God is a Capitalist

Wednesday, August 27, 2014

Entrepreneurs in the Big Short

Michael Lewis is the bestselling author of many books, but the first one I have read is The Big Short: Inside the Doomsday Machine, which is about the financial crisis of 2008. Lewis’ economics is terrible, but I still recommend the book.

First the terrible part: Lewis doesn't understand good economics, by which I mean Austrian. From the book I would guess he doesn't know much mainstream economics either. If readers really want to understand the mechanics of how the crises unfolded I would recommend Slapped by the Invisible Hand by Gary Gorton. In a nutshell, it was an old fashioned bank run in which depositors got scared that their deposits were in danger and pulled their money out of the bank. Only in this case the depositors were money market mutual funds, pension funds and insurance companies and the banks were the large investment banks like Lehman and Bear Stearns. But what even the Slapped authorGorton doesn't tell readers is that the run began because of the collapse in the price of housing. It wasn't lightening out of a blue sky.

Lewis rounds of the usual suspects in crisis – evil bankers – and lynches them. That has been happening for about 300 years after every crisis so bankers should be used to it. In Lewis’ case the criminals are the sleazy bond traders. For example, after pages of character assassination, Lewis wrote, “At some point in between 1986 and 2006 a memo had gone out on Wall Street, saying that if you wanted to keep on getting rich shuffling bits of paper around to no obvious social purpose, you had better camouflage your true nature.”

Lewis may be right. Bond traders may be the most immoral people on the planet outside of politicians. And the public loves to spread the hate of bankers to people in finance. But Lewis should at least know that the moral character of market participants has little to do with how well the market works. For as Adam Smith wrote, competition will force the most wicked person serve the public good out of his own self-interest.

Also, those morally degenerate bond people could not have packaged so many subprime loans into bonds if they weren't available. They had become available in such huge volumes for several reasons: 1) Congress put a gun to the heads of bankers and ordered them to make the loans; 2) the Fed "printed" the cheap money to make the loans as well as drive up the price of real estate; 3) The Basel accords regulating banks made mortgage loans risk free; 4) the SEC gave a monopoly on rating bonds to a cartel of just three companies. 

Essentially, the Fed, Congress, SEC and Basel regulators threw a pool party with lots of booze and hookers. Lewis, like most mainstream writers in finance, sees evil only in those who attended the party and enjoyed the Fed's lavish spending. 

As for bond trading having “no obvious social purpose” Lewis needs to read Lachmann on the very valuable role of finance to a market economy. Here , here, and here are previous posts on Lachmann's take on the stock market but it applies to bonds as well.

Lewis seems to think that the profusion of derivatives was nothing but high finance meth labs manufacturing evil derivatives instead of drugs. But as I show in Financial Bull Riding, the driving force for the explosion of derivatives, and the Fed’s endorsement of it, came from mainstream economic theory:

The story begins with still more Nobel Prize winning economists. Kenneth Arrow (1972) and Gerard Debreu (1983) received prizes for their research in the 1950’s on “complete” markets, that is, markets which offered so many forward contracts, or derivatives, that anyone could buy one that protected him from an uncertain future. The investor can be forgiven for sighing, “So what?” But the Arrow-Debreu theorem was as sexy to the mathematical economists as Playboy Magazine is to men, well most men. It provided mathematical proof that markets could achieve equilibrium (or perfection) under very specific, though unrealistic assumptions. One of those assumptions involved having huge numbers of derivatives available. The theorem caused euphoria in economics and finance. Eventually, economists concluded that if the market offered enough derivatives they could eliminate risk entirely.
Financial economists continued to chase the alluring “perfect market” by refining their math skills. The Fisher-Black-Scholes option pricing model gave them the net to capture her, so they thought. As Stephen Ross wrote in 1976, “Although there are only a finite number of marketed capital assets, shares of stocks, bonds, or as we call them the ‘primitives,’ there is a virtual infinity of options or ‘derivative’ assets that the primitive may create.”44 Economist Robert Shiller went even farther: “We need to democratize finance and bring the advantages enjoyed by the clients of Wall Street to the customers of Wal-Mart. We need to extend the domain of finance beyond that of physical capital to human capital, and to cover the risks that really matter in our lives.”
Shiller proposed that financial experts create so many new derivatives that ordinary people could hedge (or buy insurance) against loss of income, collapses in housing prices, falling GDP or anything else that people might fear. And so they did. Today farmers and utilities can hedge against bad weather and voters can hedge against the wrong candidate winning. We can even think of campaign contributions as a type of derivative that large corporations use to rescue them if the market shuns their products.
The great Austrian economist Ludwig Lachmann may have had the Arrow-Debreu theorem in mind when he warned, “…such reliance on forward markets exaggerates the importance of well-coordinated expectations. Even in a world of perfect forward markets the future remains uncertain, and even the best coordinated expectations do not guard against disappointments.” But mainstream economists stuck their fingers in their ears. The possibility of Miss Perfect Market held too much sex appeal and they thought she was within their grasp.
Derivatives caused few problems since the Dutch invented them in the 17th century. It took the arrogance of mainstream economists to turn them into a nuclear winter on Wall Street.

OK, enough bashing of Lewis’ lack of understanding of economics. I highly recommend the book because it does something mainstream economics cannot: it glorifies the entrepreneur. Mainstream econ has no place for entrepreneurs. Everything happens randomly. That’s why mainstream financial academics can say with a straight face that winners like Warren Buffet are just lucky. Lewis is a good writer and he does a masterful job of explaining the difficulty, hard work and intelligence required to be an entrepreneur who drives the markets.  One version of the Efficient Market Hypothesis is correct: entrepreneurs will force the market back to rationality through arbitrage. Lewis shows financial entrepreneurs at their best, and loneliest, before making the big bucks. Mises' portrayal of entrepreneurs describes well the entrepreneurs in Lewis book:
The entrepreneurial idea that carries on and brings profit is precisely that idea which did not occur to the majority. It is not correct foresight as such that yields profits, but foresight better than that of the rest. The prize goes only to those dissenters who do not let themselves be misled by the errors accepted by the multitude. What makes profits emerge is the provision for future needs for which others have neglected to make adequate provision. (Human Action, page 867)

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