Friday, November 26, 2010

A reminder on too interconnected to fail

From AP on the Qantas the flight:

Airplanes are supposed to be designed with redundancy so that if one part or system fails, there is still another to perform the same function. That didn't always happen in this case, safety experts say.

... "What we have got to ensure is that systems are separated so that no single point of failure can damage a system completely," Woodward said. "In this situation the wiring in the leading edge of the wing was cut. That lost multiple systems."

However, Michael Barr, who teaches aviation safety at the University of Southern California, said a commercial plane can't be designed with certainty to withstand a spray of shrapnel, which can inflict damage anywhere. The proper focus, he said, should be on determining what caused the engine to fail and fixing that problem.

Is there anything financial regulators can learn from this?

Tuesday, November 16, 2010

Financial crisis event books

These are two: David Wessel's In Fed We Trust and Henry Paulson's On the Brink. Wessel's book is a much better read but the Paulson book complements the former. For instance, Wessel claims that George Bush was largely absent during the crisis as it unfolded but in some ways Paulson's book contradicts this. Paulson also provides the political drama and backdrop that were largely absent from Wessel's book. In many ways, his book highlights the political elements that were absent in many considerations of my earlier posts on the crisis. The only thing I found unbelievable was his claim that all along he thought that TARP would be used for asset purchases and the only reason he had not proposed it was it was politically unpalatable (at least that was how I read it).

One thing that both books made extremely clear to me was that despite the fact that I thought that the Fed and Treasury had powers to take over failing banks and replace management, they clearly thought they didn't. The role of lawyers in the Fed and Treasury was emphasized at critical points. Bernanke and Paulson sought their opinions even on whether bailing out AIG by invoking a clause in the Fed charter that allowed the Fed to step in when it deemed it was absolutely necessary was legal. Mark Thoma concurs:

“Since the government didn't have resolution authority for banks in the shadow system, it only had two choices when faced with the collapse of a large bank like Bear Stearns or Lehman. Let the bank fail and risk a domino effect that brings the entire system down and potentially creates a depression, or bail out the systemically important bank -- including management and equity holders (investors). [Some claim the government did, in fact, have other choices, but I don't think the key players in the Fed and Treasury believed that they had the authority they needed to take over the large banks, remove management, and put them through traditional FDIC-like procedures that impose losses on investors.] By choosing to bail out the banks, they also bailed out those who created the mess. This left the appearance that the wealthy and well-connected get bailed out, while the middle and lower classes get the bill. Typical households really can't see what they gained from the bailout since, for many, the counterfactual where the system melts down without a bailout is either hard to imagine or not believed. They don't understand, for example, why the government helping them to pay off loans wouldn't have helped banks just as much as a direct bailout. "Where was my bailout?" they wonder.”

Wessel's book was more enjoyable perhaps because it was more economics than politics. Characters like Jeff Lacker and Charles Plosser come out looking like naysayers – crying that the the crisis was not something to be worried about. Wessel seems to think that Bernanke's consensus style was sometimes a hindrance to getting things done. He refers to it as a economics seminar approach to decision making. I don't know which economics seminars Wessel has been attending (or Bernanke for that matter) but most of the seminars I was at in Rochester were nothing short of contentious. One speaker even refused to continue talking because he kept being challenged by an attendee. For instance, here's Andrew Gelman in his tribute to statistician Arnold Zeller (emphasis mine): “No matter who the speaker was, Zeller was always interrupting, asking questions, giving his own views. Not in that aggressive econ-seminar style that we all know and hate ...

What I was looking for in both books however was severely missing and is highlighted in the Thoma's piece. Neither Bernanke nor Paulson could clearly articulate what would have happened to the economy if the investment banks (and AIG and Fannie/Freddie) were simply allowed to fail. Intoning “God help us all” if the financial system collapsed is not a scenario. So in some ways, while I appreciated more the nuances of the bailout and why they did what they did I am still far from fully convinced that the bailout was necessary.

I think that when you are a participant you are biased toward believing in your priors. There is no doubt in my mind that both Bernanke and Paulson felt that the bailout was necessary. Likewise, I believe that if there were a crisis in sociology for instance, that there is a possibility that the entire field would collapse because fewer and fewer people are becoming sociologists, the field would be crying for a bailout as well (as would makers of horse drawn buggies or automobile makers – all intoning “God help us all”).

Nor were any of the books very good at linking how the collapse of the financial system affected Main Street via the unemployment rate. Were the effects psychological? E.g. “Oh my God, the financial system is collapsing, I better lay off all my workers!” or was it direct? E.g. “Oh my God, the commercial paper market has frozen solid and I better lay of all my workers!”

Friday, November 12, 2010

Cirque du Soleil Ovo

We had the chance to see Cirque du Soleil's Ovo about a month back and I enjoyed parts of it tremendously especially the parts on ants and grasshoppers. The clown acts were a little over the top I thought. Later I also had a chance to watch Alegria on DVD and came away thinking that Ovo was much better. Alegria also seems to have evolved since the DVD was made. The website indicates that there are now two contortionists instead of one.

I searched online for some literature on life with Cirque du Soleil but found very little. The clips at the end of the Alegria DVD gave the impression that all's well but I was more interested in things like how long do performers stay on with the show, what the training and practices are like, what it's like to raise a family on the road, etc. (Some information is available on Cirque's web site, including education for minors, benefits, etc - no 401(k).)

The Wikipedia entry was very informative for me. It seemed to indicate that as much of Cirque du Soleil's success might have been due to luck as it may have been due to hard work of Guy Laliberté.

I'm looking forward to their next show. This show played at the National Harbor and we ended up staying overnight at the Hampton Inns. The hotel was new so it was a nice place. In retrospect, waiting to take the bus back from the site to the hotel probably took longer than driving out of the parking lot although it was nice not to have to navigate home after a late night.

Sunday, November 7, 2010

Stiglitz and Davis reading

I found Freefall by Joseph Stiglitz more of a rant than anything else although some times buried within the chapters there would be a nugget of information or two. Unfortunately, they must not have been very valuable nuggets since I can barely recall what they were. I thought that overall the book was too much of score-settling than a rational discourse of the events. In one book (but fortunately not the same chapter) he criticizes the authorities for adopting a too big to fail policy but at the same time criticizes them for letting Lehman fail. This inconsistency annoyed me more than anything else and I found it hard to get through the rest of the book after that.

The tenor of the writing improves half way through the book and I think the few chapters or so hit the correct note on what the book should have sounded like. These are the chapters on policy recommendations and what the administration could have done better. I really wish he would stop beating the IMF tree and bringing up the Asian crisis. Yes, we get it but it really is beside the point here. I had thought that he would delve more deeply into the intellectual debate within economics and how free markets triumphed and even converted some one like Larry Summers but he didn't get into the academic part of the debate. This would be left to two other books (reviews of How Markets Fail and The Myth of the Rational Market later.)

On the other hand, Managed by the Markets by Gerald Davis was a very nice historical overview of how finance has managed to dominate the economy. I found it easier to read than expected and actually enjoyed it more than I thought I would. (Usually, history! Uggh!)

Irrationality or uncertainty

Decided to return to work full-time about a month ago and as a new employee I had to attend an employee benefits seminar. The major items in these seminars are health insurance (medical, dental and vision) as well as flexible spending accounts. I was befuddled by the array of choices and I wonder how many people are as well.

For instance if I had data on individual insurance plans of enrollees as well as their medical spending over the year as well as their alternative insurance plans, can I, based on the data, decide whether they are irrational or uncertain?

This is similar to the the observation that when faced with a decision on how to allocate their money in a 401(k), many people default to equal proportions and that many individuals (including myself) pick funds that are highly correlated and under-diversified.

Is this irrationality? It is certainly a large deviation from the plan of a perfect foresight infinite horizon agent but does the fact that we deviate from what dynamic programming tells us we should do (dang if I know since formulating Bellman's equation isn't exactly something I excel at) evidence of irrationality per se or computational limitations.

If it is the latter then this can be addressed by having asset allocation tools made available as many mutual fund companies now do. Likewise, tools to select health insurance can also be built based on projected spending and income - so does deviation from such recommendations reflect irrationality, hidden information or a combination of many factors?