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The Cassandra Hunt
Kevin Drum comments, here is Brad DeLong, and Matt Yglesias, and Arnold Kling; they make good points all around. There aren't nearly as many Cassandras as you think, once you require more of a person than "having called" the housing bubble. A simple question is what financial stocks a person had shorted as of, say, November 2007, or for that matter July 2007, and no "my wife wouldn't let me" is not an adequate comeback. And if you're afraid of an unhedged position or margin call just buy some puts.
I plead fully guilty to not having been a Cassandra. Oddly, I published an entire book in the late 1990s -- Risk and Business Cycles(cheaper on Kindle) -- on how excess risk and correlated errors could cause an economy to explode; I'll tell you more about that soon. But if anything when it came to running commentary (on this blog, most of all) I was an anti-Cassandra. First, I was too influenced by the relatively mild housing bubble collapse of the late 1980s. Second, I did not understand how much fragility the extant degree of leverage implied.
Cassandra's gift was in fact the source of continual pain and frustration. That's one reason why not so many people are Cassandras.
Fischer Black insisted in the mid-90s that the law of large numbers did not apply to individual economic forecasts of sectoral shifts and thus such errors could not be expected to "cancel out" in the aggregate. Not so many people believed him and in retrospect the failure of people to take Black seriously on this point is further evidence that the point is indeed correct in many situations.
Addendum: The end of this Kevin Drum post nails it.
Posted by Tyler Cowen on November 30, 2008 at 08:42 AM in Economics | Permalink
Comments
I'm looking forward to your comments on this book, and how it relates to the often discussed ABCT.
Posted by: Gu Si Fang at Nov 30, 2008 9:01:37 AM
What if a person never shorts? I could see the argument, if an observer shorted sometimes, but not others, and did not in this case.
I'm annoyed by the "must short" argument from economists because it says "you must have my worldview, and only then can I accept your differences with my worldiew." It is a contradiction.
FWIW, I stayed with my condo in part because SoCal real estate looked like a bubble to me. I kept my stocks at 10% of total net worth because they looked like a bubble to me. I did not short. I never short.
Posted by: odograph at Nov 30, 2008 9:04:10 AM
("You cannot have an opinion on oil unless you have short-or-long contract" is another example of this economists' demand. Whereas I might wonder if those without money on the line might think more dispassionately.)
Posted by: odograph at Nov 30, 2008 9:07:54 AM
What about the "The Roaring 2000s" by Harry Dent, published in 1998. Didn't it predict the next Great Depression starting in 2008?
I think in later books he moved the beginning of the depression out a bit, so that diminishes his Cassandra status somewhat.
Posted by: Nemo at Nov 30, 2008 10:01:12 AM
Ackman made a small fortune shorting ABK. Ron Paul has been warning us since as early as 2000.
Posted by: Jay at Nov 30, 2008 10:06:25 AM
A true Cassandra as defined by Tyler would have to know 2 things:
(1) that housing prices were going to drop, and
(2) that the majority of large financial firms had exposures such that they would suffer collossal losses in the event of housing prices going down.
I knew fact (1) all along, as did a lot of other people. The reason why I didn't know fact (2) is my lack of access to inside information about the trading exposures of financial firms.
Someone who does have the privelege of such information could easily have been a Cassandra, and I'm sure a lot of them privately were. Without such information, being a Cassandra would be much harder, requiring a very deep understanding of the institutional and incentive structure that led to the collapse. I on the other mistakenly believed the the investment banks with all their clever finance whizzes would be smart enough to position themselves to profit from the realization of fact (1).
Posted by: stubydoo at Nov 30, 2008 10:21:37 AM
"the next major bust, if there is no major interruption such as a global war, will be around 2008."
Fred E. Foldvary. 1997. The Business Cycle: A Georgist-Austrian Synthesis. American Journal of Economics and Sociology 56(4): 521-41, quote at p. 538.
Posted by: Daniel Klein at Nov 30, 2008 10:36:06 AM
Ron Paul, statement to the house financial committee (Gramm-Leach-Bliley Act), circa 1999:
[i]Madam Speaker, today we are considering a bill aimed at modernizing the financial services industry through deregulation. It is a worthy goal which I support. However, this bill falls short of that goal. The negative aspects of this bill outweigh the benefits. Many have already argued for the need to update our financial laws. I would just add that I agree on the need for reform but oppose this approach.
With the economy more fragile than is popularly recognized, we should move cautiously as we initiate reforms. Federal Reserve Board Chairman Alan Greenspan (in a 1997 speech in Frankfurt, Germany and other times), Kurt Richebacher, Frank Veneroso and others, have questioned the statistical accuracy of the economy's vaunted productivity gains.
Federal Reserve Governor Edward Gramlich today joined many others who are concerned about the strength of the economy when he warned that the low U.S. savings rate was a cause for concern. Coupled with the likely decline in foreign investment in the United States, he said that the economy will require some potentially `painful' adjustments--some combination of higher exports, higher interest rates, lower investment, and/or lower dollar values.
Such a scenario would put added pressure on the financial bubble. The growth in money and credit has outpaced both savings and economic growth. These inflationary pressures have been concentrated in asset prices, not consumer price inflation--keeping monetary policy too easy. This increase in asset prices has fueled domestic borrowing and spending.
Government policy and the increase in securitization are largely responsible for this bubble. In addition to loose monetary policies by the Federal Reserve, government-sponsored enterprises Fannie Mae and Freddie Mac have contributed to the problem. The fourfold increases in their balance sheets from 1997 to 1998 boosted new home borrowings to more than $1.5 trillion in 1998, two-thirds of which were refinances which put an extra $15,000 in the pockets of consumers on average--and reduce risk for individual institutions while increasing risk for the system as a whole.
The rapidity and severity of changes in economic conditions can affect prospects for individual institutions more greatly than that of the overall economy. The Long Term Capital Management hedge fund is a prime example. New companies start and others fail every day. What is troubling with the hedge fund bailout was the governmental response and the increase in moral hazard.
This increased indication of the government's eagerness to bail out highly-leveraged, risky and largely unregulated financial institutions bodes ill for the post S. 900 future as far as limiting taxpayer liability is concerned. LTCM isn't even registered in the United States but the Cayman Islands!
Government regulations present the greatest threat to privacy and consumers' loss of control over their own personal information. In the private sector, individuals protect their financial privacy as an integral part of the market process by providing information they regard as private only to entities they trust will maintain a degree of privacy of which they approve. Individuals avoid privacy violators by `opting out' and doing business only with such privacy-respecting companies.
The better alternative is to repeal privacy busting government regulations. The same approach applies to Glass-Steagall and S. 900. Why not just repeal the offending regulation? In the banking committee, I offered an amendment to do just that. My main reasons for voting against this bill are the expansion of the taxpayer liability and the introduction of even more regulations. The entire multi-hundred page S. 900 that reregulates rather than deregulates the financial sector could be replaced with a simple one-page bill.[/i]
And an investment in gold in 1999 would have yielded a 3x ROI!
Posted by: DDP at Nov 30, 2008 10:54:57 AM
the answer of course is that hordes of people were short, as can easily be found from the public records of short interest on the NYSE. but most of them are perma-bears and gold bugs who've been predicting this collapse since 1982, 1972, or longer. to be a cassandra you can't just be negative all the time, you have to be negative at the right time, for the right reason, and not just because you don't believe in fractional reserve banking.
And also, a lot of short-selling hedge funds that made the right call have been damaged by the Lehman lockup, redemptions by investors with other losses, and increased counterparty risk. It is very difficult to make a successful bet on generalized financial collapse when the only counterparties to the bet might also collapse. Are the people who correctly hedged their CMO risk with MBIA and AIG cassandras?
Posted by: DK at Nov 30, 2008 10:55:34 AM
Yikes, wrong tags!
Posted by: DDP at Nov 30, 2008 10:56:04 AM
I knew fact (1) all along, as did a lot of other people. The reason why I didn't know fact (2) is my lack of access to inside information about the trading exposures of financial firms.
I was short Bear Stearns in August 2007 after reading about it in Calculated Risk. The everquest IPO failure was a tip off that Bear Stearns had a lot of bad mortgage paper on its books.
see
http://www.reuters.com/article/gc06/idUSN2624218920070626
I think shorting the market as whole counts as being a Cassandra because you may not be sure who was the bag holder, but the bag holder was going to drag everybody else down.
Posted by: sort_of_knowledgable at Nov 30, 2008 11:11:56 AM
Engineer: I'm a construction inspector and I noticed the unsafe construction techniques here, this building is likely to fall down.
Building supervisor: Hey, it got inspected and the inspector they hired signed off on it. There's no problem, I'm off the hook on that.
Engineer: I notice your office is in the basement of the building.
Building supervisor: Say, do you think you could tell me which day it will fall down? I want to call in sick that day, just in case.
Building tenant: Hey, could you tell me the day it will fall down too? I don't want to move out too soon and not get the full value of my lease, but there ought to be some opportunities here. I could be half-moved with my most obsolute junk and the files that would be most convenient to lose, and then the insurance would pay off full value.
Economist: If you actually know what you're talking about, there ought to be a way you can make a profit on it. Like, you could start an Intrade bet on it. Get some bets started on which day the building falls down, and you could pick up some quick change.
Engineer: You don't understand. We're talking about a disaster, loss of life, massive destruction.
Economist: Maybe I could find out who insures them. If it's a small enough outfit I could short the stock.
Engineer: It's a disaster coming!
Economist: They all say that.
Engineer: I'm a certified professional. I do this for a living. I know what I'm talking about.
Economist: That doesn't impress me. I'm a certified professional, and I never know what I'm talking about. Why should I believe any better of you? The inspector who signed off on the work disagreed with you. And he must have been a credible source -- he got the job.
Engineer: That guy is going to lose his license.
Economist: [grins maniacly] OK, I have it. You can sell the building short. You sell this building to somebody who doesn't believe it will fall down, and you set the delivery date to sometime after it falls. Then you buy it cheap and deliver the deed.
Engineer: [looks oddly at economist] There's going to be a hell of a cleanup cost. If they refused to accept delivery I'd be responsible.
Economist: Well, this isn't something I really know anything about, but maybe you could write up a plan to save the building, and take it to your congressman. He gets it funded and then maybe there'd be some kind of competitive bidding you'd lose since you don't have the connections, but the winner would hire you as a subcontractor since you were the guy with the expertise in the first place, and you could run through the money and get the cost overruns financed, and take it from there.
Engineer: [shakes head sadly] [dials number for FEMA] This building is going to collapse, can you connect me with somebody who can do something about it??
FEMA receptionist: Sir, is this a bomb threat?
Posted by: J Thomas at Nov 30, 2008 11:15:21 AM
Actually I was hunting a cassandra based in Europe. Are you aware of any? I would like to know more on how and why we, europeans, got involved in this crisis...
Any cassandra in Europe?
Posted by: Massimo GIANNINI at Nov 30, 2008 11:18:59 AM
That's another high bar for "Cassandras" DK.
What if the stock market inflection starting in January 1995 set the stage? The Case-Shiller house price index took off shortly after that. I'm sure it would be convenient if a Cassandra could narrow the other side of the story for you, but you now ... given long cycles on these things maybe that's just not possible. (There might also not be "plays" in recognizing something dangerous about the long trends.)
I see that in May 2005 I wrote:
I think local real estate prices are somewhat bubble-like, but I don’t sweat it too much, because bubble-like conditions can last for decades.
They did, until they didn't.
FWIW, like a flag in the wind I shifted my attention from energy and The Oil Drum to finance and Calculated Risk sometime in 2006. I may not be a trend-spotter, but I know (in retrospect) that I am trend-vulnerable.
Posted by: odograph at Nov 30, 2008 11:21:46 AM
In other words, in economics as in weather hindsight is always 20/20...
Posted by: John Woodward at Nov 30, 2008 11:45:15 AM
Stubydoo wrote:
"A true Cassandra as defined by Tyler would have to know 2 things:
(1) that housing prices were going to drop, and
(2) that the majority of large financial firms had exposures such that they would suffer collossal losses in the event of housing prices going down."
This points out one of the major flaws of the self-interest-oriented free market, doesn't it? Unless there is a totally open and liquid flow of information of all transactions entered into, with full disclosure of the totality of such transactions, something which is not normally in the 'self-interest' of large and very exposed firms, then these events would continue in the absence of regulation; and the individuals who are privy to this information, i.e. the employees of the very firms under consideration, have little self-interest to reveal the depth of the exposure of their firms for fear of beginning a decline which could result in their own unemployment. The Cassandras who did think they knew (and the Foldvary quote above is truly interesting...), are thought to be just that, Cassandras, because the members of the groups involved in the risky transactions (in other words those with the fullest knowledge of their exposure) poo-pooed it all. And, finally, since they were 'knowledgeable' given their privledged position in the information stream, they are the most 'expert' in matters concerning their own exposure... so, why not listen to them?
I picture in all of this a Walt Disney employee standing at the helm of the jet screaming toward the mountain telling everyone "if you just believe in your dreams, they will all come true!"
Posted by: John W. at Nov 30, 2008 12:00:37 PM
I'm not sure what you mean there John. I'd be wary of the narrative that if there were no Cassandras (narrowly defined) then the problem (also narrowly defined) was unforeseen. If someone just said "these stock P/Es are crazy", "these house prices are crazy", "this consumer borrowing is crazy" ... would they be wrong, or just not a Cassandra?
Posted by: odograph at Nov 30, 2008 12:06:42 PM
Note: my 12:06 PM post was in response to John Woodward's 11:45 AM post.
Posted by: odograph at Nov 30, 2008 12:08:11 PM
I nominate Ambrose Evans-Pritchard at the Telegraph..
Posted by: RS at Nov 30, 2008 12:22:45 PM
Some don't short the market, as Odograph has pointed out. Some of us simply abandoned stocks completely in the summer of 2007 as the first subprime issues surfaced. We missed the ulimate top in late 2007, but we have been sleeping soundly the last year.
Posted by: Yancey Ward at Nov 30, 2008 12:28:19 PM
Since government and government regulation has been growing to unprecedented levels these last few decades, and now we supposedly find ourselves in Great Depression II, shouldn't we then admit that the libertarians were right after all?
I don't know if we can talk about "road to serfdom", but the recent bail-out folly does not bode well for the future.
Posted by: Unit at Nov 30, 2008 12:34:40 PM
It's true that I couldn't persuade my wife that we should sell the house (summer 2005) but I did persuade her that I should take early retirement (and so get the maximum lump sum out of my pension plan and get the monthly pension into payment) because, I believed, the coming collapse would be so awful as to be a threat even to one of the biggest occupational pension funds in Britain. I had planned to short the FTSE but refrained when I realised that if the banks were as insolvent as I assumed, then the counterparty risk would be too great. One thing that gave me considerable confidence in my analysis (much more than in my action) was that the vast bulk of macro-economists pooh-poohed the notion of a horror collapse.
Posted by: dearieme at Nov 30, 2008 12:40:03 PM
Should it be a requirement of a Cassandra to *not* have predicted seven of the last one recessions? After all, we don't admire the broken clock.
Posted by: Eric H at Nov 30, 2008 12:40:04 PM
Should it be a requirement of a Cassandra to *not* have predicted seven of the last one recessions? After all, we don't admire the broken clock.
That's the point, right? Somebody says the situation is unsustainable and can't continue as it is. Everybody else says "Tell us which day the collapse will come, and if you pick the wrong day it means you don't know anything."
It's like a bunch of mice find a mousetrap, and one of them says "That's a mousetrap. Stay away from it. It kills mice." And the rest then ignore him because they figure nobody knows when the trop will go off, and if they do just right they can grab all the cheese and be gone before the trap goes off.
Posted by: J Thomas at Nov 30, 2008 1:07:03 PM
@stubydoo
"my lack of access to inside information about the trading exposures of financial firms"
I must respectfully disagree. Exposures, modeling issues, & over-leverage were discussed in the Financial Times last spring. An offhand example was a consideration of Goldman on an FT blog on April 10, 2008.
Note especially the significant comments by wdm and D: "With paper assets down 10-20% across the board, it’s better having level II or III’s so you don’t have to use market metrics, which would eradicate book net worth across the financial system;" "$96 bln of basically unsaleable, unreckonable assets and a whole $50 bln of shareholders’ equity!" (Emphasis added.)
This is particularly chilling when you recall that people felt Goldman was one of the better-run firms! If this was the situation of the "good guy," imagine thus the bad!
That the whole charade would collapse in Sept. was made clear by an NY Times article on Aug. 4, noting the massive increase in default rates on certain categories of mortgages. Look especially at the graphs. Then think about how that would affect cash flow for banks and MBSs.
Altho' the overall point of the article "While it is difficult to draw precise parallels among various segments of the mortgage market, the arc of the crisis in subprime loans suggests that the problems in the broader market may not peak for another year or two, analysts said" is mistaken, that graph tells the tale for those who understood the basic MBS structure, how it relied upon the steady stream of payments.
The issue with the overall market not heeding this information was that most people — and this includes Tyler and the MSM business types — didn't know enough about how the business had changed and was actually working. Over-confidently reliant on their own judgment, they were 3 years behind the times, and also lacked understanding of the insight power contained in technical comments like wdm's above. This despite the fact that even non-serious players know to scour the FT & NY Times with a toothbrush.
But let's say people don't read newspapers much anymore: would a rational person have been given pause at the fact that last year it seemed like several basic cable channels had a program along the lines of "Flip This House?"
Thus stubydoo, please forgive me when I suggest that lack of knowledge wasn't due to lack of inside access, but rather, a lack of attention, lack of up-to-date business practice, or perhaps lack of understanding of what info was out there.
Actually, now that I think about it, this really links back to Tyler's information post and the need for a prediction market to aggregate such technical & business practice info in a way more concrete to more people.
Posted by: StreetWalker at Nov 30, 2008 1:09:43 PM
