Thursday, January 14, 2010

The Godfather of Efficient Markets Hypothesis Speaks

John Cassidy interviewed for New Yorker the godfather of the efficient markets hypothesis, Eugene Farma. The interview was wide ranging and at times fascinating. Here's Farma on Paul Krugman and Larry Summers (Questions in italics from original):

So you don’t accept the view, which Paul Krugman, Larry Summers, and others have put forward, that what has happened represents a rehabilitation of government action—that the government prevented a catastrophe?

Krugman wants to be the czar of the world. There are no economists that he likes. (Laughs)

And Larry Summers?

What other position could he take and still have a job? And he likes the job...

...what about Paul Krugman’s recent piece in the New York Times Magazine, in which he attacked Chicago economics and the efficient markets hypothesis. What did you think of it?

(Laughs) My attitude is this: if you are getting attacked by Krugman, you must be doing something right.

Here's Farma on the bailouts:

The experiment we never ran is, suppose the government stepped aside and let these institutions fail. How long would it have taken to have unscrambled everything and figured everything out? My guess is that we are talking a week or two. But the problems that were generated by the government stepping in—those are going to be with us for the foreseeable future. Now, maybe it would have been horrendous if the government didn’t step in, but we’ll never know. I think we could have figured it out in a week or two.

So you would have just let them...

Let them all fail. (Laughs) We let Lehman fail. We let Washington Mutual fail. These were big financial institutions. Some we didn’t let fail. To me, it looks like there was not much rhyme or reason to it.

What about Ben Bernanke and Hank Paulson’s argument that if they hadn’t taken action to save the banks the whole financial system would have come crashing down?

Maybe it would have—for a week or two. But it pretty much stopped for a week or two anyway. The credit markets stopped for more than a week or two. But I think that was really a function of increased uncertainty about the future.

Did you think this at the time—that the government should let the banks fail?

Yeah—let ‘em, let ‘em. Because the failures of, like, Washington Mutual and Wachovia—other banks came swooping in to pick up their deposits and their other good assets. Of, course, they didn’t want their bad assets, but that’s the nature of bankruptcy. The activities that these banks were engaged in would have continued.

Why do you think the government didn’t just step back and let it happen? Was the government in hock to Wall Street, as many have claimed?

No. I think the government, Bernanke...Bob Lucas, I shouldn’t quote Bob Lucas, but what he says is “not on my watch.” That, basically, there is just a high degree of risk aversion on the part of people currently in government. They don’t want to be blamed for bad outcomes, so they are willing to do bad things to avoid them. I think Bernanke has been the best of the performers.

Below, Farma comments on the crisis itself. It's really too bad he doesn't get business cycle theory, because on a gut level, he seems to really observe and figure out quite accurately what's going on (Although, I would argue that at least in the case of Hank Paulson that Paulson damn well knew and was focused on doing whatever was needed to bail out Goldman. Further, I would not be surprised if Paulson and his cronies started the runs on Bear Stearns and Lehman Brothers.) Farma on the crisis is also a wonderful antidote to those who claim that Austrian business cycle doesn't apply anymore because people anticipate bubbles in advance:
Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst.

I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.

I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.

That’s what I would think it is, but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

Are you saying that bubbles can’t exist?

They have to be predictable phenomena. I don’t think any of this was particularly predictable.

Is it not true that in the credit markets people were getting loans, especially home loans, which they shouldn’t have been getting?

That was government policy; that was not a failure of the market. The government decided that it wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower grade mortgages.

But Fannie and Freddie’s purchases of subprime mortgages were pretty small compared to the market as a whole, perhaps twenty or thirty per cent.

(Laughs) Well, what does it take?

Wasn’t the subprime mortgage bond business overwhelmingly a private sector phenomenon involving Wall Street firms, other U.S. financial firms, and European banks?

Well, (it’s easy) to say after the fact that things were wrong. But at the time those buying them didn’t think they were wrong. It isn’t as if they were naive investors, or anything. They were all the big institutions—not just in the United States, but around the world. What they got wrong, and I don’t know how they could have got it right, was that there was a decline in house prices around the world, not just in the U.S. You can blame subprime mortgages, but if you want to explain the decline in real estate prices you have to explain why they declined in places that didn’t have subprime mortgages. It was a global phenomenon. Now, it took subprime down with it, but it took a lot of stuff down with it.

So what is your explanation of what happened?

What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.

But surely the start of the credit crisis predated the recession?

I don’t think so. How could it? People don’t walk away from their homes unless they can’t make the payments. That’s an indication that we are in a recession.

So you are saying the recession predated August 2007, when the subprime bond market froze up?

Yeah. It had to, to be showing up among people who had mortgages. Nobody who’s doing mortgage research—we have lots of them here—disagrees with that.

So what caused the recession if it wasn’t the financial crisis?

(Laughs) That’s where economics has always broken down. We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. (Laughs again.) We’ve never known. Debates go on to this day about what caused the Great Depression. Economics is not very good at explaining swings in economic activity.
This guy is absolutely amazing. When he is just observing things, he is spot on. As a theorist, he fails. He's clueless about business cycle theory and his efficient market hypothesis shows he doesn't get that some holders of information can be in error about the information they hold.

Here's why he cancelled his subscription to The Economist:

In the past, I think you have been quoted as saying that you don’t even believe in the possibility of bubbles.

I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble. People have become entirely sloppy. People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it.

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