Author Archives: Diane Coyle

Macroeconomics and aliens

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Over a few weeks, I’ve been reading Big Ideas in Macroeconomics: A non-technical view by Kartik Athreya, an economist at the Richmond Fed. I’ve found it very interesting and illuminating, but what it has illuminated has tended to confirm my scepticism about much conventional macroeconomics.

The kind of macroeconomic debate that most people are familiar with from the blogs (see Simon Wren-Lewis, the National Institute blog, Noahpion etc) and the economics journalists – discussing why GDP growth is what it is, the effects of fiscal policy, how long interest rates need to stay so low, what is the risk of deflation in the Eurozone etc – is wholly absent from this book.

It is instead about macroeconomic theory. It seeks to explain without equations the deep theoretical foundations of macroeconomic models, the models later used in central banks and elsewhere to inform the practical policy discussion. Although billed as ‘non-technical’, and hence the absence of equations, it is still pretty tough going. Athreya’s starting point is general equilibrium theory derived from Walras in its modern Arrow-Debreu-McKenzie (ADM) manifestation. The first four chapters cover this theory, other theoretical foundations in the form of game theory and overlapping generations models, and the use of four often-criticised techniques or assumptions: aggregation, rationality, equilibrium and mathematics. Chapter 5 turns to policy advice, and chapter 6 to “recent events”. Even these, though, are discussions of the theoretical models.

The book is therefore an excellent guide to macroeconomic theorising – although too hard for a general audience, useful for students of macroeconomics, probably at the graduate level. However, I was genuinely startled by its implicit claim that the ADM model is both the right approach to practical macroeconomic policy and the approach in use in the policy world. This is not because I have any doubts at all about the usefulness of some mathematics, nor of the modelling assumptions of rationality and equilibrium in many contexts. I am a huge fan of markets as a process of information-discovery and co-ordination. But I’d imagined the insistence on the abstraction of the general equilibrium approach to macro was in retreat and now dug deep into in its bunkers in university departments and academic journals.

There is a telling passage in Chapter 2 where Arthreya writes of “the pervasive orderliness of the world in the absence of any central co-ordinator.” Many economists have noted this – Paul Seabright’s The Company of Strangers is one wonderful, accessible example. But many have also, I would say, pointed out the frequent disorderliness of the world at the aggregate, macro level. ” ‘ADM minus some markets’ seems like a useful description of the real world,” the book claims – just before noting that the ‘minus some markets’ strikes out financial markets subject to asymmetric information, those with too-big-to-fail entities, and markets characterised by externalities. Then it claims that there are no other important areas of oligopoly power – oh, except for those where innovation is important. I can think of a few other areas of market power too! When ‘minus some markets’ ends up being a very large chunk of the aggregate economy, there is a lot of wishful thinking going on here about the practical relevance of the general equilibrium model.

What about the crisis? Athreya concludes that: “Macroeconomists lack models that can fully account quantitatively for the use of various contracts….Macroeconomics therefore has a good deal of unfinished business.” The crisis has led to a sensible shift in modelling priorities towards including some financial contracts, he says – and the book rightly notes that Keynesian or Minskian models would not have included relevant types of financial contracting for predicting the crisis either. Athreya thinks these evolutionary, internally-driven reforms are all that macro needs. I find this dispiriting.

After reading the book, I read some other reviews and found that John Quiggin had more or less the same reaction as me. I’m not all that persuaded by the revamped Keynesian non-DGSE versions of macro either (unlike Quiggin, I think); for me, we’re simply back to the drawing board on macro, and the most interesting starting points would be something like the Moore/Kiyataki models with credit cycle and labour market interactions at their heart, plus Perez on long-term technology and financial cycles. The former seem to me like heirs of the much-underrated Malinvaud approach.

Still, as Quiggin says, the DSGE cult prevails still in academic economics – and, it seems, in the policy world too. Which means Big Ideas in Macroeconomics is worth reading to understand how they think, alien as it may be.

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Money and me – and you

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It’s an exciting moment – the advance copies of Dave Birch’s book, Identity is the New Money, have arrived here at Enlightenment Economics Towers.

OK, as series editor, I’m biased, but this is an exciting book. Dave’s one-man expertise on the technological issues involved in both identity security and digital money have converged in an absolutely illuminating and highly entertaining read. He argues that there is no trade-off between our financial/data security and our privacy; the marriage of mobiles and social networks means we can have both. As the infrastructure is put in place, cash use will evaporate – and a good thing too, in his view.

It’s available for pre-order on Amazon and will be shipping soon!

Time to stop and think

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Every Friday morning I treat myself to reading the weekly 3am Magazine philosophy interview by Richard Marshall. I don’t always understand them but it’s good to have a point in the week when you stop and think. Some of the interviews have been collected by OUP into a book, Philosophy at 3am, edited by Marshall. My copy just reached me – it’s out in the UK in a couple of weeks. Now I can stop and think at any time. If I were teaching philosophy, I’d be putting this book on my students’ reading list, for an accessible and even witty overview of the frontier of the subject. There are many more interviews online, so maybe a second volume will follow.

Thinking time

How can there be a borrower from hell?

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The joy of a four-day weekend – as well as cooking and gardening, I’ve read a thoroughly enjoyable economic history book with great relevance for the present debate on sovereign borrowing. It’s Lending to the Borrower from Hell: Debt, Taxes and Default in the Age of Philip II by Mauricio Drelichman and Hans-Joachim Voth.

Part of my enjoyment was that I studied this period for my history A level (and almost read history at university before economics captured me), and so was absorbed in 16th and 17th century Europe during those impressionable teenage years. It’s extraordinary that so many Europeans know so little about it now – certainly, British schoolchildren jump from the Tudors straight to World War II and the Cold War. For a sense of how turbulent and decisive a period it was, the novel Q by the Italian collective Luther Blissett is hard to beat; I have the Wu Ming “sequel”, Altai, on my in-pile now.

However, even if you don’t share my specific interest in the period, this is an essential book for economists interested in sovereign debt – and which of us is not at the moment? It fills in some important detail about an episode in debt history that features in the data set of the monumental This Time is Different. A large part of the achievement of the authors is the collection of a highly impressive data set on the debt issuance, repayments, revenues and expenses of Philip II of Spain, based on obviously extensive archival research as well as secondary sources.This was, of course, the period when New World silver started to reach the coffers of the Castilian crown in large quantities. The Borrower from Hell underlines the concept of resource curse.

Philip II has the reputation of being the Borrower from Hell because of the frequency with which he defaulted – there was a payment suspension more often than one year in every five during his reign. As the authors point out, the Reinhart-Rogoff data set shows 20% of countries in default on average in every year since 1800, so the reputation may be unfair; but the scale of the borrowing was large and Philip II defaulted a record-breaking 13 times in succession: “No country in recorded history has defaulted more times.”

So the question is why he got the opportunity to do so; why did bankers continue lending to him? How can there be a ‘borrower from hell’? The book carries out an IMF-type sustainability exercise on the historical data set and concludes that the debt burden was sustainable although there were liquidity crises due to events – usually a military loss. It also argues that the structure of the lending meant there was a kind of balance of power between king and lenders. The form the lending took was syndicated loans provided by a relatively small and tight-knit group of families; 130 people from 63 families lent Philip money over the years but 3 families accounted for 40% of all loans and 10 families for 70%. The banking network was stable and dominated the available funds. So whereas two hundred years earlier Philip IV of France had executed those who lent him money (Jews, Lombards, Templars) when he couldn’t pay, Philip II of Spain had a long relationship with his financiers. The ‘absolutism’ of the 16th and 17th centuries was in fact constrained, a useful fiction for both monarch and elites.

The data indicate that despite the defaults, holidays and renegotiations, the average return on the loans was highly favourable. The book argues that the lending was understood to be contingent and that a renegotiation would ensue if events turned out badly for the king. The negotiations were typically speedy, as was the return to lending. The bankers were sharing the risk with Philip, their return amply compensating them for it. It sounds not unlike Robert Shiller’s proposal for event-dependent sovereign loans in his book The New Financial Order.

Lending to the Borrower from Hell is a useful reminder that, not only is sovereign lending wholly intertwined with the state, it can perform a useful rather than a solely destructive function. The book does not indulge in drawing lessons for modern finance, but it’s hard to escape the conclusion that the structure of modern financial markets deserves close scrutiny in evaluating lessons from the crisis. And that the balance of power between, say, the Greek government and Wall Street banks has been made completely clear by the terms of Greece’s “rescue”.

As for the resource curse, Drelichman and Voth conclude with a discussion of the reasons for later Spanish economic decline: “The inability to raise state capacity must ultimately be traced back to a resource windfall – silver. It kept the Crown fiscally sound without the need to strike a bargain that would have helped build a stronger, more capable state in the long run.”

A final note: this is a tremendously well-written book, a pleasure to read.

 

High-speed predators

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There have apparently been some reviews sniping at Flash Boys, the latest book by Michael Lewis on the financial markets, not that he will care given how well it’s selling. The grumpy reviews are wrong. It’s an excellent book. Lewis writes like a dream, and brings characters to life as well as any novelist. There are laugh out loud moments. And he explains as clearly as it is possible for a general reader the way today’s super-super-fast US equity market functions, or rather malfunctions.This is a great achievement, as it is very complicated.

I’ve not read other reviews of the book, but I gather from Twitter that some people accuse Lewis of exaggerating and making out all high frequency trading to be bad when it has cut commissions and increased liquidity. They’re wrong. Maybe there are one or two good guys doing HFT. But when there are frequent crashes and spikes in prices, and when the HFT firms do not make losses on any day, these traders are not taking on risk and enhancing liquidity; they are tax farming and increasing volatility through massive amounts of ultra-fast trading activity.

I got interested in HFT early in 2012 when I was preparing for my Tanner Lectures. It seemed the most extraordinary example of performativity, the shaping of reality by economic theory, as the options pricing formula devised by Black, Scholes and Merton had ended up causing a tunnel to be drilled through the Allegheny Mountains so a new fibre optic cable from Chicago to New Jersey could send information at something closer to the speed of light. Flash Boys starts with the same new line, built by Spread Networks. Lewis writes about the contract Spread Networks offered the Wall Street banks, whereby they could use the line for their own proprietary trading but not for their brokerage customers: “The whole point of  the line was to create inside the public markets a private space.”

The HFT markets serve the HFT firms and the big banks, which operate “dark pools”, or private markets in which they execute customers’ trades. Even giant hedge funds get a worse deal than the proprietary traders. Indeed, HFT firms pay Wall Street firms for access to their dark pools – to prey on the orders in there. No matter how big the investor, they would know nothing about how their orders were routed or when executed once they had issued the buy or sell order.

The market dysfunction had come about because of Regulation NMS, a stock exchange rule issued by the SEC with the intention of making sure investors got the best prices but with the unintended consequence that it created a spaghetti junction of orders moving around exchanges, with delays that HFT firms could use to their advantage. It isn’t just Lewis who says the rule backfired: here is a Wall Street Journal write-up questioning the benefits of the regulation. The regulation created short-term profit opportunities from gaming it, and the proliferation of exchanges it encouraged. As one character says, “It’s hard to be forward thinking when the whole of corporate America is about next quarter’s earnings.” High frequency traders, including those in big Wall Street banks, give themselves an information advantage over investors (including the funds looking after your money and mine); once an investor asks its broker to buy or sell shares, the information about the order belongs to the broker.

The solution to complexity that can be gamed and privileged information lies in simplicity and transparency, and the narrative thrust of Flash Boys is the creation of a simple, transparent exchange, IEX, by good cowboy Brad Katsuyama, who left Royal Bank of Canada to found it once he started to uncover the absolute scandal of the way high frequency trading was operating. Unexpectedly, Goldman Sachs emerges heroically, being the first major institution to route large volumes of orders through IEX. Lewis speculates that its senior people had come to realise: (a) Goldman is not very good at HFT because it has an old computer system; (b) one day, the highly complex and unstable equities market created by HFT will cause a huge, but huge, market crisis and they don’t want Goldman to get the blame. Goldman Sachs also emerges as villain for getting the FBI to arrest a Russian programmer, Sergey Aleynikov, for “stealing” some of their computer code – although found guilty and imprisoned, he had sent himself – openly – some mainly open source code when he quit the firm.

The book ends with a puzzle: the FCC license number 1215095, fixed to a microwave tower in Pennsylvania. The license application was filed in July 2012. Follow the lead, Lewis says, and you will find “another incredible but true Wall Street story, of hypocrisy and secrecy and the endless quest by human beings to gain a certain edge in an uncertain world.” Naturally, a lot of people have already done so.

As this ending suggests, he doesn’t argue that high frequency traders are evil. But the book does make a powerful case that the financial system is a dangerously complex system that creates damaging incentives. Like all complex systems, there will be a straw that breaks the camel’s back, a grain of sand that causes the whole pile to collapse. The world is uncertain in the sense that the specific straw or grain – which one, when -  is unpredictable, but the collapse is inevitable. There is an interesting question as to why innovation in finance – unlike in any other sector of the economy – so often works against the interests of consumers, not in their favour.

Lewis cites some others who have written about HFT: Sal Arnuk and Jospeh Saluzzi in Broken Markets; Eric Hunsader, founder of Nanex, a stock market data company; researcher Adam Clark-Joseph (pdf), whose work on HFT led the CFTC to shut its programme giving researchers access to data. There is also a book, Dark Pools, by journalist Scott Patterson. Publications like Automated Trader are well worth a look too.

Anyway, Flash Boys joins Lewis’s earlier book on the 2008 crisis, The Big Short, and John Lanchester’s Whoops as must-read guides to the insanity of modern finance.