes in a variety of flavours. Weaker versions of the theory claim that rational stock picking will not on average outperform the market because the market already incorporates all the relevant information about the value of companies into the stock price. In other words, it's very hard to beat the market averages, unless you're very lucky or Bernie Madoff (too soon?).

Stronger versions of the theory claim that market prices accurately reflect the fundamental values of corporations and thus cannot be improved upon. In other words, when a share in Company X is worth $50, that price is based upon all the available information about Company X. And if the price of a share in Company X is worth $0.50 the next day, that's because investors responded (rationally!) to new information, nothing more. Even though nobody actually believes that ALL investors are rational, it is assumed that capital markets are close enough to the ideal to allow rational investors to prevail.

The EMH is used in academia primarily for modeling discipline, but the theory also underpins many of the models and tools used by Big Finance. Unfortunately, it appears as though the beautiful simplicity offered by models of market rationality can lead to some pretty disastrous consequences. For example, Felix Salmon has a great piece on the formula that killed Wall Street. The article tells the story of how a mathematical model was developed which appeared to take the risk out of pricing risk. The formula explicitly assumed a strong version of the EMH and it spread like "a highly-infectious thought virus." All of the qualifications about the limits of model were buried under the stacks of money that this little formula was earning for financial executives. This is definitely worth reading.

But what's the problem with EMH, anyway? For one thing, it's tautological: how do you define the correct, most efficient economic outcome? If the answer is: "the outcome achieved by perfect markets," you're back where you started. The EMH appears to simultaneously assume a) a non-determined process driven by human choice, and b) that this spontaneous process is working towards some final end which is somehow "correct." Willem Buiter puts it more colourfully, as usual:

The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time - a God-like father figure - who makes sure that nothing untoward happens with long term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.
What this shows, not for the first time, is that models of the economy that incorporate the EMH - and this includes the complete markets core of the New Classical and New Keynesian macroeconomics - are not models of decentralised market economies, but models of a centrally planned economy.

Put that in your efficient markets pipe and smoke it! Whether the fallout from the financial crisis will shift the balance towards more behavioural models of economics remains to be seen. At the very least, the crisis has forced a critical re-examination of the assumptions underlying modern finance; a re-assessment of what we thought we knew. That can only be a healthy thing.

(photo of the friendly auctioneer at the end of time from Wonder's photostream)

George Soros makes a great point:

Institutions such as the International Monetary Fund face a novel task: to protect the periphery countries from a storm created in the developed world. Global institutions are used to dealing with governments; now they must deal with the collapse of the private sector. If they fail to do so, the periphery economies will suffer even more than those at the centre.

Soros then goes on to point out how differing perspectives about the financial crisis on both sides of the Atlantic threaten to derail any substantial progress in upgrading our international financial institutions. But he's only telling one-half of the story.

Yes it's true that the IMF needs more resources, but it also needs customers. The problem is both the stigma attached to countries that go to the IMF cap-in-hand and the strings attached to IMF loans. These are two of the mains reasons why the East Asian economies have built up very large currency reserves: applying for an IMF loan is punished by market actors that interpret such activity as a sign of weakness (not prudence), and is "punished" by the IMF in the form of disruptive policy reforms.

Recognizing this problem, the IMF has just launched a new Flexible Credit Line (FCL) that is specifically designed for "countries with very strong fundamentals, policies, and track records of policy implementation." It has considerably fewer strings attached and is aimed at being a precautionary tool, rather than a last resort. But the optics problem remains and countries are reluctant to apply.

Until yesterday, that is. Mexico is seeking $47 billion under the FCL to act as a buffer against the fallout from the financial crisis. In other words, Mexico has bravely volunteered itself to test how the market will react to the IMF providing pre-emptive financial assistance to a country that has their "strong fundamentals" stamp of approval. Has the financial crisis caused such an upheaval in the market mentality that this prudence will be rewarded? Or are serious investors unconvinced of Mexico's "fundamentals" and going to punish it just like old times?

One of my conservative friends remarked yesterday that the Dow's 4% decline should be chalked up to the market's fear of an Obama presidency. I could go at this statement on so many levels. I instead went looking for the historical context of yesterday's performance.

David Gaffen at MarketBeat looked at the Dow's inauguration day performance since 1937 (excluding Obama, his article was published yesterday afternoon), the year inauguration was moved to Jan. 20th. He concluded that "the day of the inauguration has historically been a lousy one for the Dow Jones Industrial Average." He found that out of the past 10 inaugural days, just 2 ended higher for the Dow (85 and 97). The worst day? The Gipper's 1980 inauguration.

So if recent history is any indication, Obama had little to do with yesterday's decline. It was instead driven by a heavy sell-off in financials, which speaks more to the Bush administration's utter failure to address the fundamental problems in the banking sector and place a floor under the US housing market.