Must-Read: Matt Levine: People Are Worried About Unicorns

Must-Read: Matt Levine: People Are Worried About Unicorns: “There was a time when my big question about the Theranos story was…

Jeffrey J Cohen on Twitter If grilling unicorn over long weekend for safety s sake ensure internal temperature reaches 165 degrees b4 eating https t co Cq7ZUJAVrG

…is it a revolutionary company with a great technology that is being unfairly nitpicked, or is it a company whose technology has big serious problems?… Now my big question is… a story of smart well-meaning people who are working on a great idea… who got a bit over their skis, or… darker? It is silly, so late in the game, to fixate on one Theranos detail and say ‘that’s weird,’ but here is a story about Theranos’s relationship with Walgreens, and this is really weird:

While Theranos didn’t provide a device to Hopkins, Walgreens got a prototype, and members of Dr. Rosan’s team set it up in a cubicle. The prototype came with kits to perform esoteric tests that other labs and test makers apparently didn’t offer, producing results such as ‘low’ and ‘high’ rather than numeric values. As a result, Walgreens couldn’t compare results from the Theranos machine to any commercially available tests.

I will leave it as an exercise for the reader to think of an innocent explanation for that…. Here is a unicorn being barbecued in what looks like a medieval manuscript that I will just assume prophesies the coming of Theranos:

And lo, a Unicorne shall come among ye, and ye shall call it by the name Theranos, or in the Old Tongues, Elasmotherium Haimatos. And it shall take your Bloode, but only a lyttle bit of your Bloode, and it shall do strange Magick upon said Bloode, and tell ye many Things. But then it shall come to pass that its Magick was [makes ‘so-so’ hand gesture], and that those Things were mostly not true. And ye shall barbecue that Unicorne.

Must-Read: Pascal Seppecher, Isabelle Salle, and Dany Lang: Is the Market Really a Good Teacher?

Must-Read: Pascal Seppecher, Isabelle Salle, and Dany Lang: Is the Market Really a Good Teacher?: “Our learning model is an ever-adapting process that puts a significant weight on exploration vis-à-vis exploitation…

…We show that decentralized market selection allows firms to collectively adapt their overall debt strategies to the changes in the macroeconomic environment so that the system sustains itself, but at the cost of recurrent deep downturns. We conclude that, in complex evolving economies, market processes do not lead to the selection of optimal behaviors, as the characterization of successful behaviors itself constantly evolves as a result of the market conditions that these behaviors contribute to shape. Heterogeneity in behavior remains essential to adaptation in such an ever-changing environment. We come to an evolutionary characterization of a crisis, as the point where the evolution of the macroeconomic system becomes faster than the adaptation capabilities of the agents that populate it, and the so-far selected performing behaviors suddenly cease to be, and become instead undesirable…

Must-Read: Pedro Bordalo, Nicola Gennaioli, and Andrei Shleifer: Diagnostic Expectations and Credit Cycles

Must-Read: Very clever indeed…

Pedro Bordalo, Nicola Gennaioli, and Andrei Shleifer: Diagnostic Expectations and Credit Cycles: “We present a model of credit cycles arising from diagnostic expectations…

…a belief formation mechanism based on Kahneman and Tversky’s (1972) representativeness heuristic. In this formulation, when forming their beliefs agents overweight future outcomes that have become more likely in light of incoming data. The model reconciles extrapolation and neglect of risk in a unified framework. Diagnostic expectations are forward looking, and as such are immune to the Lucas critique and nest rational expectations as a special case. In our model of credit cycles, credit spreads are excessively volatile, over-react to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

Must-Read: Thomas Philippon

Must-Read: An absolutely key issue: why doesn’t the logic of cost-reduction via scale and technology work for finance as a whole? It certainly works for commissions…

Thomas Philippon: Finance vs. Wal-Mart: Why are Financial Services so Expensive?, in Rethinking the Financial Crisis, edited by Alan Blinder, Andrew Lo, and Robert Solow (Russell Sage Foundation, 2012): “Despite its fast computers and credit derivatives…

…the current financial system does not seem better at transferring funds from savers to borrowers than the financial system of 1910. “I would rather see Finance less proud and Industry more content…” –Winston Churchill, 1925

Must-read: Roger Farmer: “Pricing Assets in an Economy with Two Types of People”

Must-Read: Roger Farmer: Pricing Assets in an Economy with Two Types of People: “This paper constructs a general equilibrium model…

…with two types of people, where asset price fluctuations are caused by random shocks to the price level that reallocate consumption across generations…. Asset prices are volatile and price-earnings ratios are persistent, even though there is no fundamental uncertainty and financial markets are sequentially complete. I show that the model can explain a substantial risk premium while generating smooth time series for consumption and financial assets across types. In my model, asset price fluctuations are Pareto inefficient and there is a role for treasury or central bank intervention to stabilize asset prices.

Must-read: Anat Admati: “The Missed Opportunity and Challenge of Capital Regulation”

Must-Read: Anat Admati: The Missed Opportunity and Challenge of Capital Regulation: “Capital regulation is critical to address distortions and externalities…

…from intense conflicts of interest in banking and from the failure of markets to counter incentives for recklessness. The approaches to capital regulation in Basel III and related proposals are based on flawed analyses of the relevant tradeoffs. The flaws in the regulations include dangerously low equity levels, complex and problematic system of risk weights that exacerbates systemic risk and adds distortions, and unnecessary reliance on poor equity substitutes. The underlying problem is a breakdown of governance and lack of accountability to the public throughout the system, including policymakers and economists.

Must-read: Kevin Drum: “Life at the Top Is Pretty Sweet”

Must-Read: Kevin Drum: Life at the Top Is Pretty Sweet: “My new favorite hedge fund manager…

…is the guy who ranked #15 on this year’s list:

Michael Platt, the founder of BlueCrest Capital Management, took home $260 million, according to Alpha. It was a difficult year for his firm, once one of the biggest hedge funds in Europe with $37 billion in investor money. He lost investors in his flagship fund 0.63 percent over the year and then told them he was throwing in the towel.

Platt’s fund lost 0.63 percent and he basically shut it down in disgrace, and for this he earned a quarter of a billion dollars. Pretty sweet gig, no?

Questions for the medium run…

Take the mechanics of demand stabilization and management off the table. Move, in our imagination at least, into a world in which short-term safe nominal interest rates rarely if ever hit the zero nominal bound. In that world, as a result, the full employment and price stability stabilization-policy mission could be left to central banks and monetary policy. Furthermore, confine our thinking to the North Atlantic, possibly plus Japan.

It seems to me then that there are four big remaining questions:

  1. Can, in a political-economy sense, central banks be trusted with this mission? Are they not captured, to too great an extent, by the commercial-banking sector that, myopically, favors higher nominal interest rates to directly improve bank cash flows and indirectly dampen inflation and so redistribute wealth to nominal creditors–like banks?

  2. What is the proper size of the twenty-first century public sector?

  3. What is the proper size of the public debt for (a) countries that do possess exorbitant privilege because they do issue reserve currencies, and (b) countries that do not?

  4. What are the real risks associated with the public debt in the context of historically-low present and anticipated future interest rates?

I gave my preliminary answers to (2), (3), and (4) here. But what about (1)? And what about others’ takes on my answers to (2), (3), and (4)?

I think that these are among the most important questions for macroeconomists to be grappling with right now, and yet I am disappointed to see relatively little serious work on them. Am I missing active literatures because I am not looking in the right places?

Does anyone have any bright ideas here?

Must-read: Gary Gorton: “The History and Economics of Safe Assets”

Must-Read: Gary B. Gorton: The History and Economics of Safe Assets: “Safe assets play a critical role in an(y) economy…

…A ‘safe asset’ is an asset that is (almost always) valued at face value without expensive and prolonged analysis. That is, by design there is no benefit to producing (private) information about its value. And this is common knowledge. Consequently, agents need not fear adverse selection when buying or selling safe assets. Safe assets can easily be used to exchange for goods or services or to exchange for another asset. These short-term safe assets are money or money-like. A long-term safe asset can store value over time or be used as collateral. Human history can be written in terms of the search for and production of safe assets. But, the most prevalent, privately-produced short-term safe assets—bank debt, are subject to runs and this has important implications for macroeconomics and for monetary policy.

Must-read: James Kwak: “Profits in Finance”

Must-Read: It used to be that we collectively paid Wall Street 1% per year of asset value–which was then some 3 years’ worth of GDP–to manage our investment and payments systems. Now we pay it more like 2% per year of asset value, which is now some 4 years’ worth of GDP. My guess is that, at a behavioral finance level, people “see” commissions but do not see either fees or price pressure effects.

Plus there is the cowboy-finance-creates-unmanageable-systemic-risk factor, plus the corporate-investment-banks-have-no-real-risk-managers factor. We are paying a very heavy price indeed for having disrupted our peculiarly regulated and oligopoly-ridden post-Great Depression New Deal financial system:

James Kwak: Profits in Finance: “Expense ratios on actively managed mutual funds have remained stubbornly high…

…Even though more people switch into index funds every year, their overall market share is still low—about $2 trillion out of a total of $18 trillion in U.S. mutual funds and ETFs. Actively managed stock mutual funds still have a weighted-average expense ratio of 86 basis points. Why do people pay 86 basis points for a product that is likely to trail the market, when they could pay 5 basis points for one that will track the market (with a $10,000 minimum investment)? It’s probably because they think the more expensive fund is better. This is a natural thing to believe. In most sectors of the economy, price does correlate with quality, albeit imperfectly…. And this is one area where I think marketing does have a major impact, both in the form of ordinary advertising and in the form of the propaganda you get with your 401(k) plan…. The persistence of high fees is partly due to the difficulty of convincing people that markets are nearly efficient and that most benchmark-beating returns are some product of (a) taking on more risk than the benchmark, (b) survivor bias, and (c) dumb luck.