Economic Models Need to Include Leverage…(duh)

May 2nd, 2012 at 8:49 am

Great piece by Peter Orszag here on one reason why macro-models failed to adequately forecast the Great Recession: they didn’t account for leverage and its impact on the depth and length of the downturn.

This has a strong ring of truth.  The folks who saw this coming, like Dean Baker (and Jamie Galbraith, Roubini, Krugman, Shiller…me, after Dean convinced me) either didn’t depend on such models or gave a prominent role to the debt bubble in addition to the standard models.

Peter cites Bernanke, who points out that while the bursting of the bubble was of a similar magnitude in terms of lost wealth, “the housing crisis was much more damaging because the initial impact was concentrated in a highly leveraged financial sector and then substantially amplified as those losses cascaded.”

I’d add a related wrinkle: when a bubble bursts, it mops up more quickly because of the difference between “mark-to-market” in an equity bubble and “extend-and-pretend” in a debt-financed housing bubble.  The fact that your pet rock shares go from valuations of $1,000 on Friday to $1 on Monday rips the bandaid off in a way you don’t get when banks can inflate for months on end their balance-sheet value of non-performing loans.

What should we do about this very salient limitation to economic forecasting?  Over to Peter:

…here’s a rough rule of thumb: Whenever a reasonable financial-stress index…is particularly elevated, be very skeptical of economic forecasts from models that pay scant attention to the financial industry. They will be making the housing- meltdown-is-just-like-the-tech-one mistake all over again.

You’re probably wondering why economists would leave leverage out of our models.  Good question.  It’s because we’ve historically viewed financial markets as basically an intermediate input in the economic process, distributing savings to their most productive sources.  Greenspan added the assumption the hyper-rationality would lead market participants to self-regulate.

Keynes and later Minsky recognized the folly of this shortsightedness.  Minsky in particular saw how the inherent instability in financial markets has derailed economies for as long as there’s been credit and debt.  Financial “innovations” have only added to this instability.

I’d like to cite the Who here…but I think I’d better not.

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14 comments in reply to "Economic Models Need to Include Leverage…(duh)"

  1. foosion says:

    I would have thought the main reasons the bursting of the housing bubble had worse effects than the bursting of the bubble were

    – more people had more of their net worth tied up in housing than stocks. Not many people own stock worth much, while a lot of people owned homes

    – more people were employed in in housing related activities than related activities. There were a lot of construction workers, while the high fliers in were start-ups with few employees or more traditional tech companies that greatly ramped market valuation without greatly ramping employment.

    I’d also mention that the financial sector has been much more able to get free money (or free guarantees) from government than just about any other industry. Too big to fail creates massive distortions not seen in other areas.

    • Anonne says:

      The housing industry’s weakness has a lot more collateral damage because it also affects other industries – retail goods (furnishings, electronics, etc.) and the industries that manufacture those goods. Home Depot was famously hurt by the recession.

  2. Sandwichman says:

    “…an intermediate input in the economic process, distributing savings to their most productive sources…”

    Which is to say that the economic model builders of 2008 (and 2012) know less about credit that Charles Davenant knew in 1699. No wonder those folks don’t care much for history of economic thought!

  3. marcel says:

    Wow, I had been aware that Schiller had such foresight. Can you point me to the poem (and line?) in which he predicted this particular mess?



  4. perplexed says:

    -“I’d like to cite the Who here (…but I think I’d better not.”

    So lets see, so far, since the crisis began more than 5 years ago we have:

    1. Done nothing to dismantle or control our TBTF banks and financial institutions (they actually control a larger portion of the market now).
    2. Continue to provide free public insurance to our TBTF institutions.
    3. Chose not prosecute any of the criminal fraud conducted by these institutions.
    4. Continue to allow them to defraud people out of their homes with falsified documents.
    5. Allow them to protect their wealthy clientele by fighting inflation and stimulus when that’s what needed by the other 95% of the population to break out of this economic death trap.
    6. Allow them and their plutocrat friends to buy and control our media and turn our sources of news and objective information into entertainment shows that impede our understanding of what’s really going on instead of exposing it for what it is. (watch this:

    But we won’t get fooled again?

    They no longer even try to fool us, its all done out in the open now. They have shown that our ability to self govern and control them can be exceeded with enough money and the right strategies. Some models are working pretty well aren’t they?

  5. readerOfTeaLeaves says:

    Glad to see this, but IMVHO it doesn’t go nearly far enough in identifying how leverage creates (exponentially) powerful incentives to control legislative, judicial, and political power in order to protect the processes of financialization.

    To illustrate, I’ll compare my investment processes against what I understand to be the processes involved in our current, ‘financialized’ era:

    1. Back in the ( day, I decided to invest. My first question was **always**, “how much can I afford to lose?” An investment is a risk: I assumed the risk of losing money was higher than the chance of making it; for that reason, leveraging risk was never part of my strategy.
    2. I studied opportunities, then ‘bought shares’ in companies. I never borrowed a dime for any of this ‘investment’.
    3. I did quite well, but I *always* viewed it as a risk.
    4. At every point in the entire process of buying or selling stocks, I was *always* supportive of the companies and their prosperity: I only did better IF AND WHEN they prospered and were well-run. My incentives *as an investor* were consistently aligned with the companies’ productivity.
    5. At no point in that process did I ever use leverage, despite making (at my best) returns as high as 24:1. In other words, even when I made $24 for each dollar that I invested, not a single penny of leverage was involved.
    6. I viewed my ‘investment money’ the same way my grandfather viewed his seed corn: it has potential, but it’s not your main food source – don’t gamble what you can’t afford to lose.

    In contrast, consider CDOs and CDS’s, where the incentive structure becomes completely upside-down, and then accelerates to increase risk. Leverage exaggerates and distorts this underlying problem.
    For instance:

    1. Let’s say that I ‘create’ an ‘investment vehicle’ by clumping 1,000 mortgages together. Suppose I divide each mortgage into 100 ‘bits’. I call my ‘investment vehicle’ something manly and virile, like “Timberwolf”.
    2. I sell each of the 10,000 ‘shares’ in “Timberwolf”, marketing this heap of schlock to banks, pension funds, and investors. I claim that my activities make me a ‘market maker’, and neglect to mention that I’ve paid off the ratings agencies to sanctify this dreck as AAA.
    3. However, because I have insider information (which I will never admit to possessing), I know that “Timberwolf” is economically dicey: I’m highly likely to be made a fool, plus impoverished, by holding onto this cluster of dreck. I have to offload it to some other sucker. Therefore, using LEVERAGE, I decide to ‘hedge’ my bets that maybe Timberwolf may tank. Going to the (dark) ‘swap’ market, I use leverage to pay only $1 for an ‘insurance policy’ (called a ‘swap’) against the risk that many Timberwolf mortgages will foreclose. I can do this secretly, because the swaps are not on an exchange.
    4. Using leverage, I only need to pay $1 to buy $30 worth of ‘credit protection’ against the risk of Timberwolf going south. Multiply these odds by about 10,000 ‘swaps’ — each of which I can place a bet against — and you begin to see the potential financial payoff that will come my way if — and only if — Timberwolf tanks. I can multiply my odds and profits many, many times — each time, using leverage. (Ahhhh, the giddiness of the multiplier effect…) With leverage, my risk accelerates, because I’m either going to win really, really big. Or lose everything. (I have friends who don’t ‘get’ this point, maybe because Jon Stewart hasn’t covered it.)
    NOTE: This incentive structure is the complete opposite of the old era investment structure, where I: (a) used my own money, (b) knew I was taking risks, and (c) did well *only* when the companies did well. What we have with CDOs and swaps is completely opposite: there is an accelerated incentive toward destruction, in order to get the swaps to pay off.
    5. My incentives have now shifted: it is now in my interests to stealthily ensure that Timberwolf tanks, because that is the only way for me to reap the guaranteed insurance contract ‘swaps’ payoffs; the vehicle that I use to cream off $29 for every dollar that I ‘invested’ gambled by using leverage to buy the ‘swaps’.
    6. Those ‘swaps’ do not actually represent any socially productive, viable economic activity: they’re a way of reallocating money via insurance contracts. In other words, there’s a lot of paper money sloshing around, but no commensurate economically productive activity.
    NOTE: Anyone investing asks, “What am I being asked to buy?” To me, CDOs and CDSs are “socially sanctified garbage.” I see *no* genuine investment opportunity in this scenario, and at the level of state and local governments it appears to produce scorched earth.

    7. This “Timberwolf” scenario is not *economically* viable. Because it is not economically sustainable, it is going to require manipulating legal, law enforcement, legislative, and political forces to enforce what are fundamentally fraudulent insurance contracts, whose sums are so vast that it requires entire populations to make them ‘whole’. To ensure that entire populations hand their tax dollars over to pay off fraudulent insurance contracts, you have to control political, legislative, and judicial power: PACs, dark money, and no-holds-barred campaign spending *become necessary.*

    8. Consequently, to keep these ‘swaps’ plates spinning in the air, financial interests must buy and control political and legal protection, via PACs and lobbying. (See also: Dr. Bernstein’s set of graphs correlating income inequality/financialization of the economy with political campaign finance dysfunctions, which appear to increase exponentially as the economy becomes financialized, probably in roughly the way that hurricanes intensify as climate becomes destabilized.)

    Economists who fail to discuss leverage should be viewed with the same derision as doctors who are ignorant of inflammation and diabetes.

    But in all honesty, Dr. Bernstein, Barry Ritholtz, Yves Smith, ‘Jesse’ (Cafe Americain) and Dylan Ratigan are the economics folks that I see consistently pointing out that the term ‘POLITICAL economy’ actually derives from the fact that political processes determine economic ones, and vice versa.

    Until we have some more frank conversations about leverage, how that affects economic incentives, and whether leverage actually generates wealth, I don’t see us making much headway in cleaning up a deeply rotten system.

    And FWIW, given the OWS movement, plus a Presidential candidate with $20,000,000 stashed in the Caymans, now seems a good time to have those conversations.
    I’m getting a bit worried about the supply of seed corn, and I’m really tired of bankers stealing it all.

  6. Comma1 says:

    The problems are bigger with the housing bubble because of that elephant in the room that economists try so hard not to talk about… distribution. The dot com bubble dealt with a smaller distribution of actors, and those actors were sophisticated and able to tolerate risk — for example, if Bill Gates lost half his fortune in he was still sitting pretty. On the other hand with the housing bubble, the distribution hit unsophisticated actors, who could not tolerate risk, and gave them signals the risk was lower than that, everybody who needs housing. Here when Grandma loses half the value of her house and is foreclosed on, she is now homeless.

    Good job smart people for ignoring distribution for fifty years against all common sense.

  7. markg8 says:

    So Jared it seems as if you’re saying most of the money invested in the bomb wasn’t borrowed but most of the money invested in housing was. I guess that makes sense. Many people could stand to lose $20,000 or $50,000 in the bust from their IRAs and 401Ks with little more than a hard lesson learned. But to lock themselves into a home mortgage contract with $20,000 or $50,000 down that loses $100,000 or $200,000 in value over the next few years puts them and the economy behind the credit eightball for a long, long time. Add the leveraged mess on Wall St and the the number of unemployed and we have the demand side problem in a nutshell.

  8. urban legend says:

    Besides what foosion correctly said about the housing component of net worth affecting the masses versus a minority of dot-com investors, those dot-com investors knew all along it was phony wealth — the product of “irrational exuberance” — so they never really considered it part of their actual net worth. Billions were spent convincing the average homeowner buying a home or taking out a home equity loan that real estate is different, it always goes up, and so on and so on.

  9. Sams says:

    Interesting, what’s your take on Steve Keen and other Post-Keynesian economists who would agree and “see finance as more akin to petrol than oil” (from Keen’s Debunking Economics)?

  10. Concerned says:

    Economists really need to start giving credit where it is due, and not to those who have arrived to the party late. The Great Recession was predicted by the likes of Steve Keen and for the reasons that Orzstag and others are just now discovering. It’s a shame Dr. Bernstein is either unaware of this or is interested in keeping the accolades in the family of fellow like-minded folks who have been slow to the realization.

    And let’s not forget what, at bottom, are the true causes and ideas that caused the Great Recession: the ideas of unfettered markets, deregulation, and that that society is nothing but individuals scurrying about for their own short-term selfish interests. The degree to which Democrats were spineless in the face of this paradigm juggernaut by the right or actually bought into it is the degree to which they are also responsible.

  11. Steve Roth says:

    Great post, thanks. Just to say that you really gotta add Steve Keen to the list. Yeah, ignore is odd definition of AD, but look at what he’s said about private debt, and his spot-on predictions.