What I’m Reading

Two books that attack conventional economic modeling, especially in light of the financial crisis. I have a preview copy of Economics for Independent Thinkers, by Daniel Nevins. I have a review copy of The End of Theory, by Richard Bookstaber. I am likely to recommend the former. The latter is certain to make it onto my list of “best books of the year.”

It is interesting that both authors have backgrounds in applied option pricing. So do I. Is it a coincidence that we all ended up taking heterodox positions? If you toss in Fischer Black and Nassim Taleb, you start to wonder if there isn’t something in the option pricing water.

A reader points to Diane Coyle’s negative review of Bookstaber. She writes,

his complaints about economics are both wearily familiar territory and decreasingly true; economics is and has been changing a lot. In finance specifically, think of Andrew Lo’s new book, Adaptive Markets.

I disagree with her on all counts. One indication that Coyle has missed the point is that she thinks that Bookstaber’s critique applies only to macro/finance. I can readily apply it to the way economists model the demand for health insurance, the demand for home ownership, and principal-agent contracts, among other microeconomic phenomena.

I am drafting a review essay, which reads in part,

If I could reduce it to a bumper sticker, it would read, “Stare more at the world and less at your model.”

…All of the major fields in economics are inclined to follow strict technical procedures at the expense of realism. In the 1500s, if mapmakers had been similarly inward-looking and rigid, they would have continued to draw maps of the globe that ignored the lands discovered by Columbus and subsequent explorers, insisting that “The state of cartography is good.”

Turning to a relatively minor passage that resonated with me, here is Bookstaber’s description of the role of collateral in repurchase agreements and derivative bets on p. 159:

Let’s say your bookie demands that you put up $20,000 of collateral for a marker on a $15,000 bet. You give him your gold Rolex watch, worth $20,000. He comes back to you a week later and tells you that you need to put up another $3,000. Why? “People, they aren’t so much interested in these Rolexes anymore. It’s marked down to $17,000.” …You say, “Wait, I see prices for watches just like it, anywhere from $20,000 to $24,000.” He says, “Hey, do you owe them money or do you owe me money? You’ve got the marker, and I’ve got the watch, and I say that today it’s worth $15,000.”

By appraising collateral, notably mortgage securities, at low values, investment banks like Goldman Sachs caused runs on other firms. Gary Gorton termed it the “run on repo.”

[note: the following paragraph is my own. Although I cannot confirm that Bookstaber would endorse it, to me it seems likely that he would.]

But it was not just repo. The run on AIG was to demand collateral for credit default swaps. Think of a credit default swap as flood insurance and think of collateral as used because you don’t entirely trust that the insurance company will have the wherewithal to pay off. You have a house near a river, and when you get flood insurance you have the insurance company give you some Treasury bills as collateral, until the insurance policy expires. Then, a big rain comes, and the river starts to rise. Your house is still dry, but you are more worried, so you ask for more Treasury bills as collateral. That is what Goldman Sachs and the other investment banks did to AIG during the crisis. As it turned out, most of the houses never got flooded (that is, most of the bonds that AIG insured did not default), but the demands to put up more safe securities as collateral became impossible to meet, especially because similar demands were being made all over Wall Street for firms engaged in derivatives and repurchase agreements.

The quoted passage does not in any way capture the book’s larger, more ambitious theme. I was struck by it because it fit my understanding of what happened, which policy makers at the time seemed to me to miss. Had they been cognizant of the real problem, they would have applied a remedy closer to the one that I was proposing at the time. I called this the “stern sheriff” model, and it would have meant telling Goldman and other firms to stop making their outlandish collateral calls.