Wednesday, 24 February 2016

What I've been reading (vol. 3)

The third volume of "What I've been reading" is centered around bubbles, animal spirits, crises, and its predictors (real and self-proclaimed). I'll start chronologically:

Shiller, Robert (2005) Irrational Exuberance. Second edition. Princeton University Press

In the sequel of his highly acclaimed first edition that predicted the 2000/2001 crisis a few months before it happened, Shiller continues to debunk the rationality assumption in market behavior as he draws out a specific set of psychological, cultural and structural factors that can be held responsible for bubbles and wide-range volatility on financial markets. His price-earnings (PE) ratio (what eventually landed him a Nobel prize) as a method to predict when the market is due for correction is what got him the well-deserved critical acclaim. The PE ratio (pictured below, real time data available here) measures "how expensive the market is relative to an objective measure of the ability of corporations to earn profit". What Shiller did is that he compared 20-year annualized returns with the 10 year price-earnings (P/E) ratio using almost a 100 years of data and concluded that long term investors did well when prices were low relative to earnings. When P/E is high, risks are high, so one should lower his or her exposure in the market, but get into it when P/E is low. 
Rober Shiller's S&P 500 price-earnings ratio
Notice how the spike in the PE ratio in the year 2000 is exactly what led him to conclude that a market correction was inevitable. The dot-com bust that happened a few months after the book got published rose Shiller to prominence among the media and the general public. Interestingly enough, it seems that the correction that happened back in 2000 had its consequences postponed for a whole decade (possibly due to the Fed's response and its fueling of another bubble), when the PE ratio was still high despite the decline in 2001. But the problem then wasn't so much the PE ratio as was the housing market. 

The difference with the earlier edition is that this one includes a chapter on the housing market, where Shiller presents his home price index (the S&P/Case-Shiller Home Price Index, pictured below). It is in this chapter that he draws on his prediction on the inevitability of a correction on the housing market, just like he did 5 years earlier. Despite the media attention Shiller remained down to earth, which can be seen from his careful assessment in chapter 2: "It is difficult to judge whether the trend is building up or slowing down and when it might eventually stop completely and then reverse itself. Moreover if one extends a forecast to five or ten years out, one is likely to feel that one has virtually no idea where prices will be". It is obvious that Shiller is no Hedgehog when it comes to forecasting - he is a true Fox (see clarification below, in the third book review).  
S&P/Case-Shiller Home Price Index
The housing market index garnered a lot of (positive) attention, which is certainly what contributed to the success of the book as well. Even thought the book offers much more than that. It offers a complete pictures of what drives bubble behavior. The irrational exuberance, a quote borrowed from Alan Greenspan's 1996 speech, is what makes markets overvalued which leads to bubbles and finally bubble bursts and crises shocks. It includes precipitating factors like demographic trends or political decisions (there's 12 of them, surveyed in chapter 3) and all of its amplification mechanisms (such as fraud and a host of other factors that inflate speculative bubbles). Once the bubble starts it basically enters into a state of a reinforcing feedback loop where prices just keep going up. Until, of course, it bursts. The best part of the book is arguably part 4 which describes the underlying psychological factors that help fuel bubbles. Things like anchors, investor overconfidence, hubris and heard behavior, availability bias, there's a narrative fallacy in there as well (although he doesn't call it that), are all responsible for inflating the bubble and keeping it in expansion mode. I won't go too deep in explaining each of these, as I'll leave this for when I review Kahneman's Thinking Fast and Slow (I'm currently finishing it). 

The newest edition (third) of the book was published last year, and it includes a new section on the bond markets. I'm sure it's equally interesting as the stock market and housing market chapters. 

Akerlof, George and Shiller, Robert (2009) Animal Spirits. How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton University Press

In this hit book from the beginning of the financial crisis the authors attempt to attribute the crisis to human psychology, in particular the vibrant part of our psychology – our animal spirits (they borrow this exciting term from Keynes). Things like overconfidence, temptations, envy, illusions, biases, etc. tend to be the driving events behind all financial crises. Their effort to place an emphasis on the downsides of human psychology as opposed to the standard rationality assumption in economics is laudable and welcomed, so it's easy to see why the book garnered much critical acclaim back when it was published in the midst of the storm. 

However my main objection to their argument, even though I applaud the re-emphasis on Keynes’ long forgotten idea of animal spirits and the importance of psychology, is that these heuristics have been present, well, all the time. I understand and agree with the idea that the efficient market hypothesis is wrong, that economic agents are not rational (at least not all the time) and that they are prone to biases in judgement - this part isn't problematic at all. The problematic assumption laid out in this book is that animal spirits are responsible for turning the burst of the housing bubble into a recession. This is hardly the only reason. In fact, there are a number of factors that led to the accumulation of risk in the financial sector, psychology being just one of the underlying, indirect causes. Let's not forget the regulatory decisions that made the artificial demand particularly buoyant in the pre-crisis decade, or the CRA and GSE target-oriented policies. All of these were triggered to make the system better, more robust, and in fact more fair, but they've instead made it worse, increasing systemic risk. We can't say that the regulators were being led by heuristics when they've decided to increase the exposure of banks to, what was considered safe, assets. We can blame the house-flippers, the investment bank traders, the hedge fund managers, the rating agencies and the like for being greedy (again, this is something that's always present) and for acting irrationally, but the problem was systemic.
Which is why animal spirits in themselves are not enough of an explanation. Why haven’t they turned the 1987 stock market crash into a recession? Or the dot-com bubble? Or any bubble that subsequently hasn’t resulted in a painful recession? Or if they cause bubbles, they why aren’t they more frequent? The thing is that animal spirits don’t come and go, they are here to stay. We are constantly subject to the same biases, the same heuristics. Sometimes they drive us to good outcomes, sometimes they force us to make rash decisions with long-lasting consequences. Allowing the entire explanation on pure psychological errors which are present all the time is an understatement and oversimplification to say the least.

I understand the notion of a necessity of a Keynesian revival in lieu of the crisis, and I applaud the push of animal spirits back at the helm after they were marginalized during the neoclassical revolution of economic thought, but reintroducing them as one of the most important counterfactuals is one thing – overemphasizing them is something else – it is borderline platonification (vast oversimplification of the problem, most likely as an attempt to reach a broader audience).

And then there are the solutions – a Keynesian stimulus. Lately I vary from the austerity vs stimulus debate primarily since neither of the two can actually be proven to have worked, or more importantly neither can be disproven (falsified as Popper would say). Furthermore parts of the analysis seem to be subject to historicism, selection bias (not mentioning the 70s stagflation that was the key reason as to why there was a neo-classical revolution and abandoning Keynesianism in the first place), and a mistaken correlation for causality. In an effort to explain to a wider audience what happened and how the economy works the authors oversimplified, resorted to biases, unscientific reasoning (which is surprising given some of their earlier work I’ve read – e.g. Akerlof’s Lemon’s market is brilliant! As is Shiller’s P/E ratio theory, not to mention his Irrational Exuberance book, reviewed above), and have thus produced a book that, although promising in its attempt to bring back psychology at the fore, missed its target completely.

The paradoxical thing is, the best parts of the book are those that have little to do with economics. It’s not so much the analysis as the interpretation and faulty explanations of certain economic phenomena. And finally, the agenda of the book was to change the way we interpret and understand economic events. It has done no such thing. Perhaps it would seem that way to an average layman, but for an academic audience (I know, the academia wasn't their target in this case), it fails to live up to the hype.  

Overall, it was good to place a re-emphasis on psychology (Kahneman, Thaler, Taleb all do a better job of this however), but the conclusions are very biased. I’ve read much better books about the financial crisis, not to mention about 'how the economy works'. I had high expectations of the book (given the earlier work of both authors), perhaps that’s why I was a bit disappointed.

Roubini, Nouriel and Mihm, Stephen (2010) Crisis Economics. A Crash Course in the Future of Finance. The Penguin Press

"One man saw it coming. As far back as 2006, Professor Nouriel Roubini - aka 'Dr Doom' - warned that the US housing bubble was set to crash, and what would begin as a national disease would soon spread overseas resulting in a deep recession."

Well, as nice as all this sounds, and as true as his doomsday predictions turned out to be back then ("a once-in-a-lifetime housing bust, a brutal oil shock, sharply declining consumer confidence, and inevitably a deep recession"), I can't help at not being as impressed as much as I should (should I be impressed?). Particularly after having read Taleb and after learning to recognize (1) hindsight bias, (2) overconfidence in predictions, and (3) distinguishing luck from skills. I'm not saying Roubini is a bad forecaster, nor that he is not a good expert at what he does. He is certainly an expert in financial markets (I also enjoy and recommend his textbook on macroeconomic political cycles written with Alesina) and can make some very good predictions from time to time. It's just that I'm not as impressed with his 2006 predictions about the crisis after hearing him shockingly announce a whole set of other crises every year after the Great Recession. For example in 2011 he gave a doomsday prediction that stocks would fall by 20% that year. They didn't (on the same link check out the story from 2009 when he claimed that the US government would have to nationalize its banks as the market contraction would be too big). In 2012 he called another stock market crash by December. This one didn't materialize either. In 2014 he called the mother of all asset bubbles in 2016 (ok, we still have to wait and see whether this actually happens). Just google "Roubini crash 20xx", and see for yourself, there are many other examples of his doomsday, headline-grabbing and vastly pessimistic forecasts.

It seems that Dr Doom is a Hedgehog (see Tetlock's distinction between Foxes and Hedgehogs, two types of forecasters). A hedgehog forecaster sees one big thing, tip-of-the-nose perspective, and interprets all information he or she receives to fit the pattern of his one Big Idea. It seems that Roubini's one Big Idea is - crises. Capitalism is prone to crises. That pretty much sums it up. And another thing, hedgehogs never evaluate the precision of their forecasts. "Maybe it didn't happen now, but it's coming", is what a typical hedgehog would say. After it happens they will be the first to say "I've told you so!" And then comes the media attention that takes every next forecast as a sure thing. 

Now none of this has much to do with the book, I know. But I feel it is important to keep this in mind when evaluating the "crash course in the future of finance", as the book's subtitle reads. So, where to begin? I'll focus on the predictability part, and mainly disregard the oversimplifications, the dumbed-down writing style, as well as his "radical remedies".
After stating how Roubini correctly predicted the crisis, the book goes on to talk about other financial crises and the central idea seems to be that crises are both probable (true) and predictable (certainly not true). He (I'm deliberately emphasizing only Roubini as the book is in some passages written as an ego booster) emphasizes the fragility of financial systems. From this he draws a conclusion that crises are probable. The analysis, although simplified to fit the regular reader, is fine, however, it's the second big emphasis that's worrying for me. Roubini claims that crises are White Swans (as opposed to Taleb's Black Swan analogy) - predictable events. With this I can't agree. And not because I find Taleb's arguments more plausible and much more convincing, it's because I find an enormous hindsight bias in Roubini's analysis. He draws a lot of similarities of today's crisis to those in the past, and while there are similarities to be found, his cherrypicking of ex post predictable causes for each of these events is - naive at best. He does it as to show that he wasn't only correct in predicting this crisis, he would have been correct in predicting every single crisis from the tulip mania in 17th century Holland, to each and every banking crisis in 19th century USA, to the Great Depression, to the Great Recession. Hindsight bias at its best (worst?). 

He offers his own grand view of the global economy, a grand view that helps him formulate a framework for forecasting (a framework that he doesn't actually give to the reader - it is after all his comparative advantage over the rest of us). The grand view is that crises are "hardwierd into the capitalism genome", which must, by that logic, make them inherently predictable. Maybe not the date per se, but in general surely. The same logic can actually be applied to Marxists - they too say that capitalism is prone to crises and that its demise is certain. It's just a matter of time. And just like every Marxist rejoiced in 2008 claiming that this was the end they saw coming since 1876, Roubini too suffers from the same problem. "Economists have successfuly predicted 9 out of the last 5 recessions", Paul Samuelson once said. After having read Roubini's "grand theory", I can't help at feeling he too falls in the same category. On a positive note he does recognize the systemic imbalances that caused the current crisis (chapter 3, parts of chapter 4) as he correctly identifies a myriad of factors that each contributed to the spread of systemic risk. Whenever he focused on the specifics, it was informative, but whenever he drew generalities, it was unconvincing to say the least. 

To conclude, I've read a lot of financial crises books since 2008 (including Johnson, Rajan, Reinhart and Rogoff, Krugman, Rinholtz, Lewis - I actually prefer him to all the economists, Friedman, Kling, etc.). I'm sorry to say this one does not classify as one of the best.

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