Wall Street | Random Observations for Students of Economics

What I've Been Reading

Economics Comments Off

Feb 202010

I enjoy good memoirs. At their best, they can give you a sense of what it would be like to lead a different life, to walk in another’s shoes. Political memoirs are usually a disappointment, as the writers typically have an agenda, such as establishing a place in history or angling for the next job. They seem more like spin than truthful self-assessment. Memoirs by nerdy academics, rare as they are, are among my favorite, in part because I can easily see myself in them and in part because the authors are often brutally honest.

All this is a prelude to a book recommendation: My Life as a Quant: Reflections on Physics and Finance, by Emanuel Derman. I have never been a physicist or worked on Wall Street, but this book gives a good sense of what both career paths are like.

The book was written, by the way, before the recent financial crisis. As a result, one does not get a sense of how the author would put recent events into perspective. But by the end of the book, the author is skeptical enough about the use and abuse of financial models that I suspect he would not be terribly surprised when they went awry.

A Note from Inside

Economics Comments Off

Jan 232010

One of my many friends working for President Obama sends me this email, along with permission to share it with my blog readers:

My perspective here has given me an unusual window into the looking-glass mirror of how things I see on the inside are interpreted on the outside.

The most vivid case in point is the recent policy announcements about implementing the Volcker ideas about separating investment and commercial banking.

This policy process has been in the works for months, and it came to fruition in the normal course of policy operations after extensive meetings and consultations among Treasury, NEC, the PERAB board, and other parties.

Regardless of how one evaluates the wisdom of the policy (and I fully acknowledge that reasonable people can differ on this), in practice the timing of the announcement (coming after the loss of the Massachusetts Senate seat) is being interpreted as “the Administration has finally decided to cave in to the populist temptation.” As a result there is a lot of uncertainty about whether Bernanke will be reappointed and whether the new policy signals that the Administration is going to dump him. Honestly, dumping Bernanke was NOT the point of this announcement.

But it seems like Wall Street is interpreting this as “Summers, Geithner, and Bernanke are on the way out because Obama has finally decided to go populist.” Honestly, that is truly not right, though I can see how from the outside it would look like it.

Oddly enough, this is one of those cases where the whole thing could be a self-fulfilling prophecy. The policy announcement had nothing to do with Bernanke, but now the sharks are scenting blood, inTrade is putting Bernanke’s odds of confirmation much lower, and a lot of Senators are starting to waver and back off and say they won’t vote to confirm him, so now maybe he can’t get through. If not for the misinterpretation of the get-tough-on-banks move, though, Bernanke’s standing would not have changed.

[name withheld]

PS I know it’s a fool’s game to try to explain moves in the stock market, but I have a friend on Wall Street who tells me that the selloff in the last couple of days is more due to uncertainty caused by the sense that Summers and Geithner are losing out to populism than to specifics of the bank plan.

Thanks for helping to get the true story out.

The Bank Tax

Economics Comments Off

Jan 152010

President Obama has proposed a special tax levied on large financial institutions. In general, I am skeptical of narrow-based taxes, as they feed a particularly nasty kind of politics, where the majority gangs up on a minority. And I am turned off by the populist rhetoric coming from the administration, which suggests the issue pits Wall Street fat cats against ordinary Americans. Nonetheless, on the economic merits, there may be a case for the bank tax.

One thing we have learned over the past couple years is that Washington is not going to let large financial institutions fail. The bailouts of the past will surely lead people to expect bailouts in the future. Bailouts are a specific type of subsidy–a contingent subsidy, but a subsidy nonetheless.

In the presence of a government subsidy, firms tend to over-expand beyond the point of economic efficiency. In particular, the expectation of a bailout when things go wrong will lead large financial institutions to grow too much and take on too much risk.

You may recall that I made precisely this argument regarding Fannie Mae and Freddie Mac some years ago when I was CEA Chair. (No, I was not a prescient genius. The potential problem was apparent to anyone who cared to look.) But now the problem of implicit subsidies is far more widespread. We have in effect turned much of the financial system into government-sponsored enterprises.

What to do? We could promise never to bail out financial institutions again. Yet nobody would ever believe us. And when the next financial crisis hits, our past promises would not deter us from doing what seemed expedient at the time.

Alternatively, we can offset the effects of the subsidy with a tax. If well written, the new tax law would counteract the effects of the implicit subsidies from expected future bailouts.

Will the tax law in fact be so well written? It certainly won’t be perfect. But it is possible that it will be better than doing nothing at all, watching the finance industry expand excessively, and waiting for the next financial crisis and taxpayer bailout.

Random Observations for Students of Economics