Back of the Envelope

On the State of Macro

2009-09-17T22:28:00.015+05:30

Amidst all the battering that macroeconomics has been taking in the blogosphere, here is a more detached - and in my view, realistic - looking-back (by Prof. Kocherlakota at UMN).

HT: Greg Mankiw's blog

Update: The number of articles can almost make a mini-anthology now. May be useful later now (including ones on efficient markets / state of financial economics) :

1. Darren Acemoglu's (MIT) - one of the first one

2. Krugman's tirade: Mistaking Beauty for Truth

3. Cochrane's response

4. Krugman on 'fresh' rage

5. Mark Thoma's compilation

6. David Laidler at Western Ontario

7. From the Economist: On Macro; On financial economics; Robert Lucas's piece; Lucas roundtable

8. From the Economist 2: What went wrong with economics

9. @ VOXeu: 1

10. Mark Thoma comments on William Buiter

11. Justin Wolfers comments on Kocherlakota

12. Mark Thoma comments on Justin Fox

13. Mark Thoma on whether econometrics is any use

14. Krugman on economics' equilibrium decadence

15. Thoma comments on Economist pieces

16. Dani Rodrik (Harvard) joins in

17. Thoma comments on mathematical formalism in economics (Kaletsky)

18. Kahneman's ideas

19. Robert Levine responds to Krugman

20. David Altig at Atlanta Fed

21. The last temptation of risk - Barry Eichengreen

22. Arnold Kling agrees with Krugman

23. Econospeak disagrees with Cochrane

24. How could Brad de Long not be a part of this

25. Economics and its Discontents - economicprincipals.com

26. Robert Gordon of Northwestern

Being Realistic - I

2008-11-05T01:47:00.000+05:30

In Defense of Greenspan - The Behavioural Explanation

Disagreement among people all of who want 'to belong' is uncommon - which may be one of the reasons why warnings were ignored. Robert Shller reminds.

HT: Greg Mankiw's blog

Bailouts

2008-10-19T23:31:00.000+05:30

1. 20th Oct: French government to inject E10.5 bn in the country's six largest banks: BBC reports

2. 19th Oct: Dutch government considering injecting E9 bn in ING: Reuter reports

On the Crisis: Role of Credit Rating Agencies and "the Confidence Game"

2008-10-19T22:53:00.000+05:30

1. When A was not A - "Man's Confidence in Man" and Moody's rating of structured debt (Sam Jones)

2. The confidence game - "It's complacency that precedes bear markets" (James Grant)

3. Dominic Connor, while not directly dealing with the topic (he is only dealing with the mundane issue of how to destroy a bank, you know), reminds us that why, given the current situation, the rating analysts will almost always fail to figure out the risk associated with exotic instruments with any degree or accuracy:

" The next villains in this mess are the ratings agencies. Their job is guessing the odds of a debtor not paying back debts, whether that is bonds, or payments to suppliers. This is an eclectic mix of accountancy and PhD-level mathematics, though of course it is mostly done by MSc-level people at ratings agencies, trying to vet the maths of PhDs. Guess how well that ends? The MScs are not only cheaper than PhD Quants, they ask fewer awkward questions...It is thus convenient that the smart quants at the banks can outclass the MSc and often BSc-level agency employees. Ironically the agencies have the harder job, since they are trying to work out the value of an instrument whose real value is often intentionally obscured."

True. I can vouch for it. Dismal as it may sound, I don't think we have seen the last of such crisis yet. The roots go deep. Way deep.

On the Crisis: The Conflict between the Boon of Derivatives and the Curse of Information Asymmetry

2008-10-17T19:58:00.000+05:30

Kenneth Arrow reminds:

While advances in economic theory in presence of uncertainty tells us that "spreading risks among many bearers improves the functioning of the economy" [so arguing for the expansion of markets], it also warns that "there are large differences of information among market participants and that these differences are not well handled by market forces" [but recognizing that markets may not come to exist, or if they do, they may fail to work].

So, if "...individuals in the market have different degrees of information, the ability to create securities or engage in other forms of contracts becomes limited; the less informed understand that the more informed will take advantage and react accordingly."

He concludes that:

"...the root is this conflict between the genuine social value of increased variety and spread of risk-bearing securities and the limits imposed by the growing difficulty of understanding the underlying risks imposed by growing complexity."

[HT: Al Roth's Market Design blog]

On the Bailout (I)

2008-10-17T19:31:00.000+05:30

1. 14th Oct: The drama behind the $250 bn deal

[HT: Al Roth's Market Design blog)

Some FAQs on the Recent Financial Crisis

2008-10-16T16:14:00.000+05:30

From guest posts by Anil Kashyap and Douglas Diamond of the University of Chicago on the Freakonomics blog:

* As things look like on 15th Oct: Everything you need to know about the financial crisis

* and as they did on 18th Sept.: On the recent financial upheavals

Update: Also see http://igmchicago.org (Initiatives on Global Markets at GSB Chicago)

* Stiglitz at Oxford (on iTunes): HT BBC

Macroeconomic Derivatives: I

2008-03-21T01:44:00.001+05:30

I am supposed to give a talk for an internal study group at my workplace. I think I'll talk about Robert Shiller's work on macroeconomic derivatives.

But even though I would love to talk about his work, I am not sure the audience would be too forthcoming. It's going to be a post-lunch talk so not that I have much hope...but unless I have some data / numbers / equations, I am going to loose 'em all (yes, pretty much we are all a little on the nerdy side).

Even before I came across Shiller's book, I had worked on pricing of GDP Indexed Bonds (assisted a friend rather). That should hopefully provide a decent middle ground.

Despite several failed forays, it's an exciting area and something to watch out for in the future. Here is an intro that appeared in one of the issues of NBER digest:

W11929 in the above link refers to one of the most cited survey papers in the area. More later.

Expectations vs. Arbitrage Pricing (Baxter & Rennie): II

2008-03-19T21:49:00.000+05:30

Well, as I thought it might be, it was the semantics that was causing the confusion. Still, I think a word is in order on BR's use of the terminology.

BR warn against the use of 'expectations pricing' - a term that they use for pricing using the average of future possible payoffs (justification being the Strong Law of Large Numbers).

I was wrongly interpreting expectations pricing as an alternative term for risk neutral pricing. I may be mistaken but I don't think I have come across this term very frequently, either in texts or in papers - except, of course, in BR. A quick check in Google for the string 'expectation pricing' and 'derivatives' throws up 73 results. Also, if anything, Mark Joshi uses the term expectation pricing interchangably with risk neutral pricing. I didn't check all the links, but most of the other links are seemingly using the term expectations pricing similarly too.

That said, the warning at the outset (the term is first used in Chapter 1, page 2) to th ebeginners to guard against thinking about derivative pricing in the law of large numbers sense is appreciable. The use of the term expectations pricing, however, could have been avoided.

Expectations vs. Arbitrage Pricing (Baxter & Rennie): I

2008-03-19T00:32:00.000+05:30

I am told that Baxter and Rennie (BR; Financial Calculus) warns against always starting out with Expectations based pricing by arguing that it assumes the strong law of large numbers to hold - in essence, a statistically motivated argument.

I haven't seen where BR says that (so may be I shouldn't even talking about it), but that to me is quite wrong motivation for favouring no-arbitrage based pricing over expectations based pricing. Expectations based pricing works under the risk-neutral measure, or alternatively, assuming that agents making investment decisions are risk neutral. The reason why it works isn't based on the statistical properties of the stock price process.

Theoretically, of course, the mathematical equivalence between no-arbitrage and existence of a risk-neutral measure always holds. In practice, favouring one over the other would depend on the problem. So, it was rather surprising to come across a statisitcally motivated argument. Since it's claimed to be coming from a source like BR, it's likely I am interpreting it wrongly. Should check it out on my own.