Saturday, November 26, 2011

Some crisis and economics readings

Crisis Economics by Nouriel Roubini and Stephen Mihm. The NYT review is here and here and another one is here. I was hoping for a radical new economic approach to thinking about crisis but this is not what the book is about. It gives a nice summary of the events and ideas that led to the crisis although it did not shed any new light. I was hoping for something radical on the part about reforms. Unfortunately this was not the place for any radical departure from the current debate.

The only proposal that sounded radical was to break up the big banks but this has already been put forth by different parties, among them Mark Thoma. All in all, I was disappointed by the book but some may find it a good place to start.

The Origins of Financial Crises by George Cooper was where I found the “radical proposal” that  I was looking for which I had hoped that Roubini would be brave and daring enough to espouse. This proposal is that central banks should actively seek to pop bubbles, i.e. take the punch bowl away from the party when the fun is just beginning. Some reviews are here, here and here. The argument that the origins of all financial crises is excess liquidity (or his preferred measure is credit creation or some broad definition of money supply) is nothing new. However, he manages to craft his arguments very simply in terms of the Minsky’s financial instability hypothesis.

These were the best parts of the book but like many economists, Cooper suffers from the same physics envy that brought the financial profession into the brink of self destruction not unlike the current crisis, dot-com valuation, and LTCM. His proposal that central banks can work to pop bubbles and in fact to manage the economy by creating smaller waves of small booms and busts rather than allowing a bubble to expand to such an extent as to create a systemic risk is very well argued. In fact it is too simply argued using as an analogy (I think) James Clerk Maxwell’s paper “On Governors” which is included as an appendix. Not surprisingly, Maxwell’s paper which is a predecessor to control theory and systems and deals with controlling the steam engine is filled with differential equations again not unlike much of finance theory and macroeconomics.

The weakest link in his argument I think is that Cooper seems to believe that the macroeconomy can respond to various central bank levers such as interest rate within some reasonable uncertainty bounds and is hence “controllable” but in reality monetary policy responds with long and variable lags. However, I am not convinced that his argument can simply be dismissed just because of this. The idea of Keynesian activism however is to smooth out the booms and busts of the economy, not to create booms and busts because of unsustainable booms. Perhaps it is time to revise the ideas of what Keynesian activism should be.

The Road from Ruin by Matthew Bishop and Michael Green was more enjoyable than I had expected. A review is available here. It is a very useful account of various things that have happened in financial history and why we need to learn (or relearn some of the lessons). Unlike Cooper, the lesson they take from history is the bubbles are a result of financial innovations rather than credit creation. For instance, if securitization is to be blamed then it should be banned or more highly regulated. The authors argue however that it was this higher degree of regulation that prolonged the great recession (p. 43). In may ways the authors cheer for free markets and the benefits that they have brought and tend to tread more lightly on the costs.

Plight of the Fortune Tellers by Riccardo Rebonato starts out with the premise that the current state of financial risk management is not working. It is too heavily dependent on measurement when measurement cannot be precise enough and when it can be precisely measured what can be measured is not relevant. A review is available here. This was what grabbed me but unfortunately, the book was not able to hold me. It goes through a discussion of Bayesian statistics and value-at-risk but what he actually wants to say essentially comes down to the fact that risk management is all judgment. We have a lot of tools that can help us make a decision but when it comes down to making some kind of decision it is all judgment and nothing else. We should not pretend that statistics, theory, data and computers are going to be able to quantify the risks and uncertainties precisely because they won’t.

And the Money Kept Rolling In (and out) by Paul Blustein was in some ways belated and in someways timely in light of the current Euro crisis. It is again a reminder of how tenuous the recovery was in Argentina and still is even today. Though the book is not as good as The Chastening it has the same characteristics of access to the cast of characters and internal IMF documents. (The phrase “abc was and still is a confidential internal IMF document” pretty much fills the end notes of the book.)

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