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The rising fortunes of John Geanakoplos
It is a front-page WSJ article, read it here. Excerpt:
In a 2000 academic paper, Mr. Geanakoplos offered a theory. He said that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them "natural buyers."
Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.
I thank Daniel Lippman for the pointer.
Posted by Tyler Cowen on November 3, 2009 at 10:36 AM in Economics | Permalink
Comments
And how is this different from the hundreds of similar theories offered before?
Posted by: sa at Nov 3, 2009 10:52:00 AM
Another way you can look at this is that persons other than the Fed created a new money supply; that the collapse of this alternative money supply caused the Fed to supplant its own money supply with the receding money supply based on layers of collateralized financial instruments.
Posted by: Bill at Nov 3, 2009 11:10:02 AM
I had the privilege to listen to him five a seminar this paper. The one thing he mentioned is that he needed to have empirical studies to prove/disprove his theory. I must say though that the paper in theory seemed valid, but the Professor himself is still waiting for empirical evidence.
Posted by: Ryan at Nov 3, 2009 11:21:51 AM
This is why Rand is important. Economics is not amoral. And the moralists are often immoral.
Posted by: Andrew at Nov 3, 2009 11:21:54 AM
I too had the privilege. Both myself and the theorists I spoke to afterward found the talk mostly incomprehensible.
Posted by: anon at Nov 3, 2009 11:46:23 AM
And...? This isn't terribly different from the ideas of Friedman, Bernanke, Minsky, Keynes, or pretty much anyone else who thought about this problem for more than fifteen minutes.
Posted by: Reed at Nov 3, 2009 11:49:20 AM
And, understand how fractional reserve is like leverage and your journey to the dark side will be complete. They should of course be called unnatural buyers.
It's almost shocking that this stuff is not better understood. I feel like Neo who said "either nobody told me, or nobody knows." But, it's understandable from a contrarian perspective because some people equate understanding things this way with an attack on their worldview. And you are relying on the altruism of people like me to harangue you while all the while being called names by the people on the government's payroll. At some point we say, "hell, let's just go make money off these fallacies."
Posted by: Andrew at Nov 3, 2009 11:54:36 AM
"An alternative point of view is that, due to a lack of a perfect rational ity, the market is not in perfect equilibrium and thus prices do not simply passively reflect new information. Under this view the market acts as a non-linear dynamical system: agents process information via decision-making rules that respond to prices and other inputs, and prices are formed as a result of agent decisions. Since this information processing is imperfect, the resulting feedback loop ampli es noise. As a result a signi cant component
of volatility is generated by the market itself."
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1112664
Thank goodness somebody has found a way to explain this to economists.
Posted by: Michael F. Martin at Nov 3, 2009 12:00:13 PM
ooooooo, "Animal Spirits" did it.
This statement does not prove his genius.
What kind of kookiness is the "efficient Markets" theory that it is violated when individuals make bad investments and then suffer losses on those investments?
Is there some theory that says "Markets" are always allocating resources in their most efficient fashion? Uh, news flash. That theory is
wrong.
And what kind of kook thinks that a change in the
market environment (suddenly folks decide there is
too much investment in housing) leads to an uninterruptable downward spiral?
Posted by: roversaurus at Nov 3, 2009 12:03:36 PM
If Bill is right this guy is wrong, because interest rates would respond to increase/decreases in money supply regardless of source. Something the Fed can track.
So something else must be the true source of the "excessive" lending.
People underestimated the risks they were taking. Some people didn't understand the game they were playing. Think of poker players deciding to play with two decks instead of one. If they don't understand how that has changed the odds of a winning hand they will not bet correctly.
A rational market can be wrong if people collectively discount the chances of a future bad outcome.
Posted by: DanC at Nov 3, 2009 12:19:34 PM
If Bill is correct, this guy is wrong. Interest rates will reflect an increase/decrease in money supply regardless of source. So interest rates, that the Fed can track is still key.
Posted by: DanC at Nov 3, 2009 12:23:30 PM
Reed: "This isn't terribly different from the ideas of Friedman, Bernanke, Minsky, Keynes, or pretty much anyone else who thought about this problem for more than fifteen minutes."
You guys are crazy if you think that John Geanakoplos's work is little different from prior work! The difference between older work this work is that Geanakoplos incorporates these concepts into today's models. Anyone who thinks it's somehow the same as previous work is an idiot -- thinking about a problem for fifteen minutes is not the same thing as writing an academic paper. Keynes had the right idea, but would have required a modern education to understand Geanakoplos, who is at the forefront of research in mathematical economics and general equilibrium modeling. Part of the problem with past work has been its lack of rigor, and we are just getting into an age in which we have rigorous models that can satisfactorily incorporate collateral and default. Making the arguments in a rigorous style makes them more convincing, and yields better policy recommendations.
Posted by: KH at Nov 3, 2009 12:52:36 PM
Sorry, but what happens when the supply of money increases. Interest falls. What happens when financial institutions create additional money in the system by layering collateral on collateral--using CDOs as collateral and then leveraging to make more loans. Doesn't the money supply increase when non-bank banks increase their lending with excessive leverage on these assets? Since I'm Bill, Bill would say the professor is right, and Bill is not wrong--what the professor is saying is that excessive leverage expanded the money supply, and that is what the professor was saying as well.
I'll be honest: I am not a monetary theorist, but that seems to me what the professor is saying and what I think probably happened.
Posted by: Bill at Nov 3, 2009 1:05:26 PM
Get out the Bible and find all the references to money and debt. Convert it to mathematical formulas that only people with modern education can understand.
Posted by: 8 at Nov 3, 2009 1:12:58 PM
Well gee Bill
Non Banks can increase the velocity of money and the money supply.
So the root cause becomes that the Fed kept interests rates too low for too long and Government policy supported excessive risk taking in real estate.
Money aggregates have less meaning in policy, because of non bank banks - but who really tracks that much anymore?
Posted by: DanC at Nov 3, 2009 1:52:16 PM
And btw the Clinton administration and Mr Rubin fought meaningful and needed oversight of derivative markets while offering the government as a fallback option
Posted by: DanC at Nov 3, 2009 1:59:16 PM
If you take out a blank piece of paper and draw boxes and arrows for lenders, brokers, and appraisers, it seems like the problem would jump out at you.
When your collateral value is based on the appraised value based on the last sale that was paid for by borrowed money based on the value of the collateral, how could the result be any different?
Toss in the Chinese who are repatrioting our dollars as loans to buy more stuff and the question is why it took so long to happen this big and why wasn't it obvious?
What lies did we tell ourselves to keep the game going? What other forms can those lies take?
(8, nice)
Posted by: Andrew at Nov 3, 2009 2:07:23 PM
8,
We have formalized Jubilee as official policy. We call it "Quantitative Easing."
Posted by: Andrew at Nov 3, 2009 2:20:05 PM
8,
The fact that there are other sources -- ancient as they may be -- that reference debt and interest, provides little policy insight. Why? Because the implementations that are suggested are unworkable -- the bible suggests that we charge no interest at all.
Building a workable theory of collateral and debt provides us with a framework for testing and forecasting, which were not available before. The Lucas critique suggests that model parameters should be invariant to policy changes, so that a workable model can provide reasonable predictions. Most economists would agree this is where Keynes' work was insufficient.
An example that one can cite here is of option pricing. Sure, options existed before Black-Scholes (people who thought about it for fifteen minutes could come up with the idea), but the advent of a pricing formula made them accessible because it provided a believable quantitative framework.
Economists have struggled with this issue (collateral) for a long time exactly because of this problem, namely, that the framework didn't exist for proper evaluation of policies, or predictions. Because of this, although cycles related to liquidity and default could be observed, they were difficult to forecast and their welfare effects were difficult to measure.
Current methods exist for a reason, not just for fun. Generally speaking, most economists actually eschew complexity, especially if it is unnecessary. However, putting all of the pieces of this model together in a realistic way creates a huge amount of complexity, and that is where the contribution of Geanakoplos' work is most apparent.
Most countries that base national policy on religious texts don't do a very good job on the economy.
Posted by: KH at Nov 3, 2009 4:10:25 PM
Reading the WSJ quote, I say, "yep, that describes why the previous finance crisis occurred over the past eight centuries."
As for his lacking empirical data, it hows a real lack of initiative on his part; from the authors' own comments and the comments of those taken by the book, the book This Time is Different: Eight Centuries of Financial Folly is loaded with lots of empirical data.
Reminds me of the empirical work of Milton and Anna in A Monetary History...
Why are so few economists willing to do the empirical work??
Posted by: mulp at Nov 4, 2009 3:25:58 AM
"Why are so few economists willing to do the empirical work??"
Division of labor.
Posted by: KH at Nov 4, 2009 2:32:03 PM
"Why are so few economists willing to do the empirical work??"
Because it is arduous and unrewarded relative to its difficulty.
Posted by: DD at Nov 4, 2009 5:03:06 PM
"Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets."
That sounds wrong to me. When we're talking about a consumption good such as a house, the value depends on people's tastes and their ability to pay to satisfy their tastes. Thus, efficient market theory would say that if someone stops being able to borrow, the true value of their house falls. The efficient price of an asset depends on the state of the economy, and is always changing.
Posted by: Eric Rasmusen at Nov 4, 2009 10:19:53 PM
With all due respect to the very intelligent and talented John Gee-whiz, did he actually use this theory to then successfully predict the housing-related financial bubble and crash?
If not, then it looks like he's just some guy the people at Treasury grabbed because he'd written a theory about it and because he's a professor at a fancy school.
They're stil missing the true measure of merit: Did this guy actually call the problem before it happened?
Speaking of a guy who saw the problem before it blew up, I see no sign of Raghuram Rajan in that WSJ article that mentions all those economists.
I suspect it's because he was right when everybody else wasn't, and nobody wants to admit that by having him in the room. So now a bunch of "big names" will work the problem, even though they're not the ones who actually successfully predicted the problem.
Welcome to the false "meritocracy" among present-day economists.
Posted by: Keith at Nov 6, 2009 4:23:30 PM
