Online Debate on the Financial Crisis at Economist.com

Proposition: "It would be a mistake to regulate the financial system heavily after the crisis"

Pro: Professor Myron Scholes, Stanford University
Con: Professor Joseph Stiglitz, Columbia University
Moderator: Henry Tricks, Finance Editor, The Economist


Comment to the Moderator on Professor Scholes' Opening Statement:

Sir,

The financial system needs to be regulated mainly because the theoretical underpinnings of modern finance are quite weak and outdated. For example, let us take the Modigliani-Miller theorem which forms the central theme of Professor Myron Scholes' Opening Statement in this debate. This theorem states that the value of a firm is independent of its debt-to-equity ratio. For its simplicity and effectiveness, this theorem is definitely a creditable achievement of modern economics. Indeed, its discoverers Professors Franco Modigliani and Merton Miller went on to win the Nobel prize in Economics (at different times), for this theorem and other achievements. When this theorem was first established more than 50 years ago, it applied very well to the industrial economy of that time.

In those days, if an entrepreneur wanted to start a business for the first time, say a small factory or a retail shop, his/her initial investment (down-payment) would have to be substantial, say 25 percent or more. A financial institution, like a community bank, would lend the rest of the money. The bank can verify that its money is being used to actually build the factory, a physical asset, and thus it has a fairly good understanding of how its money is being employed for making profits. After several years, if the business runs successfully, the entrepreneur goes back to the bank to help build a second factory. After this process happens a few times, the company has grown quite large, having established a successful business model with a well-understood revenue/profit stream. At this point, the entrepreneur realizes that to reach economy of scale, (s)he has to jack up his/her business plans by an order of magnitude, and (s)he would have to find access to much larger sources of finance. The result is that the company goes public. Note that the entrepreneur also benefits personally because his/her own investment in the company, which is now made into shareholding claims, has become more liquid. The company could issue more shares in the stock market, i.e., increase equity, or issue bonds in the credit market and/or get more loans, i.e., increase debt, to raise capital for its further business ventures.

Now, by the time the company has reached this situation, invariably, its balance sheet would have grown to include far more than just equity and debt. Due to accumulation of profits over the years, it would have reserve funds. Then again it would have to pay into its employees' pension funds. It would be helpful for the reader to keep in mind some large corporation of the 70s and 80s, like Bethlehem Steel. The company would have a large number of assets and it would indeed be a huge undertaking, far more than just the sum of its equity and debt. The Modigliani-Miller theorem says that the total value of the firm, as given on its balance sheet, would not be dependent on the ratio of its equity and its debt. Moreover, the creditors (those who have furnished the company with its debt) can also understand the business model of the company by verifying the company's assets, which are mostly tangible and real. Here I would like to point out that it is not in the creditors' interest to take over the company, because the entrepreneur-industrialist brings substantial expertise about how to pursue profit-making opportunities during the day-to-day functioning of the company. In this context, the theorem provides the (very) useful information that while analyzing the balance sheet of the company, one need not worry about the debt-equity ratio.

In contrast, there are a lot of problems when one tries to apply the Modigliani-Miller theorem to figure out whether regulation of today's finance industry should stop with 'capital requirements and pricing flexibility', as mentioned in Professor Scholes' Opening Statement. Now, a typical 'bulge-bracket' investment bank (like the top few Wall Street firms) would have about 30 to 40 billion dollars in capital (equity + accumulated profits). However the bank would have borrowed over 800 or 900 billion dollars to finance its operations (and hence the oft-quoted leverage ratio figure of 25 to 30). At this point, it might be helpful for the reader to actually see the balance sheet of a publicly traded Wall Street investment bank (it is available for free on Yahoo Finance).

Now where did the 800 to 900 billion dollars come from? They came from the pension funds and the mutual funds. Hence, there is a serious problem here. If you asked a pension fund manager in 2003 about the details of the mortgage securities, (s)he would have had no idea how the whole process works, because financial innovation was happening at a furious pace, and there was a whole alphabet soup of CDOs, CDSs, AAA MBSs being created newly every week or so. Thus, while the industrial economy of the 1950s, 60s and 70s had the entrepreneur operate at leverage ratios less than 10 and gave his/her bankers a fairly good idea about the business model, the technology and the innovation, in sharp contrast, the creditors of the contemporary finance firms have no way of knowing whether their money is being employed in the business venture in a sensible manner. And most importantly, the entrepreneur whose own stake is only 40 billion dollars controls the whole of the 900 billion dollars. Unlike the situation in the industrial economy, the long-term economic contribution of the entrepreneur is quite suspect precisely because a financial crisis could wipe out his/her business venture (40 billion) whereas the total value (900 billion) is more stable.

This is the fundamental weakness of modern finance theory. If the common (wo)man had followed the news about Wall Street since the beginning of this year, (s)he would have mostly heard about the high leverage ratios in the investment banks, about sub-prime mortgages, about the credit freeze and how it is all going to come down on Main Street as a huge financial meltdown. In talking about debt and equity, the Modigliani-Miller theorem gives the illusion that the whole of the 900 billion dollars is a part of the investment bank, when in fact, that money belongs to the pension funds. The pension funds and mutual funds carry anywhere from 20 to 50 trillion dollars of people's savings (source: Wikipedia). So, the discussion among financial experts in the media should have focused on these large accumulations of capital. This approach would have avoided fear and panic in the financial markets, but perhaps it would have also made it impossible for the Wall Street investment banks to extract more than 20 percent returns on capital year after year.

Thus, the financial system needs to be regulated until the experts of modern finance can go back to the drawing board and work out a more stable foundation. Instead of promoting financial innovation in the markets, they should conduct credible research in finance at the universities. Having said that, I have to mention that I am also quite worried that after this Presidential election in America the extreme leftists would take control of the government and the media which would lead to tax-and-spend liberalism and big government. There is a grave risk that re-regulation would quickly become excessive.

Coming back to Professor Scholes' Opening Statement, further objections to modern finance theory can be made from other perspectives. The first objection is based on the economics of asymmetric information. For an excellent overview of this perspective, please see Professor Kenneth Arrow's article 'Risky Business' in The Guardian on October 16, 2008. The second objection is more subtle. It says that economic risk cannot be quantified so easily as modern finance theory presumes. For this perspective, see Professor Edmund Phelps' article 'Our Uncertain Economy' on March 14, 2008 in The Wall Street Journal.

While the first and the second objections concern the focus of modern finance on risk management at the level of a company-firm, by far the most common criticism of finance theory is that it is ineffective in containing systemic risk. This perspective has been given much needed theoretical heft and some respect by Professor Gary Becker's article 'We're Not Headed for a Depression' on October 7, 2008 in The Wall Street Journal. Particularly striking is his statement, "The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system". Lastly, please check out my blog-post where further clarifications about the current financial crisis are given: http://selvasblog.blogspot.com/2008/10/faq-on-current-financial-crisis-q1.html


Further critiques of the Modigliani-Miller theorem from more advanced perspectives

1) Professor George Akerlof has proposed a new formulation of maco-economics which takes the Modigliani-Miller theorem as one of the given conditions of the economy (he calls these conditions neutralities). Then he attempts to derive these conditions in a rigorous way by extending on the traditional micro-economic assumptions that a firm would aim for profit-maximization and a consumer would aim for utility maximization. The extensions he assumes are basically norms on the behavior of the consumer, which he calls 'realistic norms'. Please see his Presidential address to the American Economic Association in January 2007, 'The Missing Motivation in Macroeconomics'. However, one should note that the Modigliani-Miller theorem is far from the last word even in the industrial economy of the second half of the 20th century. One should recall how many large corporations, e.g., Bethlehem Steel, had underfunded their pension plans for prolonged periods of time. In the case of the steel-making corporations, when it was finally discovered that their balance sheets had simply been out-of-touch with reality for the better part of two decades, they went into bankruptcy courts. The pension plans and health benefits of their employees had to be foregone, and they were sold for fire-sale prices to become what is now Arcelor-Mittal steel company.

2) Demographically, the aging of the baby boomers has meant that the typical American investor is aging (as measured by average age or median age). Hence portfolio management advisors would invariably be advising their clients that they need to reduce risky investments as they approach retirement. In the aggregate, this means that as a nation, the United States, and similarly, other advanced industrial countries, would prefer progressively more cautious investments in the next two decades or so. However, in saying that it does not matter whether a firm prefers debt or equity to finance itself, the Modigliani-Miller theorem does not address this demographic reality well. In fact, with the entrepreneurial culture in a capitalist society, the equity-holders take full control of the firm, even though their own stake is as much as 30 times less than the debt-holders. In modern times, there is also the conflict of interest between share-holders and management. These developments are at odds with the demographic realities of today. Thus a different theory of finance that takes into account (i) the changing risk tolerance of the population, and (ii) the relative stakes of the management, creditors and shareholders could definitely be more suited for the future.

FAQ on the Current Financial Crisis
(Continued on Thursday, October 16, 2008)

Q13. You had mentioned in your answer to Q9 that "as far as the Federal Reserve Bank is concerned, the most important and pressing need, at present, is for its Chairman, Professor Benjamin Bernanke to give a well-thought public speech that demonstrates that he understands the problems he is encountering in the markets." The Federal Reserve Chairman has indeed been giving public speeches on the current financial crisis during the last few days. On October 7, he spoke at the conference of the National Association of Business Economists (NABE). Yesterday (October 15), Professor Bernanke spoke at the Economic Club of New York and held a Q & A session after that. Does Professor Bernanke's speeches provide some assurance about his expertise in being able to deal with this financial crisis?

A. Yes, I have transcribed Professor Bernanke's speech and his Q & A session held yesterday at the Economic Club in New York. I have carefully considered his remarks in his opening address and his answers in the Q & A session. I have to say, with great reluctance and some sadness, that Professor Bernanke does not possess sufficient understanding of the current crisis in the financial markets. This is all the more worrisome because Professor Bernanke seems to have earnestly consulted his academic colleagues throughout this crisis in a bipartisan manner. One good aspect about Professor Bernanke's stewardship of the Federal Reserve is that right from the beginning of his term, he has functioned within a rational and logical policy framework which had been derived from current academic scholarship of the Great Depression. Let me explain the broad outlines of his policy framework here. For more details, the reader should refer to the transcripts of yesterday's speech given by Professor Bernanke (a copy of the transcripts is attached to this mail):

To quote Professor Bernanke (from yesterday's speech), "The crisis we face in the financial markets has many novel aspects largely arising from the complexity and sophistication of today's financial institutions and instruments, a remarkable degree of global financial integration that allows financial shocks to be transmitted around the world at the speed of light". Professor Bernanke also made some comments about the positive geo-political reality that enables the Federal Reserve to work in close coordination with the central banks of Japan, England and Europe, in contrast to the protectionist economic policies of the industrial countries during the Great Depression. But for these novel aspects, it would seem, from listening to Professor Bernanke's speech and his Q & A, that the current crisis situation can be handled with tools and techniques developed from past experiences, particularly the Great Depression. Lastly, expressing a firm "we will not stand down", as the Chairman did yesterday would, I suppose, contribute towards managing the expectations of market participants about the future.

The first lesson of the Great Depression is that the government authorities (the Federal Reserve, the Treasury, the Congress and the President) should act early and act quickly because waiting too long could mean that many financial institutions are already insolvent. The next lesson is that the central bank should provide liquidity in the financial system by keeping interest rates down and by extending large amounts of credit to the banks by way of short-term lending. Beyond this liquidity provision, the Federal Reserve, the Treasury and the FDIC should take precautions to prevent the collapse of a large number of banks through bank-runs, as happened during the Great Depression. Moreover, the systemic risk should be monitored continuously and any large financial institution whose failure is too risky for the whole financial system should be directly assisted in avoiding bankruptcy. At some point in this crisis-prevention program, the central bank would find itself out of resources, i.e., monetary policy alone would not be sufficient to prevent the escalation of the crisis. At that point or well before that, Congress and the Administration should step in with fiscal assistance. The intellectual basis for this role for government's intervention has been long established by the great British economist John Maynard Keynes during the Great Depression. Government intervention could take the form of deficit financing, higher taxation and (partial) nationalization. While all this assistance is going on, the central bank should use its mathematical models for gauging inflationary expectations to make sure that inflation does not get out of control. It may be noted in passing that this inflationary-expectations-modelling, a body of knowledge that has evolved from the collective contributions of monetary theory, behavioral psychology and econometrics, is one of the great achievements of 20th century economic theory.

This then is the broad outline of the policy framework that the Federal Reserve has been following during the tenure of Professor Bernanke as its Chairman. The practical implication of this policy framework is that the Federal Reserve provides broad intellectual support to the Treasury's actions in this crisis. In particular, the government take-over of Fannie Mae and Freddie Mac in early September and the 700 billion dollar Troubled Assets Relief Program (TARP) passed in the US Congress in early October are given theoretical justification under the Keynesian prescription for government intervention. So far, so good. Now, regarding the future, the Keynesian tradition would advocate regulating the financial markets to prevent excessive risk-taking, and injecting equity into financial firms to prevent insolvency. The moneratist tradition would insist, I suppose, on a role for the Federal Reserve in providing liquidity and the thawing of the credit freeze. The libertarian tradition would provide assurance to the finance firms that the government's involvement is only for their own benefit. Unfortunately, this policy framework does not take into account some crucial aspects of today's economic reality. Hence, I am forced to express doubts about Professor Bernanke's understanding of the current financial situation. With all due respect, I have to give Professor Bernanke a mild thumbs-down.


Q14. In what ways are the current economic situation different from the Great Depression?

A. To my knowledge, academic literature in economics does not take into account that the Great Depression fell between the two World Wars of the 20th century. As a result, the lessons of the Great Depression for today are usually specified as abstract policy prescriptions without taking into account the particular details of the political and economic reality that existed at that time. The single major difference between the American economy during the Great Depression and the contemporary one is the massive accumulation of capital, a phenomenon which I have explained in detail in my answer to Q1 above. Before World War I, the most advanced industrial nations with well-developed pension and life-insurance systems, and universal health care were in Europe. World War I wiped out the accumulated capital of these countries. America was beginning to experience the first blushes of affluence during the Jazz age of the 20s, just before the onset of the Great Depression. Thus there were no sizable accumulations of capital anywhere in the world. In contrast, the pension funds and mutual funds that hold the lifetime savings of today's workers all over the world amount to anywhere between 20 trillion to 50 trillion dollars. One should compare this figure with the fact that the annual GDP of the United States is of the order of 14 trillion dollars.

The second major difference is geo-political reality, which Professor Bernanke alluded to in his speech. During the Great Depression, countries were pursuing protectionist economic policies and severe restrictions on the flow of capital across the world. In contrast, global flow of capital, goods, labour are growing rapidly today. Moreover, nations are increasingly adopting democracy as the form of government. This has resulted in a much friendlier, co-operative geo-political environment at the global level. The third major difference is the advent of technology. The use of computers has ensured that communication is more quantitative, reliable and accurate. In this way, the flow of information which is crucial for economic decision making has vastly improved.


Q15. Why are the lessons drawn from the Great Depression inadequate for dealing with the current financial crisis?

A. One can easily see that when one takes the massive accumulations of capital today into account, then the most helpful policy prescriptions for dealing with the current crisis would try mostly to enable the private sector, which holds these vast quantities of capital, to function freely. The possibility that capital does not flow freely but is clogged up temporarily calls for an active policy of providing liquidity. But other than that direct government intervention to adjust the capital structure of the finance firms is evidently quite destructive. In short, the cures that Milton Freedman prescribed for avoiding the Great Depression, namely, ample liquidity and minimal government, seem to make the best policy for the current financial crisis. Keynesian policy recommendations might come useful, if and when the economy actually experiences a contraction in output. Moreover, it appears that the credit freeze that has come under intense focus among the economists of late was, in fact, caused by the loss of confidence in the credit markets due to the government's arbitrary intervention in the functioning of the markets, going back at least to the take-over of Fannie Mae and Freddie Mac in early September. One should also note that the term 'credit freeze' is quite misleading. There does not appear to be an actual unavailability of credit on Main Street. Credit freeze seems to refer to the high rates of interest that banks charge for lending to themselves, far in excess of the yield in the Treasury securities, and the high rates of mortgage loans. But, again, the reason for this could be that government is the 800-pound gorilla that is causing a lot of uncertainty in the credit markets by its arbitrary meddling in the functioning of the private sector. Also, inflation could be creeping up, and banks may be unwilling to lend at real interest rates that are negative, unlike the willingness of the Federal Reserve to keep cutting its interest rates. Lastly, the fact that private banks could be charging interest rates much higher than the Fed might help to attract money from the hedge funds and mutual funds which are looking for safer investments than stocks and mortgage securities. Thus it is not entirely a bad thing since it enables the free flow of credit.

(Dt. Sunday, May 04, 2008)

Update 2: A Marginalistic Interpretation of the GARCH model

In this second update to my research proposal, I would like to discuss a marginalistic interpretation of the GARCH model for estimating volatility. I had originally sent out my research proposal, 'A New Perspective on the Role of Markets in an Economy', in the third week of March 2008 (a copy of this proposal is attached to this e-mail). In my research proposal, I had mooted the idea of considering the duration of interaction between the buyer and the seller in a market, especially when the value, frequency and volume of trading are high. I had also sent out an initial update to my research proposal in the second week of April 2008 (a copy of this update is also attached to this e-mail). In this initial update, I had focused completely on the ongoing housing mortgage crisis, especially on four issues which were not given adequate coverage in the media. In this second update that I am now sending out, I would like to first clarify certain aspects of the discussion between Professor Robert Engle and Professor Joseph Stiglitz on April 25, 2008 during the Squawk Box program on CNBC television channel. Specifically, I would like to address two fundamental issues raised by Professor Stiglitz in that discussion, about the role of the mathematical models that Wall Street uses for estimating risk. After this clarification, I would like to explain how my idea for studying the duration of interaction between the buyer and the seller fits in with what Professors Engle and Stiglitz were saying.This second update is organized in three sections: I. Volatility Models, II. Professor Joseph Stiglitz's Observations on Volatility Models, III. Duration of Interaction.

I. Volatility Models

When one tries to understand the role in modern economics played by mathematical models for estimating time-varying volatility, it is important to realize that some of these models, like GARCH, provide an elegant and useful conceptual synthesis of several different streams of economic thought. Firstly, empirical observation indicates reliably that in the trading of an asset in the market, a sustained increase in the asset price is directly related to periods of reduced volatility, and conversely, periods of great volatility are directly associated with significant drops in the asset price. This empirically supported knowledge helps to capture the behavioral psychology of the individual players in the market in a quantitative manner. Now, other things being equal, the inflation-adjusted value of an income producing asset is expected to increase as time goes by, due to several inter-related factors like technological advancement, productivity gains, time value of money, increased return of profits commensurate with the systematic risk, welfare-enhancing trade, division of labor, overall growth in the economy, etc. However, if the individual players are worried about certain information that is unfavorable (in the short run) to the ownership of the asset, they would take actions which in the aggregate would reflect their anxieties as increased volatility, and also lead to a sustained period of reduction in the asset price (in the short run). Similarly, if the players in the market felt confident and certain that the short-term future would influence an income producing asset either favorably or not at all, then the price of this asset would continue to go up (for the reasons mentioned above) over the next few weeks or so. In this way, the volatility models provide a good approximation for the influence of information on the price of an asset, an influence which works its way indirectly through the psychology of the individual players in the market.

Secondly, these volatility models incorporate the Efficient Market Hypothesis, a major stream of economic thought in the 20th century. Now, if one analyzes further, the role of volatility models in predicting asset prices, the question naturally arises as to how exactly does information influence asset prices. The Efficient Market Hypothesis specifies, among other criteria, that the market should not entertain sustained and predictable arbitrage opportunities. Clearly, for this property of the market to hold, it would have to be the case that whatever information that first came to light in the past, and was relevant to the value of the asset being traded, was not hoarded by only a few players in the market, but was available to all the market participants without delay. Moreover, the assumption that markets functioned efficiently also implies that each of the individual players, once given the relevant information, are capable of rationally analyzing its influence on the asset and proceed to initiate buying or selling of the asset, which would lead to changes in the price of the asset accordingly. Thus, in an efficient market, at any given point of time, the current value of the asset has already incorporated all past information that is relevant to the asset, and any imminent change of the asset price at that point of time only depends on any new information that has a bearing on the asset's value. The mechanism by which volatility models incorporate the Efficient Market Hypothesis is called a Time Series. Time Series is a mathematical construction that is useful for recording the state of the market at various moments of time, in chronological order. The state of the market can be described by different variables whose values may depend on the elapsed time. In particular, the volatility at a given instant can be modeled to depend on the volatility at previous instances.

Thirdly, these volatility models can be fine-tuned to simulate the market's adherence to the theory of Marginal Utility. As an aside, I note that Marginal Utility Theory is the crown jewel among the achievements of 19th century economics. I have explained in my previous update how Marginal Utility Theory enables the market mechanism to retain its relevance during periods of great social and technological change by the creation and destruction of wealth at breathtaking pace. This theory values a class of similar assets by asking what the utility of one additional unit of the asset would be. Thus this theory focuses relentlessly on the present -- supply and demand determine the price of an asset instantaneously. The volatility models simulate this marginalistic aspect of asset valuation by specifying that the influence of past volatilities on current volatility is weighted in such a way that the influence decays quickly with time (at exponential rates). In fact, once the rate of decay is specified (to be exponential), then statistical techniques like maximal likelihood estimation can be used to find the weight coefficients that fit the data best.

Fourthly, volatility models possess great predictive power largely due to some major developments of the 20th century like statistical techniques, powerful computing systems, real-time news, and the wide availability of split-second economic data from reliable sources. But, there is an additional factor involved here. The ability of volatility models to predict future market behavior is also greatly influenced by the very nature of economic information and the news mechanisms that currently exists for transmitting this information to the public. We discuss this last point in detail later. Now, as an illustrative example, let us consider the fact that the average of prices of future contracts on the trading of a certain commodity can be used as an estimator of the future spot price. That is, the (informed) opinions of those market participants who have entered into future contracts is taken as an indicator of the price of the commodity in the future. It may be argued that this method also allows new information to work its way into the prices of assets through the behavioral psychology of individual players in the market. However, without further enhancements, this method is rather crude and unrefined, when compared with the volatility models. The volatility models can take into account massive amounts of data, are more computation intensive, and they provide a much more sophisticated mathematical framework for capturing the influence of new information on the price of an asset.

The obvious advantage of mathematical sophistication is that it allows for inferences and decisions to be made on a mathematical basis, minimizing the effects of any collusion or blind belief in ideology and fantasy among the market participants. Thus the volatility models help to track the behavior of the individual players, as well as to influence their behavior in such a way that they exhibit rational and fact-based responses to new information. There is another more subtle advantage to employing mathematical sophistication, as I will explain now. Mathematical sophistication, especially when buttressed with the ability of computers to analyze massive amounts of data, provides such a comprehensive grip on current reality, in such a logically sound manner that it allows for one to focus totally on new information. However, economic information, by its very nature arrives, not all at once, but in installments, through channels that themselves take time to digest and interpret the information. To mention recent examples, the housing mortgage crisis, the collapse of Bear Stearns, the impact of rising oil prices, the world-wide food shortage, global warming, slowdown in economic growth and rise of unemployment, unprecedented levels of income inequality, economic and political globalization, huge US trade deficits, rise of China and US foreign debt are all phenomena whose impact on the American economy have been unfolding on the public consciousness over long periods ranging from a few weeks or several months to a decade. In fact, one may say, almost surely, that at any given point of time, a significant portion of information on a certain macroeconomic phenomenon has already arrived. It is this fact that makes the volatility models so much more powerful in predicting the future behavior of the markets. If these models were just abstract theoretical contraptions, they would not have so much credibility and effectiveness as they do now. But, since economic news, especially new information on macroeconomic phenomena, unfolds in installments, these volatility models are able to adjust dynamically to any crisis that is currently in the process of coming to light. Thus the predictions they provide on future prices retain a lot of relevance since these predictions are not just statistical guesses or averages of public opinion or abstract logical inferences. They are all of these, but they are also rooted in the reality of recent events. It is mainly in this respect that Professor Engle and Professor Stiglitz seemed to interpret the market mechanism differently in their discussion on CNBC.

II. Professor Joseph Stiglitz's observations on the volatility models

Professor Stiglitz referred to two issues in answering the question why volatility models did not work effectively with collateralized debt obligations (CDOs) and why they could not prevent the current mortgage crisis: (1) business school graduates who are employed on Wall Street thought that they were creating totally new financial instruments that were going to change the world, but they were actually using data on the world from before they had changed it. This created a logical inconsistency in what they were doing. (2) the investment firms on Wall Street were all using similar models. In his response, Professor Engle said that the main driver of volatility and correlation is the news, not the way the financial instruments are used. Moreover, he felt that the main reason for the current crisis is macroeconomic uncertainty, and in any case, the economy is not going to do too badly but would soon recover as people become more comfortable with the future. The transcripts of the 14-minute discussion on CNBC is attached to this e-mail, and it might be useful for the reader to look at the transcripts, and read at least the first page, at this point. The video recording is also available at CNBC's website (search for Stiglitz or Engle at http://www.cnbc.com).

There seems to be a fundamental dichotomy regarding what constitutes new information in a market. On the one hand, in order to adhere to the Efficient Market Hypothesis, one needs to think that the market framework consists only of those entities that are actively participating in the trading. For example, one may assume that the Wall Street investment firms, the Securities & Exchange Commission (SEC), the pension funds, the hedge funds and other financial institutions, the brokers, the stock exchange and all the Wall Street boutique firms that provide the supporting infrastructure like software, accounting, etc, would constitute the financial markets. In this view, the house-owner or the neighborhood bank that initiated the mortgage contract would not be considered to be part of the market, neither would be a government employee in Australia whose pension fund has purchased mortgage securities in America. Thus any information about foreclosures or defaults on mortgages or the news about Fed's rate cuts or the economy's performance or the earnings announcements of publicly traded companies are all assumed to come from outside the market framework and would be treated as new information. This appears to be the perspective of Professor Engle.

On the other hand, in the modern world, any developed country is a shareholder nation, and the functioning of the markets is at least of fiduciary interest to every citizen. Moreover, at a time of rapid globalization under the aegis of market capitalism, the scale and applicability of the market mechanism is being vastly expanded. It would be quite short-sighted to specify a definition of the market that enforces strict boundaries and excludes large sections of the population. Note that if one adopts this expanded view of the market, then the Efficient Market Hypothesis almost certainly would not hold, because most participants would only spend part of their time to follow the happenings in the market. This would imply that new information does not spread without delay and does not affect prices instantly. In addition, this viewpoint would obligate the financial institutions to actively engage in finding out accurate data on the prevalence of foreclosures, say, if these firms were trading in mortgage securities, and keep themselves up-to-date on a daily basis. This appears to be the perspective of Professor Joseph Stiglitz.

As it happened, it was not the Wall Street investment firms but two academics, Professor Robert Shiller and his former doctoral student Dr. Andrew Case, who set up the Case - Shiller Housing Price Index. At a time when computers are ubiquitous and the income of every household is well-tabulated, it is quite laughable that creditworthiness for mortgages is being determined by a catch-phrase like 'sub-prime'. The definition of sub-prime borrower as one who has not paid the 20% down payment on his/her house has no other logical basis than that sticking to this definition would make it possible to sell the mortgage to Fannie Mae and Freddie Mac, because these government institutions would not deal in mortgages that don't have the 20% down payment. For a whole year, the media, presumably under the influence of the major players in the market, has bandied sub-prime borrowing as the reason for the current housing mortgage crisis. Another example is the rating of mortgage securities. With the assignment of ratings like 'AAA' to mortgage securities, the range of ratings is quite restricted, and the whole rating system simply functioned like an 'old boys club'. Even credit card companies provide a credit score, a numerical score ranging from 300 to 900, which can help the consumer keep track of his/her credit worthiness in a somewhat more continuous manner. In contrast, with the crude rating system for mortgage securities, significant pressure would be brought to ensure 'stickiness' of ratings. For instance, nobody would want their 'AAA' tranches downgraded at all, and one could have expected in advance that there would be disproportionate and undue influence to coerce the rating agencies to keep giving out high ratings. The mortgage crisis is going on for nearly 15 months now, and the financial institutions are taking a long time to get their act together. It seems fair to say that Wall Street investment firms hardly spent any resources on their own to keep track of the mortgage situation around the country, even though they are engaging in trades worth billions of dollars on these mortgage securities.

Thus when Professor Engle says the fact that the Wall Street firms were all using similar models is not the crucial factor, he means that the theory governing volatility models was derived on a sound logical basis and it had synthesized several streams of economic thought, as explained in Section I. How could the fact that all the Wall Street firms were using similar volatility models be problematic? After all if ten different people said the same truth, does it invalidate the truth? Whereas Professor Stiglitz points out that the models would have worked differently for the Wall Street firms, if the firms had each ventured out to gather real-time data on the mortgage situation as it existed in the real economy (on Main Street). In that case, the firms would have had different estimates for the probability of defaults on mortgage loans, but those estimates would have all been much more realistic. Moreover, if the firms had done their own individual assessment of the mortgage situation, instead of exhibiting herd behavior, presumably they would not have had to take write-downs in their balance sheets running in tens of billions of dollars all at the same time. One may note that such massive write-downs of the investment banks which accumulated to over 100 billion dollars during the few weeks at the end of the first quarter to the beginning of the second quarter in 2008 led to serious concerns about economy-wide credit freeze and paralysis of the day-to-day functioning of the real economy .

As for the first issue raised by Professor Stiglitz, the business school graduates took the narrow view for the definition of the market. Hence, they believed that while working from within the center of the market, namely Wall Street, they were devising totally new financial instruments that were going to change the outside world. In particular, they didn't need to take stock of the world 'outside' the markets, as they understood the term 'market' to be. Thus they believed that they were bringing some sort of a new financial revolution to the outside world. However, the prediction of price movements that their volatility models foretold depended on the data on past volatilities which in turn directly depended on the way that the market participants had reacted to the news flowing in from the 'outside world'. The end result is that the fundamental question is not whether Wall Street has been creating a new financial order for the 21st century. The most pressing question has a much more modest scale -- are the mathematical models used on Wall Street able to incorporate information efficiently, without bias and without delay?

III. Duration of Interaction

Is the recent fire-sale of Bear Stearns, a Wall Street investment bank, the modern re-enactment of the tribal ritual of human sacrifice from ancient times? Stricken with fear, panic and paranoia, did the Wall Street firms decide to sacrifice one of their own to propitiate Mammon, the false God? I must ask the reader to excuse me for making an analogy that is so bloody and ugly. But, I must point out that, in recent decades, anthropologists have come to associate deep significance to the tribal ritual of human sacrifice as a clue to understanding ancient cultures. My own argument here is that the sale of Bear Stearns illustrates that the only instruments that were available to the financial community to ward off the mortgage crisis, if only temporarily, were so blunt and crude, that comparisons with barbaric rituals of times past are inevitable. Is it a coincidence that only a few weeks later, the financial newspapers and TV Channels are proclaiming business-as-usual, buoyed by the release of less-than-dismal growth and unemployment figures for the first quarter of 2008? Why would the necessity for waving magic wands, such as the fire-sale of an 80-year old financial institution, arise if the sophisticated mathematical models that Wall Street used were behaving as they were supposed to?

Perhaps in the final analysis, Professor Engle is right that the American economy is not going to do too badly this year, and that the financial community would learn from their mistakes in the recent crisis and recover in the near future to perform successfully. In fact, if one goes with the narrow definition of the market as explained in Section II, then recently available empirical evidence already indicates that this is true. However, one might insist that the market mechanism needs to evolve so that it can be applied to solve much bigger problems in a rapidly globalizing world. One could note that there are problems like the environment or housing that are of a much larger scale than the market mechanism has successfully handled so far. After all, in his recent book, 'Making Globalization Work', Professor Stiglitz argues quite convincingly that the existing legal and economic institutional framework in capitalist countries, when applied on the international scale, have led to dire consequences. For example, the poorest region in the world, sub-Saharan Africa, has been worse off as a result of liberalization of international trade. If one takes this latter view that the market needs to address larger challenges, then the market mechanism, as understood currently, has glaring shortcomings.

The example in Section I that compared the relative performance of future contracts versus volatility models for predicting asset prices showed that the volatility models facilitate the influence of information on prices much more quickly and efficiently. However, if the value, frequency and volume of trading are very high, then the speed with which volatility models incorporate information is nowhere near the levels required for the stable functioning of the markets. Financial markets began to trade intensely in housing mortgages in this decade. The scale of this adventure is in the trillions of dollars. This is an order of magnitude larger than the earlier trading of company stocks and treasury securities. Over the last one year, one could have clearly noted how this enlarged role for the financial markets brought untoward influence on the media. The mortgage crisis is going on for nearly 15 months now. It is simply amazing that the perspective of the house-owner is hardly being addressed in the media. The house-owner has been portrayed repeatedly as a gullible ignoramus who got smooth-talked into buying complicated financial instruments. This has resulted in a situation where most of the relief that the government authorities have announced so far have gone largely to extricate the financial institutions from the mess they got themselves into. In fact, the house-owner has a more legitimate case because both the parties that initiated the mortgage contract, the house-owner and the neighborhood bank, are equally liable for the appraisal of the value of the house at the time of purchase of the mortgage. However, the neighborhood bank is long out of the picture, having sold off the mortgage to other parties, but the house-owner is still being held to the value of the mortgage.

In sticking to a narrow definition of the markets, the volatility models adjust themselves only according to the new information that is being delivered in the News channels, because this is the channel by which market participants get the information and proceed to influence the asset price according to the effect the information has on their individual behavioral psychology. If those News channels are unduly influenced to favor one section of the population, as mentioned above, then these models would go along with it. Thus the mathematical models on Wall Street do not incorporate new information without bias. Also, there is plenty of delay in these models incorporating the information that is relevant to the assets that they trade. By enforcing a strict boundary for the notion of a market, the financial institutions had freed themselves of the obligation to directly collect data on the securities that they were trading. For a small sized market, this might have worked fine. But when the value of trade is in the billions of dollars, it is simply foolish to wait, as long as a year, for the information to arrive through the News channels.

Now, one might wonder why the financial institutions on Wall Street chose to accept such delays and bias. Perhaps the answer is that having subscribed to the philosophy that markets should exchange objects instantaneously, they were forced to accept the fact that trades worth billions of dollars were going on at an instant without careful consideration as to the risks involved. So the financial firms felt that they needed to invest all of their resources and all of their attention on their trading activities on Wall Street. Making efforts to build supporting infrastructure for these transactions, like gathering secondary data on the mortgage defaults around the country, could be seen as a loss of focus. When trades are happening at such blinding intensity, keeping an eye on the outside world could be seen as a sign of weakness -- 'taking the eye off the ball'. This herd mentality was what resulted in Bear Stearns' experience of 'live by the sword, die by the sword'. The individual players in the market need to understand that when the value of the trade is in the billions of dollars, then they need to do their homework before going ahead with the trade. Thus the duration of interaction between the buyer and the seller is an important aspect of the market. The financial markets that trade in an instantaneous manner must be seen as special cases of the market mechanism where the duration of interaction, in the limiting case, is infinitesimal. But, for larger applications of the market mechanism, non-trivial duration of interaction would have to be a serious consideration.

Another important issue regarding the duration of interaction can be inferred from the current crisis in the financial markets. The marketplace is influenced to a large extent by the practices of the modern company organization. Normally, this is for the good, since it allows for the creation of wealth through risk-taking. More generally, the government, the media and the industry play direct roles in the functioning of markets. However, all these organizations suppress individual initiatives to a significant degree. This necessarily encourages herd behavior although these organizations may not be the root cause of it. In comparison, the university is a place that allows by far the most freedom of inquiry for the individual mind. If one were convinced that tribal orgies of bloodletting are to be avoided in the modern marketplace, then one would, I suppose, wonder how rational thought and scientific inquiry can be given more room in the investment decisions that happen in the marketplace. One obvious way would be to involve the resources of the university more closely in the functioning of the marketplace. Thus, to encourage thought and consideration, one should consider the duration of interaction in a transaction to be an important issue.

(Dt. Tuesday, April 8, 2008)

Update 1: Housing Example in Role of Markets

I would like to thank all the Economics Professors who were kind enough to spend their time carefully reading my research proposal. I heard back from twenty one Professors. Although all twenty one Professors said that they didn't have funds to employ me, five of them have kindly sent me incisive comments on my research proposal. I would like to thank these five Professors specially. They are, in alphabetical order of last names, Professors Kenneth Arrow, Richard Cooper, Jeffrey Frieden, John Roemer and Alvin Roth. Also, I would like to say to all the Professors that if you do not have funds to employ me, it is fine with me. I would rather much prefer to hear your intellectual opinions on my research proposal. Once again, I thank you all for your time and your patience.

In this e-mail message, I would like to provide an update on my research proposal (titled 'A New Perspective on the Role of Markets in an Economy') which I had sent out two to three weeks ago. I have now focused completely on Example 1 in my research proposal which was on the ongoing Housing Mortgage crisis. Upon following the media's coverage of the mortgage crisis in the last few weeks and reading several pre-prints of research articles related to this crisis, I felt that professional economists have done an excellent job of analyzing most aspects of the mortgage crisis. Hence, I have restricted myself to four issues on which there has not been adequate coverage or no coverage at all.

These four issues are mentioned briefly here. I have discussed them in detail later in individual sections. The four issues are (I) Securitization, on which the media coverage has been mainly that this process separates the property rights on mortgaged homes from the investments on mortgage-backed securities. For sure, this separation leads to increased uncertainty about the recovery of the mortgage loans. But, there is no coverage on the duration of interaction in a mortgage transaction (the main theme of my research proposal). (II) Theory of marginal utility, on which the media coverage has only been that the mark-to-market accounting rule has led to the perception of widespread losses, which could have supposedly been avoided otherwise. There is no coverage on the question whether the theory of marginal utility is the appropriate methodology for valuing family-occupied modern houses, or the question whether house-owners can be expected to adapt to the market mechanism in such a short time when it has taken companies many decades. (III) Comparative advantages of the US housing sector versus the technology sector as investment destinations and the resulting long-term implications for globalization in the 21st century. There has been practically no media coverage on this issue. (IV) Asymmetric information, on which the media coverage has been that the Wall Street investors of mortgage-backed securities did not get accurate information about the mortgage loans because there were plenty of information asymmetries down the mortgage pipeline all the way to the house-owner at the other end. But, there is almost no coverage from the other end of the pipeline, i.e., nothing from the house-owners' perspective on the asymmetry of information.

For the sake of completeness, let me also just list here the issues on which there has been excellent coverage, before going on to discuss the above four issues in detail: 1. Low interest rates and continued pile-up of huge trade deficits, financed by foreign countries, made credit easily available, which led to rapid increase of mortgages, 2. Bush tax cuts led to trillion-dollar investments in mortgage-backed securities which amplified the housing boom, for better or for worse, 3. Sub-prime mortgages and Predatory lending practices, 4. High leverage, 5. Shadow banking system (and hedge funds), 6. Government regulations, 7. Failure of Insurance agencies and rating agencies, 8. Liquidity crisis -- credit freeze in the financial system, etc, 9. Crisis of confidence -- sale of Bear Stearns, etc, 10. Social consequences -- foreclosures, homelessness, debt, etc, 11. Spill-over to other parts of the financial system -- prime mortgages, corporate bankruptcies, credit cards, auto loans, commercial mortgages, etc, 12. Effect of the mortgage crisis on the overall economy -- recession, unemployment, etc.

I. Securitization

Could the market framework really handle a situation wherein on one side, securities worth billions of dollars were traded through computers at an instant, and on the other side, millions of home-owners thought that they were getting into long-term financial obligations? Also, almost no consideration has been given for the fact that both parties in a mortgage loan are liable for the initial appraisal of the value of the house. Recall that in the process of securitization, a large number of mortgages, possibly several thousands, are pooled together in a single package, and using these mortgage-packages as collateral, securities (shares or bonds) are sold and re-sold in the market. So, hypothetically, we could think of this situation as a market transaction in which one side is the house-owners of the mortgaged homes pooled into a single package, and the other side is the current owners of the securities issued on this package (in practice, of course, the interaction is not so direct because the security-owners do not have property rights). Now, the 'average' house-owner expects to stay in his/her house for a period ranging from the medium term (2 to 5 years) to the long term (more than the full course of the mortgage). Typically, he/she refinances the mortgage once or twice in its lifetime, mainly to take equity out, or to take advantage of low interest rates. Whereas the 'average' security-owner trades off the security in a much shorter time, ranging from a few days to a few seconds. Each time a security-owner trades, he/she has updated information on the housing price index and the interest rate on loans (although he/she has no property rights). In contrast, the house-owner is locked in with the value of the house that prevailed at the time of signing the mortgage. Please note that this situation is not a case of asymmetric information, but that of only one party in the transaction getting the benefit of posteriori information (the information itself becomes available only much after the mortgage contract is signed and done). Would it throw enough light to just view this situation as a market with imperfect information, or are new theoretical tools necessary to analyze the mortgage securitization situation?

Now, there are two familiar situations that have been existing for a long time, in which similar phenomena happen, but the current mortgage crisis is, in fact, quite unprecedented. (i) Historically, commercial banks have taken deposits from people for the short-term and lent out money to businesses for a longer term. Thus in this case too the two sides of the transaction are locked into the transaction for uneven durations. However, the major difference is that in this case both the depositors and the borrowers are committed for non-instantaneous durations; whereas in the securitization process the security-owner transfers his/her claim almost instantaneously. Moreover, government regulations on commercial banks regarding reserves on capital, FDIC insurance and reserves from the Fed help to prevent any liquidity crisis for the bank. Also, please note that the typical road-side branch of a commercial bank is much, much smaller than the Fed, which makes it possible for the Fed to act as the guaranteeing agency. Thus the bank-run risk for a commercial bank is small and localized. In contrast, each of the investment banks which trade in mortgage-backed securities constitute a significant portion of the entire financial system (when their leverages are also taken into account). (ii) Fannie Mae and Freddie Mac have been issuing mortgage-backed securities for many decades now. However, only in recent years when Wall Street has poured trillions of dollars into mortgage-backed securities and has traded intensely on these securities with split-second information has the market mechanism for trading in mortgage-backed securities been pushed to the limits.

II. Theory of Marginal Utility

The theory of marginal utility enables the market mechanism to play an important role in determining the price of an entity, in addition to the market's primary roles of providing coordination and availability. Moreover, marginal utility theory has vastly expanded the applicability of the market mechanism. For example, if firms were to be bought and sold as a whole, then their intrinsic value could be considered (based on fixed assets, loans, earnings, bills receivables/payables, reserves, inventory, human capital, good will, reputation, market share, etc). Needless to say that if firms could only be traded as a whole, then liquidity as well as demand would be insurmountable problems. Thus trading in shareholding claims on the firm, makes it possible for the firm to raise additional capital without losing management control, and also to enable the participation of small investors.

Now, in reality, at any given time, only a fraction of the outstanding shares of a firm are available for trade in the market, and the price of these shares is determined by their current demand (which may take the firm's performance into account in varying degrees). However, in valuing the majority of shares which were not for sale in the market, it is still this market price that would be considered as their worth. This is the key fact that enables the market mechanism to retain its relevance during times of great social and technological changes. For example, at the height of the 'tech boom' in the late 90s, the vast majority of software 'start-up' companies had no earnings at all. Yet the market provided them with enough capital to compete with traditional, 'Main Street' companies, by making the paper worth of the software entrepreneur in the millions of dollars even though his/her most important asset was something as intangible as an idea or an innovation. Another important example demonstrates the enormous power of marginal utility theory to destroy outmoded wealth. And this was the prolonged languishing of the US stock markets in the 70s and 80s. This led to the drying up of working capital for many companies, since for equities as well as borrowings, the stock prices were used for the valuation of the company (with plant, equipment and buildings having depreciated). Thus followed a string of takeovers on Wall Street. Takeover tycoons would buy up shares at cheap prices to get majority control of a company and then proceed to dismember the company and sell off its assets for a handsome profit.

Enabled, largely by the power of marginal utility theory, to create and destroy wealth at a breathtaking pace, the market mechanism, of necessity, trades objects in an impersonal manner. Over the course of the last two hundred years, firms in a capitalist country have made adjustments to this impersonal nature of the demands of the market. Whether the issue concerns the workplace, or the employees, or the management, or the customers, or the community, or the nation-state, or the environment, all of these concerns have taken second seat to the priority of the modern firm to deliver profits to its shareholders. Moreover, to ensure that the share price of the firm does not decline due to the market's perceptions of weakness, publicly traded companies report their earnings each quarter. The entire operation of a modern public company is put on a schedule that is suitable for keeping the interests of the shareholders paramount. These adjustments have taken many decades to evolve.

Now, the question is could such an impersonal manner of valuation apply to the home in which a family resides, and which is located in a neighborhood shared by a community? This question, of course, does not admit a simple answer. But, we can identify the major issues here. On the one hand, during the course of the 20th century, four major technological developments have steadily added to the impersonalization of the household. Firstly, electrical gadgets like microwave oven, refrigerator, laundry-washer/dryer, blender and the vacuum cleaner have made it unnecessary to spend much time in the house to do household chores. Secondly, frequent travel, whether it be long commutes to work, or it be driving on the interstate highway or air travel on vacations have loosened one's ties to one's home. Thirdly, 24-hour grocery stores, supermarkets and restaurant chains have standardized and simplified food producing activity. Fourthly, television, cell phones and the internet have connected the residents of the house to global developments on a round-the-clock basis. So, the modern house-owner may, in fact, welcome a globally connected lifestyle with reduced ties to a fixed physical space like a residential home.

On the other hand, the residential home is the place where the family reinforces its emotional and psychological ties. There is a strong case that the utility of the house to the family cannot be measured by the going rate for the most recent house in the neighborhood, that was sold in the market, which is what marginal utility theory would prescribe. Moreover, homeownership promotes marital and financial stability. Residential homes provide enhanced quality of living for raising children. Presumably, community participation is higher among home-owners than apartment-renters. A workplace could be naturally suited for an impersonal characterization, which demands professional behavior at all times from the employee. In contrast, the home is a place for rest, recuperation, love, joy, sorrow, hobbies and entertainment. For these reasons, it may be unfair to expect the home-owner to accept the wide variations of a marginal valuation of his/her house. In any case, considering that the publicly traded firm took many decades to adjust to the valuation method based on marginal utility, perhaps it is not unreasonable to give some consideration to the fact that the house-owners have had no such period of adjustment. As a moderating influence, alternative methods of house valuations like the cost of construction approach and the price-to-rent ratio approach could be considered in a supplementary fashion.

III. Investment Destination

Modern economic and financial theories are enormously powerful and precise. Yet they are not completely adequate to deal with the blinding pace of modern technological developments. Joseph Schumpeter's concept of Creative Destruction was the last truly penetrating insight into the nature of technological change in a capitalist economy. As the most telling example of their inadequacy, we note that modern economic theories could not guide us in figuring out how to safeguard the enormous transitory wealth created during the 'tech boom' of the 90s. The NASDAQ composite index peaked at 5048.62 on March 10, 2000. Fifteen months later, in August 2001, it stood at 1805.43, before touching a 5-year low of 1114.11 on October 9, 2002. The loss in the total market capitalization of NASDAQ stocks during this 17-month period ran in the hundreds of billions of dollars. Of course, this empirical fact does not prove beyond doubt the ineffectiveness of financial markets to handle fast technological developments. However, one may note that a wealthy investor trying to make a decision in 2002 about where to make a long-term investment of his/her money would have definitely found the hedge funds dealing with mortgage-backed securities to be much more promising an option than the then-recently decimated stocks of the technology companies.

More importantly, to face the emerging challenges of globalization in the 21st century, America needs to have a clear sense of the sources of its own wealth. Rising homeownership speaks directly to core American values which include working hard to gain wealth. Away from the crime-prone inner cities, old houses are being replaced, in vast numbers, by modern energy-efficient, green-friendly, spacious homes in hundreds of towns and cities across America. The spaciousness of the American landscape, the safety of American neighborhoods especially in the towns and smaller cities, the surety of property rights, the participation of the home-owner community in local government and jury duties, the effectiveness of law enforcement are some of the strengths of the American home-building tradition. The constant supply of clean drinking water, waste management, garbage disposal, 24-hour electric supply, clean toilets and hot showers in an American home speaks directly to the impression of the American dream among the people of other nations. In comparison with the emerging economies, America definitely has a 'core competency' in home-building which would stand it in good stead when difficult challenges arise in a globalizing world of the 21st century. Thus the choice of the financial investors to pour trillions of dollars into the mortgage industry in the last 8 years, whether by design or by accident, is a sound investment that would have many positive benefits, if only the current mortgage crisis is handled successfully.

IV. Asymmetric Information

Until recently, conventional wisdom considered housing mortgages to be local markets. Many house-owners had no idea that their mortgages are counter-balancing the intense trading of securities issued against them to investors all over the world. The high value and the high frequency of trading these securities using computers, in an instantaneous fashion, could not be totally unrelated to the instability of the housing prices. The irrational exuberance of the housing boom could not have been so forceful without the massive world-wide supply of funds for the purchase of the mortgage-backed securities. Another point I would like to make is that the portrayal of the home-owner in the media as a gullible ignoramus who got 'smooth-talked' into complex financial instruments is not quite accurate. This portrayal has resulted in the continued neglect of the government authorities to directly help the home-owner, under the excuse that the home-owner is liable for irresponsible decisions. However, there is no evidence that, given the asymmetries of information, the home-owners acted in a particularly foolish or irresponsible way.

Finally, the fact that the financial markets froze up during the past few weeks may, in fact, be a positive outcome in the long run. It would have been far more destructive if, instead, an Enron-like accounting scandal had hidden the losses for now, only to have them show up later with much greater loss of confidence. Thus, in some sense, the financial markets have been functioning in a transparent manner, and this shows that the incidences of asymmetries in information, ranging from falsifying home-owner's credit worthiness to the shadow banking system, may be relatively small, after all.

(Dt. Sunday, March 9, 2008)

A New Perspective on the Role of Markets in an Economy

This article is organized into three sections: I. Introduction II. Examples III. Concluding Remarks.

I. Introduction

The struggle between two economic theories -- communism and capitalism -- occupied the major part of the history of the twentieth century. One of the main differences between these two philosophies is the role of the individual in a society. Communism took a totalitarian approach in which the freedom of the individual was largely subordinated to the needs of society. Moreover, capital was not to be allowed to accumulate in private hands, but was to be explicitly devoted to the good of all society. Whereas capitalism, especially in the form promoted by the Chicago school of economics, held that the individual was to be provided with the maximum freedom and that in a law-abiding society, the individual only needed the mechanism of the market to interact with the rest of society. The view of the capitalists was supported by two strong beliefs. Firstly, the Renaissance ideals of liberty, equality and fraternity, which emerged from the cradle of the Protestant Reformation specified clearly that the individual was to be provided with the resources needed to pursue his/her own learning, labor and pleasures. Secondly, Adam Smith's Invisible Hand hypothesis argued that the markets would by themselves lead to the best outcome for society, if only the government did not interfere.

The history of the twentieth century shows that the countries that adopted communism failed economically, rather drastically. As a result, by the end of the twentieth century, almost all the countries in the world have adopted the market mechanism, with varying degrees of conviction, for determining prices and other conditions of trade. Of course, in the meantime, work of economists on the asymmetry of information (notably George Akerlof, Michael Spence and Joseph Stiglitz) had taken into account that in many situations, the two parties involved in the trade in a market have unequal information about the object that is being traded. One of the implications of this analysis was that it was not necessary that the markets would be either stable or fair under the influence of an Invisible Hand. This paved the way, from a theoretical point of view, for the role of government in regulating the functioning of the markets. These government regulations are to be determined in a democratic way in modern times, and thus political studies once again played a very important role in economics, like in the nineteenth century. In particular, the problems in economics could not be settled in a purely mathematical way. Professors Paul Krugman and Joseph Stiglitz are two famous examples of economists playing active roles in the political system in recent times.

On the other hand, the grand consensus that had emerged at the end of the twentieth century about the indispensable role of markets in the economic life of a nation has made it imperative to gain a clear understanding of exactly what a market is. In the broadest sense, markets appear to be a natural biological instinct. The video footage on Discovery Channel of Emperor penguins assembled in Antartica in huge colonies to find mating partners during their reproductive season and to breed successfully in extreme climates, is clear evidence of it. For several thousand years, humans have been utilizing the market mechanism for such common daily pursuits as vegetable markets, or before that, barter trade.

It is generally accepted that it was Adam Smith that first developed a theoretical foundation for the role of markets in the economic life of a nation. In his analysis, the role of markets was to ensure perfect competition among the sellers to help in determining the optimal price of the object that was traded. A century later came the Marginal revolution, under which the major factors in valuing a product is its marginal utility to the buyer and the marginal cost of production to the seller. The price of the product, which was determined by the aggregate demand and supply in the market, then determined the production level. More recently, economists have studied the influence on the economic situation brought about by asymmetry of information between the two parties involved in the trade. Additionally, from the time of John Maynard Keynes, economists have tried to find theoretical explanations for market behavior based on the behavioral psychology of the individual players. Since the 1940s, economists have also relied on techniques from game theory. Statistical techniques and time-series analysis have been instruments for gauging the functioning of the markets for a long time now. Finally, in recent decades, stochastic calculus and Monte-Carlo methods have been used for modeling market behavior.

In all of these developments, the assumption has always been that the interaction between the buyer and the seller is instantaneous (some exceptions are described in the examples below). No matter that the buyer and the seller had different information about the product, or that they had different propensities for the risk involved in the transaction, the transaction itself is considered to happen instantaneously. However, in the examples that I have given below, such an assumption does not seem to reflect reality adequately. In fact, it appears that when the object being traded is only of moderate value then the transaction can be assumed to be instantaneous without loss. However, when the trade is worth, say, billions of dollars, then the duration of the transaction invariably becomes a significant factor.

II. Examples

My proposal for research is to consider the influence of the duration of interaction between the buyer and the seller on the functioning of the markets. I have listed the following examples where such a consideration could be meaningful:

1. Housing Mortgage Markets: The recent mortgage crisis, which has forced many financial institutions to take write-downs in billions of dollars, has brought to light the fact that millions of householders had been sold on mortgages about whose risks they did not fully understand. Looking at it from my perspective of duration, one sees that the householders expected to enter into a commitment over the long term -- up to thirty years. Whereas once the mortgage was signed, the seller (typically a neighborhood bank) was free to slice and dice the value into much smaller parts and sell it to other financial institutions which then traded them on Wall Street at high volumes using computerized trading. Now, one of the problems here is that to make the sale sweeter, the institutions selling the mortgages to the householders suggested that they could take advantage of the low medium-term interest rates that were prevailing at the time of purchase of the house, say five years ago. As a result, the householders invariably chose to go with mortgage rates which were variable during an initial period, after which they would switch to the fixed long-term interest rate. However, after five years, the initial period of adjustable interest rate has got over, and households find that the long-term interest rates have gone up so much in the meantime, that they could not afford to switch to the fixed rate prevailing today. According to the seller of the mortgage, the transaction was done five years ago, at an instant, and the seller is out of the picture having sold off the mortgage to other parties. Thus the market mechanism was adopted in this case without due consideration for the duration for which the transaction should have been considered open.

2. Capital Market Liberalization: East Asian crisis in the late 90s highlighted the vulnerability of free markets to the destabilizing effects of short term speculative capital. Before the crisis, proponents of free market ideology recommended opening up capital markets totally without any restrictions to the flow of capital into and out of the country. In retrospect, some considerations about the duration of the capital investment in the country's financial markets from foreign financial institutions would have served as a stabilizing influence.

3. Political Elections: The election of political leaders in a democratic country can be seen as a market (an auction market). The candidates usually go through a long period of campaigning, in which they interact with the voters. This interaction leads to better appreciation of the candidates by the people, and reciprocally, to better appreciation of the people's problems by the candidates. Thus the duration of interaction is an important factor in the selection of the best candidate here. However, at present, an economist would only have tools like theories of social choice, or game theory, or public policy, or behavioral psychology, or statistics to explain the selection process. None of these tools would consider the duration of interaction to be a determining factor. I note here, as an aside, that in recent times psephologists have gained some measure of expertise in predicting the results of an election a couple of days in advance. In spite of our lack of knowledge about the precise nature of democratic elections, these processes have been the best mechanism for due considerations of the problems of the people.

4. International Relations and Trade: Economists have been interested in exchange rates and international trade for many centuries. However, the methods they employ to determine the relative values of currencies would only take instantaneous information on the demand and supply of currencies. There is no mathematical framework for incorporating the robustness of the relationship between the countries. Yet the appearance of strength in the political and historical relations among a group of countries has gone a long way towards determining the long-term value and the stability of their currencies. I must make a disclaimer here that some ad-hoc theories of stochastic calculus have been used to model exchange rate mechanisms. In particular, the concept of martingales could account for the changing dynamics of the exchange rate over time in a probabilistic framework. However, these theories would only be effective if the probability distribution of the risk involved is known a-priori. Such assumptions are too stringent, since political relations and trade between countries are hardly probabilistic in nature.

5. Warranty of Purchase: While I was explaining these ideas to my wife, she pointed out to me that warranties of purchase provide a means for extending the duration of a transaction. A buyer of a car has a warranty for a certain period, which holds the manufacturer of the car as liable for any repairs during this period. This is an example where the risks of the transaction, which are not known in a deterministic manner at the time of purchase, is nevertheless more equitably shared by extending the duration for which the transaction is kept open. Here the nature of the risk (probability distribution) can be inferred a-priori from statistical data of previous sales, and hence the manufacturer can calculate the expected value of the warranty at the time of selling the car.

6. Interest on Loans: The time value of money is an example where duration is indeed taken into account in a financial transaction. However, it seems to be an extremely deep question why interest should continue to compound at exponential rates on large sums of money over long periods of time. That said, on small amounts (relative to the borrower’s income), money has been lent at exponential rates for ages and a whole industry has subsisted for these financial transactions for the purpose of their precise calculation. Moreover, in recent years, the institution of micro-finance has been shown to have beneficial effects on poor countries, thanks mainly to the work of Dr. Mohammad Yunus. Now, financial analysts have been somewhat successful in modeling the probability that a borrower would return the loan using stochastic analysis, time-series and some statistical techniques. However, all of these techniques assume that the nature of the risk is known before-hand. For example, due to changes in public policy or natural disasters in the future, if the interest rates have to change, it would be nearly impossible to know the probability distribution of the risk. This unpredictability has often led to money lenders charging exorbitant rates of interest in the rural areas in poor countries and has been a major cause of large-scale poverty.

7. Financial Derivatives: Derivative instruments can be employed to simulate an extension of the interaction between the buyer and the seller. For instance, if the buyer would also buy an option on the security, it provides him/her a safeguard against the vicissitudes of the value of the security. Again, this is made possible because one knows a-priori the nature of the risk involved. For example, it is a reasonable assumption that in a Western democracy the price of a stock would follow geometric Brownian motion. This assumption makes it possible to calculate the price of a call option using the Black-Scholes formula. Another point to note is that derivative instruments have no prejudice against the speculator or the hedger. A hedger may buy an option to safeguard his/her investment. Equally well, a speculator may use the relatively high leverage of derivative instruments to make a quick killing. Both these players have been known to be integral to the market for ages and financial derivatives do not prefer one over the other.

III. Concluding Remarks

Examples 1, 2, 4 provide instances where consideration of duration of interaction between the buyer and the seller in a market could have provided better insights and possibly avoided drastically unfavorable outcomes. Examples 5, 6 and 7 provide instances where the duration has already been partially taken into account to provide a better outcome. Example 3 is an instance where the best mechanism is adopted, in spite of our lack of theoretical knowledge about its functioning. Also, I note here that whereas the examples on housing mortgages and financial derivatives mentioned above show that the market mechanism does not show any preference for the hedger or the speculator, my proposal for having an extended duration of interaction would mean that the hedger is preferred somewhat more than the speculator.

In a capitalist country, the scope and application of the concept of a market is constantly being extended. Markets for new commodities and financial instruments are frequently being created. It is this dynamic nature of the market mechanism that makes it important to obtain a clear definition of the concept of a market. If markets were static and the settings they could be applied were fairly standard, then the intuitive understanding that people possess of the concept of a market would be sufficient.

It is my understanding that Karl Marx was the first person to have pointed out the subtle asymmetry in the exchange of goods for money -- whereas money can be transferred instantaneously, there are usually many unsolved implications when a property or a loan or commodity is transferred. Marx’s solution was to completely eliminate the market, and have the State prescribe the price, liquidity and supply. One should note here that Marx’s approach completely relies on the instruments of law to solve an economic problem. Even in a capitalist country, if the market mechanism fails, for example, in the case of bad debts, bankruptcies, or severe economic conditions like unemployment, inflation or stagnation, then the only recourse is to turn to the legal framework. The crux of my proposal is to enable the market mechanism to solve more economic problems on its own, before the necessity of going to a legal court or public policy arises.

My research proposal can also throw some light on the recent debate about how much capitalism and democracy are related and whether they are essentially independent. The example of the rapid growth of China in the last twenty years having adopted free market policies even while maintaining a strict communist form of government has served as the main motivation for this debate. If one views the defects of the current usage of the market mechanism from my perspective of duration of interaction between the buyer and the seller, then one could get some new insights about how far capitalism can go without democracy. In particular, the example of political elections in a Western democracy mentioned above, shows that a large part of the risks and uncertainties regarding the economic performance of a country are sorted out in the public debates during political elections, which allow for an extended interaction between the people and the candidates. This serves as a compensation for the fact that markets, as understood currently, exchange objects instantaneously. The robustness of the political system provides some compensating assurance to the risks of such instantaneous exchanges in the market. In the absence of such a political system, the successful functioning of the markets in China owes a large part to the a-priori success of free market policies in the West and in East Asia. That said, one must also note that China has a recorded history that goes back over five thousand years, and that Chinese society had been organized as an empire for most of its recorded history. These facts also contribute to the fact that Chinese society has functioned efficiently as a single economic unit in recent times.

(Dt. Wednesday, September 24, 2008)

Sub: The Completely Unnecessary $700-billion Market Intervention Plan That is Under Review in the United States Congress

I have been watching on television, some parts of the discussion in the United States Congress about the $700-billion market intervention plan proposed by the Government authorities, during the last two days. Many of the Senators, from both parties, seemed really well-informed and their questions were probing. In addition, Senator Charles Schumer was quite eloquent. He mentioned that he had been speaking with several well-known economists about the best way forward. I suppose the other senators have been consulting professional economists as well. So, it was surprising to me that the main topics of discussion were only about price-discovery, or liquidity in the markets, or injection of capital, or whether spending $150 billion now is enough, or how to cap Wall Street compensation, or how to throw in some help for the home-owners. Why didn't the economists advise the representatives of the United States Congress that this whole $700-billion market intervention plan is completely unnecessary, as explained below?

(1) Even by my crude estimate, there are at most 50 million homes across the United States whose mortgage loans are being currently traded as asset-backed securities. These mortgage loans, taken out by the home-owners, have been packaged into groups on which the mortgage securities have been issued. My guess, admittedly a rough estimate, is that each of these packaged-groups would contain anywhere from 1000 to 10,000 mortgage loans. This implies that the number of packaged-groups of mortgages in the United States would be between 5,000 to 50,000. This means that the whole information about the mortgaged homes and the securities issued against them in the United States can be processed in a single laptop personal computer! This further implies that the $700-billion market intervention plan proposed by the Government authorities and under review in United States Congress is completely unnecessary:

By directly matching the holders of a given mortgage security with the home-owners whose mortgage loans are collateral for that security, all the concerns expressed in the $700-billion market intervention plan can be addressed effectively. Because the home-owners and the security holders are more directly involved in the mortgage transaction than the Government is, the investment banks can compete with each other, and bargain with the home-owners, to facilitate price-discovery in the most optimal fashion. In particular, the Wall Street investment firms are facing the prospect of having to sell their holdings at fire-sale prices (something attested to by Professor Benjamin Bernanke in his Congresional Testimony yesterday). These same firms can, instead, devise mortgage pay-back agreements offering significant discounts to the home-owners, and still recover a much better price than the fire-sale levels they are facing now. Moreover, these discounts can be designed to reward good behavior on the home-owners' part. For example, if the home-owner had been paying his/her mortgage installments without fail, (s)he could be given a rebate. Further, (s)he could be promised that if (s)he continues to pay down her loan sincerely in the future as well, then rebate(s) would be given at the end of a year, at the end of five years, and so on.

This direct-matching plan would reduce foreclosures because the home-owners get a 'rebate' on their loan obligations. But these rebates are determined completely by market forces, and not by the intervention of the Government. Since the number of foreclosures are reduced, this keeps the market values of the homes from falling precipitously. Moreover, its costs very little for the Government. All that is needed from the Government is that it maintains and provides reliable information about each packaged-group of mortgaged homes and the securities issued against it. Also, since this direct-matching plan reduces uncertainty immediately -- much quicker than the $700-billion market intervention plan which would need elaborate auction arrangements -- the freezing up of the markets would ease quickly. Thus liquidity in the markets would emerge automatically, without any Herculian efforts by the government authorities and the Congress.

Lastly, it seems to me that those home-owners whose mortgage loans are clubbed together in a single packaged-group would share some common features, like geographical proximity or similar standard of living, or same time of entry into the housing market, etc. Strictly speaking, these details are not necessary for the direct-matching plan proposed above. But these details can be utilized to provide further effectiveness in the solution.

(2) It seems to be that any public discussion about the current financial crisis quickly moves into comparisons with the Great Depression of the late 1920s and the early 30s. Particularly, grave concerns are expressed about the freezing up of the markets due to break-down of trust. As a result, the mind-set of the participants simply focusses on macroscopic interventions by the Government or the Federal Reserve to intervene in some way or the other. In my opinion, though direct comparisons with the Great Depression are useful in some ways, it is a mistake to restrict the focus of the discussion solely on the Great Depression, or other previous financial crisis that have occured in earlier decades.

Sure, illiquidity in the markets is caused by break-down of trust and other psychological factors like fear and panic. However, a equally strong factor is the lack of real-world information about the securities that are being traded. In this single respect, the current financial crisis differs seriously with the Great Depression. The modern economy is much more information-based. Just by using a few laptops, credible and reliable information about who the other party in the transaction is, can be uncovered. This information helps to design the features of the transaction in such a way that liquidity is facilitated automatically. Please recall that I had been emphasizing that the direct gathering of mortgage information through econometric methods is important in my "Update 2: A Marginalistic Interpretation of the GARCH model" which I had sent out on Sunday, May 4, 2008. Thank you.

Sincerely,
T V Selvakumaran

(Dt. Sunday, September 21, 2008)

Update 3.2: A Mathematician's Apology

I request the Professors' indulgence for receiving another e-mail from me, hardly two weeks after I sent a hurried "Update 3: Fire-sales, Bazookas and Hospitals" on Monday, September 8. My excuse is that the ill-advised, bazooka-wielding bailout of Fannie Mae and Freddie Mac on Sunday, September 7, had so compelled me to send out an unplanned update urgently the next day, that I feel the need to elaborate further to complete my update properly. So, I request the reader to please treat this message as the second part of the same update sent on September 8, i.e., Update 3.2. This article is divided into four sections -- I. Introduction, II. Risk Management, III. Game Theory, IV. Econometrics. At the end of this update is a Corrigendum to one of my previous updates, "Update 2: A Marginalistic Interpretation of the GARCH Model", which I had sent out on Sunday, May 4, 2008. I need to remove one sentence from that previous update -- it does not seem that an assumption that markets are efficient necessarily implies that changes in asset prices are solely caused by new information (i.e., asset prices are random walks).

I. Introduction

Most professional economists around the world would agree, I suppose, that the American economy is currently going through its worst financial crisis since the Great Depression of the late 1920s and the early 30s. There is plenty of debates and discussions about this crisis going on all the time, across all sections of society, all over the world. However, no one seems to be able to explain convincingly where the root cause of the problem is, nor when this crisis would end. Even after this crisis comes to a conclusion, it is seriously doubtful that anyone could truly understand exactly where things went wrong. Being a mathematician, I figure that I owe an apology -- one plausible root of this crisis could be the fundamental failure of 20th century mathematics to come to grips with some subtle issues concerning the modern economy. Yes, a major cause of this financial crisis, according to me, is the failure of the mathematical theories of economics, for example, asset pricing, equilibrium theory, game theory and econometrics, to adequately capture the nuances in the economic reality of the day. I can assure the reader that it is no pleasure to have to apologize for it. I can only ask that the blame for the failure of mathematical theories be amortized against any credit the reader is willing to give me for this update and for earlier articles on my research proposal.

According to the conventional wisdom, financial crises, as they come, are initiated by speculative bubbles. Historically exacerbated levels of human vices, like greed, profligacy, fear, panic and paranoia are, in general, naturally suited environments for speculative bubbles to thrive. In a financial crisis, the initial spark of a speculative bubble, provided by human fallibility, is further amplified by the incompetence of the institutions of the state at the macroeconomic level. These amplification factors include mismanagement of the monetary supply, failure to provide liquidity at the right instances and at the right amounts, political expediency, and lack of transparency in decision making. Lastly, hovering above these short-term contributions, is the Marxian critique that in the long-term, capitalist systems are inherently unstable, because of the over-accumulation of surplus value, a distinctly Marxian notion. Economists like Milton Friedman/Anna Schwartz, John Kenneth Galbraith, Charles Kindleberger and Karl Marx have done a much better job of recording the characteristics of a financial crisis from these human and social perspectives than I, as a mathematician, could ever hope to do. Perhaps posterity would yet decide that these causes, just stated, would provide the best possible explanation for this current financial crisis as well.

The perspective of Galbraith can be seen as providing an Economist's Apology for financial crises -- that it is beyond the economist's professional ability to anticipate human fallibility, and that the economist's proper role is to accurately record the crisis after its occurrence. If my responsibility stopped with writing the mathematician's equivalent of the Economist's Apology then it would undoubtedly be a great honor to attempt to emulate such stalwart economists as mentioned above. However, I emphasize once again that my task is far from a happy experience. Whereas the challenge of writing prose as clear and elegant as Galbraith's would indeed be an honor, there is no similar honor nor any pleasure in seeing celebrated mathematical theories fail so decisively. My task is further complicated by the fact that to provide a reasonable estimate of the measure of the blame that should be accorded a mathematician, one has to first make sense of this human, all-too-human drama that has been unfolding on the markets this year.

On the Right, politicians have been promising this week, an 'expeditious and comprehensive' program to prevent 'systemic risk'. It is no matter that an expeditious program is simply not possible, because there is no one in the whole world who understands the full extent of the current financial crisis. Moreover, it hardly seems to matter that there does not exist any clear description of 'systemic risk' to date. 'Systemic risk' was the reason put forward for the 30-billion-dollar rescue of Bear Stearns in March 2008. The same 'systemic risk' is the reason being put forward now in September 2008 for establishing a half-a-trillion-dollar mortgage bail-out program modeled after the Resolution Trust Corporation of the 1990s. It appears to me that 'systemic risk', if it exists at all, is the one-size-fits-all ghostly garb of witchcraft. In fact, the concept of risk, as understood currently, does not adequately address the uncertainties faced by the economies around the world today, as I will try to explain in the next section. As a result, any comprehensive solution to the current crisis is, to my knowledge, necessarily years ahead in the future. In addition, Right-leaning economists have been suggesting that the finance industry is too bloated and needs to shrink. If so, where are the corporate profits going to come from, given the current state of manufacturing, food, energy, automobiles, wholesale and technology industries? Also, does this mean that these economists agree that globalization is the only adequate source of economic growth in the next decade? Worst of all, the starkly Right-wing interpretation of the concept of the 'prime borrower', which is the predominant interpretation among the economists and the media-pundits today, has greatly obstructed the democratization of finance across America. Please recall that I had severely criticized the method, currently employed by the finance industry, for measuring the credit-worthiness of a homeowner in my "Update 2: A Marginalistic Interpretation of the GARCH model" (dt. Sunday, May 4, 2008).

On the Left, economists have been demonizing Wall Street executives -- that the high bonuses that these executives take home during the good years is somehow an indication of fraud. If so, would they admit that the famed innovations in the finance industry during the last two decades have no economic value? Please recall that I had stated clearly in my 'Update 1' (dt. Tuesday, April 8, 2008) that "... modern economic theories could not guide us in figuring out how to safeguard the enormous transitory wealth created during the tech boom of the 90s". The tech bust of the early 2000s, I suppose, would make many people agree with that quoted statement. In the next two sections, I will try to explain why modern economic theories are not properly equipped to capture the economic value of financial innovations as well. I had stated further in my Update 1, that "... to face the emerging challenges of globalization in the 21st century, America needs to have a clear sense of the sources of its own wealth. Rising home-ownership speaks directly to core American values which include working hard to gain wealth." It is important for the Left to realize that they need to put aside, even if only temporarily, the Utopian notion of the 21st century's innovation economy, and actually focus on finding solutions to this financial crisis. The solutions need to be something other than just telling themselves, 'let's nationalize our way out of this annoying distraction that people call a financial crisis', or 'Alan Greenspan is responsible for this financial crisis because he kept interest rates too low for too long'. Blaming Alan Greenspan, the former Chairman of the Federal Reserve Bank of the United States, who retired 31 months ago, is not going to solve any problem. Moreover, Greenspan has done yeoman service to the world by having the American economy cash in on the 'empire-premium', as I will explain in Section III.

Thus, I embark with what I hope is ample warning that a mathematician's willingness to apologize for the current financial crisis, should be strongly tempered with a bird's eye-view of the layers and layers of human follies that are unfolding, in real time, on the American economy these days. I might also draw attention to the fact that this game of smoke and mirrors that is being played out in the financial markets and in the political arena is especially murky this year given that this is a year of Presidential election. Then again, I would like to point out that Friedman/Schwartz, Galbraith and Kindleberger published their respective studies on financial crises several decades after the Great Depression, which was the single most important event during the periods covered in their studies. Whereas, in my case, I am writing this apology right in the middle of the current financial crisis, an individual situation which is quite incongruous for a mathematician to be in, because a mathematician's insights arrive at their own time. On the other hand, perhaps my situation is not so inappropriate for me, because a mathematician, by training, should see his/her own faults quickly, for how else would (s)he know for certain, the difference between a proof and a fallacy, except by purely intellectual reasoning? In that case, I should also state that the clarity of a mathematician's viewpoint should not be held as evidence that (s)he is anywhere nearly as close as the other idiots are, to blame for this financial crisis.

II. Risk Management

If one asked a natural scientist about the concept of risk, one would, no doubt, be provided with an explanation based on probability and statistics. In contrast, it appears that some schools of economic thought have pursued their own non-quantitative, intuitive understanding of the concept of risk. I became aware of this only recently. A day after I sent out my "Update 2: A Marginalistic Interpretation of the GARCH model" on May 4, 2008, I received a message from Professor Edmund Phelps referring me to his Op-Ed article in the March 14 edition of Wall Street Journal entitled, "Our Uncertain Economy". Upon reading it, I came to understand that 'Hayekian uncertainty' and 'Knightian uncertainty' are terms that appeal to well-established traditions in economics and that economists have an intuitive recognition of the phenomena referred to by these terms. I am yet to gain a thorough understanding of Professor Phelps' Op-Ed article. However, I would like to explain here how my view on economic uncertainty, as developed in my research proposal, "A New Perspective on the Role of Markets in an Economy", which I had sent out in the second week of March, 2008 is different from the what Professor Phelps discusses in his Op-Ed article.

My view on economic uncertainty is simply an extension of that of the natural scientist. Basically, if any phenomena we come across in the real world could be repeated under independent and identical conditions, then the probability theorists and the statisticians would have a lot more to say about the real world than they do now. This is because, in trying to apply probability theory to their data, statisticians assume that a random variable has been sampled repeatedly under identical and independent conditions. Further, most of the results in probability theory, like limit theorems and stochastic models, deal with collections of identically and independently distributed random variables. However, the world is constantly changing. Except for obviously independent events like coin tosses, it is not clear that experiments, particularly those measuring instantaneous, microscopic events, could be repeated under identical and independent conditions. There is a fundamental doubt whether the statistical measurements that one makes do, in fact, constitute a single random variable, or they are each simply disparate, unrelated phenomenon. Hence, my view on uncertainty tries to avoid making such unreliable measurements. Instead, if one allowed the duration of interaction between the buyer and the seller in a market to take non-instantaneous values, then one could possibly build more robust theories about the functioning of markets. This is the basis of my research proposal and the subsequent updates on it that I have been sending out.

My aim in the previous two paragraphs was to make the reader understand that risk is an extremely subtle concept. The usual understanding that the risk involved in an asset is indicated by the volatility of the asset's price, and that volatility is measured by the variance and other higher order moments of a probability distribution is indeed quite simplistic. On the other hand, it is precisely this quantitative formulation of risk that has made it so applicable in many different contexts. The concept of risk that entrepreneurs encounter in their business ventures has a strongly psychological, non-quantitative component which shares some basic features with the kinds of uncertainty that Professor Phelps refers to in his Op-Ed article. Whereas the concept of risk that the Wall Street establishments deal with in their financial calculations needs precise calibrations, even if it is, at times, divorced from reality. Thus these finance firms work within the probabilistic framework. This leads us to the question as to what exactly is the economic value of the activities of the Wall Street investment banks during the last three decades, activities that particularly involved heavy use of derivative instruments? In my opinion, the great achievement of the financial innovation that these Wall Street firms undertook over the period of the last three decades is risk management. This credit due for this achievement is all the greater when one keeps in mind that the variety of assets that needed to be valued in daily economic activities had undergone an explosion after the underlying foundations of the economies of the first-world nations shifted from manufacturing to services to information technology during the course of the twentieth century. In addition, the nature of the most valuable assets became more and more intangible, subtle and ephemeral.

To appreciate this point properly, let us go back in history and consider the basis of economic wealth. In the agricultural economy, the wealth of an individual was reflected by the ownership of arable land. Mercantilism was the economic theory that existed in 18th century Britain, just before the time of Adam Smith. In the Mercantilist's view, the wealth of a nation was measured by its reserves of gold. This attitude would have suited the agricultural economy whose activities were mainly concentrated on producing edible goods. However, the only prescription that Mercantilism came up with for producing wealth for a European nation was gun-boat diplomacy -- to enforce payments in gold for the trade with its colonies. It was Adam Smith's great vision that manufactured goods and non-perishable agricultural goods, like spices and cotton, also accounted for economic wealth, and that the free trade of these goods maximized a nation's wealth. Adam Smith's worldview laid the foundation for the industrial economy. Over time, the factors of industrial production, which were classified as land, labor and capital came to be considered as the basis of economic wealth. Capital constituted of buildings and machinery, and more liquid assets like cash, bank deposits, bonds, promissory notes and company shares. Money-lending did exist, but was invariably looked upon as greed. Even at this early stage in economic theory, the relative importance of land, labor and capital was a greatly controversial topic, involving the lifetime efforts of famous economists like Thomas Malthus and David Ricardo.

In the later half of the 19th century, Karl Marx attempted to develop a complete sociological theory based on the notion of intrinsic economic value. In this theory, the value of a good was proportional to the effort it took to produce this good, and thus labor could be made to play the predominant role in the measurement of economic wealth, by simply having capital and land administered by the state. Marxist theory had the great advantage that inequality of wealth could be avoided altogether. Moreover, Marx had deep insights about the nature of knowledge, social justice and history. However, there were some severe drawbacks in his theory from an economic perspective. Already in Adam Smith's Wealth of Nations, published in 1776, the famous example of improving the output in a pin-factory, even while keeping the factors of production constant, by employing division of labor was analyzed thoroughly. Thus efficient utilization of the factors of production and technological improvements proved to be two issues that had continued to be important considerations for producing economic wealth since Adam Smith, even though it was not always clear how to measure them. The emphasis on efficiency provided a role for the entrepreneur who supervised the distribution of resources, with the goal of optimizing production, keeping his own self-interest in mind.

Now, labor was compensated regularly by wages and salaries, whereas the capitalist-entrepreneur had to wait for the duration of the production cycle, which could be as long as a year, in the case of internationally traded goods or cash crops. Moreover, Marxist theory of intrinsic value worked well for goods which are basic necessities, but not so well for luxury goods. For one thing, the inherent unpredictability of human gratification meant that scarcity and abundance could not be ignored in valuing a good. Thus marginal utility came to play an important role in ascertaining economic value, as demonstrated by the oft-quoted diamond-water paradox. This meant that there was great uncertainty about the compensation that should accrue to the capitalist-entrepreneur at the end of the production cycle, even if one ignored the fact that the capitalist-entrepreneur waits for his/her compensation unlike the laborer. The cause of the uncertainty was that the market would determine the value of the produced good according to the supply and the demand prevailing at that later time, not according to an intrinsic value of the good. Thus it came to be regarded, through the theory of marginal utility, that the risk that the capitalist-entrepreneur was assuming in his/her business venture accounted for the compensation that was due for his/her capital.



[The rest of this article would be made available next week, upon request]



PS: In the interest of full disclosure, perhaps I should state here that I hold a software job in the mid-West with an annual salary of $40,000. In defending the role of Wall Street in this article, I do not obtain any monetary benefit whatsoever.