History of Finance and Financial Regulation

The Economist reviews the history of finance and financial regulation, arguing that

institutions that enhance people’s economic lives, such as central banks, deposit insurance and stock exchanges, are not the products of careful design in calm times, but are cobbled together at the bottom of financial cliffs. Often what starts out as a post-crisis sticking plaster becomes a permanent feature of the system. … The response to a crisis follows a familiar pattern. It starts with blame. New parts of the financial system are vilified: a new type of bank, investor or asset is identified as the culprit and is then banned or regulated out of existence. It ends by entrenching public backing for private markets: other parts of finance deemed essential are given more state support.

The Economist identifies five major events that shaped modern finance:

  • Hamilton’s bank bailout in 1792.
  • The creation of joint-stock banks in England after the “emerging markets” crisis of 1825.
  • The railroad crash of 1857, global panic and the Bank of England’s stricter requirements for discount houses to hold cash.
  • Financial fraud and low cash holdings, the 1907 panic, the National Monetary Commission’s demand for a lender of last resort and the 1913 Federal Reserve Act establishing the (third) central bank in the US.
  • Recession and financial meltdown in 1929, the bank holiday of 1933, publicly funded bank recapitalization, Glass-Steagall and the FDIC.

Dynamic Stochastic General Equilibrium (DSGE) Models

Noah Smith wonders in a blog post why the private sector does not use DSGE models for forecasting purposes if these models are useful. He writes:

As far as I’m aware, private-sector firms don’t hire anyone to make DSGE models, implement DSGE models, or even scan the DSGE literature. There are a lot of firms that make macro bets in the finance industry – investment banks, macro hedge funds, bond funds. To my knowledge, none of these firms spends one thin dime on DSGE. I’ve called and emailed everyone I could think of who knows what financial-industry macroeconomists do, and they’re all unanimous – they’ve never heard of anyone in finance using a DSGE model.

Self-Correcting Research?

The Economist doubts that science is self-correcting as “many more dodgy results are published than are subsequently corrected or withdrawn.”

Referees do a bad job. Publishing pressure leads researchers to publish their (correct and incorrect) results multiple times. Replication studies are hard and thankless. And everyone seems to be getting the statistics wrong.

A researcher suffers from a type I error when she incorrectly rejects an hypothesis although it is true (false positive); and from a type II error when she incorrectly accepts an hypothesis although it is wrong (false negative). A good testing procedure minimises the type II error given a specified type I error that is, it maximises the power of the test. While employing a test with a power of 80% is considered good practice actual hypothesis testing often suffers from much lower power. As a consequence, many or even a majority of apparent “results” identified by a test might be wrong while most of the “non-results” are correctly identified. Quoting from the article:

… consider 1,000 hypotheses being tested of which just 100 are true (see chart). Studies with a power of 0.8 will find 80 of them, missing 20 because of false negatives. Of the 900 hypotheses that are wrong, 5%—that is, 45 of them—will look right because of type I errors. Add the false positives to the 80 true positives and you have 125 positive results, fully a third of which are specious. If you dropped the statistical power from 0.8 to 0.4, which would seem realistic for many fields, you would still have 45 false positives but only 40 true positives. More than half your positive results would be wrong.

The Financial Crisis

The Economist’s “schools briefs” on the financial crisis: Parts 1, 2, 3, 4, 5. Quoting from the first part:

… it is clear the crisis had multiple causes. The most obvious is the financiers themselves—especially the irrationally exuberant Anglo-Saxon sort, who claimed to have found a way to banish risk when in fact they had simply lost track of it. Central bankers and other regulators also bear blame, for it was they who tolerated this folly. The macroeconomic backdrop was important, too. The “Great Moderation”—years of low inflation and stable growth—fostered complacency and risk-taking. A “savings glut” in Asia pushed down global interest rates. Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy securities. All these factors came together to foster a surge of debt in what seemed to have become a less risky world.

“Credibility For Sale,” CEPR, 2013

CEPR Discussion Paper 9562, July 2013, with Harris Dellas. PDF.

We develop a sovereign debt model with official and private creditors where default risk depends on both the level and the composition of liabilities. Higher exposure to official lenders improves incentives to repay but carries extra costs, such as reduced ex-post flexibility. The model implies that official lending to sovereigns takes place in times of debt distress; carries a favorable rate; and can displace private funding even under pari passu provisions. Moreover, in the presence of long-term debt overhang, the availability of official funds increases the probability of default on existing debt, although default does not trigger exclusion from private credit markets. These findings help shed light on joint default and debt composition choices of the type observed during the recent sovereign debt crisis in Europe.