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It Does Not Seem to Me That Charles Ferguson Has Gotten It Right... - Grasping Reality with Both Hands

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Grasping Reality with Both Hands The Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, RealityBased, and Even-Handed Department of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.

Economics 210a Weblog Archives DeLong Hot on Google DeLong Hot on Google Blogsearch October 05, 2010

It Does Not Seem to Me That Charles Ferguson Has Gotten It Right... Oh, back in 2005 Rajan was right and Summers was wrong. But it did not go down like Charles Ferguson says it does. Charles Ferguson: Larry Summers and the Subversion of Economics - The Chronicle Review - The Chronicle of Higher Education: Summers remained close to Rubin and to Alan Greenspan, a former chairman of the Federal Reserve. When other economists began warning of abuses and systemic risk in the financial system deriving from the environment that Summers, Greenspan, and Rubin had created, Summers mocked and dismissed those warnings. In 2005, at the annual Jackson Hole, Wyo., conference of the world's leading central bankers, the chief economist of the International Monetary Fund, Raghuram Rajan, presented a brilliant paper that constituted the first prominent warning of the coming crisis. Rajan pointed out that the structure of financial-sector compensation, in combination with complex financial products, gave bankers huge cash incentives to take risks with other people's money, while imposing no penalties for any subsequent losses. Rajan warned that this bonus culture rewarded bankers for actions that could destroy their own institutions, or even the entire system, and that this could generate a "full-blown financial crisis" http://delong.typepad.com/sdj/2010/10/it-does-not-seem-to-me-that-charles-ferguson-has-gotten-it-right.html

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and a "catastrophic meltdown." When Rajan finished speaking, Summers rose up from the audience and attacked him, calling him a "Luddite," dismissing his concerns, and warning that increased regulation would reduce the productivity of the financial sector. (Ben Bernanke, Tim Geithner, and Alan Greenspan were also in the audience.) I was there. From my memory, it does not seem to me that Ferguson's summary of the exchange is fair. As I recall--and as the transcript shows--Summers made six points: 1. The problems that Rajan points to are very real. 2. He is probably wrong to say that they are more salient now than they have been in the past. 3. His proposed solution #1--sand in the gears to return us to plain-vanilla banking-is too drastic and throws away very large and very real benefits from financial risk-spreading. 4. His proposed solution #2--align incentives of managers with ultimate owners--is not drastic enough because LTCM and Shleifer-Vishny show us that it really cannot do the job. 5. Our best chance is rather to make finance transparent--public transactions in standardized financial vehicles via exchanges so everybody can see what short and long interest are. 6. And (implied) to rely on central bankers who understand Bagehot's rule and are willing to apply it in emergencies. I still agree with Larry on (1), (4), and (5). Larry was wrong on (2). And I am on the fence on (2) and (6). Let's roll the videotape: Lawrence Summers: I speak as a repentant, brief Tobin tax advocate, and someone who has learned a great deal about the subject, like Don Kohn, from Alan Greenspan, and someone who finds the basic, slightly Luddite premise of this paper to be largely misguided. I want to use an analogy, not unlike the one Hyun Song Shin did, but to a rather different conclusion. One can think of the history of transportation over the last two centuries as reflecting a gradual and determined move away from arm’s length transactions. People once supplied their own power. Then, they started carrying on transportation using tools that they owned. Then, they increasingly relied on tools that other people owned that were provided by intermediaries. In that process, the volume of transportation activity increased very substantially. Over time, people became almost entirely complacent about the safety of the transportation arrangements on which they relied. Large sectors of the economy came to be organized in reliance on the capacity of planes to fly and trains to move. The degree of dependence on individual hubs—like O’Hare Airport— increased substantially. The worst accidents came to be substantially greater conflagrations than they had ever been in an earlier era. Yet, we all would say almost certainly that something very positive and overwhelmingly positive has taken place through this process. Something that is overwhelmingly positive for individuals is that the number of people who die in transportation-related episodes is substantially smaller than it was in an earlier era. The best single way to think about the process of financial innovation is as http://delong.typepad.com/sdj/2010/10/it-does-not-seem-to-me-that-charles-ferguson-has-gotten-it-right.html

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representing a similar process of movement across spaces, spanned not by physical space, but by different states of nature. It seems to me that the overwhelming preponderance of what has taken place has been positive. It is probably true that—as we didn’t use to have transportation safety regulation and we do now—an evolving system does require an evolving regulatory response. But it seems to me that one needs to be very careful about stressing the negative aspects of the evolution, relative to the positive aspects of the evolution. I was going to make the same point that Don Kohn made about the Japanese financial system and the Scandinavian financial system standing out for the magnitude of damage done and the reliance on vanilla banking, relative to other activities. Something similar could be said about the history of U.S. business cycles. The history of the business cycles prior to 1970 would place very substantial reliance on problems that came out of the financial sector and the regulation of the financial sector. I was surprised by the tone of the recommendation around the incentives because it seems that if you take what is the central, most plausible area of concern that is suggested by what takes place in the paper, it is the notion that speculation involves negative feedback over a certain range, then positive feedback once you get outside of that corridor, and that process is very substantially exacerbated by hedge fund phenomena. Indeed, if one looks at the Shleifer-Vishny paper that Mr. Rajan refers to, hedge funds and the behavior induced by hedge funds and hedge fund liquidations are the central example. Yet, hedge funds would be the primary example we have of a financial institution where those who were running it did in fact have, as Raghu Rajan recognized in his comment on Long-Term Capital Management, very substantial wealth that was involved. While I think the paper is right to warn us of the possibility of positive feedback and the dangers that it can bring about in financial markets, the tendency toward restriction that runs through the tone of the presentation seems to me to be quite problematic. It seems to me to support a wide variety of misguided policy impulses in many countries. I would say as a final example of what has come out of the discussion for the 1987 crisis is that if those who wish to protect their assets had bought explicit puts rather than portfolio insurance, the situation would have been substantially more stable. That also argues for the benefits of more open and free financial markets, rather than for the concerns they bring. Brad DeLong on October 05, 2010 at 08:49 PM in Economics, Economics: Finance, Economics: Macro | Permalink Favorite

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Comments Felixsalmon said... "Lead-eyed"? What on earth does that mean? It's obviously a mistranscription of "Luddite", as Ferguson reports. Reply October 05, 2010 at 09:09 PM Full Employment Hawk said... "Summers was wrong" This is why he should never have become Obama's main economic advisor. He should have been treated as a toxic pariah and kept at arm's length. In this capacity he got it wrong again in only favoring a stimulus strong enough to prevent an economic disaster, when what was needed was a stimulus strong enough to make the economy grow fast enough so that the unemployment rate was coming down at a solid rate during the 6 months before the election. A stimulus with a heavier emphasis on infrastructure investment might have been larger. At least they should have tried. And there could have been a second stimulus in the 2009 budget using reconciliation, which only required 50 votes. Other things could have been done, such as speeding up the rate at which expenditures that had already been authorized were spent. And promptly filling the vacancies on the Board of Governors with full employment hawks. But this Wall Street elitist totally failed to understand the crucial importance of having a good job and not having to worry about losing it (both for themselves and their relatives and friends)is to ordinary voters, who vote against the incumbents if it is not happening. Just how much of the blame for the losses the Democrats will suffer in November is Summers' fault will have to be determined by economic and political historians, but it looks like it is an awful lot of it. Reply October 05, 2010 at 09:16 PM Brad DeLong said in reply to Felixsalmon... Indeed... Yours, Brad DeLong Reply October 05, 2010 at 09:19 PM dilbert dogbert said... Re: Transportation I don't think a single train wreck or airplane crash, or even a bunch of them, ever brought down an economic system. Is this guy the sharpest knife in the drawer? WTF? Reply October 05, 2010 at 09:58 PM Anon said... I don't think the analogy works very well either, they are both about trusting complex systems with some catastrophe risk, but the key difference is that transportation complexity brings clear cost reductions. lots of things are much cheaper becuase of containers. But since somebody (Rodrik?) asked what the concrete benefits of financial complexity were, the most people have been able to come up with are ATMs. Summers http://delong.typepad.com/sdj/2010/10/it-does-not-seem-to-me-that-charles-ferguson-has-gotten-it-right.html

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was missing the major point that it seems like our wonderfully complex financial system is also terrible at putting money where there is good return. While 2005 was a little early to identify a housing bubble, the worry about it should have lead him to a much more caveated point. Reply October 05, 2010 at 10:20 PM Tim said... "I would say as a final example of what has come out of the discussion for the 1987 crisis is that if those who wish to protect their assets had bought explicit puts rather than portfolio insurance, the situation would have been substantially more stable. That also argues for the benefits of more open and free financial markets, rather than for the concerns they bring." So Mr Summers believes that instead of people replicating delta hedges they bought put from people who the executed the delta hedges on their short puts it would make a difference -he's an idiot The only time this can make a difference is if someone (retail conned into it via structured products they don't understand) who does not delta hedge can be persuaded to take the other side of the vol trade. This is why the Street is selling so many reverse converts at the moment, retail does not get that they are short vol. Reply October 05, 2010 at 11:32 PM Joshua Skov said... Brad, I agree that it's important not to let people get away with vilifying others. On that point, yes, Ferguson may deserve to be corrected. But isn't that a rather small point compared to the shocking degree to which really smart and well-positioned people like Summers didn't see the financial crisis coming? Larry's tone isn't cruel and attacking, but it is dismissive and nonchalant, and his extended metaphor (neat, I'd say) is a musing about the long haul, not the moment of 2005. It was the nonchalant musings of certified Smart People that allowed our regulatory apparatus and policy establishment to see too little until it was too late. So...perhaps we shouldn't spend bandwidth defending them. Perhaps they deserve occasional gratuitous vilification (and Ferguson's is modest) more than they deserve our defense of their character. Perhaps, after all, Ferguson has the key points right. Best, Josh Reply October 06, 2010 at 12:00 AM Peter K. said... A fictional Larry Summers has a funny scene in "The Social Network." Great movie. Summers says "I would say as a final example of what has come out of the discussion for the 1987 crisis is that if those who wish to protect their assets had bought explicit puts rather than portfolio insurance, the situation would have been substantially more stable." Did not enough people buy explicit puts this last go-around? The situation didn't look very stable after the repo-run on Lehman brothers. Reply October 06, 2010 at 03:49 AM Cranky Observer said... > The best single way to think about the process of financial innovation is as http://delong.typepad.com/sdj/2010/10/it-does-not-seem-to-me-that-charles-ferguson-has-gotten-it-right.html

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> representing a similar process of movement across spaces, spanned not by > physical space, but by different states of nature. It seems to me that the > overwhelming preponderance of what has taken place has been positive. Essentially the same thing Donald Rumsfeld said in summing up his time as Dubya's Defense Secretary. That worked out well too. Cranky Reply October 06, 2010 at 03:49 AM Robert Waldmann said... There is something odd about this post. It seems to me that the odd names are not "Rajan" and "Summers." Ferguson links Rubin with Greenspan. In fact he assumes there is no need to distinguish them at all. He criticizes Greenspan-Rubin. You have expressed very strong views about Rubin (for example IIRC writing that if you were the only elector he would be Presidend). IIRC Larry Summers also expressed a view of Rubin very vividly saying that he wanted to force people to play tennis with wooden rackets. My guess is that people just assume that Rubin acted as they imagine a Goldman Sachs CEO would act. In noted contrast, I did not find the name "Gramm" neither Phil nor Wendy. Somehow laws seem to have been changed without Congress being involved. Also nominally independent regulatory bodies were controlled by the Fed or Treasury (no need to distinguish -- they are run by the same three headed monster). Is Ferguson really willing to claim that Rubin bears more responsibility than the Gramms put together ? He definitely makes that claim casually, in passing, and as if he is just mentioning a well known fact. Can he, or anyone, defend it ? Reply October 06, 2010 at 04:27 AM Robert Waldmann said... There's another name missing. "Clinton." How exactly did Summers and Rubin gain the authority to sign bills into law ? Why couldn't Clinton fire them ? Why don't the cossacks work for the Czar ? Reply October 06, 2010 at 04:37 AM save_the_rustbelt said... Is this during the period Summers was being handsomely paid by D.E. Shaw? Or before? If this is to defend Summers it is not exactly a rousing defense. Summers' speech reminds me of a faculty meeting, where the PhDs have to preen and show off just how brilliant they really are, like a peacock strutting contest. Reply October 06, 2010 at 05:47 AM Rich Puchalsky said... "But it did not go down like Charles Ferguson says it does." Are you aware that your claim is wrong? (Now that you know that "Luddite" actually was said.) Charles Ferguson's summary was accurate. Reply October 06, 2010 at 06:05 AM Macheath said... Sorry, Brad, Summers got this wrong. (Rathan has his own problems, especially nowadays, with his analysis that government can't do very much useful, but his analysis in the case under discussion beats Summers.)

http://delong.typepad.com/sdj/2010/10/it-does-not-seem-to-me-that-charles-ferguson-has-gotten-it-right.html

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Others have pointed out why, but let's remember Hyman Minsky. Finance is NOT transportation--it is the bloodstream of the entire economy, and the misalignment of incentives to financial firms as profit-seekers is in conflict with the need for "vanilla" (in Summers' derisve term) banking to keep the system stable. When the risk and profit seeking infect broad sectors of finance, you get a "Minsky moment" as we are suffering now. And was Summers working for hedge funds at the time he made this comment? Sorry Brad--I know you want to defend Summers all the time, but he's just wrong here, like many others were, with the costs that we now see. Reply October 06, 2010 at 06:26 AM Richard said... Don't want to pile on, but I don't see where Ferguson is wrong. Maybe Summer didn't "attack", but Ferguson got the key parts of the exchange right. Reply October 06, 2010 at 06:45 AM Full Employment Hawk said... After Summers' role in advising Obama to follow economic policies that will lead to serious defeats for the Democrats this November, Summers cannot be vilified enough. Perhaps Democratic leaders will finally recognize him as the toxic Pariah who should be shunned that he is. Reply October 06, 2010 at 06:56 AM Neal said... Naked, puts, insurance... What's the difference when the losses are big enough to endanger the system? That's the real problem. And what is the down side for the "loser" to beg bail-outs from the government? Cash in a few of the chips that the "loser" piled up during the good times--it's a cost of doing business. The real problem is too big to fail. Bailouts are axiomatic at that point. Reply October 06, 2010 at 07:20 AM Brad DeLong said in reply to Peter K.... The problem was that they had all bought specific puts from AIG... Yours, Brad DeLong Reply October 06, 2010 at 07:39 AM James Wimberley said... Brad: ¨And I am on the fence on (2) and (6).¨ Do you mean (3) and (6)? Reply October 06, 2010 at 08:05 AM George J. Georganas said... I will second the question in the last post. What about (3) ? The transportation analogy breaks down in another respect. Finance, unlike any other industry, is about the future. One would expect Summers to have noticed. Reply October 06, 2010 at 08:46 AM Grizzled said... Rajan makes two specific points:

http://delong.typepad.com/sdj/2010/10/it-does-not-seem-to-me-that-charles-ferguson-has-gotten-it-right.html

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1) Money managers are subject to perverse incentives that may lead them to destroy their institutions. 2) Their institutions are central enough and interconnected enough that if they go down they might take the rest of the economy with them. Summers' analogy conspicuously fails to address either of these point. Summers expresses concern with the productivity of the financial sector. I wonder how much increased financial sector productivity it will take for how long to make up for the production lost in this recession. Irrespective of how smart you are, when you're this arrogant and you get it this wrong with these consequences you're in line for some serious flack. Nor do I think that Ferguson either mis-states or over-states the case. Nor do I think that anyone with the financial ties to Wall Street Summers has should be anywhere near financial regulation. Anywhere outside academic journals Summers is bad medicine. Reply October 06, 2010 at 09:22 AM Banana_Republic said... 'S'OK. Round about 2020 or so DeLong will begin to catch on that his pal Larry wasn't exactly a pillar of integrity, let alone wisdom. But did DeLong **really** say that he'd like RUBIN to be president?!?!? Whoa.... Reply October 06, 2010 at 10:24 AM bakho said... A big part of the problem is abandoning all labor policy to the whims of international elite investors. This does not work and has never worked in the past. The economic boom in the 1990s was based on investment in the internet come to fruition. In the 1990s we invested in ???? Al Gore wanted to invest in a replacement for the internal combustion engine. Gore wanted to invest in climate change transition. In the Bush decade, we invested in a foreign military adventure to bring Iraqi oil to market. Beyond that, we invested in???? In an unmanaged economy, investment dollars will find the latest dot.com bubble or housing bubble. They don't necessarily find the the money to overcome high barrier costs to market entry. Instead they go to countries that pay for the barrier costs. The problem with finance is not that it ended up creating a bubble. The problem was lack of good domestic investments. There were too few good domestic investments because the Federal government stopped paving the way with infrastructure to make those investments possible. Who would invest in fuel efficient cars if cheap oil erodes the market? Who would invest in clean alternative energy if you are out competed by dirty coal? Who would invest in high speed rail if highways and air travel get all the subsidies? Who would build a plant in the US when other countries cover the cost of worker health care? Our labor and industrial policy is pathetic. It leaves an environment where the most attractive investments are bubbles and speculation. Reply October 06, 2010 at 10:49 AM kharris said... http://delong.typepad.com/sdj/2010/10/it-does-not-seem-to-me-that-charles-ferguson-has-gotten-it-right.html

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Productivity in finance is a fine thing, assuming two things. One is that finance serves the rest of the economy, so that profits generated by finance are a reward for that service. Profits should not be "the product", but the overwhelming change that seems to have accompanied the financial sector overtaking tech as the biggest producer of Fortune 500 guys is that finance capture more profits. Claims of increased productivity imply fewer inputs for the same or more outputs. If fewer inputs to finance result in more benefit to the rest of the economy, then bravo. What we have seen in brains full of math being draw by high wages in finance, and so becoming unavailable to the rest of the economy. What we have seen is finance becoming a larger part of the economy, sucking up more resources, which doesn't look that much like "productivity" at first glance. When the durables sector increases productivity, it does so with fewer workers, in response to price pressure. Finance doesn't look like that, at all. The other assumption necessary to cheer for financial productivity is that the riskreward mix not get ugly as the price of that productivity. Doesn't look to me like giving up the best math brains to foster the expansion of finance as a share of the economy while wages stagnate elsewhere, and risk was piled upon risk, justifies cheering for more "productive" finance. Doesn't look like the units Summers has in mind when measuring productivity are something I care about. Summers is a creature of the culture he is praising. He doesn't need to be a bad person to aggrandize finance. He just needs to be a human, with human weakness. He is clearly that. Reply October 06, 2010 at 11:39 AM C.H. Pooter said... Surely, no one could describe Summers's response as anything but disingenuous. The analogy is bollocks, and if Summers is among the smartest guys in the room he surely knew it. Could he give an example of a car crash, a plane crash, a train crash that threatened to bring down the whole transport system? Could he give an example of a transport method designed so that the driver/pilot would survive (and do very nicely) but the passengers be wiped out? The argument seems to be here that Ferguson is the polemicist and Summers an earnest and well-meaning victim. Doesn't read that way. Reply October 06, 2010 at 11:43 AM Samuel Clark said in reply to C.H. Pooter... Hi C. H Porter, I too do not understand his analogy to transportation. Perhaps a fatal incident could occur if the air traffic control towers stopped communicating with one another, sharing information about the movements of planes etc., but I guess this is why Air Navigation Service Providers are strongly regulated by the Civil Aviation Authority... Sam Reply October 06, 2010 at 01:15 PM Geoff said... I do, actually, recall a case where a small number of plane crashes brought down the transportation system. 9/11/2001. Reply October 06, 2010 at 01:54 PM Ragout said... On the contrary, Rajan was wrong about everything, and Summers was mostly right. Rajan was wrong for (1) http://delong.typepad.com/sdj/2010/10/it-does-not-seem-to-me-that-charles-ferguson-has-gotten-it-right.html

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repeatedly claiming that the chances of a financial crisis was "small," (2) dismissing traditional financial regulation as mostly useless, (3) praising the light-touch regulatory hand of Alan Greenspan, (4) proposing "market friendly" "industry self-regulation" such as requirements that fund managers hold a stake in their fund. Summers deftly skewered Rajan's industry self-regulation ideas by pointing out how poorly they have worked in the hedge fund industry. Summers main point is that technocrats like him can protect us from the risks of catastrophe, and allow us to reap the benefits of innovation. Truly it is bizarre that this exchange between the laissez-faire Rajan and the technocratic Summers is being spun as if Rajan was a progressive and Summers a libertarian. Reply October 06, 2010 at 02:09 PM C.H. Pooter said... Thanks, Geoff. I like your extension of the analogy. Though Summers used the word 'accident', your take suggests that AIG, Lehman, et al were deliberately trying to bring the system down. Reply October 06, 2010 at 02:50 PM Nathanael said... You'll correct yourself on (3) sooner or later (Summers was wrong about that one). As for Summers, the main problem with him is not his ideology but the fact he's *always wrong*. He seems to learn from his mistakes, but his policy advice is *always wrong*, and he corrects himself too late. Did it as President of Harvard, spent his entire academic career doing it. Fine for an *academic*, you can always be wrong and still be a great teacher and a good foil for others -- but terrible for a policy advisor. The Tobin tax is necessary, also. Reply October 06, 2010 at 09:42 PM Ragout said... Here, Summers rejects any proposal about new regulation, as he must, under the theory that financial managers will act rationally if they have skin in the game. In other words, same old same old analysis. You have this exactly wrong. It's Rajan who wants regulation replaced by requirements that managers have skin in the game, just like they do at hedge funds. Summers devotes much of his remarks to criticizing this nonsense. I'm guessing that like most of Summers' critics, you haven't read Rajan's paper? Reply October 07, 2010 at 04:28 AM Ragout said in reply to RhZ... RhZ said: "Here, Summers rejects any proposal about new regulation, as he must, under the theory that financial managers will act rationally if they have skin in the game. In other words, same old same old analysis." You have this exactly wrong. It's Rajan who wants regulation replaced by requirements that managers have skin in the game, just like they do at hedge funds. Summers devotes much of his remarks to criticizing this nonsense. I'm guessing that like most of Summers' critics, you haven't read Rajan's paper?

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