What I Read: “SCIENCE!”-Articles mk. III

Disclaimer: This post was mostly written in June 2012.

1. “Who Are These Economists, Anyway?” by James K. Galbraith (2009)

Short Summary: Galbraith provides a list of a few economic ‘school of thoughts’ that predicted the housing bubble: Why were they able to predict it and the recession correctly? How did they do it? He includes the Marxian view (“habitual cassandras” (p. 88)), Dean Baker of the CEPR and calls him a pre-emminent ‘practitioner of bubble-detection’ (p. 89), Wynne Godley (a Keynesian), the Minskyians and then his own work (an institutional perspective), although he does not cite his own work, but Gary Dymski’s.

Comment: A very short outline of economic schools that predicted the bubble, have some solutions to current problems and rival mainstream economics. It’s not extensive and far from complete (no Steve Keen? no MMT?), but can serve as a basis for further research. It’s easy to read and I although I don’t fully agree with his closing notes, contains interesting remarks.

2. “Cognitive Democracy” – by Henry Farrell & Cosma Shalizi (2012)

Short Summary: In this article the authors try to outline a third way of problem solving (cognitive democracy) instead of the the two most common approaches: hierarchy/bureaucracy (represented by Thaler & Sunstein) and markets (represented by F.A. Hayek). They argue that democracy has cognitive benefits that the other two don’t have and describe how new technologies may help to overcome obstacles in the modern world.

They first assess the normative dimension of institutions – and so don’t focus on justice and stability – but “whether [.] institutions are useful in helping us to solve problems” (pg. 2). Most problems can be characterized as social (involving many diverse actors) and are therefore rather complex. To deal with these problems macro-institutions should enable the actors to communicate their viewpoints easier and provide equal influence in the decision-making progress to all participants.

They then further discuss the strengths and weakness of the above mentioned problem-solving mechanisms: markets & hierarchies and find both flawed when compared to their democratic model. Democracy is able “to harness diversity so as to generate useful knowledge” (p. 15), which then can be applied. They make a strong case of debate between (partly/sometimes) opposite groups, because it identifies new, possibly better solutions, which is why they call it cognitive democracy. They then present different studies that under certain circumstances groups produce more and better solutions, which supports their theory.

The problem often is how different arguments are presented and assessed in a society. Here, they say, the Internet provides an opportunity to go beyond the existent information-processing structures. Its possibilities should be used to experiment with different institutional designs (as information-processing systems) to provide platforms for exchange.

Comment: To be honest, I’m not sure exactly what they’re proposing: experimenting with technology? In what way do they want our institutions to change? We already have hierarchies, markets and democracies co-existing and processing information ‘together’ or under a framework that has developed over time. Why can’t the three complement each other in some way (like they are doing now)?

The Pirate party in Germany is experimenting with “Liquid Democracy“, but it doesn’t seem to be very effective. Most of these systems are dependent on interest in politics, society and economics and I just don’t see a surge in interest happening. eParticipation etc. have not been helpful so far. They don’t provide a platform for NEW participants, but rather a NEW platform for OLD participants. What technology would change that?

I also don’t think the Internet only leaves traces. The opposite seems to be the case as old websites are basically gone, E-Mails deleted or destroyed by server crashes etc. Information on the Internet – apart from being archived on websites such as Wikipedia – is very fleeting. This doesn’t mean that the Internet doesn’t have any merits, I just don’t think that this is one of them. Communication has never been cheaper and easier, knowledge becomes accessible more quickly (though I think there’s also a significant downside to that) – but will this help democracy or the opposite?

I think they provide some valid normative points – whether they are based on empirical evidence is another question – to why it might be a better model, but at the same time feel that they’re empirically very wrong. This might have to do with their ‘abstract’ way of argumentation. They don’t overlook the factor of ambiguity as in: more information doesn’t lead to better outcomes, debate does not foster solutions, but polarization. I guess, we’ll see.

3. “Deciphering the Liquidity and Credit Crunch 2007-2008” by Markus K. Brunnermeier (2009)

Short Summary: The article first gives us an overview of the mechanisms behind liquidity and credit crunches: repackaging loans (securitisation) and shorter maturity financing by the banks. This in turn increased the funding liquidity risk through a mechanism of maturity mismatch and allowed the banks to pursue “regulatory and rating arbitrage” (p. 80). The consequences were cheap credit and the US housing boom (NINJA-loans).

Brunnermeier then takes us through the various states of the financial crisis: the development of the CDS, ABCP etc. market, the TED spread (the interest rate difference between the LIBOR and the Treasury bill rate), and how the central bank intervention tried to stop the ‘illiquidity waves’ (resulting from fire sales and margin calls), as the interbank market froze up. And this all happened before Bear Stearns, Fannie Mae & Freddie Mac, Lehman Brothers and AIG got into trouble. The consequence was a coordinated bailout by states and central banks across the globe, thwarting an immediate severe crisis.

In a section called “Amplifying Mechanisms and Recurring Themes” he names the problem of ‘funding/market liquidity’ and how the interaction of the two “can cause liquidity to dry up” (92f. esp. Fig. 4) through loss spiral(s) reinforced by a margin/haircut spiral(s), moral hazards, precautionary hoarding, bank/margin runs and network effects (counterparty credit and gridlock risks).

Comment: A thorough and substantive article on the mechanisms behind liquidity and credit crunch(es) that affected the financial crisis and caused states and central banks to intervene. It provided me, so someone who doesn’t study economics as his major and lacks some of the background knowledge an easy and explanatory read.

I’d have liked to see a more extensive account of counterparty risks/network effects and some solutions to the “too big to fail” problem. Is “too capitalized to fail” an option during a financial crisis? Won’t it only depress credit? How are banks supposed to capitalize themselves at the moment? However some of these questions arouse after 2009 and it was never Brunnermeier’s intention to solve them. Despite this I very much recommend others to read it.

Further Reading: A short FAZ-Interview mit Brunnermeier (German), INET-Conference Video with Brunnermeier.

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