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Financial crisis presentation

November 9th, 2008

I’m attaching my presentation to the BrisScience lecture series on The Financial Crisis and what it means for you(2.7 Mb PDF). It incorporates part of a cartoon exposition that circulated early in the year, in the style of (but apparently not by) xkcd. I left a fair bit out, partly because I only give PG-rated talks and the cartoon was NSFW (coarse language), but you can read the whole thing at BoingBoing.

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  1. Sinclair Davidson
    November 9th, 2008 at 15:30 | #1

    Paul Krugman has a nice diagram setting out the macro trillema in one of his late 90s books. You might want to include that. in terms of the presentation its not clear that a lack of capital control lead to the crisis and its not clear what the consequences would be of returning to a BW type system – that might come up in questions. The cartoons suggest that a whole lot of micro decisions were the problem while you end up talking about capital controls – the link may come out in your presentation but its not clear in the slides.

    The risk premium may be permanently reduced – that remains to be seen (Fama and French have a paper on this early 2000s) but its not clear that this crisis is definitive or simply another of the many banking crises we have seen since WWII. There will be more and different regulation – that will stimulate another round of financial innovation.

    An implication you don’t bring out but should think about is that get rich quick schemes always end in tears. Financial innovation should work to enable the real economy to function better, but should never be the objective in and of themselves.

    you got a typo on page 41.

  2. gthorpe
    November 9th, 2008 at 16:04 | #2

    Page 37 – might want to change it to 2008, not 2007

  3. naomi
    November 9th, 2008 at 19:07 | #3

    love the stick figure presentation John, first time I feel I’ve understood just what happened with sub-prime

  4. charles
    November 9th, 2008 at 19:17 | #4

    How can we go back to Bretton Woods? The US doesn’t hold the gold reserves this time around, without that why would you base a regulated system on the US dollar. Might be time to dust off Keyne’s alternative proposal.

  5. Ikonoclast
    November 9th, 2008 at 20:16 | #5

    The sub-prime explanation was hilarious and sobering at same time. Funny, gentle de-mystification is the best gear on the planet.

    Isn’t back to Bretton-Woods back to Keynes anyway?

    What a pity there isn’t a way to post the talk that went with the slide show. I guess one had to be there eh? :)

  6. MattYoung
    November 9th, 2008 at 21:01 | #6

    Great cartoon, and it explains something many of us miss. The various tranches of debt are not independent variables, and should not have been priced separately. The risk of the super tranche is still highly correlated to the risk of the weaker tranches, and that is where things fell apart.

    But isn’t that the essence of accounting fraud, to hide variable dependencies from the regulators?

  7. rog
    November 9th, 2008 at 21:46 | #7

    No mention of Congress and the Fed?

  8. jquiggin
    November 10th, 2008 at 07:45 | #8

    Rog, you may not have heard of Alan Greenspan (as in ‘Greenspan put’), but if you look him up you’ll see that he was connected to the Fed for a while.

  9. rog
    November 10th, 2008 at 09:50 | #9

    My point remains, no mention of the Fed and Congress in particular and monetary politics in general. Whilst the Fed maintains that the Act was designed to keep politics out of finance Bernanke maintains that the Fed acts in an environment influenced by Congress regulation (like the GSEs and the CRA)

  10. Socrates
    November 10th, 2008 at 10:01 | #10

    The cartoon is great. I would add two things:
    - the role of rating agencies (we pay them to say the crap is AAA and people believe them!)
    - sub-primes were mixed with prime mortgages, which weren’t crap, or is that the mixing referred to?

  11. jquiggin
    November 10th, 2008 at 10:03 | #11

    As regards Congress, I was time constrained but of course Gramm-Leach-Bliley was the culmination of a series of deregulatory actions that contributed to the crisis. Similarly, I didn’t have time to mention the Bush Administration and its cheerleading for the bubble. There is, as I’ve mentioned before, plenty of blame to go around.

    Also, I didn’t have time to refute silly talking points about the CRA, but that’s been done to death by economists more eminent than me. Even to mention it is clear evidence that you are woefully misinformed.

  12. Uncle Milton
    November 10th, 2008 at 10:57 | #12

    Krugman reckons the one thing we don’t need to do is go back to Bretton Woods. He was asked this the day he won the Nobel Prize. He reckons the one part of the financial system that has worked well in this crisis is the system of floating exchange rates.

    I reckon he’s right. And the marking of the $A, which initially seemed wrong, now looks correct, with China caught in the crisis.

  13. Joseph Clark
    November 10th, 2008 at 11:01 | #13

    (Sorry to double post this, posted first in wrong window)

    Had a quick look at the slides for “The Financial Crisis and what it means for you� presentation. Very interesting stuff.

    I think the last line in the slides is wrong.

    “Risky investments (shares) for the young, safe
    investments (bonds) for those nearing retirement�

    A rational person maximising the log of wealth at retirement will hold the same portfolio proportions at all ages. Your are advising either advising people to be irrational or suggesting that an irrational choice should be made on their behalf.

    Paul Samuelson deals with this in “Lifetime Portfolio Selection by Dynamic Stochastic Programming� (RES, 1969). A more readable version is at the link below (17-19 for the main argument).

    http://www.bus.ucf.edu/cschnitzlein/course%20pages/The%20Long-term%20case%20for%20equities.pdf?bcsi_scan_26D0E565465B1A98=0&bcsi_scan_filename=The%20Long-term%20case%20for%20equities.pdf

  14. jquiggin
    November 10th, 2008 at 11:17 | #14

    To be clear, I’m not advocating a return to Bretton Woods in the literal sense of a revival of the policies that prevailed from 1945-71. I am suggesting we need a regulated global financial system, with greatly more powerful international/intergovernmental bodies and much more constraint on the actions of banks and other private parties.

  15. jquiggin
    November 10th, 2008 at 11:27 | #15

    Thanks for that very interesting ref, Joseph. You’re right on the result for the simple model, but as Samuelson points out, the standard wisdom is restored once you take account of the fact that non-diversifiable human capital is correlated with equity. Via Mankiw, this insight is one of my preferred reasons for the equity premium.

  16. Jim Birch
    November 10th, 2008 at 11:50 | #16

    The idea that we need to dig up very large quantities of a moderately rare metal at great cost and then dump it in fortified warehouses for ever in order to have to have an economic system that functions optimally sounds clearly crazy to me.

    I’d need a helluva lot of convincing.

  17. Joseph Clark
    November 10th, 2008 at 12:00 | #17

    True enough, but that argument requires that people not be able to borrow on or capitalise their human capital, and even then the investment mix is constant as a proportion of total capital.

    It’s very interesting to link this back to the equity premium puzzle. I’m not convinced that there is a real puzzle for precisely the reasons Samuelson lays out. The empirics seem too much like pricing the odds after the race is run.

  18. rog
    November 10th, 2008 at 14:22 | #18

    The CRA was one talking point that the St Louis Fed did not feel too silly to raise. That a central bank has a defined function in “community affairs” was something I was unaware of.

  19. Uncle Milton
    November 10th, 2008 at 14:37 | #19

    From Rog’s St Louis Fed link on the CRA

    “the Community Reinvestment Act (CRA), which required federal financial regulatory agencies to encourage regulated financial institutions to help meet the credit needs of their local communities, including low- to moderate-income neighborhoods.”

    Note the key word, “regulated”. The investment banks who invented CDOs were not regulated. They had no obligations under the CRA. Neither did the mortgage brokers.

    “The law specified that such community lending activity be consistent with safe and sound operation of the institutions.”

    Note the key words, “safe and sound operations”. Lending money to people with no means of paying it back, other than the hope of ever rising house prices, is not safe and sound banking.

  20. jquiggin
    November 10th, 2008 at 18:11 | #20

    Oh dear, Rog. Surely even you can tell the difference between a neutral description of the CRA and the inane Republican talking point in which the CRA is blamed for the crisis (Uncle M saves me the trouble of garbage collection on this). But I guess, having supported Bush from start to finish, you’ve had plenty of practice at this kind of thing.

  21. Donald Oats
    November 10th, 2008 at 18:26 | #21

    And while we are on keywords, in the quote Uncle Milton #19 has given, the second line uses the word ‘encouraged’. Not ‘compel’ or some other synonym with the involuntary element of compliance of the regulated financial institutions. Whew!

    Put simply, the regulated financial institutions could decide whether to do anything at all about community housing, and if so, by how much. If a regulated financial institution found itself in trouble this year because of the CRA, which was created all that time ago, then the RFI deserves condemnation for lousy CEO selection, board selection, and so on. Shame on ‘em for using the CRA as a whipping boy!

    This Friedmanite ostrichist idiocy of insisting that corporations must not indulge in social responsibility has so pervaded everyday thinking that we don’t think beyond to the consequences.

    To quote Milton Friedman, 1973:

    “When an executive decides to take action for reasons of social responsibility, he is taking mondey from someone else – from the stockholders in lower earnings or from the consumer in the form of higher prices.”

    Annnnd that kind of loopy thinking leads directly to global pollution, unregulated pretend medicines (aka alternative and complementary medicine) comissioned low-doc mortgage sellers, CDOs, melanine poisoning and tax-payer funded financial crisis bailouts. Koool.

    PS: Loved the cartoons in the presentation Pr Q, very clearly put and funny too.

  22. Ernestine Gross
    November 10th, 2008 at 20:01 | #22

    “This Friedmanite ostrichist idiocy of insisting that corporations must not indulge in social responsibility has so pervaded everyday thinking that we don’t think beyond to the consequences.”

    The notion of ‘social responsibility’ is rather broad. Setting this difficulty aside, his stance on corporations is about the only aspect in Friedman’s writings with which I concur. The nature of competition is such that asking CEOs to take on social responsibility is likely to increase the risk of heart attacks among the gentler senior managers and nothing else. It seems to me legal and regulatory measures together with taxation are a better way to make corporations act ‘socially responsible’. Furthermore, the idea of ‘socially responsible corporations’ provides the managers of these legal constructs with yet another lobbying possibility.

  23. rog
    November 10th, 2008 at 20:02 | #23

    According to my moon chart you are 3 days premature, dear John.

    If the global financial system is to be (ultimately) presided over by one man, the chairman of the Fed, then we have a problem Huston.

  24. Socrates
    November 11th, 2008 at 11:19 | #24

    Friedmans position on the (lack of) social duty of corporations has been thoroughly debunked years ago. See John Boatright’s excellent “Whats so special about Fiduciary duties”. Essentially Boatright shows that Friedman’s justification is internally inconsistent and hence false: social (moral) obligations are overruled by CEO’s fiduciary duties, but the latter are moral duties as well.

    Friedman’s paper is deeply flawed in logical terms, so why is it still quoted? Because it tells peopel what they want to hear: that they are morally justified in doing what they want for personal gain. Its rubbish, but convenient rubbish, and hence will always be popular.

  25. Ernestine Gross
    November 11th, 2008 at 13:57 | #25

    “Essentially Boatright shows that Friedman’s justification is internally inconsistent and hence false: social (moral) obligations are overruled by CEO’s fiduciary duties, but the latter are moral duties as well.”

    Where is the internal inconsistency?

    Fiduciary duties are legal obligations. According to the above quote, this duty corresponds to a moral obligation. Accepted. However, it does not follow that therefore all other social (moral) obligations have the same legal standing for CEOs. Other social obligations which, according to the above quote, should have the same moral force, should hence be treated equally in law. If they are not, then the postulated inconsisency cannot be solved by CEOs.

  26. Michael of Summer Hill
    November 12th, 2008 at 11:38 | #26

    John, tops.

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