Fear, greed, fairness, imagination and finance

I’ve thoroughly enjoyed reading Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew Lo. I should say that, apart from being a distinguished MIT finance professor and the co-author of the classic A Non-Random Walk Down Wall Street, Andrew is an old friend. But this should not put off any readers. This new book will become another essential read for anybody interested in financial markets.

The book aims to do what ultimately all of economics must do, and situate economic decisions and behaviour in the context of our biology and evolutionary history. Behavioural economics and finance have gone some way toward this in introducing the now-familiar heuristics such as loss aversion and framing effects, and herding is a familiar phenomenon in finance models. The issue with these has been how if at all they relate to rational choice models and the Efficient Markets Hypothesis. The Adaptive Markets Hypothesis is a synthesis, proposing that context makes the difference, and when conditions are sufficiently stable for long enough, financial markets are efficient. Otherwise, fear, greed, fairness, imagination – the characteristics evolution has given the human brain – kick in.

The opening chapter starts with a powerful demonstration of the potential efficiency of markets: after the Space Shuttle Challenger tragically exploded on 28 January 1986, a five month inquiry pinned the blame on a part, the O-ring, manufactured by one of four contractors, Morton Thiokol. Yet on the day of the accident, the share price of Morton Thiokol plummeted – the markets knew the company was to blame almost immediately, without the expert verdict: “Somehow the stock market in 1986 was able to aggregate all the information about the Challenger accident within minutes, come up with the correct conclusion and apply it to the assets of the company.”  The decline in its market capitalization – about $200m – was  almost exactly equal to the damages, settlement and reduced future cash flow, a later study found.

But often, of course, financial markets are all too obviously sometimes not efficient. The intellectual challenge is to figure out when they are in which mode. The book voyages through neuroscience, psychology, evolutionary biology and AI to try to answer this. The Adaptive Markets Hypothesis reverses the conventional framing: rather than thinking about a rational benchmark with a set of psychological quirks sometimes kicking in, we are a collection of quirks, but sometimes we can get beyond the heuristics to rational choice.

Frustratingly, although perhaps inevitably, there is no neat list of conditions for being in efficient rather than non-efficient mode: it depends, in particular on having had enough time in stable conditions to learn from experience. But Andrew does hold out hope for the prospects of being able to make better investment decisions – with socially useful outcomes – and being able to manage financial markets better so events like the 2008 crisis are far less likely to recur. In line with the Adaptive Markets perspective, he argues for treating financial markets as an ecosystem (so the interconnections are front of mind), using AI techniques to monitor markets and adjust regulatory instruments such as cyclical buffers. There is an interesting section on the role of technology in finance, including HFT, a technological arms race being one of the predictions of the Adaptive Markets Hypothesis. Currently, he is exploring ideas from biology such as immune responses and ecosystem management techniques. He also recommends introducing a body similar to the National Transportation Safety Board that would analyse market crashes and make recommendations for regulatory change. (One thing not spelled out here is whether this would have to be a global body.)

The book is a thoroughly interesting and enjoyable read. It is not technical, the explanations are super-clear, and there is some excellent story telling. Andrew recounts how in 1986 he and his co-author Craig MacKinlay, presenting at the NBER the work that turned into A Non-Random Walk Down Wall Street, were savaged by discussants from the world of academic finance. Since then, the academic community’s faith in the Efficient Markets Hypothesis has wavered significantly, but it is still the benchmark – as the book says, it takes a theory to beat a theory. I find the Adaptive Markets Hypothesis a persuasive theory, but then I firmly believe economics must be consistent with what we learn about ourselves from the other human sciences. I guess the test will come in the shape of how widely market participants themselves embrace it.41CpHzPtybL

 

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Humans and financial markets

Well this is exciting: the proof copy of the new book by my brilliant former classmate Andrew Lo (now director of the MIT Laboratory for Financial Engineering) has arrived. It’s Adaptive Markets: Financial Evolution at the Speed of Thought. Paging through, & from conversation with him, the book is a synthesis of modern financial economics and psychology/evolutionary biology, with some AI and neuroscience in the mix. It aims to get away from the stale ‘the efficient markets hypothesis is right/wrong’ dichotomy and looks instead at the interaction between rational calculation and what we know of the structure and non-rational habits of human decision making.

The book starts with a historical perspective; it ends with the financial crisis and recent developments, and discusses what regulatory framework is appropriate. A proposal that seems utterly sensible is to establish a financial market analogue to the National Transportation Safety Board, a standing expert (sorry!) body that investigates transport accidents to determine causes and recommend regulatory adjustments if necessary.

I can’t wait to read it. The book is equation-free and I know from graduate school experience that its author (also co-author of the classic A Non-Random Walk DOwn Wall Street) is so clever he can explain really difficult things ultra-clearly. Looks like one for all interested in financial markets. It will be out in April so I’ll review it properly closer to the date.)

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Capital and its morals

 by Brooke Harrington, a sociologist at Copenhagen Business School is utterly fascinating. Harrington trained as a wealth manager over a two year period and then conducted 65 interviews around the world with other wealth managers – mainly white middle aged men, mainly from fairly well-off backgrounds themselves. This is a rare window into their world – I’ve often wanted to see more sociology or anthropology looking at the financial markets, and here is exactly such a study.

[amazon_image id=”B01INP11GU” link=”true” target=”_blank” size=”medium” ]Capital without Borders[/amazon_image]

One intriguing aspect is the way families are the organising social structures managing the staggering wealth of the one percent. Harrington notes that the wealth managers’ main role is ensuring assets stay within the family over generations, but adds: “In some cases the fortune that holds the family together may also destroy it.” The wealth managers find themselves arranging payments for mistresses, negotiating divorces, dealing with siblings at war – protecting the family assets in spite of the family.

The book starts with a history of the emergence of the role of the trustee in mediaeval and later English common law – the trust being the main vehicle still for wealth management, with innovations from the likes of the British Virgin Islands. Wealth managers are often lawyers trained in the Anglo-Saxon legal tradition because of this heritage. The history of the role lies in a knightly tradition of loyalty and chivalry, rather bizarrely; certainly, the interviewees emphasise service and loyalty to their ‘clients’. They are far less well paid than many other roles in financial services.

The character of the business is changing, however, with the emergence of so many ‘ultra-ultra-high net worth individuals’ from Asia, who are far less comfortable than, say, traditional British rich families with the idea of handing over control of their assets to a trust structure. As one interviewee comments of the ‘new rich’: “It takes them a while to grasp the idea that it’s not their money once they put it in trust.” They enjoy the fruits but the assets themselves are to be safeguarded for the family and the future. I must say I find this idea that one can control the future strange indeed, but it clearly motivates many of the very wealthy.

The other part of the one percent world view that shines out of the interviews is their absolute belief in the injustice of any claims on their wealth – taxes of course, thieving governments, but also any creditors. The book cites Gabriel Zucman’s excellent

on the scale of the tax losses. Harrington writes: “For ultra-high net worth clients, it seems, being obliged to honor their debts, pay the costs of government, and otherwise obey the laws of the land are offenses to liberty.” She adds that this fear of governments, laws, taxes, makes the business of wealth management one of safeguarding assets, rather than growing them. It is a profoundly un-productive business – the parable of the talents comes to mind. By freezing wealth on this scale, productive economic growth is diminished.

London and the British Virgin Islands (a UK territory) are the main hubs of this secretive wealth management business. One wealth manager says Asian clients refer to offshore corporations in general as ‘BVIs’. But there is competition from the up and coming Cook Islands, a speck in the middle of the Pacific – twice blacklisted by the Financial Action Taskforce and criticised by the EU as an ‘unco-operative jurisdiction’. They don’t care: the business now accounts for 10-15% of GDP. The Caymans also get a special mention for creating the Special Trusts Alternative Regime, which can last for ever and in total secrecy. The STAR trusts allow the ultra-ultras their wish to guarantee the continuation of the family’s assets for generations to come, paying no tax, in total secrecy, and with an unusual degree of control.

Harrington asks interviewees about their ethical perspective, given the context of concern about inequality. After all, their training teaches them that discretion is more important than reporting illegal activities by their clients. So, she asks them, are they not concerned about the erosion of the tax base and hence public services, or the growing inequality? Not much, is the answer. Indeed, the wealth managers’ key skill is regulatory and tax arbitrage between different nation states, so how could they agree? Shockingly, a London-based wealth manager she interviews, ‘Drew’, based in a law firm, boasts that his firm employs a significant number of the UK’s 14 Parliamentary Agents. I didn’t know about this role: these are the only non-MPs allowed to address Parliament and the critique draft legislation. They are fixed, hereditary positions. Harrington points out: “It actually gives an institutionalized voice, at the highest levels of government, to the representatives of the richest members of society. While that once meant representing the railroad barons and landed gentry of the United Kingdom, the Parliamentary Agents at Drew’s firm – and others – now typically act as a voice for the interests of high net worth individuals from outside the country.”

My one frustration with the book is that Harrington does not offer any potential solutions – and why should she? However, there is a passing comment that Israel has created incentives for its wealth managers to co-operate with the tax authorities – but she does not explain how this happened or how it works. I’d have liked to know because all national governments clearly need to do the same, and especially the UK’s government, having created the giant maw of illegal finance in London.

 

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The devil take the debt

Adair Turner’s

– out this month – joins a select group of books that provide as clear an explanation of the financial crisis as one could hope for. It complements John Kay’s
, with its emphasis on globalisation, financialisation and the switch from relationship to transactional finance.
emphasises above all the inherent instability of banks’ ability to create credit, when not restrained by policy, especially given the scarce supply of that all-important asset, real estate. The growth of the shadow banking sector amplified this pre-existing source of volatility.

[amazon_image id=”0691169640″ link=”true” target=”_blank” size=”medium” ]Between Debt and the Devil: Money, Credit, and Fixing Global Finance[/amazon_image]

The book starts by pointing out that it was always foolish to think financial markets would satisfy the criteria for efficient (and stable) outcomes. The pre-crisis orthodoxy of liberalisation ignored the pervasive information asymmetries and non-rational choices in finance.

features prominently here. As Turner points out, it isn’t as if there was any shortage of evidence from history that financial crises occur reasonably frequently. He adds the distinctive feature of the recent crisis, the increased inequality of incomes driving demand for easy credit, which banks were only too happy to meet. (Echoes of of Raghuram Rajan’s
.)

The third part of the book covers the global dimensions of the crisis, in particular the China-US flows, and the role of the Euro. The financial flows not intended for direct investment were both immense and destabilizing, he writes. Among the high income countries, gross cross-border flows increased from less than 10 times GDP in the 1970s to 37 times GDP in the 2000s, with even larger proportionate increases for middle income countries. There is no evidence at all, he argues, that financial flows on this scale play any socially useful role at all.

And in this context of unsustainable credit growth at home and destabilizing flows across borders, only a minority of banks proved able to manage their balance sheet risks. To make matters worse, those that were good at risk management looked after themselves by offloading their bad risks onto other financial institutions, less well able to manage them. So the outcome for the system as a whole was even worse.

Given the difficulty of tackling the three drivers of the crisis – a limited supply of land and real estate, income inequality and global imbalances – what does Turner, a former head of the FSA, recommend? His answers are interventionist, suggesting a total rejection of the idea that finance can be left to ‘the market’. “To achieve a less credit-intensive and more stable economy, we must … deliberately manage and constrain lending against real estate assets,” he writes. He also advocates central bank monitoring of credit growth, constraining it when necessary; taxation of land values; taxation of debt to bring its treatment in line with taxation of equity; and raising bank equity ratios and minimum liquidity requirements (a step advocated by every, but every, economist who has given a moment’s thought to the crisis – shocking that the banks have lobbied their way out of this minimal step towards systemic stability).

Indeed, the book’s final chapter has some sympathy for even stronger measures: outlawing private money and credit creation; taxing credit creation funded by debt; and encouraging equity and hybrid instruments in place of debt.

However, the book concludes with a caution: “We face a choice of imperfections, and some of the imperfections are unfixable.” Financial markets are imperfect; so are policy-makers. Simple rules will never deliver stability, Turner argues. Far tougher constraints on the financial sector are needed. But policymakers will always have to make judgments as conditions change, and will get it wrong sometimes. Still, he suggests, not as wrong as in the mid-2000s.

Turner is at the tougher end of the spectrum in terms of his recommendations for constraints on the financial sector. But his calls for reforms join an honourable roll call of economists – as well as

and
,
,
, for example. As
points out, millions of people are still suffering from the effects of the financial crisis. Yet the policy response has been minimal, and there is nothing to stop the whole thing from happening all over again. At least if it does, nobody will be able to blame the economists this time for not having sounded the warning.

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Sharks and economists

I’m very much looking forward to hearing Joris Luyendijk talk about his book

at the Festival of Economics in Bristol next month. It’s an excellent piece of reportage on the City and the ways in which it traps its workers into certain forms of behaviour.

[amazon_image id=”1783350644″ link=”true” target=”_blank” size=”medium” ]Swimming With Sharks: My Journey into the World of the Bankers[/amazon_image]

However, Joris’s attack on economics in The Observer this weekend is, unfortunately, stuffed with all the false old chestnuts critics of the subject always trot out: economics is not objective like physics (string theory? hello?!); modelling involves the assumption that there are ‘timeless truths’ in economic behaviour; GDP is not an objective temperature measurement of the economy (I can recommend him

– by an economist – on that issue!)

[amazon_image id=”0691156794″ link=”true” target=”_blank” size=”medium” ]GDP: A Brief but Affectionate History[/amazon_image]

He writes: “Why should bankers ask themselves if a lucrative new complex financial product is safe when the models tell them it is? Why give regulators real power when models can do their work for them?” That question answers itself: because it was more profitable. Surely a sociologist of the City would find that almost nobody in banking gave much thought at all to the underlying economics of financial markets? Financial economists have much to answer for, but there is an odd tendency among critics of economics to attribute extraordinary power to  ‘the model’ rather than to politics or the sociology of financial institutions.

The article argues there should have been more research into the sociology and anthropology of the City. Quite right. But isn’t that what sociologists and anthropologists do? Economists like me have no training or experience in those research methods. I agree, too, that there are economists who disguise their politics as technocracy; I’d call them macroeconomists but some of them take umbrage when I do so. There is tons we don’t know about aggregate behaviour in actual economies. Neither that fact nor its acknowledgement make economics rubbish, or even unscientific. There is tons we don’t know about the natural world too. And by the way, physicists, biologists and chemists all use models. So do historians, just with words instead. Possibly even sociologists.

Don’t read me as saying economics has no criticisms to answer; it certainly does. But it is exasperating to read the same old same old nonsense from a critic who uses the misuse of one sub-field of economics by people in the financial markets to rubbish the whole subject, about which he seems to know very little. So I look forward to welcoming Joris to the Festival, where he’ll be able to hear a lot of economists engaging with the public, and talking about the environment, social mobility, immigration, the scope of government and many other issues.

Meanwhile, I agree with Dani Rodrik’s tweet:

rodrikdani
One reason I wrote Economics Rules is commentary like this, which misleads more than it illuminates https://t.co/y1v2dk5d76
11/10/2015 22:35

and recommend strongly his

. I might buy a copy for Joris.

[amazon_image id=”0393246418″ link=”true” target=”_blank” size=”medium” ]Economics Rules: The Rights and Wrongs of the Dismal Science[/amazon_image]

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