Jul

6

Tyler Cowen gave an interesting talk at the NY Junto about the economics of worry, what you should worry about and what you shouldn't. He touched on his bearish views for the stock market, and felt Dow 8000 was a good goal because of the conjunction of the real estate and commodity crises, and various psychological anomalies. I kept wanting to say "Et tu, Tyler?" because I don't believe in bear markets, and always believe it's right to buy, especially at times like this.

John De Palma adds:

I greatly enjoyed the lecture on Thursday. It was the best talk I've attended this year.

1) He attributed part of the origin of the subprime problem to a calculation error where the perceived default rate could have been 1% in securities when the true probability of default was 4%. (Somewhat relatedly, Richard Clarida wrote in an October PIMCO commentary, "The proximate cause of this 'hard day's Knight' was the more or less simultaneous realization by millions of global investors that their underlying assumption about the distribution of returns on a wide "variety of asset-backed securities" was fundamentally flawed.")

I also think a rational bubble was a source. The Keynesian beauty pageant as an asset pricing model could be consistent with buying and selling of assets at values that adhere to an overall market convention that is inconsistent with how each market participant would appraise the asset if unable to flip it to another participant. (Keynes BTW compared investment to "a game of Snap, of Old Maid, of Musical Chairs"). In my view the bursting rational bubble would just be a breakdown in the pricing convention.

If a bond fund manager gets evaluated by Morningstar ratings and receives capital inflows on the basis of a narrow trailing 2 or 3 year performance, then the incentives to harbor blowup risk in a portfolio is such that the manager marginally setting prices in the market could be apathetic about whether he privately believes that default rate is 1% or 4%.

It conjures up an interesting thought experiment: Can credit risk be underpriced and yet everyone in the market thinks bonds are overvalued? Or the parallel inquiry from a rational bubble section of my senior thesis in college: Can eToys be worth $10 billion when mutual fund managers collectively think it is worth $1-$2 billion? (I surveyed fund managers, many of whom owned the stock, and the average response was the latter figure at a time when the market cap was multiples higher.)

2) I liked how Cowen's view of the macroeconomy was nuanced instead of a one dimensional scapegoating of an overly accomodative Fed, over (or under) regulation, etc. that is so popular. I find scary the compulsion towards narrative fallacies, attribution errors, and cramming world events into a preexisting ideological view.

3) His metaphor comparing subprime securities to poisoned water seemed apt. Bill Gross chose a "Where's Waldo" metaphor to eloquently make the same point in some of his commentaries during the financial crisis– ("…While market analysts can guesstimate how many Waldos might actually show their face over the next few years - 100 to 200 billion dollars worth is a reasonable estimate - no one really knows where they are hidden…"). In analyzing earlier crises Mohamed El-Erian has also related the lemons problem to EM debt pricing.

4) Cowen spoke about how the inequality of happiness in Denmark is similar to the U.S. despite a lower income inequality there. My takeaway from Daniel Gilbert's book was happiness set points and the power of habituation. Couldn't the inequality of happiness just converge upon some distribution regardless of the level of income inequality if there haven't been recent changes?

Also, I think in Gilbert's book there is an assertion about how the most realistic people (i.e. least susceptible to cognitive biases) are ones that are classified as mildly clinically depressed. Similarly, if people generally worry too much (which seemed to be your contention even if there are certain things people worry insufficiently about), then maybe some self delusion would be useful to avoid excess sensitivity to perceived threats.

5) In general comments on income inequality he mentioned how the rate of inflation varied by income right now. This is a bit of a non sequitur, but it's a topic I've been thinking about in the context of the Fed's fervent interest in inflation expectations. Surveys show how expectations differ by region and even gender in normal conditions. People's expectations have a consistent upward bias and overweight more frequent purchases. If the Fed is so obsessed with controlling these expectations than perhaps we need separate monetary policies by region, gender, and income so that we can reset an expectations-augmented Phillips curve to a price stability point. Since we of course don't, then maybe the Fed and market participants shouldn't look at these surveys to the second decimal place and pretend that the fate of the economy depends on 1.8% vs 2.2% inflation.

6) He made a point on health care about how people are blindly deferential to not properly incentivized doctors reminded me of this good column that David Leonhardt wrote in November– ("… Economists sometimes refer to this situation as an "expert service problem," because the same expert who is diagnosing the flaw is the one who will be paid to fix it. In most of these cases, consumers aren't sophisticated enough to make an independent judgment. That's why they went to the expert. The problem, of course, extends well beyond the car business. Anytime you call a plumber or roofer to your home or anytime you visit a doctor or dentist, you're at risk of having an expert service problem…If anything, Professor Hubbard argues that the expert service problem is more serious in medicine than in auto repair, because most people are less willing to question a doctor than to question a mechanic. Any effort to reform American medicine has to grapple with these conflicts of interest…").

7) Cowen commented that a catastrophe isn't more likely because markets don't price the prospect more aggressively now than in the past. However, in an article he linked to on his blog, Peter Thiel said the pricing is distorted because no one would be around to collect the insurance payout in the event of the catastrophe– ("…The catastrophe is so large that no functioning market or government remains: This is the only case where one would incur catastrophic "losses," although nobody might be left to collect them…" ) Similarly, there was recent speculation that a market on a Large Hadron Collider-motivated catastrophe would break down because of the inability to collect a payout in an apocalyptic event. ("…Unfortunately this is one kind of question where an Idea Futures market would not work too well, because people who correctly bet that the reactor will destroy the earth may not be able to collect their winnings. This would cause the market to under-estimate the risks…")


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