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June 19, 2012

Pareto

Will financial economics post crisis be more Keynesian in spirit?

CARLO ZAPPIA (University of Siena) reflects on the history of financial economics and how it is being challenged post the financial crisis. It covers the works of all key economists who have shaped finance- from Harry Markowitz to Robert Merton.

The interesting part of this paper is linking financial economics to decision theory. Both the fields look at how people make decisions in uncertainty and both use Bayesian thinking which is flawed. Bayesian decision theory is not suited to thinking about uncertainty and this explains how financial theories keep missing the crisis. Bayesian models do not make distinction between risk and uncertainty. He suggests instead focusing on behavioural decision theory as suggested by Itzhak Gilboa of Tel Aviv University.

It is interesting to note that Keynes was highly interested in this issue of uncertainty. However, Keynesians believed it is impossible to formalise. The recent research by Gilboa et al. shows how the initial Keynes ideas can be extended to decision theory. Hence, the new decision theory and financial economics assumptions which emerge after the crisis will be “Keynesian in spirit”.

United States Then, Europe Now

This is the title of the Nobel Lecture of Tom Sargent (2011).

He points how the euro zone can take lessons from the United States of America to develop its fiscal union. In 1780s, the U.S. consisted of 13 sovereign states and a very weak centre. The states could levy taxes while the Federal Government could not. There was a crisis as government debt was 40 percent of the GDP which was very high for a poor country. The founding fathers rewrote the Constitution making a grand bargain. The Central Government bailed out the states, and the states gave up the power to levy tariffs. The creditors were reassured with the knowledge that the Federal Government had the power to raise tax revenues and that their debts would be repaid. This led to the formation of the U.S. fiscal union which was formed ahead of a monetary union.

The fiscal union led to expectations of another bailout in 1840’s when the states once again got into trouble over rising debt. However, the Centre did not pay off the debts leading to debt defaults. This led the states to adopt balanced budgets and discipline over the same.

Both these lessons are important for Europe. However they do not apply completely as the contemporary euro zone conditions are different from those of the U.S. in 1780s. U.S. then, was a poor state but the euro zone countries are developed nations. But it can be agreed that the broad lessons are still adequately relevant in this situation.

The lecture ends on the note that the U.S. cannot live with high fiscal deficits. For monetary policy to work, fiscal has to be in control.

Image: Brooks Elliott

Why have a central bank at all?

House Domestic Monetary Policy subcommittee of U.S. recently held a hearing  on Improving the Federal Reserve System. PETER KLEIN says the issue is not of reforming Fed, but in its very existence in the first place. He belongs to the Austrian School which has always believed that money should also be traded like normal goods and services with private players deciding on the demand and supply.

Come to think of it, monetary policy is associated with Friedman’s views of free markets. Fiscal policy is seen as interventionist policies of Keynes. However, central banks are nothing but government/planning agencies protected from competition to manage money. The Central Bank is run by an elite corps of apolitical technocrats and can take almost any action it deems in the best interest of the nation.

Central banks also perform badly like most other government agencies. Monetary planners lack the incentives and information to make efficient decisions about open-market operations, the discount rate, and reserve requirements. Add the standard problems of bureaucracy—waste, corruption, slack amongst others— and it becomes increasingly difficult to justify control of the monetary system by a single bureaucracy.

A scathing criticism of our current monetary system.

Negative consequences of overambitious school curriculum in developing countries

LANT PRITCHETT and AMANDA BEATTY look at the puzzle of flat learning in a must read paper. Flat learning occurs when students do not learn much despite spending a lot of time at schools. This has been seen in recent findings on the education standards in India. While the student enrolments have risen the quality of the education is dismal with students of the 5th standard unable to comprehend concepts taught in the 1st standard.

The usual question on this is “why are the students lagging behind with the curriculum?” The authors reverse the problem and ask, “Why is the curriculum so ahead of the students?” What follows is a thought provoking discourse on how one can use tools of economics to understand a given problem.

They introduce a concept called Potential Pedagogical Function (PPF) which looks at the existing skill sets of students and the potential learning. The PPF can take various shapes depending on how one analyses the situation and gives way to an array of student skills and curriculum. The paper shows how curriculum which is faster paced than the student skill leads to little learning and as the students graduate to higher classes it becomes almost no learning.

Tracking the learning that leads to the narrowing of the curricular gap and early remediation are the only way out. The idea is to bring the curriculum closer to the centre of the skill sets of students.

Why is the financial industry so expensive despite huge gains in technology?

THOMAS PHILIPPON points to another paradox of the financial industry. Ideally one would imagine that costs of financial intermediation would have declined with growing technology. After all finance also used information technology heavily like the retail industry. If cost of retailing has declined with technology as shown in the numerous studies, so should be the case of finance. Right? Wrong. Cost of financial intermediation has actually been going up.

Historically, the unit cost of intermediation has been somewhere between 1.3 percent and 2.3 percent of assets. The cost of intermediation grew from 2 percent to 6 percent from 1870 to 1930. It shrinks to less than 4 percent in 1950, grows slowly to 5 percent in 1980, and then increases rapidly to almost 9 percent in 2010.

The author’s answer is that technological improvements in finance have mostly been used to increase secondary market activities, i.e., trading. Trading activities are many times larger than at any time in previous history. Trading costs have decreased, but there is no evidence that increased liquidity has led to better (i.e., more informative) prices or to more insurance.

Modern day evidence on “where are the customer’s yachts?”


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