Tuesday, October 28, 2008

What's happening?

Guest post by Professor Rabee Tourky, University of Queensland

These are interesting times for economists. I hardly know a serious economist whose attention in the past weeks has not been fixed on the changes in asset prices.

An emerging narrative is that for some years we have seen a bubble in US house prices, asset prices did not reflect the inevitability of this bubble bursting, this was made worse by the behaviour of brokers and bankers who through short-term thinking compounded the belief in the notion that there are never-ending arbitrage opportunities in the market, and that there was a failure in the market for credit default insurance and the prices of credit default swaps. All of this was exasperated by the behaviour of ratings agencies.

This emerging narrative with its various derivatives needs some tweaking before it becomes entirely convincing.

One variant of this narrative adds that all agents behaved rationally in this process, and another distinguishes itself by the thinking that bankers and agency analysts behaved rationally by duping, as it were, non-expert investors (Joe six pack house buyer). I think that it is reasonable to dismiss this second addendum to the narrative and to suppose that we are all adults.

A foundational conclusion in economics is that prices are the (exclusive) transmitters of information regarding relative scarcities. They are formed by equating demand and supply, which are influenced by peoples tastes and in the case of assets their beliefs about future events. There has been very little work about what we mean in an exact sense by prices transmitting information. This is particularly the case when models involve uncertainty. One can  fathom from thoughtful models of price formation under uncertainty that prices of assets reflect beliefs regarding future value.

Prices of derivatives therefore reflect beliefs about beliefs and this hierarchy of beliefs is consistent at equilibrium in an information theoretic sense as well as in a way that avoids the presence of arbitrage opportunities. Mind you I'm not aware of a theoretic work that addresses hierarchies of information involving prices.

Now it is rather difficult for me to imagine a convincing economic model whose conclusion is that assets prices do not reflect and aggregate beliefs regarding future prices and which at the same time does not involve arbitrage opportunities. Of course, there are no arbitrage opportunities in a competitive market. This brings us to the idea that there was an assets bubble in the US assets market.

So what is an assets bubble? Well that's not clear though there is a limited number of theoretical and experimental work on this topic. It appears that an assets bubble has the following characteristics:

1) A rapid increase in the price of an asset.
2) A catastrophic fall in the price of the asset.
3) Analysis showing that either:

The information available at the time of the price increase did not justify the increase in price.

There was some kind of fraud in terms of misrepresentation of the nature of the asset by people who could profit from the formation of the bubble.
There are of course assets bubbles involving fraud and misrepresentation, pyramid schemes come to mind. However, I have not seen models that convince me of the possibility of assets bubbles in which the available information is not reflected in prices. Prices can't tell you the future but they reflect a good guess at the time, and they can be wrong ex post simply because agents were not aware of future possibilities or that their best guess did not realize. Nevertheless, in such cases prices do reflect information available at the time that they are formed. The main thrust of arguments involving the possibility of endogenous bubbles not involving fraud is that the market does not work as expected. Well there is a desperate gap between such claims and the scientific models that we have at present.

So in regard to the assets price increases that we saw in the US, and which eventually collapsed, a main non-economic question to my mind is a legal one. Is there evidence of fraud? In the absence of serious fraud my own narrative regarding what is happing is somewhat different from the emerging narrative.

I do think that there was a market failure in the sense of market incompleteness. In a complete market one can ensure themselves against any economic risk. However, there are occasions in which certain markets are missing. I'll give two very extreme examples. Can one insure herself, using available assets, against the possibility of a world wide medical epidemic of unknown type? Can one insure themselves in regard to the collapse of government and its guarantee of private property?

Similarly, it seems that there was no available means to ensure against the collapse of the entire financial system. Credit default swaps provide a measure of insurance in regard to the default by a single (or multiple) agent(s) but cannot be used for the purpose of ensuring against endemic default.

In short, what we are seeing is the effects of the incompleteness of the kind of instruments available to the market and not the result of too many complicated assets. Derivatives are not weapons of mass destruction on the contrary the price changes are due in large to the incompleteness of the derivatives market.

In this narrative there is some sort of market failure but the nature of this failure probably means that governments and central banks should engage the market in ways that are different from the approach they would take should the emerging narrative prevail.

In the emerging narrative governments ought to reduce the kinds of financial instruments available in the market.

In the narrative I outline above the idea is for governments to intervene to help complete the market - one extreme idea is to provide its own derivatives that can help ensure against the kind of systemic collapses that we have seen. In the second narrative governments should disengage from the markets in all ways except for making explicit the kind of insurance it provides that guarantees the ongoing operation of the financial system. They should encourage financial innovation and even participate in that process.


davidp said...

Am not a finance person so I may be restating what is already out there. But, the sort of event (for which there is a missing market in the analysis above) is a presumably low probability event. I can recall that, in other contexts, there exists contracts for low probability events (called catastrophe insurance). This might be the sort of thing that is missing for this context (though if someone knows more about it, would appreciate the information).

Another potential problem is defining what (state of the world) is happening - it seems like this is a bit of a problem in what is happening now. It would be an issue for setting up such a market i.e. the state of the world has to be clear for the contracts to be paid out - single defaults are relatively easy to define.

It is an interesting argument (and have found your earlier posts on this interesting too!)

jc said...

In the narrative I outline above the idea is for governments to intervene to help complete the market - one extreme idea is to provide its own derivatives that can help ensure against the kind of systemic collapses that we have seen.

You can, you short banking indexes any time you want

hc said...

Rabee, The market does not seem incomplete if we allow for short-selling though in practise this seems an expensive form of insurance because bubbles can last a variable and possibly long time.

I think that irrational beliefs ('animal spirits') drive lots of real and financial investment decisions. Once a view takes hold it can easily result in a bubble where masses of people participate in a bubble.

The task of regulatory policy is to diffuse these herd instinct/correlated risk problems.

jc said...


It's interesting that previous pro-market economics such you have now ditched free markets in favor of more regulation when the illness has been so badly diagnosed by people like you who should know better. That's a crying shame.

1.Let's take out a demand supply curve.
2. the price is allowed to move lower.
3. let demand shift to the right
4. Supply is also increased.

That's what happened in the US banking market. The "price" fall was the cause of the Feds destructive interest policy.

In other words everywhere you look the shambles was an enormous government failure of mammoth proportions.

You've sold out Harry. Why?

rabee said...

JC and Harry,

When prices are rapidly increasing you can't afford to short the banks.

The idea is you have to have very deep pockets to short exponentially increasing prices.

The other problem is I don't know how to short real estate prices in suburbs you want to live in.

There is a theory that you can complete the market through continuous time trading. But I'm not sure that it applies when there are limits on the types of debt you can have and when you are dealing with house prices.

jc said...


Are you hedging or speculating?

If you're looking for a hedge then the price direction shouldn't matter to you as you're hedging, right?

The other problem is I don't know how to short real estate prices in suburbs you want to live in.

But you're asking the government to supply you with an instrument that would allow you to short you're own street? Seriously.

You may not be able to short your own street but in the old days, when shorting was allowed you could short the developers and pick on the developer that focused on the product line you don't like.

rabee said...

By the way Harry, the ability to short existing assets does not complete the market, it does not increase market span.

One can develop very simple dynamic models with market incompleteness that display catastrophic price increases and falls.

At this stage governments ought not
throw the baby out with the bath water but should take measured thoughtful approach to tackling the financial crisis. There are no ideologies in modern economics, just science and we are constrained by the models that we presently have.

As I noted in a previous comment "I hope that kabbalistic and alchemical economics doesn't emerge from this crisis and that sound prudent and scientific economics dominates the policy debate this time round." This terrifies nearly as much as the ongoing near collapse of the financial system.

jc said...

buy a put on the index. That's complete's you :-)

rabee said...


Who is writing the put? A bank? Who'll pay me? That's like taking insurance on the possibility that an insurance company goes broke, and buying the insurance from that company.

Basically, the insurance contracts that were taken out could not be payed, when the collapse happened. They were worthless.

Systemic market collapse cannot be insured against without the help of governments.

sir henry casingbroke said...

I think, Rabee, yours is a circular argument or should I say "narrative". There wasn't any fraud by misrepresentation by people who could profit from the formation of the bubble because the bubble wasn't "formed" but came into being by degrees as people got into the only game in town (cf. Damon Runyon).

It reminds me of another of Damon Runyons sayings: "always try to rub against money, for if you rub against money long enough, some of it may rub off on you."

The culprit in all this is of course Harry Clarke and his mates.

By seeding their sleepers into the decisionmaking rooms of the economy (where all the levers are) they created the US of today, a huge dark star that sucks in the world's liquidity.

A tsunami of easy money flooding into the US, Australia and in Britain created bubbles in assets because punters wanted to park the cheap borrowed money somewhere where the asset base would appreciate at a greater rate than the credit owed; property seemed like the obvious place. But it could have been tulips. or S American trading rights. The paper wealth thus created by such illusory arbitrage was then spent on more assets. Thus the bubble.

It was perfectly reasonable to do this because people "made" money for doing nothing - this includes you and me Rabee, through our super funds. Don't tell me you didn't rub your hands in glee when the super statement came in telling you about that 20 per cent that your fund "made".

It was called wealth creation by Johnny Howard and he took credit for it but which he generously shared with his cretinous treasurer.

The fact the Britain has very quickly become the idiot in the room in the OECD is no accident. Thatcher destroyed the infrastructure and Britain's productive capacity so it had no alternative but to make money by shuffling paper - now worthless.

Julian said...

Rabbee, Your concern about counterparty risk is valid.

A good joke going around about credit default swaps is:

"Buying CDSs is akin to buying insurance for the Titanic from someone on the Titanic."

The way this problem is successfully dealt with in many financial products is an exchange guarantees the trade. The CFTC and the clearing firm system is run well and is a good example of how they deal with what you describe.

Government appointed oversight or new government derivatives are unnecessary. Because everyone now knows about this counterparty risk and now demands some form guarantee. This will evolve naturally. The problem is now known and will be dealt with. If a government doesnt set up some sort of system, the private sector will. It would have been done earlier if so many risk managers were not so far behind the curve.

Hedging for systemic market collapse does not need government influence. It will evolve in new products in the private sector from firms risk management departments. It has to, as new products are always ahead of regulation anyway. A failure of assessing counterparty risk has happened. It wont happen again like this for decades, because every risk manager will have our current situations drilled into him from a young age.

Its the risk that we cant see that we should be worried about.

Sanatizing the world of risk management by creating government derivatives or government guarantees is not what I want. It will breed inefficiency, laziness a false feeling of security that is detrimental in the long term.
Plus that whole moral hazard business.

rabee said...


I don't fully understand what you are saying.

Prices may go up and may go down; I don't think anyone can predict how things turn.

But I am convinced that for social democracy to be effective the state must be wealthy. As far as we can tell capitalism and the market system works better than centralized economies.

As far as we can tell, no matter what governments try, people will conduct their economic affairs in an economic way; markets emerge even in the abyss of economic totalitarianism. They are here to stay.

The main progressive concern ought not be in regard to the economic system but in regard to the political system. Democratic institutions in the US have been eroded over the last eight years. There is practically no international institutional framework. Indeed, next week Americans will vote for the most important political office in the world. The rest of us will have no say in the decision. To my mind that ought to be the principal concern of the global progressive solidarity movement. Not how the economy functions, but how those who have exclusive rights to redistribute income are chosen.

PS. My super has always been in a non-market non-cash fund. I have no clue how they invest it. I've lived in a rented house most of my adult life. I have never sold a single asset so I have no clue about making money. I donate a portion of my income to typically progressive charities; and to extended family members.

jc said...

Who is writing the put? A bank?

You can purchase it on the exchange. If you're a big enough player in over the counter markets you can also insist on mutual margain.

Who'll pay me?

as long as you end up with the cash, who cares.

That's like taking insurance on the possibility that an insurance company goes broke, and buying the insurance from that company.

Oh come on.

Basically, the insurance contracts that were taken out could not be payed, when the collapse happened. They were worthless.

Well we should choose our counterparts wisely then.

Systemic market collapse cannot be insured against without the help of governments.

Seriously, Rabee how can any government insure against systemic collapse as it would collapse too. As frightening as it seems we have not had a complete systemic collapse which is what you are referring to. That would mean even government finances would go.

jc said...

anyways Rabee, we have a form of systemic collapse insurance and it the deposit insurance the government is proposing.

Mind you it is quite possibly the biggest moral hazard we have ever seen and we will regret the decision. Small banks, credit union and soon to be money market funds will be assessed as having better risk than BHP etc.

rabee said...


The difference between government and the rest of us is that in our political system government has the exclusive right to compel us to do things (pay taxes, drive on the left hand side of the road, compel BHP to share its rail tracks).

It is clear that there was a danger of financial collapse and that government policy saved the financial system.

The value that money has is based on government ability to compel us to do things we would otherwise not want to do and our confidence that government will keep the show running.

I was however very surprised that governments around the world had no processes in place for the kind of crises that we had. They seemed to have "winged it."

jc said...


Sorry, governments can't "compel" market forces to behave in the way they want.

Economic laws can't be broken.

They may have "saved" the system but the bill is going to come in other ways. Perhaps meager growth for a decade if they're lucky.

There's no free lunch.

rabee said...

Yes but governments can compel you to pay taxes.

sir henry casingbroke said...

I didn't mean to reflect on you personally Rabee, but that is how it regretfully came out.

I am embarrassed that it led you to explain your circumstances - an explanation which I did not seek.

I was just making a general point that we all sipped from the poisoned chalice.

But really what I was on about was that I took issue with your apparent confusion about the origin of the bubble. We seem to be talking at cross-purposes now.

In relation to pricing, which was the core of your extended discourse earlier, it is set not by what they are "worth" in some intrinsic way, like a price to earnings ratio but what credible punters are willing to pay.

The willingness to pay is spurred on by greed, by an imagined continuing bull run and a desire to get in on the gravy train.

But eventually the bidding up of a price of an asset into an area where it bears no resemblance to the real world is what creates the chasm of real economy on the one hand and the funny money economy on the other.

If a polity or a society builds its "wealth" on an illusion, no matter how many punters share that illusion, and reality intrudes, then the wealth disappears like a bubble pricked.

If it were all real, how is it possible for all that wealth to suddenly dissolve like a chimera, literally, in just days? Houses don't dissolve in days. Life's intellectual capital does not dissolve in days.

You also raise another issue claiming "for social democracy to be effective the state must be wealthy".

The converse is clearly untrue, as per Saudi Arabia, so I'd like to hear you make a genuine case for that.

And it doesn't support your narrative, in any case.

jc said...

Yes but governments can compel you to pay taxes.

Up to a point, Rabee. Beyond a certain point (combined with bad economic policies), they'll be paying me as I'm out of a job. :-)

they can try and do all they want. They can send us to prison. But they can't defy economic laws.

Andrew said...

The mistake most economists make is the assumption that the economy can achieve equilibrium. The system is too complex, the variables are changing all the time and information takes time to diffuse through the system. The resonances are exaggerated when monopolist players (typically, but not always government) change the goalposts, often with unexpected consequences.

rabee said...


There are various notions of equilibrium. In a meta sense an equilibrium is a definition of the state of the economy we as analysts expect the economy to be at. Even out of equilibrium models have an equilibrium notion.

But as we can see even with the financial crises of the century the real economy is doing pretty well. Doom and gloom merchants keen-ly looking forward to long lines at soup kitchens will have to recalibrate their message.

I expect that hocus pocus financial chartist analysis will also need to be recalibrated, and even well respected economists have been dragged in this direction (they should know better).


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