An insight into the Credit Crunch

The clear lesson of the credit crunch was that nobody actually understood derivatives, but had convinced themselves they did.

One reason why banks and other financial institutions committed so much to trading derivatives was because they had models that told them that their investments were sound. This all turned out to be false.

The attached article is a challenge, but illustrates the problem of assumptions and abstracting. The Black-Scholes equation was the first equation which valued investment options in a seemingly reliable way. It worked for a long time and encouraged the use of similar mathematical models that valued more complex assets in what were essentially gambles.

Regardless of what we may think of banks gambling with their clients money, the way these valuation models worked is fascinating. The bankers made assumptions on volatility and various other variables and the models became more ambitious. It turned out that the models did not survive reality with disastrous results. Yet it was quite clear that the models could never survive reality to anyone outside the financial sector.

The article is excellent reading for all those interested in financial economics and doing economics at university.

The Guardian article is here

Crucial questions on policy

Despite appearances to the contrary most economists do not spend their time on designing policy. They actually spend their time on the 'basic science' of economics. The answers they come up with allow others to design policy accurately.

In a recent FT article by Lord Skidelsky and Felix Martin suggest a 'Plan C' is needed for the UK economy.

Plan A was cut the deficit and by this remove prssure on the hard pressed 'wealth creating' sector.
Plan B was print money to reduce interest rates and encourage investment (Quantitative Easing).


The authors argue that Plan B would not work due to theoretical issues raised by Keynes. They then back this up with evidence from the experience of QE, principally pointing out that confidence is the main determinant of capital investment, not interest rates.


They present Friedman's argument that liquidity is a key element of preventing depression, but don't give it the credit it deserves. Perhaps because it is a short piece, or perhaps because they are both Keynesians and have been waiting thirty years for a chance to get their own back.


Whatever their motives their piece is an excellent survey and shows the requirement to understand how the relationships in the economy actually work before policy is designed. Sadly the theory often lags reality.

The FT article is here

An expected Nobel Prize

Professors Tom Sargent and Chris Sims are the 2011 winners of the Nobel Prize for Economics. I was expecting it for years.

The important work for which they have received the prize is their contribution to modelling expectations. Prior to their work economists used a method known as 'adaptive expectations' to predict how households and firms would react to policy changes. This meant the computer models of the time used an equation that implied expectations moved slowly after a change in policy or events. Without being too technical this meant that policy changes could have big effects on behavior even though the policy was very predictable and mechanistic.

Sargent and Sims showed that expectations changed faster than previously thought and that by manipulating the expectations of firms and households policy, say to reduce inflation, would be much more effective. Many of you will have already looked at the importance of inflation expectations in the inflation process.

Today their work is very important in deciding macroeconomic policy, particularly in designing monetary policy. Take for example the debate on the pace of deficit reduction. Confidence is crucial in consumption and investment and based on their work it could be argued that more public spending and higher budget deficits will actually cause a worsening of confidence due to the effect it has on the expectations of households and firms.

The Nobel website has a Popular Information section, look at the 'Information for the Public' link and that allows you to download an excellent, non-technical,  summary of their work. (Pretty important for anyone considering Oxbridge/LSE/Warwick/Southampton/UCL economics.)

Nobel site link here

The Guardian coverage here