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Vendredi 16 Octobre 2009

Michel Clérin, expert-journaliste, partenaire Finyear

Is America Changing ?
Economist graduated from the Louvain School of Economics and the University of Chicago, Michel Clerin worked initially at the Bank of America, Merrill Lynch and the BNP PARIBAS Group. He acted as policy advisor for various governments on behalf of the European Commission, USAID and the World bank

Michel Clérin
Michel Clérin
You have visited lately some prestigious US Universities. Could you explain your views about the changes in economic theory ?

Michel Clérin : Neoclassical models have dominated the fi eld of macroeconomics since the mid-1970s. The global credit crisis has raised criticism on the neoclassical framework’s blind spots, particularly their failure to predict the current financial crisis because of its unrealistic assumptions according to which markets are rational and free markets correct themselves. Nobel Laureate Paul Krugman believes economists must wake up to the «inconvenient truth and reality that fi nancial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowd”. Second they have to admit… that Keynesian economics remain the best framework for making sense out of recessions and depressions.

Critics of the rational and free economic actor model have long attacked the assumption that markets are rational, driven by rational self-interested economic actors. The Effi cient Market Hypothesis (EMH), designed by professor Eugene Fama and Nobel Laureate Professor Merton Miller, and the models it has sowed show the similar lack of relevance to how fi nancial markets actually work. Trading rooms are certainly not fi lled with bankers pontifi cating on the fi ner point of economic theory; but the tools they use on a daily basis, – from derivative pricing models to risk management metrics such as VaR, – are all ultimately based on a world that assumes constant liquidity and the near impossibility of extreme events.

The belief in effi cient market theory, promoted by the University of Chicago, blinded most of the economists to the emergence of the biggest bubble in history. It also played a signifi cant role in infl ating that bubble. For US households, $13 Tn. in wealth have evaporated and more than seven million jobs have been lost.

From 1985 to 2007, a false peace settled over the fi eld of macroeconomics. The Eastern Coast universities (Princeton, Yale, Harvard and MIT) have a more Keynesian vision of what recessions are all about, i.e. inadequate demand requiring government intervention at times of crisis. The University of Chicago neoclassical purists believe that all worthwhile economic analysis starts from the premise of the rationality of people and markets. But these were years of the Great Moderation. East Coast schools believed that the FED had everything under control. Chicago scholars didn't think the Fed's actions were benefi cial but they were willing to let matters lie.

During this fi nancial and economic crisis, the Fed drove interest down from 5.25 % to close to zero like in the Great Depression. When monetary policy is ineffective and the private sector can't be persuaded to spend more, the public sector must take its place in supporting the economy via a fi scal stimulus approach. It is not only the ideas of the effi cient market theory of the U of C but a wholesale rejection of the concepts of Nobel Price Milton Friedman as well. Friedman believed that the Fed policy, rather than changes in government spending, should be used to stabilize the economy.

It was the followers of Friedman who denatured his ideas and theory. Professor Casey Mulligan of the U of C suggests that unemployment is so high because of the choice of many workers not to take any jobs. He suggests that workers decide to remain unemployed because that improves the odds of their receiving mortgage relief. But how can anyone seriously claim that the US has lost more than 7 million jobs because of the few Americans who do not want to work ?

In fact, the U of C School is in a cul-desac because once you assume that people are perfectly rational and fi nancial markets are perfectly effi cient, you have to conclude that unemployment is voluntary and recessions are desirable. The crisis has for this reason put the U of C School in absurdity. At the same time the “the new Keynesian” East Coast schools have been required to introduce in their models some fudge factor that, for reasons unspecifi ed, temporally depresses private spending. If the analysis of where the US is now depends on this fudge factor, how much confi dence can the decisions makers have in the model's predictions ?

The concept of Value at Risk (VaR) should also be exorcised. Visionary economists have always blamed the formerly glorifi ed VaR model as risk radar which was adopted a long time ago by regulators for the purpose of calculating capital requirements for banks trading activities. The indictment of VaR is that it rests on one main charge; i.e. as a construction that borrows from past data and from improper probabilistic assumptions. The new Basel formula adds something called “stressed VaR “. That is the new capital levies required for market punting. It will be the number that the previous reigning technology would have produced plus an add-on determined by that stressed item. The new VaR should contribute in enhancing the fi nal capital charge. Some studies have calculated that under the new VaR charges could be increased as much as three-fold.

What school of economic thought is being presently the most credible?

The school that seems to be the closest to reality is known as “Behavioral Finance”. They emphasize two things :

• fi rst, many real world investors bear little resemblance to the cool calculators of effi cient-market theory: they are subject to herd behavior, to bouts of irrational exuberance ;
• second, even those who try to base their decisions on cool calculation often find that they can't due to trust and credibility issues and limited collateral require them to run with the herd.
Behavioral Finance tries to answer to this irrationality by related it to known biases in human cognition like the tendency to extrapolate too readily from small samples. Behavioral economists have correctly diagnosed the vast bubble which brought the world close to its knees. Prices of assets like real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole.

In Behavioral Finance there are eleven hurdles that could be a major factor in risking your investment and economic strategy :

• The Bandwagon effect: it's the idea that it is OK to follow the herd because so many people believe in it. It's irrational because it places faith in the safety of numbers disregarding the fundamentals.
• Loss aversion: people tend to have a strong preference for avoiding losses over acquiring gains.
• Disposition effect: this is the tendency for investors to lock in gains and ride out losses.
• Outcome bias: judging a decision by its outcome, rather than the quality of the decision at the time it was made.
• Sunken costs effect: treating money that has already been spent as more valuable than money that is to be spent in the future.
• Recently bias: weighting recent data more heavily than earlier experiences.
• Anchoring: this is the tendency of people to rely on information available when making a decision. Investors based their decisions on information that may be faulty.
• Believe in the law of small numbers: this is when investors base their conclusions on a slice of data that is way too small.
• Endowment effect: people tend to value something once they own it. As in housing, people tend to overvalue what belongs to them, blinding them of its real value.
• Disconfi rmation bias: this makes people critical of information which contradicts their belief, while accepting information which is in line with them; in short it is a trap whereby people believe what they
want to believe.
• Post-purchase rationalization: This is when investors persuade themselves through rational arguments that a purchase was a good value. Of course, if a decision needs to be rationalized after it had been made, it was probably wrong.

A new theory has proven that the markets can stay irrational for a long time. Arbitrageurs need capital to do their jobs. A sever plunge in assets prices, – even if it makes no sense in terms of fundamentals, – tends to deplete that capital. As a result, the smart money is forced out of the market and prices may go in a downward spiral.

Indeed the general ideas underlying models of fi nancial instability have proved highly relevant to economic policy. A focus on the depleted capital of fi nancial institutions helped guide policy actions after the fall of Lehman and these actions headed off an even bigger collapse. Economists are now facing the inconvenient reality that fi nancial markets fall short of perfection and that they are subject
to extraordinary delusions and the madness of crowds. Economists have had to accept that Keynes’ economics remains the best framework we have for making sense out of recessions and depressions.

Shouldn’t policy makers keep in mind the impact of the unpredictable ?

• First of all, Mr. Alan Greenspan’s role, as Head of the Fed for 20 year, turned out to be largely negative with his prolonged low interest rates and a laissez-faire attitude towards regulation. He should make an apology and not come across like a hero in all the conferences he gives. Let’s hope that the future policy makers will not the same mistakes but even more importantly relax these projected stiff new
regulations in the coming years
• They should also listen to Mr. Bill Gross, the originator of the largest world bond fund. He says that the entire US economy has been structured as a gigantic Ponzi scheme. According to him, under the policy-endorsed cover of technology and somewhat artifi cial increases in fi nancial productivity, the US became a nation that specialized in the making of paper instead of things! And it fell to Wall Street to invent ever more clever ways to securitize assets and the job of “Main Street” to equalize or, in reality, to borrow more and more money.
• Let us hope that the future crises will be different and that they will not share the same fundamental source, which is the unquenchable capability of human beings when confronted with long periods of prosperity to presume that this will continue.

Could you briefl y explain the Black Swan Theory ?

Professor Nassim Taleb’s theory of the “Highly Improbable” or “Black Swan” should be known to every policy maker. In a much vivid way, the Black Swan approach consists of the following points :

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.
2. No socialization of losses and privatization of gains whatever may need to be bailed out should be nationalized; whatever does not need a bail-out should be free and risk-bearing.
3. People who are driving a school bus blindfolded (and crashed it) should never be given a new bus. The economic establishment lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of the mess.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your fi nancial risk. Odds are he would cut every corner on safety to show “profi ts” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups.
5. Counter-balance complexity with simplicity. Complexity deriving from globalization and highly networked economic life needs to be countered by simplicity in fi nancial products. Capitalism cannot avoid fads and bubblers; equity bubbles have proven to be mild; debt bubbles are vicious.
6. Do not give children sticks of dynamite, even if they come with a warning. Complex derivatives need to be banned because nobody understands them and few are rational enough to know it.
7. Only Ponzi schemes should depend on confi dence. Governments should never need to “restore” confi dence. Cascading rumors are a product of complex systems. Simply we need to be in a position to shrug off rumors in the face of them.
8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is denial. The debt crisis is not a temporary problem; it is a structural one.
9. Citizens should not depend on fi nancial assets of “fallible” expert advice for their retirement. Citizens should experience anxiety about their own business they control and not on the investments they do not control.
10. Make an omelet with a broken egg. This crisis cannot be fi xed with makeshift repairs. We will have to remake the system before it does it itself.

As a joke Professor Taleb says: “Let us move voluntarily into capitalism 2.0 by helping what needs to be broken on its own, converting debt into equity, marginalizing the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong even some time in jail, clawing back the bonuses of those who got us here and teaching people to navigate a world with fewer certainties”.

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