Posts Tagged ‘Greg Mankiw’

The Modern Banking Crisis

March 3, 2010

I thought I understood the basics of the 2009 financial crisis, but I did not understand how bad subprime mortgages could bring the entire US financial system to its knees.  Well, browsing Greg Mankiw’s site today, he linked to an interesting paper by Yale economist Gary Gorton answering these very questions.  I highly recommend everyone read, but here I will summarize the basic ideas.

First Gorton explains that basically all banking crises work the same way: too many investors want to withdraw their deposits from the banks which cannot cover all of the withdrawals.  This type of crises is probably as old as banks themselves.  Banks lend out a certain percentage of deposits, so if there is a panic, not everyone can get their money back.  This financial crises is similar, but less tangible, because it involves an unregulated banking system used by institutional investors and not average individuals.

The Repo market has been growing steadily for the past 30 years.  It is basically an unregulated market where institutions can deposit and borrow money outside of the normal banking system.  Because there is no FDIC for this market, deposits are backed by collateral, which is how most US banks worked pre-1930.  This collateral is longer term, secure investments such as bonds and other securities.

Why is there demand for such a market?  As Gorton explains it, imagine you are an institutional investor and you need a secure short-term (overnight) interest-gaining deposit for $100 million.  You cannot deposit this at the local bank, FDIC will only cover $100k, so you must go to another banking system.  Now imagine you are a bank with mortgages trickling in cash.  You can package these mortgages and sell them to add immediate cash to your bottom line.  These securities can then be used by as collateral for a Repo deposit.  Both parties have benefited from the Repo market and it has been growing accordingly, but because it is so unregulated, no one really knows how large it became!  Estimates are at around $12T, which means there should be at least that much in collateral for it to function properly.  To give you an example of how large that is, the entire US GDP for 2009 was $14.2T.

This is where the subprime mortgages come in.  While subprimes are a small percentage of the total mortgage-security market ($1.2T out of $20T total), no one knew which securities were contaminated by them.  Gorton compares this to an E. coli scare where all ground beef is shunned even though only a small percentage is actually contaminated.  The Repo market became the target of a panic because the collateral used for deposits became suspect.  There was a run on  Repo banks which could not possibly honor all of the withdrawals (he estimates a deficit of $2T).  The US Government was forced to step-in and bail out some of the crippled banks while many others simply failed.

So while this crisis may seem extraordinary at first, when compared with the history of banking it can bee seen as the same old story repeating itself.  There is much more detail and references in the paper, including some nice graphs, so check it out.

Update 9/7/2010: Ben Bernake references Gorton’s research into the financial crisis in his testimony before before the Financial Crisis Inquiry Commission.


Is Macro-Economics a Science?

November 14, 2008

A couple of posts ago I asked whether leading researchers in fields besides physics actively debate on blogs.  Well the answer is a resounding “YES,” and one example I recently came across is an active debate between world-class economists on causes of the Great Depression.  Even recent Nobel Prize winner Paul Krugman gets involved!  What I find so surprising about this is they were debating the core concepts of one of the most important events in 20th century economics based on what seemed to be philosophical grounds: whether they were “Keynesians” or “Monetarists.”  This also somewhat corresponds to the political parties of Democrats and Republicans respectively.

The basic debate is whether it is better for wealth to be controlled by public (Keynesians) or private (Monetarists) entities.  On these blogs the disagreement is whether Keynesian policies caused the depression or brought the country out of it.  The fact that there is still no consensus by experts on the causes of the Great Depression is especially troubling at the present time since we appear to be entering a serious recession.

I believe the main problem is that it is difficult to experimentally test macro-economic theories, so economists are left to follow their philosophies.  We can only hope that in the future there will be ways to actually test theories, because otherwise is it really a science?

UPDATE: In one week, Greg Mankiw defends Keynsian policies during this recession, and he takes Krugman to task for using philophy instead of a metric!  He appears to be the good exception to the rule, by not letting his polical views interfere with his analysis.

How Polling Works

November 13, 2008

Terrence Tao has a great blog entry about the mathematics of polling.  One thing he points out, which to me at first was unintuitive, is that polling accuracy is independent of the total population size given a few basic assumptions (simple random sampling , honest responses, fixed poll size, etc…)  I higly recommend reading his post, if only for his intuitive examples of why the total population size is irrelevant.

[Update: some of his examples are so good, so I will just share them here. To test the salinity of the ocean accurately how many water samples would you need to take?  Although the ocean contains ~10^{21} liters of water, only a sample of a few milliliters (10^{-3} ) is necessary to get a good estimation.   That’s -24 orders of magnitude (compared to  -5 orders of magnitude for presidential polls).   Although I would guess that the entropy (uniformity) of ocean salinity is much higher than that of political opinions.  Another example is identifying faces.  Faces have their appearance based on millions of cells, however, people can readily identify a face based on only a few bytes of data such as a black and white pixelated image.]

So what can we do with this polling magic?  FiveThirtyEight is a great website where baseball statistician Nate Silver used his techniques to predict the presidential election.   He predicted, before the polls opened, Obama would receive 349 electoral votes and he actually received 365.  The only states he missed were Indiana and Missouri — pretty impressive.

Another great site which deals with predictions is Intrade.  This is where people buy contracts on certain future events.  The price of the contract reflects how likely the market believes it to be true. (although as economist Gregory Mankiw has pointed out this might not necessarily be true, since it is also an effective hedging instrument.)   I believe Intrade also only missed predicting Indiana and Missouri before the polls opened.