Super Economics Team-Up Special! Paul Krugman and Jason Lutes

Whether it’s the salt or freshwater economic models that fail to predict bubbles, we need some fresh thinking. I offer here a simple solution that is based on the optimistic premise that we can innovate our way out anything. I’m not talking about innovations in software or manufacturing, but in the financial services industry, itself. I propose that we create a new commodity that would make measurable a kind of hidden commerce that affects us all – the buying and selling of politicians, legislators and regulators.

Let’s take a hypothetical example. Say that Wall Street is interested in investing in companies that harvest the remains of old people and turn them into weapons grade biological material. Or maybe, they want to use the remains to create food and the street plans to make a killing in Soylent Green futures. Wonderful ideas to be sure, but there are some pesky legal issues that can only be resolved at the legislative level. Of course, this would mean increased funds for political campaigns, lobbyists, and so on. In response to rumors of these moves, the Legislator and Regulator Futures would soar and thus alert us to a potential bubble made possible by the legalized profiteering for which our democracy is now so famous.

This new commodity would make visible the potent economic force that has thus far made our markets inefficient, the invisible hand job.

I guess you are a big fan of BERLIN, eh, Mr. Josephs?

“Invisible hand job” is pretty good.

Krugman hasn’t been relevant in economics since the 80s.

e360, Did you bother reading the article, which explains how “markets are perfect” become orthodox until the 2008 crash shamed everyone back to sense? Or are you someone claiming that markets are perfect and Krugman is a nut who doesn’t understand the invisible hand?

If you did read the article, I’d love to hear comment. If not, can we assume you’re a crank?

Re: e360, your casual dismissal is exactly what the article is about:

‘Back in 1980, Lucas, of the University of Chicago, wrote that Keynesian economics was so ludicrous that “at research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.” Admitting that Keynes was largely right, after all, would be too humiliating a comedown.’

Unlike the mythological Second Foundation which constantly is adding new equations to the master plan behind the scenes, Economics is a constantly changing metamorphic beast. Capitalists on Wall Street (and elsewhere) will game the system, exploring ways to make money which aren’t regulated, or aren’t regulated sufficiently. Eventually, people and corporations (which the U.S. legal system treats as people) lose a lot of money, governments create new rules, and the system resets to a new equilibrium.

The current real estate bubble… banks loaning money to people who should have known better. Some had bad credit, some invested in mortgages which produced onerous payments.

One wonders if there is a MacKay School of Economic Theory.

Something Krugman couldn’t examine in detail, but it relates to the point of his article: the Gaussian copula function, which bond traders used as justification for trading tranches of collateralized debt obligations.

Here’s what killed your 401(k) David X. Li’s Gaussian copula function as first published in 2000. Investors exploited it as a quick—and fatally flawed—way to assess risk. A shorter version appears on this month’s cover of Wired.

Probability

Specifically, this is a joint default probability—the likelihood that any two members of the pool (A and B) will both default. It’s what investors are looking for, and the rest of the formula provides the answer.

Survival times

The amount of time between now and when A and B can be expected to default. Li took the idea from a concept in actuarial science that charts what happens to someone’s life expectancy when their spouse dies.

Equality

A dangerously precise concept, since it leaves no room for error. Clean equations help both quants and their managers forget that the real world contains a surprising amount of uncertainty, fuzziness, and precariousness.

Copula

This couples (hence the Latinate term copula) the individual probabilities associated with A and B to come up with a single number. Errors here massively increase the risk of the whole equation blowing up.

Distribution functions

The probabilities of how long A and B are likely to survive. Since these are not certainties, they can be dangerous: Small miscalculations may leave you facing much more risk than the formula indicates.

Gamma

The all-powerful correlation parameter, which reduces correlation to a single constant—something that should be highly improbable, if not impossible. This is the magic number that made Li’s copula function irresistible. [. . .]

As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them—an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn’t matter. All you needed was Li’s copula function.

Even if the bond traders didn’t really know what they were doing, they could point to the Gaussian copula function as their justification, and unless you had enough knowledge of the industry and math to point out their mistakes, you couldn’t argue with them.

It’s tempting to think that the pragmatic “saltwater” economists are Democrats and the “freshwater” economists are Republicans, but it’s not that simple. Radical liberals who want the government to create utopia don’t realize that money has to come from economic activity. The financial sector accounted for about 31 percent of the U.S. GDP in 2006. When you realize that a lot of that sector’s activity (and the companies’ associated profits) doesn’t produce anything tangible — they’re just manipulating numbers to their benefit — it creates the feeling that the country’s in trouble and there’s not really anything you can do about it.

SRS

What always seems to get ignored in these discussions is that the bubbles WERE predicted by the so-called “Austrian-School” economists. But because no one in the government-banking nexus or its court apologists cares for what the Austrians prescribe — getting government completely out of the business of regulating money and credit — they are considered too unfashionable to be taken seriously.

Of course, some of us DID listen to them. I heard their description of the housing bubble and its impending collapse back in 2003, sold my Southern California home in 2005 for a tidy profit, and am waiting things out in my low-cost Flyover Country home, until the other shoe drops. And buying Silver Eagles when I have a little extra money.

they are considered too unfashionable to be taken seriously.

Based ion the description I read, the Austrian school cannot be taken seriously. Like Libertarian principles, their ideas are wonderful as abstractions but useless in the real world. There are far too many bad actors who would take advantage of consumers for the U.S. economy to be unregulated. Practically speaking, associating Ron Paul with the school is sufficient to discredit it.

I doubt that any Libertarian-like style of governance will work anywhere except self-sufficient islands.

SRS

So, this fear of bad actors taking advantage of consumers leads you to support a central banking system where the smoothest of the bad actors can gather to rip us all off in grander style. Makes sense to me.