The Ambrosini Critique

Well no actually, I love it.

I just hate that this was announced on April Fool’s Day.

Mark Thoma asks what went wrong with the risk models during the most recent crisis. He has a good discussion of structural vs. reduced form models. In practice, people use the later models because the former are pretty bad. We don’t know, in general, the causal mechanism between any two variables.

With reduced form models, measuring the correlation between two variables allows us to predict how changes in one variable will change the other variable. Because we know gold prices are inversely correlated with GDP, we can predict that in a recession gold prices will go up.

The problem with reduced form models is that we don’t understand what’s causing the correlation and that causal relationship might change over time. Maybe, in the past, gold prices happen to go up because demand for gold tooth fillings goes up in recessions as people switch their diets to cheaper, sugary foods. But in this recession corn prices, and thus corn syrup, has become much more expensive, sugary foods aren’t cheaper and thus gold prices don’t go up. (WARNING: I completely made up this example.)

In any case, you see my point. Correlation’s not causation and all that.

But that’s not I want to talk about. What I want to question is why do we think the risk models failed? The risk models don’t guarantee against negative shocks, they make them less likely. We happened to hit a state of the economy where lots of returns where zero. This doesn’t mean the models didn’t anticipate zero returns. Because it was an unlikely, but not impossible, event, its likely the models had this set of events priced in.

Would we ask this question if returns were unusually low, but not zero? Probably not. What’s so special about zero returns that realizing them means our models are broken?

I almost titled this post, “Life has a measure zero.”

Well according to this tool, I should definitely leave Davis and move to San Francisco. I might consider moving to Boston or London, but not definitely not Atlanta.

Here’s Richard Florida talking to Will Wilkinson.

… unless there’s a REALLY BIG problem. Or so says Brad Delong (see MR for the pertinent excerpt).

Granted I’ve been a little distracted lately tussling in my little corner of the library, but I don’t see a problem with the usual econ 101 indicators of recession. Unemployment looks ok. Employment decreased in January for the first time since the last recession, but employment changes were negative several times in the nineties after that decade’s recession had already past. Consumer confidence is at a 5 year low, but we weren’t in a recession 5 years ago. Personal income and consumption is up. Industrial production is up, capacity is increasing and capital utilization is about at its historic average. Sales are flat the last couple of months but there’s growth over last year at this time.

So what’s the REALLY BIG problem? Well, if banks start seeing risk where there ain’t (e.g. credit lines businesses use to make payroll), then we might to see a problem. Seeing risk everywhere, they won’t make loans that should be made.

The Fed’s actions (including lower rates) can be see in this light. They want to calm the finance guys down so they don’t cause a real problem. If you ask me, the Fed is basically doing something because something must be done. Lowering rates and taking “unprecedented” actions over the weekend are somethings.

Having no insight into the psychology of bankers, I’m not sure if there is or there will be a REALLY BIG problem. To the extent psychology isn’t a fundamental, the fundamentals look good… or at least ok.

PS – This is a neat site. It shows what the recession timing committee looks at when deciding when recessions start.

PSS (or is it PPS) – The Fed may also be inflating to reduce the real size of mortgages. If it can be proven that Ben is explicitly doing this, I’ll petition to have him canonized.

• Prof. Carroll, new to the faculty this year, got a huge Department of Education grant to study why some qualified high school grads don’t go to college… I eagerly await his results as they’ll touch on my research
• Prof. Cogley became an editor at JEDC, which is ranked as a top 30 journal overall and top 5 macro journal by various methodologies
• This is a couple months old, but new to me… Prof. Olmstead became president of the Economic History Association

Go team!

Recessions spread geographically.

This picture of the effects of the 1985 drop in oil prices is interesting. The light green states in 1985 are oil producing States put into recession by the change in oil price. The sub-national recession spreads out from those States but never becomes national.

Looking at recessions geographically is interesting because it reframes the issue of business cycles as one of distribution rather than efficiency. A reduction in the price of oil was great on average, but crappy for those live just west of the Mississippi.

The great contribution of RBC models was to repair efficiency in cycling economies. Meanwhile, the new Keynesians try to undo this result, but images like the one above suggest economists should spend more time on the distributional aspects of business cycles.

Notice, this is an invitation to discuss distributional issues without the usual normative baggage. Its just a fact that various supply shocks induces recessions in some places and booms in others.

Yes, one sentence of enduring value:

Those who view mathematical science, not merely as a vast body of abstract and immutable truths, whose intrinsic beauty, symmetry and logical completeness, when regarded in their connexion together as a whole, entitle them to a prominent place in the interest of all profound and logical minds, but as possessing a yet deeper interest for the human race, when it is remembered that this science constitutes the language through which alone we can adequately express the great facts of the natural world, and those unceasing changes of mutual relationship which, visibly or invisibly, consciously or unconsciously to our immediate physical perceptions, are interminably going on in the agencies of the creation we live amidst: those who thus think on mathematical truth as the instrument through which the weak mind of man can most effectually read his Creator’s works, will regard with especial interest all that can tend to facilitate the translation of its principles into explicit practical forms.

— The Right Honourable Augusta Ada, Countess of Lovelace

(h/t Roger Bourland)

I’m annoyed with this psychology that, if it were born into a world where spells and potions did work, would pine away for a world where household goods were abundantly produced by assembly lines.

— Eliezer Yudkowsky

Proof that anybody can learn anything from google and blogs.