The Map & The Territory

By Alan Greenspan

The Financial Crisis & Forecasting

Greenspan states that “macromodeling unequivocally failed when it was needed most, much to the chagrin of the economics profession”. The Federal Reserve Board’s highly sophisticated forecasting system “did not foresee a recession until the crisis hit…nor did the model developed by the prestigious International Monetary Fund”. Even private institutions failed to see what would happen with JP Morgan projecting 3 days before the crisis hit that “the U.S. GDP growth rate would be accelerating into the first half of 2009”.

Greenspan asks “What went wrong? Why was virtually every economist and policy maker of note so off about so large an issue?”.

My inquiry begins with an examination of “animal spirits”. The term Keynes famously coined to refer to “a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities”.

Greenspan had come to the conclusion that “spirits” do in fact display “constituencies” that can enhance our ability to identify emerging asset price bubbles.

Time Preference

Time Preference is the self-evident propensity to value more highly a claim to an asset today than a claim to the same asset at some fixed time in the future.

“The stability of time preference over the generations can be demonstrated; indeed, in fifth-century BC Greece, interest rates exhibited levels similar to what we see in today’s market”.

Herd Behaviour

Greenspan writes that “There is a universally observed human trait to follow or emulate a leader of some sort. It is driven by most people’s need to achieve the security of belonging to a group. It is arguably one of our most important propensities, second only to fear, and a signifiant driver of economic activity”.

As I noted in the Age of Turbulence happiness depends far more on how people’s incomes compare with those of their perceived peers, or even those of their role models, than how they are doing in any absolute material sense. When graduate students at Harvard were asked a while back whether they would be happier with $50,00 a year if their peers earned half that, or $100,000 if their peers doubled that, the majority chose the lower salary.

Rationality

Most human responses to daily economic events fall into the category of intuitive or “fast” thinking.

Albert Einstein, when queried about the source of his insights, described the process “A new idea comes suddenly and in a rather intuitive way. But intuition is nothing but the outcome of earlier intellectual experience”. Not surprisingly, important intuitions occur only to those whose mental databank are sufficiently endowed.

Risk Management Fails

Greenspan asks “Why did the large array of fail-safe buggers that were supposed to counter such developing crises fail?”.

Global banks were authorised, within limits, to apply their own company-specific risk-based models to judge their capital requirements. Most of these models estimated their parameters based on the last quarter century of observations. But even a sophisticated number-crunching model that covered the last five decades would not have anticipated the crisis that loomed.

In particular, we failed to fully comprehend the size of the expansion of so-called tail risk. Tail risk is financial jargon that risk managers employ to identify the class of investment outcomes that occur with very low probabilities — but are accompanied by very large losses when they materialised.

The Partnership Model

Greenspan speculates whether U.S. Investment banks would have taken on such high leverage had these firms remained the partnerships that they were nearly four decades earlier.

Lehman Brothers and Bear Sterns almost surely would not have departed from their historically low leverage. Before incorporation, fearful of the join and several liabilities to which general partnerships are subject, those entities shied away from virtually any risk.

Partnership Model’s avoid Moral Hazard which is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.

Creative Destruction

With his theory of creative destruction, Schumpeter described a certain deus ex machina for free market economies. “The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process,” he wrote in Chapter VII of “Capitalism, Socialism and Democracy.”

The dark side of capitalism is that wealth is created only when obsolescent technologies and companies are allowed to fade out and are replaced. There are no ways to fully eliminate the pain experienced by those who are the market casualties of creative destruction.