By Michalis Zaouras on March 25, 2009

Where has rational expectations gone

I think this is very typical from a young economist to question. But the latest ponzi scheme that has hit the world financial markets, has raised this question again. To be honest the concept of the credit crunch crisis violates partially the idea of rational expectations, even though the bubble has been rationalized but an adaptation of expectations. To get to my main point, there has been quite a fuss with Madoff's ponzi scheme, 'deceiving' some of the elite in the financial market industry, starting from worldwide bank institutions to celebrities. Some of them pointing out that they were the victims of a plot designed by an ingenious, prestigious trader, excuse me for the abuse of defining Madoff as a trader. But is that all?

To make things clear, Madoff has been widely promising return on investment above 10% and in some cases as much as 47%. In my view there are two cases, these people were honestly declaring that they were tricked or they knew that there is something wrong going on but they were betting that Madoff will not get caught. Someone may believe that these attitudes are fully rational, but not in my view because the probability of this scheme to fail is almost one. It will fail because at some point when a crisis, negative productivity shock or demand driven shock you can call it as you want to, hit the financial market then he would not be able anymore to deliver the excess returns that he promised, because he will attract attention of the regulators and get caught. Also at this point, there will be no arrival of new clients, he will not have enough money to finance his promises to his existing clients, there will be deterioration of his position even further and as a result of that go bust. So why would anyone suspicious of a ponzi scheme join in, that is not rational at all.

To be honest there is a simple answer for my question, a person knowing of this scheme can join for a short time hoping to leave the scheme soon enough. For example, someone that has been promised a return of 15%, she can get the value of her money within 5 years, without reinvesting you will need 7 years. In contrast if you save with interest 5% you will need 15 years for your money to double. So you need the scheme to run successfully for a long period of time to find it worthwhile to join. To be more precise, you will need the scheme to survive into the medium run because we know that in the long run it will fail. But Madoff’s story with his scheme dating from 90’s and according to some from 80’s, points out that this is possible to achieve. It will be interesting though to see if any of Madoff’s clients left the scheme years before, or if they were reinvesting. If the last holds it makes them even more irrational because as the years passes, then the probability to get caught increases.

My answer to the statement above is a simple backwards induction argument, a rational investor who knows about the scheme and knows that it has been running for some time he will not enter because the probability of the scheme to be revealed to financial authorities is too high. This means that Madoff at medium run will have a bigger problem to find new clients even if a crisis is not around and the probability to fail to its promises increases, but then an investor at short run will not invest at all because the probability of failing even at medium run is too high. The backward induction argument holds, if we assume rational expectations.
I would like to close my comment with a great story that a friend of mine told me. During the 80's a guy had a car accident, he survived the accident but it caused him a reasoning problem, he became too rational. This is a true story and psychologists have explored further his case. An example of his reasoning problem is the following, when this guy wanted to have a lunch he had to choose first if he would take it at city centre or not, he would then visit all the places to find the most suitable one and then he would visit all the restaurants to get the best deal and at the end of all these, it was dinner time. So people are not as rational as we believe, based at least on our definition of rationality. Conclusion, are we missing something?

By Alexander Apostolides on March 20, 2009


I have to admit that I was intrigued by a comment posted concerning the current financial crisis and subsequent remarks concerning the resemblance of our current economic woes to the era known as the “Great Depression”. I have to admit though, that I was dismayed by the fact that consensus opinion in that comment appeared to be geared towards the argument that the importance of the current economic downturn trails by a relatively wide margin the severity of the economic woes experienced during 1929-1933. We maintain that this is not the case as the implications of the current downturn are too far-reaching and too serious to be dismissed as just another recession. We believe that the economic and social crisis just beginning, and worldwide demolition of wealth, are revealing the uncomfortable truth.

As you all know, the world economy is now entering an exceptionally uncertain phase which is subject to considerable downside risks. Although in the past we experienced many other economic downturns, also embodying financial crises (most notably US housing woes in the 80’s and also Sweden, Japan and Asia in the 90’s), we maintain that the origins, severity and magnitude of the current economic situation can only be paralleled to the Great Depression. Yet our capacity to learn from the Great Depression is limited because of different policy actions and because we do not know how economies would have evolved after 1938 if politics had not intervened.

We also maintain that current government policy is unprecedented and hence this reinforces our optimism that the US economy will not end up in a Great Depression as it did in in 1930. Hence the result is that we must now endure not Great Depression II, but Global Credit Crash I, with adequate government intervention spreading the pain over a number of years implying a shrinking credit system, slow economic growth and declining profits in the business sector for many years to come. Although this by default implies further drops in asset prices and additional banking woes and deflation we believe that this will be prevented (or reversed) via exploding budget deficits, which will push up interest rates so far, however, that asset prices will start falling too far again. Hence inflation could surge again steeply in the future as governments will have to respond to exploding budget deficits by artificially suppressing interest rates again. Also with governments and central banks bringing private sector losses onto their balance sheets, fiscal deficits soaring in the next two years and with the US Fed and the Treasury taking a massive amount of credit risk, the long-term solvency of the US government could be put at risk.

In drawing the parallels between the current state of economic affairs and 1929 we first have to examine the roots of the current economic cycle:

In the 1980’s and 1990’s more and more countries (in Asia and Eastern Europe) entered the global economic stage. As they developed their domestic economies, huge industries were created, mainly aming to produce for Western markets. At a macro-economic level this led to a transfer in prosperity from the West to the East whose magnitute would have normally led to economic contraction in the West and to high economic growth in the East. This process would have eventually come to a halt as the West should had lost the purchasing power needed to offset production in the East. Moreover, the currencies in Asia and SEE should have appreciated so much that their cost advantage would diminish.

None of the above developments took place because many Asian countries kept their currencies pegged to the dollar whereas a lot of Eastern European countries opted for a link with the Euro.

In addition the Western Economies started to grow fast because various factors systematically supressed inflation (emergence of densely populated economies after the fall of communism providing the West with cheap products plus a high rise in productivity combined with relativel low wage rises). As a result, interest rates continued to ease. Investment in assets became more profitable as asset prices surged further boosting consumer confidence. Simultaneously savings steadily decreased while consumption borrowing went up leading to corporations and lenders to look the future with more confidence based on the assumption that asset prices would continue to rise against a high growth environment and low inflation. In the end this became a self fullfiling prophecy as easing risk premiums, high growth and rising asset prices continued to reinforce each other. What actually happened is that the West lost a great deal of its competitive position to the East. It was able to disguise this for decades by means of a credit explosion. Unfortunately, this was used for more consumption instead of being invested to create a future source of income.

Thus to begin with, the cause of the current cycle is in the credit bubble inflated over the past few decades. The background against which the amount of credit has grown so rapidly is falling inflation from the 1980’s upwards. Due to falling inflation long term interest rates were also dragged down. The lower interest rates fell, the more asset prices rose. Virtually all asset classes prices rocketed upwards from 1990 upwards. While housing prices, in particular, were rising, debts were mounting, particularly those of consumers and financial institutions as consumers starting borrowing more to buy houses but also to consume more. After all real wages have hardly risen over the past few years and rising asset prices offered consumers sufficient security to save less and borrow more. Simultaneously it was assumed that asset prices would continue rising and growth would remain high.

The cycle of indebtedness became a reinforcing spiral as low inflationary expectations led to relative flat yield curves suggesting lower earned credit spreads on loans by financial institutions that were subsequently forced to increase the provision of credit facilities in order to ensure high profitability. Credit spreads would have widened as indebtedness increased but this was avoided via financial engineering (bundling and reselling loans and spreading risks through the Credit Default Swaps market). Credit spreads were also kept low by the fact that the Fed and the Central Bank of Japan kept pumping more liquidity into the system than the economy could absorb, in an attempt to fend off deflation (deflation is disastrous for highly indebted countries). In fact there was so much surpluss money into the income that bankers and fund managers had little option but to take increasingly high risks. Thus based on an over-rosy outlook too much was lent on over-easy conditions.

Under these conditions, housing prices in the United States rose by around 160% in the period between 1991 and 2006. Then inflation started rising (very high commodity prices and extremely low interest rates) so the conditions were no longer perfect for asset prices. The Fed had to raise interest rates in an attempt to curb inflation. As soon as housing prices fell by around 8% from their peak, the credit crisis broke out. The fact that housing prices only needed to fall by so little in relation to the preceding rise shows how unstable the system was. After all, it was based on the perfect conditions and outlook for asset prices and the debt mountain built on top.

Back into drawing the parallels to the Great Depression we have read and understood that the later at its peak it was effectively “collective insanity”. We also maintain that there are conflicting interpretations as to the causes of the mayhem. The bottom line though is that the Great Depression threw the survival of the economic system, and the political order into serious doubt. Similarly in 2008, markets and business leaders came to doubt the durability of the financial foundations that had supported consumption and asset price growth after the New Economy fiasco.

Various explanations have been put forward to explain the Great Depression. Some blame the failure of self-correcting mechanisms; others blame the low money supply suggesting that the Fed chose to follow the wrong policies. Given the exactly opposite nature of current government policies, we cannot identify any similarities to the current crisis from this viewpoint. Traditional monetary policy proved to be ineffective at the first stages of the current crisis, thus other unorthodox policies have been used including massive provision of liquidity to financial institutions to unclog the liquidity crunch and reduce the spread between short-term market rates and policy rates; quasi-fiscal policies to bail out investors, lenders and borrowers. Even more unorthodox policy actions were utilized in order to reduce the rising spread between long-term interest rates on government bonds and policy rates and the high spread of short-term and long-term market rates (mortgage rates, commercial paper and consumer credit) relative to short-term and long-term government bonds. Even though it is too early to give any credit to the above policies we do maintain though that if it were not for the trillions of dollars committed to current government interventionist policies then the Great Depression could be dwarfed by the meltdown that we would be faced with.

Other economists blame over-production and under consumption. We do not have any evidence to support if this is the case today. However we do point out that this is one of the dangers that we could face in the near future if the consumer credit bubble does not deflate in an orderly manner.
Another school of thought blames the 1929 downturn to increased protectionism that finally led to less demand for US produced goods. We cannot draw any parallels to today’s crisis, but we would like to point out that today, government policies are becoming more and more protectionist (remember Obama’s “Buy American” logo?).

Other economists (including Ben Bernanke) in explaining the Great Depression cite the inherent limitations imposed to policy makers by the gold standard. We also recall that another school of though further villifies the gold standard system by blaming it for transmitting the problem to the rest of the world. Although we do not have a gold standard today, we would like to point out that we do have the Euro and plenty of involuntary currency interventions.

We like the explanation put forward by several economists that consider the key reason for the Depression to be the expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom. I am sure that you can all see the similarities here to the current crisis. We also like the explanation put forward by the Austrian School of economics which blame the easy credit policies of the Federal Reserve during the 1920s (similarities to Greenspan’s Fed after 2000 anyone?).

The next view on the causes of the Great Depression is very closely related to our current situation and relates loose credit to over-indebtedness, which fueled speculation and asset bubbles. We are sure that you can all see the parallels to today’s crisis.

Finally we would like to point out that as in today, back in the 1920’s there were structural weaknesses in banking. Graham and Dodd (the fathers of security analysis) argued that prior to the Great Depression major banks were holding over inflated risky equity investments while also they made risky loans based on an over-rosy outlook. Graham and Dodd also argued that part of the the credit boom of the 1920’s was brought by investment banks that underwrote bond issues by practically insolvent companies in order to meet investor demand for fixed income investments. We are sure that you have all spotted the striking similarities to the current crisis here.

As a last point, I would like remind you all that the US Economy is in recession since November 2007 (according to the Economic Bureau). The financial crisis emerged in September 2008 following the collapse of Lehman. If it was not for the Lehman debacle (and Fannie Mae and Freddy Mac a few days earlier) then AIG and WM would probably not have had their credit lines cut off – and AIG could had been able to roll-over its derrivatives positions successfully. Prior to that we just had the subprime collapse and the credit crunch thing (I think that both emerged to the surface in early to mid 2007 – but the actual slowdown in the US economy started in 2006). Both the Subprime crisis and the credit crunch were precursors to the current financial crisis (more like mini-crises) but they were by products of the economic slowdown and not trigger events for it. We also remind you that through the 1920’s thrift failures were also very common.

By Alexander Apostolides on March 04, 2009

Dr. Orphanides vs Deutche Bundesbank? - not really.

I thought they were rumors but it seems Bloomberg also hints at a rift within the ECB. According to the article the Fed trained Dr. Orphanides, president of the central bank of Cyprus, is pushing the ECB to drop interest rates even further.

What the article seems to ignore here is that the ideological division within the ECB is taking place between people who accept the same principles of economics, i.e. this is not a rift between Catholicism and Protestantism but a debate over the proper reading of the scriptures within the Catholic orthodoxy.

All in the ECB believe in the basic monetarist tenets: the money market has a direct impact on the real economy and peoples incomes, and thus interest rate reductions stimulate the economy (or increasing inflation) even in the current economic climate.

Thus this so called "battle" is not battle of ideas but more a disagreement of versions of history. Dr. Orphanides is evidently a believer of the Bernanke (Head of the US Federal Reserve) / C. Romer (Chair of the US Council of of Economic Advisers) view of the Great Depression. The Romer / Bernanke synthesis argues that the recovery from the Great depression was due to an expansionary monetary policy and the restructuring of the banking sector. Others in the ECB, possibly led by Professor Axel Weber, president of the Deutche Bundesbank, have the horrors of stagflation of the 1970s and the hyperinflation of the 1920s firmly entrenched in their mind. In their interpretation of the same monetarist tenement, inflation is dynamic and comes after a lag of 6 months to a year after a interest rate cut; it is simply not worth having future inflation in order to prevent a possible reduction of output today as the cost of inflation in terms of future lost productivity far outweighs the effects of a current downturn. Both schools see the restructuring of the banking sector as crucial, and i am sure they feel hampered by the diverse responses of the EURO-area countries in terms of bank restructuring, where the ECB has no direct input.

However the issue facing the world is that economics are not united in providing responses to the current crisis. Rather than accepting any one school of thought, a collection of different policies drawn from all schools would surely provide a better outcome, due to the fact the objectives of each school are as diverse as the needs of the policymakers.

It is not clear if the monetarism has the answer to the needs of politicians in increasing output and providing employment; some economists argue that interest rates are so low that we have fallen below the threshold where monetary policy ceases to be effective, thus falling in a "liquidity trap". According to Neo-Keynisian economists (who also sit in the council of economic advisers) what is needed is direct investment in the real economy by the government (more schools, roads, ect) in order to safeguard jobs and increase output - interest rates cuts simply will not work anymore.

While there might be a definite disagreement on what the monetarist solution is for Europe, both parties within the ECB accept that the ECB holds the answer and fiscal policies of the respective European countries are at best complimentary but at worst unhelpful. However, the debate for the way out of the current global mess needs to take place by taking all schools of economic thought into account in order to have a correct policy response. Yet strangely enough the focus has been on global action without having a global discussion on what is the way froward in terms of economic theory.