Equilibrium Economics does NOT Predict Financial Crises

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I looked up Collateralized Debt Obligation on Wikipedia.  The first CDO was issued by Drexel Burnham Lambert in 1987.  (Remember Michael Milkin, the Drexel VP who went to prison for illegally manipulating the bond market?)  Drexel later went bankrupt and the savings and loan company that bought the CDO was taken over in 1990 by a government agency called the Resolution Trust Company.  

There were some references to articles on Gaussian cupola theory, first applied to CDO risk analysis by a Dr. David X. Li, allowing rapid pricing of CDOs.   I looked at the Gaussian cupola theory.  I know about multivariate Gaussian distributions, and used them in my doctoral work, but I had not known previously about this cupola theory.  I was struck by the complexity of the equations. They must have used every letter in the Greek alphabet in addition to some Roman characters.  The math may have been correct, but the whole theory is based on some simple assumptions that have turned out not to be true.

On Wednesday, there was an interesting Op-Ed article in the New York Times titled “This Economy Does Not Compute”, by Mark Buchanan, a theoretical physicist.  http://www.nytimes.com/2008/10/01/opinion/01buchanan.html?ei=5070&emc=eta1

The article makes the following points:

  1. Equilibrium economics does not predict what really happens in markets.  Good dynamic computer simulations do a better job.  Unfortunately, most academic economists stick to equilibrium economics, whereas theoretical physicists rely more on simulations.
  2. We’re not likely to avoid future crises with a little fiddling of the regulations, but only by exerting broader control over the leverage that we allow to develop.  
  3. A tax of 0.1 percent of the transaction volume, for example, would deter rapid-fire speculation, while preserving currency exchange linked more directly to productive economic purposes…So far theoreticians have found tentative evidence that a transaction tax may stabilize currency markets, but also that the outcome has a surprising sensitivity to seemingly small details of market mechanics – on precisely how, for example, the market matches buyers and sellers.  Application to equity and debt markets may be similar, but the simulations have not been done yet.  I don’t think these results would apply to collateralized debt obligations, mortgage-backed securities and credit default swaps, because there is no centralized market for these types of securities.

 

On Wednesday evening, Charlie Rose interviewed Warren Buffet, the world’s greatest investor.  Buffet said, half-jokingly, beware of geeks bearing equations.  Greed and fear are inherent parts of human nature.  In Buffet’s view, it is inevitable that, absent regulatory oversight, people will find ways to increase their leverage because of the greed factor.  Too much leverage always leads to a crisis, which is followed by fear.  Now we are in the fear phase, with many people frantically trying to deleverage at the same time.  We have had an economic equivalent of Pearl Harbor, he said, and we don’t have time to investigate why all the battleships were in port at the same time.  We have to fight the war that has been thrust upon us.  Buffet said that the bill passed by the Senate is not perfect, but it is close enough and the need for action is urgent.  The House should pass the bill, and we can debate how to fix the remaining problems later.

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