Thursday, March 27, 2008

Robert Shiller's bogus defense of financial innovation

Before I put my buzz saw to work, let me make a few things clear. First, I have a good deal of respect for Robert Shiller's work. Anyone who was willing to tell Greenspan in 1996 that he ought to be worried about asset bubbles has a good deal of foresight. Second, I am a fan of Project Syndicate; I've featured many of its articles. Third, I am not opposed to financial innovation per se (although that term is so all-encompassing as to get in the way of useful discussion, and the term "innovation" has such positive connotations as to put critics on the back foot).

However, Robert Shiller's Project Syndicate article, "Has Financial Innovation Been Discredited?" can only charitably be interpreted as incredibly sloppy, but since this is an area where he claims expertise, it must be deemed to be intellectually dishonest.

Let's go through it:
Skeptics of financial liberalization and innovation have been emboldened by the crisis in the world’s credit markets that erupted in mid-2007, when the problems with sub-prime mortgages first appeared in the United States. Are these skeptics right?....

The entire sub-prime market is largely a decade-old innovation – the word “sub-prime” did not exist in any language before 1994 – built on such things as option adjustable-rate mortgages (option-ARM’s), new kinds of collateralized debt obligations, and structured investment vehicles. Previously, private investors in the US simply did not lend to mortgage seekers whose credit history was below prime.

First, option ARMs are not a subprime product; they were targeted to prime borrowers (see here and here from the esteemed Tanta). This is a striking error from a supposed expert on housing markets. Second, financial innovation does not equal "securitization of subprimes" which is what his second paragraph implies. CDOs frequently contain heterogeneous assets; many CDOs contain only corporate bond exposures.

Back to Shiller:
But, while it does sometimes appear that the current crisis is due, at least in part, to financial innovation, financial-market liberalization has been shown to be a good thing overall.

A study published in 2005 by economists Geert Bekaert, Campbell Harvey, and Christian Lundblad found that when countries liberalize their stock markets, allowing them to operate freely without government intervention, economic growth rises by an average of one percentage point annually. The higher growth tends to be associated with an investment boom, which in turn seems to be propelled by the lower cost of capital for firms.

This is a misrepresentation of the Bekaert, Harvey, and Lundblad paper. I am pretty certain the article in question is "Growth Volatility and Financial Liberalization." I will be generous and assume that he did not get past the abstract, which uses the term "equity market liberalization." However, when you read the paper, it analyzes opening financial markets in a development economic context, and the primary focus is on increasing receptivity to international capital, not on lowering regulatory standards. This is the question the paper is seeking to answer:
Is the cost to a country for opening its financial markets to foreign portfolio investment increased economic volatility?

Other quotes to show its emphasis and conclusions diverge from what Shiller implies:
...there is an extensive literature on the benefits of international risk sharing. This literature explicitly recognizes that open capital markets lead to international risk sharing, which should improve welfare....Our study contributes to this debate by testing directly whether consumption growth volatility changes after financial liberalization. If there are genuine benefits to international risk sharing, we expect to observe reduced consumption growth volatility....

And consider this:
A substantial interaction analysis shows that countries with relatively large government sectors and developed banking sectors experience significant reductions in volatility but countries with poor investor protection experience significant increases in volatility (boldface ours).

So to the extent this article discusses regulation of markets in the manner Shiller implied, it found that greater investor protection, i.e., regulation, was beneficial.

Note also that per our post earlier today, Dani Rodrik disputes the conclusions of this paper, that financial liberalization is good for developing countries.

And in any event, extending conclusions from equity markets, which by nature are speculative, to credit markets, where investors expect to get their principal back, is also quite a stretch. Ditto applying work on developing markets to mature economies.

Back to Shiller:
.....The US is one of the world’s most financially liberal countries. Its financial markets’ high quality must be an important reason for America’s relatively strong economic growth. Indeed, given a very low savings rate and high fiscal deficit over the past few decades, the US might otherwise have faced economic disaster.

This discussion is pretty confused. "Markets" covers a multitude of sins. Public equities and bonds are in fact highly regulated, as are exchange traded derivatives. It's when you get into certain OTC markets that things can get wild and woolly. And the notion that US financial markets are "high quality" is no longer widely accepted. Foreign buyers have compared our mortgage products to China's toxic toys.

Although the SEC's enforcement isn't what it used to be, the basic framework of regulations hasn't changed dramatically; indeed, measures like Rule FD and decimalization were forced on the industry. A 1993 Harvard Business Review article by Amar Bhide, "Efficient Markets, Deficient Governance," makes observations that still ring true:
Without a doubt, the US stock markets are the envy of the world. In contrast to markets in countries such as Germany, Japan, and Switzerland, which are fragmented, illiquid, and vulnerable to manipulation. US equity markets are widely respected as being the broadest, most active, and fairest anywhere. The Securities and Exchange Commission strives mightily to keep it that way.....

US rules protecting investors are the most comprehensive and well enforced in the world....Prior to the 1930s, the traditional response to panics had been to let investors bear the consequences......The new legislation was based on a different premise: the acts [the Securities Act of 1933 and the Securities and Exchange Act of 1934] sought to protect investors before they incurred losses.

Bhide describes the three main approaches: detailed description of the company, its financial performance, and the securities offered, with requirement for extensive periodic disclosure; measures to bar insider trading; rules against market manipulation.

Bhide discusses at some length that extensive regulations are needed to trade a promise as ambiguous as an equity on an arm's length, anonymous basis. In hindsight, it may be that the halo effect of America's successful equity markets facilitated the sale of dodgy debt instruments.

To Shiller again:
In 2000, Stewart Mayhew, Assistant Chief Economist at the US Securities and Exchange Commission’s Office of Economic Analysis, surveyed the extensive literature on this topic. Mayhew concluded that it is rather difficult to tell whether derivative markets worsen financial-market volatility, because their creation tends to come when existing financial markets already are more volatile, or can be predicted to become so. Moreover, he found that there is no evidence that derivative markets create volatility in underlying cash markets; in fact, they may even reduce it.

The effect on underlying financial markets’ volatility may not even be the right question to consider in deciding whether to permit new derivative products. The right question is whether these products are conducive to economic success and growth.

Here, Mayhew concludes that new derivative markets clearly increase the liquidity and quality of information in existing financial markets. And it is this liquidity and quality of information that ultimately propels economic growth.

First, it's revealing that Shiller cites a dated paper to support his position. Mahew's paper did indeed look at research on options and futures markets to a wide variety of cash markets. However, these were all exchange traded markets.

Shiller conveniently ignores the elephant in the room: the systemic risk posed by OTC derivatives. We have a $45 trillion credit default swaps market, for instance, which has the potential for large-scale counterparty failure. Indeed, some observers think that the risk of cascading CDS losses was the reason the Fed rescued Bear Stearns and was willing to pony up such a large credit facility (Bear was a large CDS protection writer, the side of the transaction susceptible to default).

And his comment that " liquidity and quality of information that ultimately propels economic growth" is unadulterated financial services industry bullshit. Economic growth is a function of demographic growth and productivity growth. Perhaps Shiller can make a case that liquidity and high quality financial market information produce higher productivity growth. Merely asserting it doesn't make it so.

Shiller again:
The sub-prime crisis has exposed serious problems that we must address. For example, we need stronger consumer protection for retail financial products, stricter disclosure requirements for new securities, and better-designed vehicles for hedging risks.

Some of the innovations associated with the sub-prime crisis – notably option-ARM’s, when extended to borrowers who couldn’t handle them – seem to have little redeeming value. But others – those involved with the securitization of mortgages – were clearly important long-run innovations, because they can help spread risks better around the world.

The first paragraph is more or less motherhood and apple pie, although it isn't clear what he means by "better designed vehicles for hedging risk"

In the second, he gets it wrong again on option ARMs. They were around long before subprimes, and they are a perfectly fine mortgage when sold to its proper market, which is fairly narrow. Some private banks offered them in the 1980s, if not sooner, to investment bankers. They are perfect for people who have low salaries and high bonuses. The product fits their cash flows: low monthly commitment with discretionary additional paydowns when the big money arrives. (Naked Capitalism) Those users don't suffer the negative amortization that can make the product so damaging.

Shiller once more:
So, we should not slow down financial innovation in general. On the contrary, some of the fixes that result from the sub-prime crisis will probably take the form of still more innovation, further increasing the sophistication of our financial markets.

This gets back to the disingenuous idea that regulation is tantamount to stifling innovation. But now distrust of opaque structures, poor underwriting standards, and unreliable credit ratings is so high that it is naive to think that many investors will have appetite for complexity absent tougher regulation. Preserving innovation is far down the list of concerns these days. Merely keeping the wheels from coming off the financial system will be a considerable accomplishment.

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