SFI Community Event – 2017 Ulam Lectures: John Geanakoplos on Debt and its Discontents. Part 1


welcome everyone thank you for coming
out and they’re sort of chilly autumn evening we might burn John if he doesn’t
tell us to rate things if I have a fireplace going so all right so there’s
a special lecture it’s a part of a two nights lecture series it’s the annual
deulim lecture series named after stanislav alam the polish american
mathematician who worked on the Manhattan Project he invented a whole
range of extraordinary techniques including cellular automata the Monte
Carlo method he suggested nuclear pulse propulsion which is a intriguing way of
sending rocket ships out into space and he has many other accomplishments he
also wrote a beautiful book called adventures of a mathematician and I
think he has a cry of a quote from that book that seems very fitting for what’s
going on in this country over the last couple of weeks or the world I should
say and he wrote with respect to his experiences working on the Manhattan
Project sometimes I feel that a more rational explanation for all that has
happened during my lifetime is that I am still only 13 years old
reading Jules Verne or HG Wells and have fallen asleep right time to wake up
let me just recognize I’m Claire and Steve Reiner who are here tonight and
they’re over there somewhere I can’t really see you but Claire is Stan ulam
daughter and so we’re just round of applause for the folks ordinary family and we’re so delighted that the wine has
remain involved with SFI support esse fine and income to all of our events
thank you to Thornburg investment management for their support of the
series and of course to the lens Athiya tur for hosting these lectures so
tonight and tomorrow so if you came tonight come tomorrow today as an
appetizer tomorrow’s the main course if you prefer today as the main course
tomorrow’s the dessert you pick and our speaker is John gianopolous he is the
James Tobin professor of economics at Yale and external professor at SFI John
got his BA in mathematics from Yale and his MA and PhD in economics from Harvard
working with the Nobel laureate Anna Pharaoh and Jerry Green so at SFI the
social sciences and Natural Sciences have always coexisted intermingled
conjugated and reproduced and starting very few years after we were found in
1984 and as early as 1987 and running for a series of years Ken ro John’s
advisor the Nobel laureate working with another Nobel laureate Phil Anderson
convened a series of meetings at SFI to apply concepts of evolution to the
creation of a new economic theory and John sustained that ambition and in 1992
91 and then 99 to 2000 he directed the economics program at SFI and in fact in
as early as 1991 John was exploring the role of machine learning and statistical
inference to predicting financial systems which of course has now come of
age John is in many ways pre adapted to life identify what does that mean
exactly it means that in 1970 he won the United States Junior Open Chess
Championship and at SFI we’ve long had an interest in combinatorial games of
zero chance a chess and go and so forth John’s dad was also a professor at Yale
and he was actually a professor of Antron cultural and religious history
wrote many beautiful books and I was told that when John first got to Yale as
professor in 1980 they would give lectures in parallel and his dad’s
lectures would be attended like this hundreds of people fawning after him and
and hanging on every word and John would have about three people in his audience
so he’s moved on so I should say that since the onset of the late 2000
financial crisis John’s work on the relationship between leverage and asset
prices the so-called leverage cycle has been prominent in both popular and
academic discussions on market fluctuations and regulation John also
has an applied side like many SFI affiliated faculty and he was one of the
founding partners in 1995 of Ellington Capital Management where he remains a
partner don’t make a personal note about John and I hand over to him over the
years John and I have maintained a collegial and some people might claim
childish debate on the precedents of evolutionary thought of economic thought
my position or economic thought over evolutionary thought John’s position and
at stake is whether the combination of Adam Smith and Malthus recognized the
essential role of competition and resource distribution as a foundational
force for order John claims or whether they overlooked the evidence stumbled
about the crime scene as most economics economists are one to do and where it
took the originality and genius of Darwin to solve the great puzzle of
nature the argument the argument is futile I’m right
but it does give you a sense of how these different great intellectual
traditions can begin to be integrated just in closing just to say that John
was elected a fellow of the economic Society in 1990 the American Academy of
Arts in science is 99 he won the Samuelson Prize in 1999 and was a wooded
the first Buddhist a key prize in economics in 1994 so John take it away well thank you very much it’s David for
introducing me it’s a pleasure to be back here in Santa Fe I never met
Stanislav I didn’t see where his daughter was by the way where is she
oh there you are hello so David reminded me about chess and Santa Fe and machine
learning and one of my first papers I wrote in Santa Fe was called when seeing
further isn’t seeing better and I attempted to explain how chess
algorithms worked and basically tried to show that the computer would never beat
Gary Kasparov and I presented the paper to Gary Kasparov at lunch just a few
months before he was defeated computer so the the subject of my talk is dead
and its discontents it’s something that everybody knows about because almost
everybody has been in debt at one point and thought about lending money or
borrowing money debts plagued multitudes for millennia it’s caught you know
debtors prison it’s caused booms and busts wrecking economies we’ve created
central banks to manage credit we created macroeconomics to study these
booms and busts and how the credit was managed we’ve had thousands of years of
philosophers talking about debt and what it means and with all that we couldn’t
stop the Great Recession of 2007 so somehow
after all that the macroeconomic consensus that had emerged before the
Great Recession needed a little fine-tuning and so I’m going to present
a proposal to change the macro consensus and central bank policy and Steven said
it’s like call it the leverage cycle and I’m gonna say that actually it’s quite
consistent with what all those philosophers were talking about all
those thousands of years in fact might have been they might have anticipated
the whole thing if they had added a little mathematics to what they were
doing I’m gonna tell you some other alternative theories from after the
crisis actually the leverage cycle was from before the crisis and I’m gonna
explain what mathematical economics is and why it’s useful to do mathematics
and economics almost everything that you hear about debt you can tell a story
about so what’s the point in mathematics well the person who had the greatest
impact on making economics mathematical not the first but the one with the
greatest impact was Kenneth arrow who my thesis advisor who David referred to and
the starter as it were of the economics program so I’m going to explain a little
bit what he did and what how my theory fits into that and why he didn’t think
of it and then then I’m going to in the next lecture flesh out the leverage
cycle and try to make a little more practical and try to explain what
happened in the crisis here the Great Recession in America and what’s happened
and still happening in Europe although both places are getting a little better
now so I probably don’t have to remind you that the Great Recession was pretty
bad this is a picture of of GDP from 1932 actually to last year or the year
before I forgot to update the slide and you can see that it goes steadily up it
has these little blips downward but every time it has a little blip downward
I’m starting after the depressions that was a big blip downward but after that
from 1930 to 2008 seven or eight every time it went down it quickly recovered
so if you look at how fast it was going up it blip
down a tiny bit then goes up faster to catch up to where it would have been
before those were all the recessions we had before but look at what happened in
2008 there it went down a whole trillion dollars it had been going up a trillion
dollars the previous few years you know the slope so you could say GDP was down
two trillion dollars compared to what it might have been without the Great
Recession and every year after that it hasn’t caught up to where it’s been
before it’s still parallel to what it’s old trajectory was just a trillion or
two below what it was so you know you could probably overestimate the cost of
the recession this way but this has been going on for eight or nine years a
trillion or two trillion dollars less than what you might imagine it could
have been we might have lost ten or fifteen trillion dollars in the Great
Recession think of what we could have done the Iraq war was two or three
trillion we could do a lot with 15 trillion dollars and somehow we didn’t
avoid it so it’s a mistake that needs to be rectified it didn’t just happen in
America here’s an updated picture it’s happened all over Europe so this is GDP
in a bunch of different countries including Japan in the US and you can
see that all of them Spain is the top when they started a hundred you know I
normalized it to start at a hundred in 1980 they’re all cruising up and then
there’s this big crash and almost all of them they don’t improve much the worst
one is Greece that I’m going to be talking about it hasn’t grown at all
since the crash there the others you know they pick up a little bit but there
they never catch up to where they would have been before so year after year
after year after year every one of these countries is losing output losing
potential income that they could have put to some good use you’ll notice by
the way that Germany and Japan they have a tiny blip down and then they do catch
up to where they were before I’ll come back to that later
so what is the consensus what was the consensus I’m sure you know it
yourselves you just read the newspapers and you know what the basic story of
macroeconomics is and what the Federal Reserve is supposed to do
the basic idea was always emerged you know from Keynes onward it was worked
over and over again the basic consensus was well sometimes demand is too high
and sometimes it’s too low sometimes there’s too much inflation sometimes
there’s too little output and the Federal Reserve by adjusting the
interest rate when things are too hot it raises the interest rate if things
aren’t going very well that lowers the interest rate by adjusting the interest
rate it can restore the natural path of the economy and for a long time it kept
things on a very even keel now people including Keynes recognize
that if the interest rate were zero there wouldn’t be any room to adjust the
interest rate down and so there’s a little problem with the zero lower bound
which we’re of course near now but other than that it was all about adjusting the
interest rate you read the newspapers even today after the crisis and they
talk about Janet Yellen what are they talking about Janet Yellen by the way
was a graduate student at Yale about four or five years ahead of me and then
also an assistant professor at Harvard four or five years ahead of me so I
always heard about Janet Yellen I had to take out one Tobin’s course and I had no
idea what was going on for a while and I got Janet yellen’s notes and then it
became clear what was going on anyway she she if you read the newspapers it’s
all about is she gonna raise the interest rate or not raise the interest
rate or when is she gonna raise the interest rate is she gonna unwilling
quantitative easing or not on one quantitative easing that’s all about the
long interest rate was designed to keep the long interest rate low too so
they’re still talking about the interest rate now if you think of economics
macroeconomics is all about the interest rate what do you mean by tight credit
everybody every business person even non-business people they talk about
tight credit credits tight tech credits loose well if you keep if you’re serious
about the interest rate you must mean the interest rates too high of credits
tighter it’s too low if interest rate you know if credit is loose but I don’t
think that’s what business people mean when they say credits tight or credits
loose what they mean is at the interest rate that’s currently prevailing credit
is tight when they can’t get a loan and why can’t they get a loan because
the lenders think that they might default so at the interest rate that you
can read in the newspapers they can’t get a loan and then we know interested
is tight so what was missing in the macroeconomic story was default it just
didn’t appear in the story at all so what I’m going to talk about is the
possibility of default and when you think of default and very soon you can
think of collateral so the purpose of collateral is to make the lender feel
more secure about the loan so the bigger the collateral is the more secure the
lender feels and of course you have to take the ratio of the collateral to the
loan so that’s called leverage so the loaned value is the loan amount divided
by the collateral amount so for example you have a hundred dollar house and you
borrow 20 and you start you borrow 80 and you pay $20 of cash you’ve borrowed
80% of the house the loan to values 80% the margin or down payment is 20% and
the leverage with $20 you managed to buy a hundred dollar house it’s five times
your cash you got to sort of stretch it by five times it’s all those words the
collateral rate is a hundred divided by 80 is 5/4 they’re all different ways of
saying the same thing it’s a ratio that key ratio you can look at at different
ways now one important aspect of leverage that I think every investor
knows including Shakespeare by the way is that if you’re leveraged five to one
say you have a house you bought with AE dollars borrowed and put $20 down and
the house goes up by a dollar that’s one percent and you sell the house you have
to pay back the 80 so you end up with twenty one dollars but you only pay 20
down so basically you’ve made five percent on your money so the asset goes
down one dollar then you have 19 left you lost 5% of your money so leverage
multiplies your risk and that’s the way all business people look at leverage
that’s the way economics textbooks looked at leverage that everybody knows
but beyond that at least when I was a student they never said anything about
collateral and lever and I didn’t take us even in finance you
wouldn’t hear very much about leverage or collateral
not to mention never in macroeconomics so I changed the way I thought I mean so
how did I think about leverage well I decided in 1989 that I wanted to see
what was happening on Wall Street I was a mathematical economist the most
mathematical things and economics were being done in finance on Wall Street and
I had I decided to go to a little firm it’s not that little there’s a seventh
biggest investment bank at the time called Kidder Peabody
it wasn’t goldman sachs where most academic economists tried to go because
it was a very academic intellectual place but I had a little cousin who had
just graduated college and who is that Kidder Peabody and he introduced me to
the person who ran fixed-income at Kidder Peabody and that guy said why go
to Goldman Sachs and be one of a hundred economists you know in a corner working
on some little option pricing problem come and talk to me and you’ll learn a
lot more so I went there and I did learn more probably than ever at least I was
in the right place it turned out so cute her Peabody my I was there for a while
and I was reading about mortgages I didn’t really know much about mortgages
at all I didn’t realize what went on behind the scenes I had no idea at the
time that if you get a mortgage the bank doesn’t hold your mortgage it sells it
to somebody and then they package it into these big pools and they cut the
pools up and stuff like that it’s a huge complex operation actually much more
mathematical than anything else on Wall Street so I picked exactly the right
spot and I spent a year there and had a good time talking to this guy and at the
end of the year he said you know I’ve learned from you that my research
department isn’t very mathematical why don’t you run the research department
from Yale and hire me a new really said hire me a new research department so I
hired 25 people over the summer before I went back to Yale but he said okay
you’ve hired the first 25 run the department from Yale so I thought my
gosh this might be interesting I didn’t realize what was interesting and also a
little frenzied and a little more drama the night
but I did it and it turned out that Kidder Peabody became the center of
mortgages in America and securitization so my there was a scandal in the
mortgage department and my little cousin his early 20s got promoted to be the
head of of mortgages collateralized mortgages and he built it into the
biggest mortgage operation on Wall Street so we did 20% of all the
mortgages on Wall Street by the time he was 28 or so he issued half a trillion
something like that dollars of complicated mortgage derivatives and
Kidder Peabody was just booming along and as I was seeing all this activity
everything around me was involved collateral every single deal they made
they’d say all this guy might not pay us what’s the collateral he’s putting up
when you get a mortgage you might remember what happens is you get a
mortgage the bank buys your mortgage so they feel safe because the house
collateral eise’s it then they sell it into a pool and the pool is split up
into other pieces the pieces are collateralized by the pool then the
buyers of the complicated pieces they don’t pay for them by cash they borrow
most of the money and use the pieces of themselves as collateral for what they
buy so there was collateral everywhere back and forth I couldn’t keep track of
how much collateral there was and I’d never seen it in any economics course so
I decided I should be writing about collateral equilibrium so that was the
first thing I did at 1997 well after 135 years Kidder Peabody closed it was one
of the early scandals on Wall Street it was a traitor in the government bond
department name Joe jet some of you were old enough to remember this and he’d
apparently made a trillion he apparently made 200 million dollars the year before
but actually it turned out on closer examination he’d actually lost a hundred
million dollars and so they they fired him and then he sued them for
discrimination because he was black and so it was a huge scandal as the front
pages of the newspapers for incredibly long time
and then suddenly General Electric decided to close Kidder Peabody and I
had to go back to my office at Kidder Peabody and invite the 75 people who
worked for me in research and say I’m sorry you’re fired
I’m sorry you’re fired the 75th person left and I went to the office next door
the guy said I’m sorry you’re fired and so we all fired each other 6000 people
got fired in one day and I didn’t realize at the time what had done I’m
wrong but the interest rates had it was 1994 and the interest rates which had
been going steadily down went up eight times and it was part of a leveraged
cycle but I didn’t realize I had no idea what’s going on at the time so we
decided to form my cousin decided to found this hedge fund called Ellington
and Ellington was going to now buy the securities that he’d previously been
creating and he you know our model was we created the mess let us clean it up
and we didn’t get too many investors with that model but but we did make a
lot of money because it was right after a crash and it turns out that that’s the
best time to be an investor something else I was learning for the first time
so we were booming along at Ellington and pretty soon we were doing so well
began to attract a lot of investors and things were going really well and then
one of our competitors was much bigger and more famous than us awful not bigger
in mortgages but in general name long-term capital they went out of
business you may heard of them founded among by 12 people including two Nobel
Prize winners in economics they almost destroyed the reputation of economics
Nobel Prizes but they went out of business and we celebrated one of our
best you know competitors going out of business well a few months later we got
a margin call so that what does that mean that means on a Tuesday morning we
got caught got Tuesday morning on a Friday morning we got called before 10
a.m. and we were told we had to produce a
certain amount of money a margin call and if we didn’t raise the money by four
o’clock then we would our assets would all be sold that were collateral and of
course if we’ve borrowed 80 in the assets are worth 100 they only
need 80 they’re not gonna sell them probably as efficiently as we might they
probably only get 80 for them and so this is a disaster for us and we
couldn’t raise the money by the afternoon and so it was big drama we
thought we’re all gonna go out of business we had all these lawyers come
in and tell us that you know if you lose all a little bit of money you’re a hedge
fund no one cares you lose all the money you’ll be sued for incompetence or worse
than that and they might take your house and and so so we didn’t know what we
were gonna do and then my cousin decided that we would try to auction these
assets ourselves over the weekend it was Columbus Day weekend so anyway we ran an
auction we split it into three pieces and the first piece we auction them off
you know we just told people to bid and we got all the bids in and they were all
80 and that wasn’t good and so my cousin said we’re gonna answer all the emails
and tell everybody they were outbid so we told everyone they were outbid and
then we auctioned the second third two hours later and we got all the bids and
they’re at 95 and then they’re at 99 the third time so we survived to fight
another day but it was one of the most frightening experiences that I’ve been
through and so I thought I mean this is twice I’ve been in a place that’s nearly
gone out of business and I’ve thousands of people the first time and you’re not
quite so many the second time could have been fired and it can’t all be my fault
I was in charge of making the models maybe it was all my fault but I might
say can’t all be my fault there must be something systemic going
on and that’s when I tried to think of the leverage cycle so I presented the
leverage cycle in the 2000 econometrics Society meetings that’s going to tell
you about anyway Ellington boomed after that near crash because after crisis is
the best time to be an investor it boomed until the next crash in 2008 in
the 2007 2008 and again we teetered on the brink although not quite as bad that
time and we survived again almost very similar story
and I learned something new which was forgiveness which I hadn’t thought of
before really very carefully and all these
homeowners were defaulting and they were they were being thrown out of their
houses and the lenders were getting almost nothing back 20 cents on the
dollar they were getting back if they forgave the loan they could have done so
much better and so I testified twice in Congress about forgiveness the 17 hedge
funds wanted to forgive debt like our hedge fund they asked me to represent
them all but I thought be better to speak as a Yale professor about
forgiveness but anyway the 17 of them got someone
else to represent them and said they wanted to forgive debt and I said it was
the right thing to do and of course we didn’t do it not a single penny of
subprime debt was forgiven but I’m gonna come back to that story next lecture now
I gave the graduation speech at the University of Athens economics and
Business School and I talked about forgiveness and I basically said that
you know we should have forgiving debt in America and that would have gotten us
out of our crisis the only solution to the Greek problem is to forgive debt um
I think it’s gonna happen because how could it not happen and your families
you won’t have to grow up and leave Greece like my grandparents did to find
opportunity the debt will be forgiven and there’ll be opportunity again in
Greece so the one of the professor’s there turned out to be later the
Minister of Finance and although I probably didn’t believe a word I was
saying he asked me to help him with the great debt in the negotiation with the
troika last year so I want to talk about that as well next time so that’s how I
got that’s how the idea came to me about the leverage cycle so what is the
theoretical idea of the leverage cycle the key idea it’s that when people can
leverage more the asset prices go up it’s as simple as that
you know finance was caught in the throes of efficient markets that every
acid it’s priced and you know by a rational calculation of
dividends it’ll pay and the the market sussed us out what’s going on and
figures out the fair price given what the market knows and what everybody
knows about potential pitfalls and what the dividends can be but I was saying it
doesn’t matter I mean it matters what the dividends are but beyond that if you
take two assets with the same dividends but one of them can be leveraged than
the other can’t it’s gonna sell for a higher price and similarly if it can’t
be leveraged it’ll sell for a lower price and that works not only on the
scale of a single asset but on the scale of a whole economy and the reason is
very simple that if you the reason it’s very simple that if you point very
slowly the reason is very simple that if you if you have a bunch of
buyers and you order them according to who’s the most optimistic and who’s the
least optimistic somebody’s up the price is going to be equal to somebody’s
opinion say the marginal buyer so what happens if we can leverage more well you
need less people to buy because they can each get their hands on more money so
the number of buyers the people above the marginal buyer are the ones who
think the price is good they’re gonna be the buyers the one below the marginal
buyer will be the sellers if people can leverage more you won’t need as many
buyers so that group of buyers can shrink which means the marginal buyer is
higher but the marginal buyers valuation is now a higher person and that’s the
price so the price has to go up it’s as simple as that and these people who
these people who are can differ for all kinds of reasons they can be different
risk tolerance they can different ability to hedge they can just like the
asset differently so some people like a house and some people don’t like houses
they can be more productive on the farms than other people some people can just
be more optimistic than others there’s a variety of reasons why people would
differ and why you shouldn’t expect everyone to have the same opinion so the
second key idea is that leverage is going to depend on volatility what could
be more obvious the more dangerous the world is the more insecure the lenders
are going to feel and the more less leverage they’re gonna permit so the
leverage cycle basically works like this you start with
of acids and people can borrow say 80% time goes by where volatility seems very
low the world sees sake seems safe everything’s going well and meanwhile
there are people like my cousin doing these technologies innovations on Wall
Street to stretch the available collateral that’s what these
collateralized mortgage obligations are all about stretching the available
collateral use the same house as collateral many times so with innovation
and people feeling safe the amount you can borrow goes up don’t when the amount
you can borrow goes up the price goes up and now you can borrow a higher
percentage of a higher number so you can borrow a huge amount more so here the
world looks wonderful everything’s gone up everybody’s feeling safe things only
going up but the economy’s at its most vulnerable because everybody is
stretched so far so when a little piece of bad news comes and the price goes
down and now maybe it’s underwater a little bit some people are gonna lose
money but who’s gonna lose the most money well it’s the leverage buyers and
remember if you’re leveraged five to one you lose five times the fall of a
housing price if you’re leveraged thirty to one you lose 30 times the price of
the housing price so the left the most ambitious buyers the most opportunistic
optimistic buyers they’re the ones who are leveraged the most they are the ones
who lose all the money so because of that their demand goes away they’re
forced to sell on the price goes down even more
but now the lenders say to themselves well the world has changed it’s more
dangerous than it was before we’re not gonna lend at that amount that leverage
of ninety five percent or something and so the new buyers who want to buy maybe
they’re not as optimistic as before but they can’t even borrow the money to buy
so the new buyers really are constrained and the price falls even further so at
that point if the gap gets big enough the debt is here and the asset values
are here that’s the calamity but it’s a double
calamity because you’re never gonna get paid so if you insist on squeezing as
much money as you can out of the homeowner you’re gonna end up with less
than you would otherwise if we gave part of it and that’s the idea of forgiveness
so the Fed what should the Fed do it should prevent the leverage from
getting so high when it’s going way up and when things are going down and
nobody can borrow the Fed should step in and make borrowing easier and it should
help with forgiveness that’s my basic theme so it’s a Santa Fe theme maybe but
now here’s some evidence for it and then I’m gonna elaborate it a little bit so
it seems to fit the data pretty well so what I have here is a chart that
Ellington used to keep before anybody was thinking about collateral and we
were and the blue line is the loan to value that we had to pay or would have
had to pay the maximum loan-to-value we could get on a basket of securities that
we were typically interested in buying not that we would leverage that much but
that’s what they would allow us to leverage so you see it’s at 90 on the
left-hand side and then it suddenly drops to 60 that was the 98 crisis I I
told you about which is me what made me think about the leverage cycle but that
blip came back very quickly in a few months everybody said that the lenders
were just panicked and crazy for setting you know changing margins so drastically
and we thought and anyway but I thought maybe they weren’t so crazy maybe the
world just that happens every now and then margins suddenly change so you can
see that margins are adjusting now the red is the price of these securities
these are bonds that are floating and so the price doesn’t need to change unless
you’re afraid it’s going to default so you can see that leverage goes up there
in in 95 or so it goes up to 95 percent twenty times leverage and then it starts
to drop everybody gets a little scared about the uncertainty and look at what
happens to the asset prices they say plummet just with leverage and then they
both go up together so it’s a remarkable fit but of course it’s really only two
or three points because everything else you know but it’s seen it’s quite an
astonishing parallel so then let’s take another example the housing prices so
the blue line or the Green Line is housing prices starting in 2000 it’s the
Case Shiller index and as Shiller was fond of pointing out housing prices went
from a hundred to one hundred ninety ninety percent in this
index in in until 2006 that’s where it hits its peak 90% in six years it’s it’s
incredible it’s almost unheard of he said it’s crazy
these people are irrationally exuberant they must be telling each other things
can’t do anything but go up and you know and so it’s and so he actually predicted
that things had to turn around because things had just gone up too high said
they were crazy well they probably were crazy some of these homeowners but they
weren’t completely crazy because if you look at the loan-to-value so these are
all the non government loans of which there were half were non government
loans in this period and it’s the average loan devalue or a down payment
I’ve written as down payment that the 50 percentile guys put down so in 2000 was
14% in the same quarter that housing reaches its peak the down payment goes
to 2.7 percent so you went to almost 40 times leveraged from seven times
leveraged and then you see that leverage collapses I’ll explain why next tomorrow
and then you see that the you see that the housing prices collapsed – so
Shiller would say the housing prices collapsed because the narrative changed
people started saying oh I can’t keep going up forever something must be going
wrong and so people said we better sell before everyone else sells I’m saying
something was going wrong and it was very hard for a new buyer to get a loan
okay so take just a little bit more evidence so here is the loan devalue or
the debt to income debt household debt to income in a bunch of different
countries in 97 and 2007 so you see Italy goes up a lot you see Spain in the
middle goes up a lot you see you see Ireland on the end goes up a tremendous
amount in Norway up which and the u.s. goes up in England goes up you know from
the gray to the to the red but you see in the middle Japan it’s actually gone
down in Germany next to it it’s even gone down a little bit and then you see
what happened to the you have leverage on the horizontal axis who you know
whose leverage went up the most in the vertical axis you see whose housing
prices went up the most there it is Ireland at the top UK Spain
Norway all those countries Denmark we said and there at the left no leverage
no increasing housing prices Germany in Japan they didn’t ask what happened
after the crisis who lost the most well Germany and Japan lost the least at the
top left and there you are with Ireland and Spain at the bottom right okay now
another idea that’s going to emerge in the leverage cycle is the credit surface
so if you ask how much interest you have to pay depending on how what your loan
to value is it’s a very small loan to value the lenders are gonna feel
perfectly safe and you’re gonna pay sort of the riskless interest rate the
loan-to-value starts to go up the interest rate is eventually going to
start to go up and go up quite sharply so this picture answers the puzzle what
does it mean for tight crib what does it mean that credit is tight
doesn’t mean that the interest rate at the riskless one is too high it means
that the it goes up too fast it’s too steep the most interesting borrowers
probably the ones who are you know might default and so they’re gonna pay a high
interest rate and so their interest rate might be going up a lot even if they’re
in Ch riskless interest rate isn’t going up at all so that’s the definition of
tight credit a steep credit surface so this is not anything a practitioner
wouldn’t be aware of or think of it’s just that somehow it isn’t pictorially
captured so I got a graduate student to do the credit surface in 2013 of all the
Fannie and Freddie loans so on the Left axis you see LTV so on the back it’s a
hundred in the front as low LTVs on the right is something else that’s gonna
play a role it’s called FICO or credit score it’s true in corporates you know
in individuals you might know your own credit scores it’s actually shocking how
low they can be if you’re just a little bit late paying things but anyway the
credit score on the right is eight hundred in the near-term that’s a very
good credit score it can even be slightly higher than that and it goes
down to 650 in the back but look at the interest rate so these are the best
borrowers in America they’re Fannie Mae freddiemac conforming you know borrowers
who were allowed to enter those programs this is middle America and even for them
the interest rate goes from 3.8 percent for the good people in the in the near
term all the way up to 4.6 in the bad term so that I think captures the credit
situation in the economy and is we’re gonna see tomorrow that curve can be
that surface can be very steep or very flat when it’s steep it means credit is
tight when it’s flat it means credit is loose and it can be a different picture
depending on what the collateral is so there’s there should be a well I’m going
to show you there’s a corporate credit surface and a mortgage credit surface
and a consumer loan credit surface and if we could keep track of those if the
Fed would be producing these every quarter like my student did the Fed is
now working on this we would have a much better picture of what’s going on in
credit and and and what the central bank should do so the leverage cycle as I
said when things are getting better and volatilities going down credit standards
loosen that pushes things up and gets everything going better again and you
keep going round and round where things get better and better but then something
bad happens and you start going round and round in the other direction so okay
so my recommendation that you’re gonna see tomorrow is that we should be
keeping track of these credit services and the Fed what it’s deciding what to
do should have in mind if we lower the rate we’re gonna move the credit surface
down maybe not even in parallel and we’re gonna move the corporate credit
surface and not the mortgage credit surface and which one do we want to move
quantitative easing they bought mortgages they didn’t buy corporates so
anyway so that that’s gonna leave that for tomorrow okay so that was my idea
which I want to elaborate but I want to tell you now a little bit about the
history of this so I’m gonna first mentioned Shakespeare so Merchant of
Venice that you’ve all heard of and you’re of an age where you might have
read it although the young people today they apparently it’s not regarded as one
of Shakespeare’s great plays anymore so it’s not read so much but in my youth
everybody read it it was garden is one of his great plays and was
supposed to be a comedy and a love story but actually he was about the leverage
cycle so so the play opens many of Shakespeare’s blades open with him
telling you what the play is about so it opens with the Merchant of Venice
Antonio going on stage and he says forsooth I don’t know why I’m so sad I’m
so melancholy and the other guy says well you know it’s obvious you you
you’ve got all your boats on the oceans and you know this is so risky you must
be scared to death and he says now every boats on a different ocean I’m not
worried at all that’s not it and then the guy says well you must be worried
about love and he says no I’m not worried about love so you see
Shakespeare’s announced at the very beginning that although people think
it’s a love story in a comedy it’s really about business first and love
second and not only that but he understands diversification so so what
happens in the play the the Bassanio the hero of the play he wants to marry the
rich Portia we find out she’s rich before we find out she’s beautiful which
of course she also is wants to marry a Porsche but she can’t he doesn’t have
the money to go woo her so he needs to borrow it and Antonia doesn’t have any
money cuz it’s all tied up in his boats so they have to go to Shylock the Jewish
moneylender who’s willing to lend the money and they have this tremendous
debate about what the rate of interest should be and Shylock Antonio says
basically you you know if you were Christian you would understand you
shouldn’t charge interest and it’s just terrible that you want to charge
interest and Shylock explains what basically is today the modern theory of
impatience theory of interest which is childlike says you’re impatient you
really need the money in a hurry I’m willing to wait that’s why you need the
money for me now and that’s why you’re willing to pay interest and so you know
I’m willing to give it to you if you pay me enough interest so they go back and
forth biblical references and stuff five pages about what the rate of interest
should be then they negotiate the collateral now I
saw The Merchant of Venice with what’s-his-name on Broadway
Al Pacino thank you and I walked out with a whole bunch of people in the
audience and I said can you tell me what the rate of interest was that Shylock
charged in the Merchant of Venice not a single person whom they just seen
the play they couldn’t tell me I don’t know if you could tell me what does
you’ve probably read it not a single person could tell me
Shakespeare realized the rate of interest isn’t the key variable here
it’s the collateral and everybody can remember the pound of flesh collateral
he made it more dramatic because it’s more important so he understood it was
about the leverage cycle so what happens what happens to the loan is that the
boats apparently of Antonio have all sunk and so now they’re not going to be
able to pay back the loan and so Shylock makes the margin call he says I want my
money they say why don’t you just wait for the boats he said I want my money
he’s promised me the money I you know I’m old the money and so they have a
trial and Portia who’s so rich who’s by this time married Bassanio she’s so rich
she makes a deal with the judge maybe pays him off that and disguises herself
as the judge so she says Shylock can’t you be generous can’t you so show mercy
and Shylock says Mercy’s irrelevant here we made a deal was a contract was freely
agreed on venice has to enforce contracts that’s what make commerce run
if you don’t enforce this contract you’re going to destroy the city and she
says well you’re very right Shylock that commerce does depend on enforcing
contracts but sometimes contra it’s so important that you change that it’s
possible for the judge to intervene so the court intervenes and change is not
the interest rate or the loan amount or anything like that she changes the
collateral it was a pound of flesh but not a drop of blood they didn’t say not
a drop of law it was clear what they agreed she adds but not a drop of blood
and once they’ve changed the collateral he can’t get his pound of flesh and so
he doesn’t end up getting his money and so Bassanio rushes up and says old
noble judge you’re so wonderful can I reward you for
that great judgement she said I don’t need a reward he said oh please let me
reward you and she says when you see that ring you’re wearing I’d like that
it’s no no no no I just got married to the fair Portia and and she gave me her
ring and I promised I’d never give it up so until I died I can’t give you that
ring and she says is it important for you to reward me or not did you say he
wanted to reward me I want the ring and so he gives her the ring and so he’s
supposed to be a complete fool and I went to Harold Bloom yells greatest
Shakespeare scholar and heard his lecture on on the Merchant of Venice and
he said Bassanio is not going to last six weeks with Portia once they’re
married but in fact he there’s another scene where he sees Portia and you know
she makes him embarrassed ISM asked him where the ring is and stuff and finally
he confesses all and she forgives him of course she forgives him what else could
he do something unexpected happened something
incredibly important happened he decided he had to break his promise and he did
okay so he’s also Shakespeare’s anticipated the forgiveness now what
else did all these people say for a thousand years all of it was all of it
was about the same things I’m talking about so if and what are the things I’m
talking about when you talk about debt you have to talk about the fault you
have to talk about punishment you have to talk about collateral you have to
talk about restraining borrowing and that’s what all these philosophers were
talking about so we have the Code of Hammurabi and in that code it was
written on written on on what he call it what’s it called no slate there was
slate it was slate and there was mark you know how much everybody owed
everybody and there was also those a slate were we’ve got the slate tablets
of what was owed we’ve also got the code that says if you don’t pay what happens
terrible things can happen you can be enslaved your children can be enslaved
etc so brave punishment for defaulting so
but also in the code it says if you agree to an explicit collateral like
your house then they can’t enslave you if you don’t default if you default they
just take your house and not only that Hammurabi like several of his
predecessors he forgave the debt there were so many people and so much debt
that it was important to forgive it and they all started with a clean slate
that’s where the expression comes from as you probably know so the Greek drakul
the first person to write down the laws of Greece said if you default on a loan
you’ll be killed and/or put into slavery sorry we put
into slavery few other things you could be killed for so these were draconian
punishments he said well you know they’re draconian but that’s what they
deserve if I could think of a worse punishment than murder I’ve been killing
them I do that but since I can’t think of anything worse so they’re all so so
that’s where we get the word draconian from well he was succeeded eventually by
Solon the lawgiver one of the seven sages of Athens and one of his had lots
of pithy sayings one of them was that the best in life is to grow old forever
learning new things just before he died he memorized a new poem because he
wanted to know it wouldn’t carry it with him so he repealed Rocco’s laws
including the plate the enslavement for default and he allowed people to use
their farms as collateral which Drago had forbidden he also decreed a debt
forgiveness and he had discussed this with five of his friends who immediately
went out and took big loans and then he announced of debt forgiveness so they
knew about moral hazard back then too so Plato’s in the Republic which is a book
about justice his first definition of justice is keeping promises and what
does he discover what is what so that’s what they propose and Socrates debunks
it he says we can’t always keep your promise maybe the person you’re supposed
to you know maybe things have changed something unexpected happened you might
have borrowed a knife from someone when it comes time to return the knife the
guy might be crazy you shouldn’t return the knife in that case so keeping
promises can’t be an ironclad rule of justice Aristotle by the way thought
interest was barren you you get that you produce something
out of nothing and it’s not natural and so no interest should ever be charged so
the Romans I gotta move quickly here the Romans also enslave people and they also
had to forgive them every now and then to raise an army if there are too many
people and too much in debt they couldn’t raise an army so they had to
forgive them and Caesar himself promised to forgive the debts of his soldiers
they fought with against Pompey the Egyptians had the same kind of they
banned enslavement and the rosetta stone now all of you probably know of the
rosetta stone it’s the most visited object in any museum in the world more
people visit the rosetta stone and visit anything else in London so the Rosetta
Stone has so famous because it’s got hieroglyphics demotic Egyptian in Greek
and since we know Greek we’re able to decipher hieroglyphics and demonic
Egyptian by having the rosetta stone that’s why it’s so famous but when
nobody seems to ask what was so important that they had to write it in
three languages well it was forgiving debt ptolemy v was forgiving dead
so people were setting interest rates left and right you know did I did
everybody knew debt could lead to trouble
in Judaism they were safe they they had the seven years forgiving of debts the
fifty year Jubilee a frigate of returning you know everything freedom
property everything in fifty years and they had laws about not not lending you
know for to quote Leviticus if your brother becomes poor take no interest
from him in deuteronomy thou shalt not lend on usury to thy brother usury of
money usury Victor’s usually if anything of this length upon usury usually is
interest unto a foreigner that macemail end on usury but not to a brother ok
Christianity st. basil said interest was terrible and people being in debt you
know they ended up in jail and lost their children was a horrible thing and
so in the Council of 325 AD they forbade lending at interest in 1197 it was
called a it was a declared a mortal sin Islam forbids lending at interest so
everyone’s realized there’s a so of course everyone did lend it
interest even though it was forbidden it happened all the time
Luther thought interest was terrible but he had a change of heart in 1524 and
Calvin said you know maybe blending it interest if it’s low enough isn’t such a
bad thing after all so in 1545 Henry the eighth legalized
lending at interest just at the time of Calvin but set a maximum of 10% they
went back and forth ended up getting lowered to 6% but all this what debtors
prison was emerging and you probably know that there are several famous
people who’ve gone writers who’ve gone to debtors prison Daniel Defoe wrote
Robinson Crusoe owed 17,000 pounds and went to debtors prison and this was in
1692 and he managed to get out after a year because his creditors figured he
might be able to pay them if they let him out the father of Charles Dickens
John Dickens also went to debtors prison he got out in three months just changed
Dickens life and he writes constantly without debt and debtors prison and
David Copperfield is almost about the story but John Dickens actually got out
after three months because his mother died and left him a big inheritance so
he could pay his debts but never Daniel Defoe crusaded against debtors prison
Nietzsche in the genealogy of morals said actually conscience grew out of
debt conscience and debt are the same word shoeld at least an archaic word for
conscience and and so what happens he said after thousands of years of being
horribly punished for not paying your debts people began to feel bad about not
paying them they developed a conscience to protect themselves their conscience
wouldn’t let them not pay back then they wouldn’t be boiled in oil
in fact people even got to like seeing people punished for not paying back so
I’m gonna come back to this when we talk about Greece and so anyway I won’t go on
till the Bank of England banks were created in order to manage interest and
prevent calamities that are arisen but in all these cases you see people are
talking about the same things that I said and
everybody had these usury laws that gradually disappeared in the US the
states had them and what happened there was a huge in there was a Supreme Court
ruling in 1978 that a bank that opened in a different state could charge
interest of the new state if the bank was located in state a it could lend to
the state be using A’s interest limit so therefore you could go to some state
like Minnesota that were at Wisconsin I forgot which one it was that charged you
know how to had a high debt limit and or interest limit and he could open
branches everywhere else charging high interest so this made the states compete
against each other and so it sort of did away with the usury laws and then there
was a huge inflation in the late 70s and 80s and that made them many of the
states raised their usury laws okay so I’m going to come back now to the
leverage cycle but I want to mention some alternatives so what do people say
after the crisis now I develop this theory before the crisis I think a lot
of people have come to believe in the leverage cycle maybe they came to it
independently of me too I think there’s some sense to it but it’s not like it’s
the only theory out there and I want you to give I want you to be aware of other
alternatives so one of them is held by many people Kindleberger it was the most
sophisticated it was an MIT professor who had many anecdotes and basically
what he said is what happens in these booms and bosses there’s some
opportunity something gets invented there’s some reason why people think the
time is different and there’s now a great opportunity there hasn’t been for
years so the prices of things start to go up now they start selling the stuff
and misleading people about what they’re really buying so they’re swindling them
to on top of that when the prices are going up so much people figure I better
get on the bandwagon so I could buy and you know I can make money too
and on top of that Kindleberger said it seems curious but every time this
happens it’s very eat the interest rates are low and it seems to be easy to
borrow money so then what happens is people realized that the opportunity
wasn’t so great after all and they all realized they’re wrong and the thing
crashes so then Minsky he had he was before Kindleberger
he had a theory that a little bit to do with leverage he said that there are
three kinds of borrowers there are people who borrow business people borrow
and everything they have to repay they can repay out of the profits they make
every year then he said when people get a little bit more speculative they
borrow the interest they can pay out of their profits but the principal they
can’t repay so they have to count on rolling over the debt they have to count
on profits persisting for a long time so they can keep rolling over the debt and
then they get really optimistic and they start borrowing so much that even you
know if the current profits even if they went on forever they’d never be able to
pay off the debt so as people get more and more diluted they move from what we
call the hedge borrower to a ponzi borrower and then one day they all wake
up and they say all this was a drastic mistake we’re all wrong there’s really
they can’t pay this off and so the price of the firm’s not going to go up so
we’ll never be able to pay the debt and everything collapses okay so that’s
similar to Kindleberger a little bit now there’s one other theory and this is the
one that’s held by everyone in power and it starts with a bank run theory so the
explanation of bank runs I think is very believable you you have the depositors
in a bank and they all think to themselves you know if I take my money
out does the bank have enough assets to pay me and they have to not only worry
about pay me but about pay everyone else because suppose that the assets that the
bank holds maybe in the long run they’re worth a lot but if they had to sell them
very quickly they wouldn’t be worth very much so somebody might say a panic
Weyden’s arise because someone will say you know I think of a long when the bank
is fine but in the short run all these other guys are gonna take their money
out the bank will be selling things off to pay them pretty soon there’ll be
nothing left for me so I better to ask for my money too then they all asked for
their money and then the bank really isn’t a terrible fix it has to sell
stuff and can’t pay them back so that story of multiple equilibria if
everybody is patient they’ll be plenty there in the end but if they think the
others are going to take their money out they have to run to that idea of
multiple equilibria that’s the basis of the sort of banking lender of last
resort because if you can step and lend to the bank or by the bank’s
assets you can stop the panic and save the bank and that’s what central banks
are supposed to do so it’s a multiple equilibrium story but another way of
saying that is you have to restore confidence and that’s what all our rule
or that’s what everyone in power always seems to think so Geithner who is the
secretary of the Treasury during the crisis he wrote a book called stress
test well that’s the title of his book what did he mean by that
he invented the stress test which was meant to show in a stress situation with
the bank survive and once the bank’s passed those tests everyone was assured
that the banks were fine of course the tests in my opinion were
doctored in such a way that the banks were gonna pass but anyway the stress
test was what made gave confidence to everybody Bernanke’s book head of the
Fed courage to act so again to restore confidence so it’s they think there’s a
multiple equilibria if they can just assure everybody nothing’s gonna go
wrong the panic will stop and everything will stop everything will be okay so
they had to do all sorts of things by all kinds of stuff to restore confidence
so my story I think there’s some truth to all those stories Kindleberger Minsky
and this bank runs story you know we have Deposit Insurance
there really isn’t runs on banks anymore they must be talking about runs on in
America there is in Europe runs on banks but not in America they must have been
talking about runs on money markets and stuff like that but they got a little
confused I think because they started talking about runs on collateral the
difference between collateral and a bank is it’s your own collateral it’s my you
know I’m a lender that one house is my collateral if I think that house the
long run is going to be worth plenty of money there’s no reason why I should
panic now no one else can take that house away from me it’s not gonna
disappear maybe the housing prices are falling but
eventually that house is gonna have a good value there’s no reason why I
should panic so the bank run story depends on this first-come first-serve
and everybody’s trying to get into the same pot that’s not true with collateral
anyway lots of people around time I started writing about collateral
including Bernanke also started writing about collateral so not the only person
who wrote about collateral in 97 but the others didn’t write about leverage the
changing leverage which was the key thing okay so what I want to move to now
is explain the mathematics of the leverage cycle and I seem to be running
out of time so I’m going to spend I guess five or ten minutes on this and
then I’m going to have to leave it till next time and rethink what I’m gonna say
this is gonna be the main part of the talk so today so you might ask the
question how is it that mathematics is helpful at all in economics why
shouldn’t it be helpful in every social science why just in economics well one
obvious answer is that there are these easily measurable things price and
quantity and not only that you can multiply them together so there’s an up
mathematical operation at the basis of it now when did economics start to
become mathematical it was because of a financial crisis so in 1929 there was
the stock market crash and there was a guy named Alfred Coles and he was part
of a very wealthy and famous Cole’s family they were in media and his job
and the media empire was to run a macroeconomics forecasting company so
every week it would say buy these four stocks he every week he had four stocks
that people were supposed to buy and the day before the crash he also told people
they should buy a bunch of stocks and he was very embarrassed that he hadn’t
noticed anything about the crash and so he went around and read every other
forecasting thing and they all were the same they were just as bad as he was so
he decided it was all fraud economics was a complete fraud and it should
become mathematical and so he went to his father and they decided to start a
mathematics Institute but they didn’t know how to do it so they went to Irving
Fisher who was his Yale professor Alfred colza Yale undergraduate and asked him
what to do and Irving Fisher said yes you should start an institute but we
also should start a society we’ll call it the econometrics Society
we should start most famous society in economics now we should start a journal
we’ll call it econometrics it’s the most famous journal in economics now and we
should start a commission the Coles Commission where people who do
mathematics can come to do economics so it was like it’s interdisciplinary in
mathematical it’s like the Santa Fe Institute you might say and so one of
the most important members of the Cowles foundation was Kenneth arrow and he’s
there in the middle so there he was last year in November and at Columbia
University and he came because I was giving the Coles not the Coles the arrow
lecturer at Columbia we’ve done a graduate student and he’s there with his
to his right is a classmate of mine taka tae Joos one of Japan’s most famous
economists and he also happened to be visiting New York so he came to the talk
to so this was just before arrow died I had no idea was so sick he was the
discussant of my talk he and Stiglitz he gave a brilliant discussion at 95 and
then a couple months later he died so I thought it would be an interesting thing
to talk about what it is that arrow did and so I’m gonna spend five minutes
talking about what he did and then I guess I’ll have to stop because this was
going to lead to what I did but well I’ll save that for next time
so what did arrow do how did he make economics mathematical in a way that
hadn’t been done before well you could imagine people in this theater trading
for goods those are the four goods sitting there and you each might own
various amounts of those four Goods apples and oranges and pears therefore
fruit you like fruit differently so as Apple’s might want pears instead so how
what would happen if you traded well you might scream out offers back and forth
and all pandemonium would break loose so someone in 1874 called Vaughn Ross he
said equilibrium will arise general equilibrium there’ll be
method to what’s going on and even though everyone’s screaming and yelling
at each other and it looks so confusing in the end can all be described very
simply as part of general Librium so what is general equilibrium
well this reminds me of a similar question what is a Nash equilibrium
which is very closely related and I I after you may have seen the movie A
Beautiful Mind by John Nash what about John Nash great mathematician and one of
the creators of game theory and so right after the movie they decided wouldn’t it
be wonderful to open the Indian game theory society and have John Nash be the
featured speaker and so and they invited a few other people like me to come and
speak as well so in fact thousands of people came to hear Nash and basically
left before any of the other speakers could talk and afterwards Nash was with
his wife too we went on tour of India and every city we went to there was a
news conference you know with reporters and the first one we went to a reporter
says could each of you speakers could you say in a word what is game theory
what is Nash equilibrium so everybody tried to give a definition of Nash
equilibrium me and Nash and the last person to speak it so happened was this
guy named Robert almond and an Israeli game theorist and he said that reminds
me of when Nikita Khrushchev gave his first press conference the old premier
of the Soviet Union in the 1960s his first press conference open to
Westerners and so one said mr. Khrushchev can you say and describe in a
word the health of the Russian economy and he said good and the reporter said
okay take two words and tell us about the health of the Russian economy
he said not good and so Alan said Nash equilibrium in one word is interaction
in two words rational interaction so that’s what equilibrium is and what
happens as prices emerge so in equilibrium
even everyone’s screaming about the prices it’s as if everybody knew the
prices in advance it’s just the price of everything somehow magically gets set
and people buy and sell all they can at those prices where they sell what they
have and by what they want given that they only
have income from what they sold that’s the definition of equilibrium in Adam
Smith described you know the economy with the invisible hand that people
without any desire to make things better you know they’re just pursuing their own
selfish interest they make things as better than they would if they tried so
alright so taking me longer than I thought so how do you make all that
mathematical that’s what arrow did he made that mathematical and so simple and
he basically showed that the first thing he showed was that if you look at the
trading that happens when everybody trades look at their final allocation
you call it Pareto optimal if there’s no way to make everybody better off and
then he proved that in equilibrium the final allocation will be Pareto optimal
the market somehow will discover the right way to allocate things distribute
things so that it couldn’t be improved even if you were the central plan or a
new everything and his proof is just a few sentences they don’t have time to
give people had tried for years to explain it
and pages and pages of mathematics and he did it and that’s the whole proof
that’s the whole proof okay if there’s another allocation that makes everybody
better off each person must think that new allocation was more expensive than
the one than what he ended up with otherwise he wouldn’t have chosen what
he did but if everybody is if this new allocation cost more for everybody then
it couldn’t be feasible because the total cost of it is more than the total
cost of what’s there in the economy so it wasn’t feasible the supposedly better
allocation that’s it and then the last thing he did the second thing he did
that was quite stunning was he said this equilibrium exists so so lots of people
tried to do this the first guy Varis who described the equilibria he said look at
my Librium as if they’re el commodities you just look at demand equals supply
for el commodities and if you start with the wrong prices there’s too much demand
and one good you raise that price if there’s too little demand another one
lower that price you’ll get to an equilibrium
well that’s no proof of anything there are many equations that don’t have
solutions you can move around however you want you don’t get to a solution but
the economic equations always do have a solution and Vaughn knowing involved
lots of famous mathematicians were unable to prove it because they didn’t
quite get the details right an arrow de Bruin McKenzie three people
simultaneously did prove it and so anyway those are the two things he did
and he started so it’s so the economic system works well but if it works so
well how do you get crashes in finance what’s going on
so arrow also pointed the way to how to do finance and how and and study so many
more things and he did it with a sleight of hand okay the last thing I’m gonna
say so if you’ve got time there was no time finance is all about time so
suppose you’ve got pot commodities today in commodities tomorrow there are two
sets of markets were trading today and then we’re gonna trade tomorrow
well arrow said why not trade all at the same time now you’ve just got more eight
commodities instead of four in the same prices it’s like trading an apple today
for an apple tomorrow and then people said so you don’t have to change
anything the market if you could trade all those things would do perfectly well
and in fact trading an apple today for an apple tomorrow the relative prices of
those is like the interest rate how many apples today do I give up if I give a
point Apple today how many apples do I get tomorrow that’s just what the
interest rates like so trading commodities it’s just like finding out
the interest rate okay this was actually already thought
of by Hickson Irving Fisher himself but then arrow took one more step and he
said how do you put in uncertainty before him everybody thought of
uncertainty was normally distributed variables very complicated stuff and he
said well it’s much simpler than that think of an apple in New York on January
1st 1953 as a different commodity from the same Apple in New York in 1953
depending on the weather in Paris so you now have many states of the world so how
does this capture what’s going on in the world well you don’t know
what’s gonna happen tomorrow many different things can happen you can
describe a stock now as something you can describe a stock now these yellow
things or stocks as its payment in each of the different states and you can
define an insurance contract as what it pays in the different states so all
these things stocks and insurance contracts they’re like basket of fruits
if you could trade all these goods just like you were trading the fruit before
an insurance contract or stock is nothing other than a basket of fruits if
you know what each of the fruits are worth you know what the stock is worth
or what the insurance contract is worth so as long as you can trade all the
goods that’s the ideal world then the markets gonna solve every problem and
you’ll be able to price all the assets and price it by figuring out what the
price of those single fruits are the arrow securities they’re called so
though that invention is you know finance people after that started
talking about state prices you know the prices of payoffs in every state that
gives you the prices of the assets they talked about spanning once you have the
prices of all these individual fruits they add up to the basket of fruit so
that’s that you can price the basket and there’s no arbitrage all the words of
Finance came out of that but the key problem was that he assumed you could
trade all the commodities at time zero what if you can’t trade all the
commodities there are only a few number of stocks you can trade okay so that
well that was where he stopped and where I’m going to pick up and I want it okay
so I was going to explain where all this where all my concepts the credit service
and stuff came from and so I mean I’ll try to do that and abbreviated form next
time but what I’m gonna do next time is I’m going to give a very abbreviated
form of how I thought of the theory and how it relates to this simple framework
so you can see where the credit surface came from and all that and then I’m
going to describe what happened in Europe and America and try to show that
it conforms to the leverage cycle and that we did all the wrong things we
could have done so much better than we did do I mean we’ve come out of things
now pretty well but it’s been almost a decade later we wasted so much time that
we could have done better so that’s what I want to
talk about next time so I’ll stop here so I’m happy to take a couple questions okay I have one over here so it is
Pareto work when monopolies manipulate the prices oh you’re asking sorry
thoughts I didn’t hear the question does Pareto work when manipulate monopolies
manipulate prices and market no so the question was in in this in this world of
being able to trade every potential contingent commodity you know that’s the
idealized world where all risks can be traded
what happens if they’re monopolies well that causes a problem so you have
to have a lot of competition in order to get to the idealized world and you have
to have this ability to write every insurance contract trade every state
contingent commodity and the question is going to be not so I’m not going to ask
the question what happens with monopoly I am going to ask the question what
happens when you can’t trade every state contingent commodity yes yes yes right
so you’re anticipating when I’m going to talk about tomorrow of course oh okay
well she’s asking so I drew up its – oh you’re back okay so let me just go back
to that credit surface this is what tomorrow’s talk is gonna be about thank you here it is okay so this says
depending on the FICO and the LTV what rate you have to pay and you could do
this credit surface for corporates or for high-yield and and the questioner is
saying you know volatility is low that means it’s pretty safe
so she’s guessing that this credit surface must be quite flat which it is
and that these corporations because it’s so flat or borrowing like crazy and
isn’t that a little analogous to what I was saying about what could possibly go
wrong and so yes I am saying that a little bit but conditions are much
better than they were in 2007 because there are lots of the rest of the
economy like the banks and the household sector that’s not very leveraged
compared to what well but so we’ll describe all that tomorrow so I’m not
anticipating an immediate collapse but I am a little worried and and yeah things
are getting a little so when things look the best that’s when you should be the
worried the most so that’s that’s the okay John over here yes sorry I just I
have a question about forgiveness for example in 2009-2010 yes when there was
a change of covered in Greece and they find out that Greece had cooked the
books and they’d also cook the books key in the EU in the first place yes would
have been smart for the EU just to say Greece we will absorb your debt we kick
you out of the club you’re on your own you can reapply later would have been
much better off just to forgive them it’s very early and dismiss them from
the group then come back and later it would have been cheaper and we’d had a
lot less trouble today well that was what many people recommended so the
crowd repeats the question he said Greece where I’m going to talk about
this tomorrow but Greece and marie’s suddenly
Papandreou announced that the deficit was really much bigger than it had been
said and that had been misstated and by the way I’m going to add a little tidbit
which you probably know but it makes for a good story which I would have told
tomorrow the guy who the head of the Bureau of Statistics in
Greece who restated the debt was born in Greece but came to America to go to
Amherst College like Papandreou by the way who went to Amherst College and we
went to Amherst College and stayed in America till he was in fifth about this
early 50s worked at the IMF and saw an
advertisement in Greece for the head of the Bureau statistics and he didn’t know
anything about Greece but he thought he was qualified so he applied and they
gave him the job and so he restated the deficit and then he you know I made it
correct and then he said you know if they botched that deficit probably the
year before they didn’t get right either and he went back and examined that one
and restated that one and of course that one was wrong too he went back 20 years
and kept restating all the deficits and made them correct and last year the head
of Parliament in Greece accused him of crimes against the nation and and he was
in G dire jeopardy of being jailed so with that background the question was
when Greece had been revealed to have misstated its debt wouldn’t have been
better to forgive Greece’s debt and let them leave the EU and forgiving the debt
right at the beginning certainly would have made things much better off for
Greece and for the rest of the EU a lot of the problems wouldn’t have happened
so a question is is kicking them out of a EU you know you probably you mean I’m
not sure how far out of you you mean they’re different stages of what you
could mean by that but the Greeks would have regarded that as a calamity and so
I’m not sure that that was such draconian measures were absolutely
necessary to kick them out of the EU so I would have forgiven the debt that’s
what I’m gonna talk about tomorrow and I would have thought about whether there’s
some other way of making them feel I mean another thing you could do is you
could somehow guarantee everything so you would protect the rest of the EU let
grief suffer and now that Greece is suffered enough then forgive the debt so
the question is is how bad do you think taking Greece out of the you is is that
for Greece is that for the EU so I wasn’t in favor
of taking Greece out of the EU but that’s certainly a policy it has to do
its its forgiveness and it’s got some logic to it and many people thought that
showed blow the German Finance Minister actually wanted to do that so it’s a
sensible thing to think about but I’m gonna argue tomorrow that I wouldn’t do
that have done that yep can the Fed forgive agency debt can the Fed forgive
agency debt well that’s a complicated question about whether the Fed can
forgive so which debt should have been forgiven in is the question and I was in
favor of forgiving subprime debt that’s what I’m gonna argue tomorrow now why
subprime debt because those are the people with the worst credit ratings
those are the people who are the most underwater those are the people who are
gonna default anyway so you’re gonna get the least amount of money back for them
by throwing them out of their houses they were the first to go and that was
the beginning of the crisis so I was gonna argue that you should forgive
subprime debt of people who had kept up all their payments in anticipation of
them defaulting you should forgive part of their debts if they owed 160,000 the
house was only worth a hundred thousand you should forgive it down to ninety
because you could see that eventually they were gonna default and when they
defaulted you would get a terribly low recovery so now who was gonna forgive
the debt I was going to make the lenders forgive the debt so the lenders would be
so it wasn’t the government who was going to have to so most people think
debt forgiveness involves the government holding the bag but the subprime
borrowers all borrowed from private lenders hedge funds so it was the hedge
funds testifying in Congress that they wanted to forgive the debt because they
could tell they would get more money back in the end by forgiving the debt
than if the debt wasn’t forgiven and it wouldn’t have cost the government
anything that’s the argument I’m going to make so the question about whether
the Fed has the power to forgive the debt
without the Treasury I think that yeah the Fed would have to involve the
Treasury in forgiving the debt and potentially running a loss but I’m in
favor of debt forgiveness that makes the lender more money that’s one of the
conditions of forgiving the debt you only do it when it’s profitable to do it
and the crime and and the the tragedy is that even when it would be more
profitable to forgive the debt we didn’t do it so so an answer to your question
if he thought that it was so I wouldn’t be in favor of the Fed or treasurer
together forgiving so much debt that they would run huge losses I would be in
favor of doing in a way where they wouldn’t have to run huge losses yes I
noticed in one of your early graphs the high ratio of debt to disposable income
in Scandinavia is there something specifically Nordic about that
phenomenon you mean you know various uh well early it’s the same from Finland to
Norway yes there well I wouldn’t say it’s specifically Nordic in fact Irving
Fisher you remember Shakespeare’s Shylock who gave the impatience theory
of interest in the Merchant of Venice he anticipated Irving Fisher the guy I
mentioned from Yale who gave the modern impatience theory of interest which is
that interest depends on how impatient you are and he said the Nordic countries
are the most patient people they don’t want to borrow very much money because
they’re so patient interest rates are always lower in the Nordic countries
than in the southern countries it’s the Italians and the Greeks that are always
so prone to borrowing so I wouldn’t say that it was a Nordic malady that
explained that but it is true that a lot of those Nordic could you know in
Ireland England they’re all huge loan-to-value so I’m not sure I could
attribute it like Irvin Fisher so confidently to their ethnic origin but
it does seem curious that all those countries up there at you
that Greece did not have high personal debts
one last question back here John yeah wonder if you could talk about the time
value of money and what it’s doing to people that are retired and gonna be
retired shortly the time value of money you mean the low interest rates or well
one of the casualties of the low interest rates that the Fed has been
holding now for years is that retired people have lessen you know can’t make
money on their savings so I’m not sure you’re getting at this but it raises a
question about where do we stand with retirement programs in America like
Social Security and how badly off are they and in fact why are they so badly
off so this story that arrow had with the different time periods can be used
to understand Social Security so why do you think Social Security is in trouble
why is it that it’s running a deficit now the usual answer is probably this is
what you think the people are living longer now or that there was a baby boom
and all the baby boomers are retired or that they’re not enough children to pay
for the old people so those are the usual explanations and of course there’s
some truth to all of them there’s another explanation George Bush thought
that Social Security was just wasting the money somehow
but but actually there’s no program in American history that’s been so
efficient and so careful about keeping track of all the finances I mean less
the expenses are less than 1% per dollar contributed gets paid out a lot you know
it isn’t paid out but it’s paid to people who work in Social Security my
father died and I remember thinking you know I don’t know who I’m supposed to
tell I don’t know what’s gonna happen but but the the few weeks later his
Social Security check had already stopped I mean they figure out things
that fast so this is they’re not wasting the money they’ve got a very efficient
so what is the reason Social Security’s in trouble
can anyone tell me what the reason is what okay so here is something that you
might not have thought but if you did that little reasoning with the different
time periods you realize it Social Security began in the 1940s and
who it began 1938 and then 1940 Franklin Roosevelt started it and what did he
decide to do he said people don’t save enough for their old age so we’re gonna
start in America no one else had it we’re gonna start a Social Security
system where people are forced to contribute when they’re young and when
they’re old they’ll get paid the money back and so we’ll set aside the money
and put it in government bonds so that was how it worked for two years and then
his his labor secretary Frances Perkins first woman secretary said they’re all
these old people now they need the money right now they’re starving look at
what’s going on you’ve got all these young people contributing the money’s
just sitting there let’s give it to the old people and then
when the young people get old there’ll be more young people and they can take
the money from the new young people so sounds like a good idea but and it
worked beautifully at the beginning it solved the old-age problem in all the
destitution that was around during the Depression of the ages but what actually
happened the people in 1940 who are turning 65 who hadn’t contributed
anything they were getting Social Security but it’s not just the people in
1940 the people in 1950 it only contributed for ten years they were
getting their full Social Security the people in 1960 who had only contributed
for twenty years they were getting their full Social Security so for decade after
decade after decade we paid full Social Security benefits to people who hadn’t
made contributions or at least not commensurate contributions so of course
all of them did beautifully they got huge returns you compare someone you
know and then retiring in the 60s or 70s compared there you know what they got
their old age payments to what they put in they made a huge rate of return
but finally it had but what happened money was going out it had to come from
somewhere so it’s future generations that had to
pay for it so the way to think of social security is like if you’ve got a father
who has an operation and you have to pay a million dollars to save them and you
do it then years later you know you’re getting old and you say to your son well
you’re the grandson of I’ve saved your grandfather and paid a million dollars
why don’t you you know pay me a million dollars now and so the grandson can pay
me a million dollars so I paid a million I got a million back when I’m old and
then where is the loss well the losses in the interest because the million that
I paid I got paid back a million later but it was an a present value loss the
time value of money so what we paid when we were young we didn’t make up for when
we were old so Social Security this is how we’re paying for Social Security the
gift that we made to the original generations in the 40s 50s and 60s that
gift is reenacted every generation so if we were to stop paying Social Security
right now people like me who are about to retire you know integrity Utley but
anyway when I’m about to retire it would be me who wouldn’t get paid or you we
would lose our Social Security payments if we stopped Social Security
there’s no all that money that got given away can’t be undone it’s reenacted the
gift every generation so the amount that was given away back then 40s 50s 60s and
today’s dollars eighteen trillion dollars that’s where the social security
problem comes from we gave so much away at the beginning
I’m not saying was a bad thing to do we rescued all Volz elderly generations
that are on the brink of starvation but we have to face up to the fact that we
made a gift and somebody has to pay for the gift so every generation pays a
little bit of the gift that’s why every generation from now on is gonna get a
bad return on their Social Security we would have seen this 20 years ago but we
had the baby boom which saved us postponed the problems so many people
like me were contributing baby boom generation but we didn’t do anything
with those extra contributions we just spent them we didn’t save them now that
we’re gonna have the baby boomers retire gonna face that problem that we should
have faced 20 years ago and it’s gonna be bad returns for everybody so that’s
the problem with Social Security it was the gift we made to the original
generation by thinking a little bit in these economic terms it becomes clearer
but if you don’t think like that you’d never guess that answer not one of you
thought of that even though that’s the real reason why social stick it’s
inevitable in a pay-as-you-go system okay well we’ll see you all back here
tomorrow night thank you so much John

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