This note in TPM contains links to two fascinating articles about economics.
The first is an examination of the ideological basis of modern economics and its absurd claims to mathematical basis
http://www.prospect-magazine.co.uk/article_details.php?id=10683
The second is a defense of conventional modern economics by Paul Krugman
http://krugman.blogs.nytimes.com/2009/03/26/ive-got-keynes-right-here/
Kaletsky notes that Keynes did not do mathematical modeling and Krugman responds by quoting some mathematicish passage from Keynes. But mathematical framing is not the same as mathematical modeling and the difference can be illustrated from Krugman’s own misleading critique of Geithner’s toxic assets auction – where Krugman uses an expected value argument (vey is mir).
Expected value is just a fancy way of saying “average value over the very long haul” or more precisely “the value that one gets closer and closer to by taking more and more samples”. What Krugman does to explain the horror of Geithner’s plan is to make an example of an auction of “assets” which will either be worth $150 or $50 and have an expected value of $100. But it’s ridiculous to talk about expected value of an auction of perhaps 100 pools of shares – and in fact, using the term, smuggles in the very view of finance that sent AIG and Moody’s down the hole.
What Keynes did was use mathematical terms to be precise about what he was studying. What Krugman is doing is asserting that real-world properties can be derived from a statistical model. These are utterly different things.
The standard caution of using mathematical models is the story of the drunk who looks for his lost bottle under the lamppost because that’s where the light is. Economists, dependent on their toolbag of probability measures and models are not immune from the lure of looking where their model shows them, no matter where the object of the search may really be. Krugman is assuming that a potential purchaser of the assets (1) knows what the average value is over the set of assets and (2) is confident that he/she can purchase enough assets at the same price to assure that average value of the whole set is the average value of the purchased assets (if the expected value is 100 and you buy 10 assets that are all 50, you are in a sad place), and (3) have ZERO transaction costs and (4) the set of assets is opaque – there is no way to learn more about them than the average value.
Imagine what happens if TWO investors try the same model and make identical bids over the who set of assets. If they randomly win, then neither of them has purchased enough assets for the model to work – remember the expected value is at the limit. If you are told that a bag contains 50 gold bars and 50 copies of atlas shrugged, then when you only get to buy 50 of them, you have a chance of getting no gold bars a all! Assigning a value of 1000 to gold bars and $0 to the Ayn Rand books, the expected value over the entire set is $500. But only if you and, say, 3 other competitors each use this clever trick and bid $500 100 times, and each of you ends up with 25 items, the odds are strong that at least one of you will be weeping.
As a final note: the trick that Krugman and others assume that people will use to game the system depends both on the existence of a reliable valuation model better than anyone can get by inspecting the assets and that each of the famous non-recourse loans is tied to a single asset. The second assumption would indicate that the system is designed to be gamed – but if you look at Geithner’s proposal you can see that the loans use POOLS as collateral. That is, you cannot go to a pool of Citibank loans and buy 1000, on the theory that 501 will be winners, 499 will be losers and the losses on loans will be limited to the 499. The FDIC will take its loan out of your 501 winners too.
Interesting analysis. I have noticed that you take a bit of a contrarian view around here, so I am interested in your take on a few points I would like to make. I don’t know from this post whether you are just making a critique of Krugman but are not necessarily in favor of the Geithner Plan? Isn’t it true that the investor is putting up something like 3% of the dollars and borrowing the rest from the taxpayers. If the investment does not work out he simply returns the asset. This seems like a very attractive kind of subsidized risk to me – not that much of a downside and yet a prospect of a huge upside. Would it not be better for the investor to be required to have more skin in the game? When the original securities were first packaged, so called sophisticated investors ( many institutional ) were persuaded that they were making safe investments, but they proved no match for the banks. Why do you feel the banks will not game the securities for TALF? Or is that beside the point of your post? There is already reason to be disturbed by recent behavior of the banks who have received Tarp funds who are now, through their investment arms actively buying up “toxic assets” on the market with what amounts to be taxpayer dollars ( cash being fungible )
Why do we need a 3% partner? The money we have infused into companies like BAC and Citi,if treated like a normal investment would make the taxpayer 100% plus owners based on their market capitalization. If there is an upside why should it go to shareholders and executives and not the taxpayer?
It seems to me that the arguments that focus mostly on the arithmetic for the Geithner plan vs nationalization leave out the just as important matters of how things are actually managed and in whose interest. We know how to deal with taking over banks via the FDIC or through methods like the Resolution Trust Corp. The Geithner plan appears to be very complex and at the same time completely unproven to work.
I think that Talf should never happen if only because it leaves management in place. The financial companies have been poorly managed. If you are proven to be inept at managing risk ( while simultaneously reaping very large rewards ) then you are not someone who should be in charge of your own rescue.
I also believe that we have reason to believe, given the poor oversight of regulators and the generally cozy relationship with Wall Street from within the Obama administration that we are declaring what amounts to an opens season of looting to the banksters and “investors”. Call me a cynic, but you can never underestimate the power of greed.
The partner under the Geithner plan invests 1/12 or more which is 8% or so, not 3%. I believe that the purpose of the investor is to protect the government against the political power of the banks. The problem with the paulson plan was that the government was essentially bargaining with the banks directly and the ability of the WS Banks to create political storms is immense plus there is a problem of the externel valuators being influence by relationships with the big banks. I think Geithner did not want a situation where Chuck Schumer and Chris Dodd and Barney Frank, not to mention the Pukes were all calling the WH and complaining that the FDIC was being unfair in valuations – or open the government to lawsuits of the type that Wamu management is now pursuing. If no private investors will risk their own money at a certain valuation, Geithner has a impenetrable wall now to show that the Government evaluation was generous.
I’m really pissed off by all the people who advocate a second resolution trust – the biggest donation of public money to the rich in the 20th century. There is nothing simple about RTC type operations and FDIC operations also involve expensive giveaways. Besides Citibank and BOA and WellsFargo are way beyond the reach of the FDIC – they contain many entities that are not FDIC regulated. WTF is the FDIC going to do with the mexican banks owned by Citi if it comes down to that? They don’t even have legal authority in the US to do something with them.
Here is a link to the NY Times story that I read a few days ago. If you read through it, you will see where it points out that the investors may not be required to put up more than 3%. I have seen this discussed in much more detail at Naked Capitalism.
http://www.nytimes.com/2009/03/21/business/21bank.html?_r=1&pagewanted=1&hp
“To entice private investors like hedge funds and private equity firms to take part, the F.D.I.C. will provide nonrecourse loans — that is, loans that are secured only by the value of the mortgage assets being bought — worth up to 85 percent of the value of a portfolio of troubled assets.
The remaining 15 percent will come from the government and the private investors. The Treasury would put up as much as 80 percent of that, while private investors would put up as little as 20 percent of the money, according to industry officials. Private investors, then, would be contributing as little as 3 percent of the equity, and the government as much as 97 percent.
The government would receive interest payments on the money it lent to a partnership and it would share profits and losses on the equity portion of the investment with the private investors.”
that’s a misinterpretation of the program. At least that part is clearly explained in the Treasury on-line docs
5/6 loan (at most!)
1/6 equity split evenly between feds and investor
As for plans: My preferred plan would be to arrest the managments of the major WS firms for fraud, conspiracy, and insurrection, confiscate the firms and have the government run a not-for-profit banking center that would be then regionalized and decentralized with elected boards. And I’d put in 100% taxes on any assets over $10M or whatever – some reasonable number. But that’s not something that Obama would support and there’s no public support for it either. So I’m sympathetic with Obama’s efforts to get something done in this environment and cognizant of the political realities – as moderate as Obama is, there are extremely powerful forces that will try to destroy the state if he pushes them too hard.
Not sure I understand your objection to the RTC. How was it a boondoggle for the rich? I guess I will have to have a refresher course – I welcome any pointers on that subject. The prevalent view I believe is that it was a success in the end and minimized losses to the taxpayer. I know that Paul Volker argued in support of creating a new RTC for the present financial debacle. No doubt, like everything else in these matters, it is all too complicated!
What to do. Now that is an interesting proposal. Likelihood to happen – zero, as you no doubt know.
I think we may be in some agreement on the politics in some respects. My view is that Obama realizes that the scary black man can not do nationalization until ALL OTHER OPTIONS have been tried and failed. This is an expensive way to go and really erodes his political capital and the national treasury.
RTC was a boondoggle for the rich and a big step towards the “too big to fail” world we live in because it sold enormous assets for pennies on the dollar to people who were well connected.
The Bass family made a fortune off of getting large chunks of land and banks for nothing.
http://www.archive.org/stream/resolutiontrustc00unit
Fair enough. I will need to read up a bit more on the RTC. The doc the link takes you do is over 500 pages. Bit of a chore to read it online, and the search feature only brought up one mention of “bass’ Still, I take your point. The common notion that I think many of us have is that the RTC held on to some assets for many years and then disposed of them at good or certainly much less distressed prices. Isn’t it still superior to the Geithner plan, in that at least the ‘rescuers’ are not planning “the robbery” from inside the bank as with Talf/Partnership.
During the hearings on the RTC, Danny Wall the RTC director was explaining why Ron Perlmann was given a billion dollars and the great Walter Fauntelroy, the DC rep interrupts to ask: Do only white people get deals like that?
http://books.google.com/books?id=DaIEl3w5EbMC&pg=PA41&lpg=PA41&ots=L2wYS6Hz5J&dq=ron
ald+perlman+danny+wall&output=html
It’s infuriating that people like Krugman cite this vast episode of looting as the obvious model.
Thanks for the link – I am reading a few pages now. Maybe I’ll find the book online and order it. Looks like it might be worthwhile.
Interesting post.Here is where I don’t agree: The RTC as a boondoggle for the rich — that’s a bridge too far for me. Not that one can’t describe it that way, but fairness demands to admit that in a capitalist system, any successfully resolved financial crisis will, with hindsight, turn out to have been a boondoggle for the rich. Only a nationalization scheme that is more than a mere pre-privatization will avoid that outcome.
I leafed through that book you linked to (as far as the pages were available) and am not sure that this is a very balanced view of the RTC process either, frankly. The author is a jaundiced former banker who had his bank seized and sold off by a perhaps overly aggressive FDIC. Liquidations are inherently nasty and crude and with hindsight they rarely look well-timed (true even of Enron).
The Bass family bought into Texas real estate at a time when it was widely believed that oil would fall to $5 a barrel and stay there.
On the other hand full agreement of course on the deranged mathematical absolutism in economics.
The book is kind of wacky, but the hearing link although more tedious is full of stories of peculiar transactions.
Look at the savings and loan section in this
http://en.wikipedia.org/wiki/Ronald_Perelman
On the other hand, I think that you are correct. In any massive transfer of assets in a capitalist system, people with more capital and more influence will get rich. All the indignant remarks about the possibility of rich people making money on the TARP plan reminds me of Flo Kennedy’s great line about wondering which of the people standing in the sewer don’t smell bad.
The question should be on whether the end result is a better functioning and somewhat fairer system or not.
With hindsight it looks like Perelman/Ford got much sweeter deals than were needed, that’s clear. But again this is with hindsight since a much-dreaded super-deep recession didn’t materialize in 1990-1991 and since the price of oil never did drop to $5 bucks after 1988. The liquidation process leads almost invariably to this sort of situation since the liquidator by definition is ready to sell at almost any price. Provided housing prices don’t drop more than another 10% from here, the Paulson-Soros consortium will do very well with IndyMac too. Maybe not as fantastically well as Perelman/Ford with those thrifts since those two not only got their assets for next to nothing but then rode them into one of biggest bubbles in financial assets since Tulipomania…
So viewed from this angle, Geithner’s public private scheme is actually encouraging, because Uncle Sam isn’t just a liquidator, but will make money too.
Or actually… since tulips aren’t financial assets at all, let me rephrase that to “perhaps the biggest bubbles in financial assets since the South Sea bubble of 1720”.
You are correct about the NY Times and others getting the investor percentage wrong when the program was announced. The Treasury has it at 7%+ as you pointed out. Of course there is also another program but this is the big one for the legacy assets/toxic assets.
Here is a link for anyone else that would like to see the Treasury’s ‘fact sheet’. (pdf )
http://www.ustreas.gov/press/releases/reports/ppip_fact_sheet.pdf
Here is a link to Mish’s analysis. He also views the program unfavorably.
http://globaleconomicanalysis.blogspot.com/2009/03/geithners-galling-and-dangerous-plan.html
Back to the Geithner plan. As was discussed previously the early reports on Talf/PPIC indicated that investors would be able to put up as little as 3%. We know now that it is 7%+. There is apparently a bit of reconsideration going on that the Geithner plan is not as bad as thought. Below is a link to a post by Robert Waldman at Angry Bear that is encouraging. It also confirms Rootless’s analysis in regards to pools. Anyhow, who knows whether any of this will work. So much depends on how toxic the “legacy assets” really are. From what I read they are really bad. Anyhow, here is a snippet, followed by the link.
“The problem with this [Krugman’s] example is that it assumes that each loan guaranteed by the FDIC is used to buy a single asset that either defaults or pays in full. … But in fact the Treasury’s plan, as I understand it, is for PPPICs to bid for pools of loans/securities held by banks. The FDIC loan guarantee will apply to the pool rather than the original loan. The PPPIC will only default on the loan if the value of the pool turns out to be considerably less than the purchase price (specifically, less by the amount of the firm’s capital investment).”
http://angrybear.blogspot.com/2009/03/geithner-plan-better-than-leaked.html