Normally, I am one of Barry Ritholtz’ fans, often indulging “The Big Picture”’s expansive prose and deft selection of this chart, that graph or the other political-economy cartoon that collectively has its finger right on the pulse of this week’s market week after week. I fear, however, the tenure of my fandom is at an end, perhaps belatedly, now that I have absorbed his piece “RIP Chicago School of Economics: 1976-2008.”
Mr. Ritholtz’s Pre-Christmas missive gores Milton Friedman, citing a winding Bloomberg article by John Lippert, whose Chicago beat for Bloomberg often has him penning obiter dicta that includes the latest gossip relating to the Pritzker family, and their glowing approval at the selection of cousin Penny Pritzker as Obama’s national campaign-finance chairwoman, the climbing murder rate in Obama’s “backyard,” and the controversy over the Milton Friedman Institute at the University of Chicago.
The Bloomberg piece “Friedman Would Be Roiled as Chicago Disciples Rue Repudiation” might be forgiven the forced alliteration of its title (certainly I’ve penned worse puns during my tenure at DealBreaker), but granting it the status of some sort of indictment of the “Chicago School” is pushing very hard on the slack rope that is the article’s prose. When the only real Friedman-indicting quote one can extract from University of Chicago faculty is from emeritus professor of anthropology Marshall Sahlins, who has, conveniently, rebelled violently against homo economicus for decades, it is difficult to find some revelation, some newly discovered and conclusive epitaph for Friedman therein.
Sahlins has much to lose in the homo economicus debate, as do most social scientists who struggle to salvage idealistic concepts about the self-determination of mankind, and its ability to shape itself through the naked will of cultural change alone. (Certain European political movements in the not-so-distant past come to mind as apt comparisons). A concept so crude as the economic self-interest of man might put to the torch the noble (and vanity appealing) idea that culture alone defines the stature of a people, after all.
Of course, in many instances the Sahlins school of thought results in rather more absurd intellectual cul-de-sac, drawing Sahlins himself into arguments rationalizing, for instance, the Death of Captain Cook via the necessity to recognize the unique cultural morays of the islanders who killed him. Much simpler to just admit that Cook was an imperialist conquistador who bit off more than he could chew- but this would not allow for an expansive discourse on the otherwise marginalized relevance of the Lono deity cycle of the Hawaiian natives, an exploration of its importance in shaping modern history, the morality of Western claims of discovery, and the impact of culture clashes (or simply the boost to sales of Sahlins’ University of Chicago press publication on the topic).
If Cook himself prompted the fatal rage of natives, could their Lono deity cycle be of any interest? What would this mean for cultural study, to reduce this shining example of the importance of cultural understanding (which may have saved Cook had he only appreciated the cultural proclivities of the islanders) instead to a tale of conquest, greed and the execution of imperialistic tyranny?
As an interesting aside, in 2004 when a piece thought to be the original “Death of Cook” by John Cleveley the Younger was discovered depicting Cook as anything but a peacemaker in the fray that eventually took his life, it struck a resounding and final note in that particular debate, as European painters and Western intellectuals had been attempting for over 300 years to recast Cook as something of an innocent in the events that lead to this death. Perhaps this is one of the earlier examples of "white guilt," and being forced to admit that much of Western gains during the era were, in fact, the consequence of imperialist conquest was simply too difficult to face for the then cultural elite of the era. It is significant, I think, that their reaction was so revisionist.
It is a common complaint echoed in criticism of these social sciences that they often engage in highly circular argumentation. In the case of Sahlins that looks very much like “Assume the natives had a very unique perspective, since that would explain their actions in this case, they had a very unique perspective, and we cannot ignore their unique perspective- to do so would be to ignore the absolutely critical role of unique cultures in the understanding of reality.”
Unfortunately, the Sahlins approach also characterizes modern attacks on homo economicus and free markets. At the heart of it, and my criticism, is what I can can only see as a worldview reminiscent of the Aristotelian-Ptolemian Earth-centric view of the cosmos, which is, not coincidentally, of similar psychological appeal. This “homocentricism,” the concept that mankind has the ability to impose his cultural-moral will upon the environment wherever it chooses, is the master of his domain and is granted by divine right this power, is comforting and gratifying in that it suggests, erroneously in my view, that mankind has some agency in larger events. It soothes and obscures the pain that is looking into the wide abyss of the cosmos only to come to the consequent realization that we are infinitely small, fragile creatures doomed to a cycle of consciousness under a century in length, of vanishingly small significance when compared to the time scale required to observe anything remotely interesting about the universe’s development.
As a species we can barely manage to protect ourselves from the flashes of temper of a planetary body characterized by phenomenal geologic stability compared to its cosmic peers (250,000 people on average lose their lives to natural disasters each year, events that also cost on the order of $100 billion per year) much less live long enough to escape the earth and reach out beyond anything other than the coldest, bleakest, emptiest space. Of course it would be appealing that we might shape human interaction, the progress of nations and development (ultimately hinging on the effective and efficient allocation of resources) by will and intelligence alone.
Even this small measure of comfort, however, is a lie.
Coming, as this movement does, from the social science world, it can properly be viewed as an attempt to fill the void left by atheistic rationalism, at least insofar as that movement has gelded among intellectuals the soft comforts religion, or the belief in some grand design and larger purpose for mankind, formerly afforded. Surely, then, there must be some foundation of thought to salvage the homocentric view of the universe? Despair is a poor motivator, after all.
This urge, to find the agency of mankind, is compelling, and can be very, very dangerous. In reality, however, there are no short cuts and homocentricism is a short cut, as is the reliance on culture as an agent of change. I think, in some sense, this is a consequence of postmodern views of culture. The “all expression is art, all expressers are artists” interpretation (one with which I violently agree in other contexts) also has the consequence of making all thought culture, and all thought worthy of attention. Combined with the school of thought of, e.g. Sahlins, we are quickly thrust into a world where no concepts are irrational, inclusion is the most important feature and any hint of closed-mindedness is decryed. The rise of the politically correct movements and the “tolerance at any cost” of multiculturalism (often flying in the face of all reason) presents a stark example of the effects hereof.
Paradoxically, any mass inclusion mandate has the effect of stifling any skepticism, even rational skepticism. Criticism of any concept (no matter how absurd that concept) is framed as some form of bigotry or discrimination. An attack on the belief systems of the holders of absurd thought. Inter-tribal strife (even the modern version) is attributed to a lack of mutual understanding, and some fault on the part of the victim (the Captain Cook) for failing to understand the quaint, but critically important and valid beliefs of the perpetrators. (Failing to accept the stoning of women for alleged adultery, for instance- or to respect the conquest driven precepts of certain interpretations of centuries-old religions).
It with this background that we arrive at Mr. Ritholtz’ piece.
Ritholtz’ principal claim appears to be that the Chicago School has been debunked, and its demise late in the coming. Sayth Ritholtz:
Its [sic] long overdue. From the efficient-market theories, to the concept of man as rational profit maximizers, much of the edifice that is was the Chicago school of economics is based on a foundation that is false, disproven or otherwise questionable.
Ritholtz describes his introduction to neoclassical price theory, and classifies it as “authoritarian, a worship of a form of mob rule outside of the usual legal channels.” He continues with: “The view that regulation and other government intervention is always inefficient compared to a free market has now been made laughable.”
He then, disingenuously in my view, sets up his detractors thus:
I had occasion to study with Fama, and Friedman, both skewered in the Bloomberg article, and while my law school experience seems long past, my business school experience seems less so. Perhaps I meet Ritholtz’ pre-emptive definition of the trite detractor as a consequence, but it seems hard to take such ex ante ad hominem attacks seriously. I suppose I expected more from Ritholtz.
This is not what agitates me about the Big Picture piece, however. Rather, it appears Ritholtz has fallen prey to kind of the homocentric appeal that leads to arguments that free markets are some sort of authoritarian assault on what would otherwise be a fair and just democracy. How else can we explain a line of argument that calls a “hands off” approach to economics “worship of a form of mob rule” and suggests them undemocratic and anti-representative? It would seem Mr. Ritholtz’ would prefer a purely representative government. One need look only as far as California’s recent passage of Proposition 8, amending the state constitution to ban gay marriage to realize that the gridlock of “absolute democracy” is folly, and that a pure democracy is far more authoritarian and reactionary than most dictatorships. This is particularly so when the majority begins to realize they can vote themselves largess, collected by force, from the whole of society, all legitimized by the sanctity of “majority rule.”
Underpinning these lines of thinking is the absurd notion that individuals are entitled by right to happiness and prosperity. That the role of government is to create fair results, rather than a fair system. The United States Declaration of Independence itself managed to avoid this particular tar pit, and did so quite consciously. It is the “pursuit of happiness” that is enshrined in that text. It is due process that is afforded the individual, not a favorable process.
Perhaps Mr. Ritholtz, and modern free markets detractors, misunderstand what the Chicago School actually stands for. Certainly, it was popular to paint the movement in draconian terms. Friedman was, and still is, attacked rather viciously for his involvement in Chilean development during the tenure of Pinochet, but these criticisms misunderstand both Friedman’s involvement in Chile, and the nature of his belief in free markets.
If the Chicago School stands for anything it stands for the power of free markets to undo authoritarian political systems. That Ritholtz gets this exactly backwards and then confounds his error so severely rises to the point of totally discrediting his missive. Friedman pointed out that any economic system other than Laissez-Faire capitalism, of necessity, requires the use of coercion and force- not least to compel the collection of taxes. He also pointed out that free markets, including the free movement of labor and goods, would always dissolve central control of economies, and make draconian leadership impossible. To see Friedman’s espousal of these concepts in Chile as anything but his efforts to peacefully undermine statism and authoritarianism is akin to willful blindness. Can we, after all, ignore the effect those forces had on the oppressive regime of the Soviet Union and the Warsaw Pact, both dismantled by free markets with barely a shot fired? Friedman always stood for the premise that freer markets resulted in freer individuals.
Neither I nor Friedman have advocated anarcho-capitalism, though erecting this straw man is a typical tactic for Chicago School detractors. Government clearly has a role in fostering fair markets, but beginning to make markets a little bit “more fair” for a particular constituency quickly exceeds the Chicago School brief. This particular detail is often lost on Chicago School critics, as it is on Ritholtz.
Similarly, it has become fashionable to point fingers at people and (more disturbingly) at theories, like Black-Scholes (ironically both people and theories) thought to represent the Chicago School as responsible for the current collapse. Eric Falkenstein “The World's Most Dangerous Mean-Variance Optimizer” nicely parries these attacks with specific reference to Nassim Taleb by wondering how we can any more blame Black-Scholes than the Fisher equation, or even rational thinking as a whole for the present credit crunch.
Moreover, blaming the current economic crash on the Chicago School is about as rational as chastising Shakespeare for Nicholas Hytner’s production of Henry IV. The structure of the market in mid to late 2008 bore such little resemblance to anything the Chicago School represented that it seems near impossible to even mention the two in the same paragraph without straining the prose to such an extent as would grate even a Bloomberg reporter’s literary sense. That hasn't stopped anyone though. Consider:
In late 2007 we had billions upon billions of dollars flowing to prospective home-owner borrowers who, in any other circumstance, could not possibly have been thought worth the risk. These outflows were facilitated by two massive entities, both seriously politically beholden to the legislature and stuffed with senior managers selected primarily for their ability to raise capital for political campaigns or otherwise service the then-current, ruling political class. The pervasive and stated objective of these entities was to lower the cost, in the short-term, of “The American Dream of Home Ownership.” Effectively, a group of legislators decided that home prices were too high, and lenders too risk averse and resolved to correct this "unfair" market result. This they accomplished only too well.
The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 gave the power to dictate the particulars of home ownership incentives that would bind the GSEs to the Office of Federal Housing Enterprise Oversight, created within the United States Department of Housing and Urban Development by the same act.
Step back and consider this for a moment.
Billions of dollars was forcibly injected into the housing market for the least qualified borrowers in the form of massive and artificially created demand from Fannie and Freddie as dictated by the wisdom of less than a dozen senior members of the political class in the United States. In 1996 that amounted to $48 billion in mortgages for otherwise unqualified borrowers that probably would not otherwise have been written. By 1999 Freddie was penning deals to be the exclusive purchaser of loans written by third parties (Norwest was the first such entity). Underwriting standards, and their natural check on risk, were never to be particularly connected to the mortgage process again. This was hailed as a great victory for the Dream of Home Ownership. By 2000 HUD set Fannie and Freddie to purchase $2.4 trillion (that’s not a typo) in low-grade loans over the next 10 years with significant penalties if they failed. The GSEs knew the fist of an angry legislative god would descend upon them like no fury they had heretofore experienced if they failed in their appointed task. How do you think they reacted exactly?
Step back and consider this for a moment.
A small administrative cadre was centrally setting the level of demand and liquidity flow for a major portion of the country’s economy, and, in a cruel multiplier effect, was therefore indirectly setting prices that influenced all the actors in that sector.
By the end 2000 GSEs held 1/3 of all multi-family mortgages. The speed alone by which these entities captured a 33% market share of a multi-trillion dollar market should have raised eyebrows. Does anyone really think this possible in a business formerly posessed of such slim margins without a major market distortion? By now both GSEs were also buying “NINA” loans. (No income, no assets). No, I’m not kidding. That too was mandated.
It bears mentioning during this period that competitors, unable to function in a market this skewed, complained bitterly that the GSEs were distorting their ability to profit, and that they were, in effect, using government subsidies to advertise their services to prospective homeowners.
Let’s put this into perspective. In what other context would any system calling itself a "free market" ever permit this? What would we think if the United States government poured advertising dollars into a government sponsored entity producing computer operating systems in direct competition with Linux, Apple and Microsoft?
Those protesting were shouted down with the rationale that the advertisements were not direct to consumers, but rather merely there to educate consumers about the mortgage process, and that the detractors were only looking to increase the cost of home ownership (which, in fact, they were). No, I’m not making this up either.
The GSEs going public exaggerated the results. The likes of Countrywide now had to compete with Fannie and Freddie for investor capital. Their own returns on equity would now be held up to the skewed standard of the GSEs, which showed greater than 20% returns on equity for almost two straight decades, fueled by ever increasing mandates and capital to buy-buy-buy the worst mortgages on the market.
Unsurprisingly, the risk models employed by non-GSE firms made it difficult if not impossible to make a buck when the GSEs were siphoning off anything and everything at reduced rates. To compete in the distortion, firms like Countrywide resorted to rather creative tactics. Countrywide Mortgage Investment was created by Angelo Mozilo, for instance, to collateralize Countrywide Financial loans outside of the mortgage size bands dominated by Freddie Mac and Fannie Mae. Mozilo and Countrywide can hardly be blamed. Unable to compete in any market where Fannie and Freddie were participating, their business had to evolve into something different. CMI later evolved into the failed IndyMac, whose abysmal standards for lending have now become the subject of FBI investigations, ironically for doing exactly what the legislature was mandating the GSEs to do, ignore underwriting standards to boost low-income home ownership. IndyMac took it somewhat further, and forged documents, among other offenses, or did they? Do we really think no one in the underwriting department of the GSEs did the same?
Post 2000 and 2001, in an environment of historically low interest rates, the impact on the housing market, particularly the low end of the housing market, was predictable. It ballooned. The primary cause for low interest rates? Another anathema to the Chicago School, intervention by the Federal Reserve to recover from the dot-com collapse and 9/11.
As a consequence of the boom, GSEs, and everyone else, had to put all the mortgage paper somewhere. Technically, their mandates ran afoul of capital regulations. There was literally no way that the number of loans they were being compelled by statute and the regulatory urgings of HUD to buy could be kept on their own balance sheets. That should have been the cap right there. And if not for the dire consequences of missing their targets, it might have been. There is only so much mortgage risk you can keep on your balance sheet with the capital requirements then in place. They were eased repeatedly, but not enough to allow the GSEs to satisfy their political masters. Eventually, they would run afoul of the simplistic regulatory capital requirements that burdened them. Enter Wall Street. "Of course, we can solve that problem." We will just securitize it all. Faced with daunting requirements, Fannie and Freddie had little choice, and, therefore, either did anyone who had to compete with them. It should be pointed out that this, in itself, was entirely within the sort of conduct permitted by the regulation of the time.
Here is where the story seems to throw otherwise rational thinking beings: The market was doing exactly what it was supposed to do at this point. Exactly what it was supposed to.
You had legislators and executives from both parties (Newt Gingrich was an adviser to IndyMac, for instance) telling the market “I want a huge spike in debt-funded home ownership for low income households short-term, and here are positive and negative incentives to accomplish that.” The Federal Reserve is telling the economy “Nope, nope, no recession today. I want lots of borrowing, and, since I’m making your returns of safe instruments vanishingly small, I want that cash to flow into more speculative instruments.” Paradoxically, regulators were also telling everyone in the market “You better watch how much risk you hold in any one entity.” The market dutifully complied. Homes “owned” by poor quality borrowers skyrocketed in the short-term, just as our brilliant leaders wanted them to. Underwriting became divorced from the mortgage writing process because none of the incentives created by government intervention rewarded careful underwriting and several incentives created by government intervention explicitly penalized careful underwriting. What exactly did everyone expect? Disneyland?
It is telling that Barney Frank seems to have emerged as one of the leading central controllers somehow qualified to save us all from this mess. That Congressman Frank is enjoying anything other than ignominious ostracization as an utterly failed and deposed elder statesman for his role in destroying the mortgage economy and everything connected to it (i.e. everything) is a testament to the inability of society to select competent leaders. This, in itself, should serve as a cautionary tale to Chicago School detractors. Alas, denial ain’t just a river in Egypt.
It should also be recognized that when individual entity risks started to escalate, the market, again, did exactly what it was supposed to do. Exactly. It created mechanisms to transfer that risk from risk averse entities (that aversion artificially mandated by unsophisticated risk and capital limitations) to risk seeking entities in the form of securitization. And when clever Wall Streeters realized that 200 pieces of mortgage paper rated B could be mashed together and their lack of default correlation would permit the likes of Fitch, Standard and Poor’s and Moodys to throw a AAA rating on the aggregate, well, the market was doing just what we told it to- considering we required large institutions to meet particular credit standards in their portfolio, and because we measured those standards by the woefully inadequate analysis pawned by the ratings agencies. Specifically: a centrally mandated metric for risk, created by the legislature and enforced by regulators, specifically: the blessing of the ratings agencies, was the centerpiece for evaluating the risk in institutional portfolios. Make no mistake, the regulation of the day not only endorsed reliance on the poor models employed by the ratings agencies, it mandated it. In retrospect, could anything look more daft?
The entire system was geared to spike home ownership among poor quality borrowers in the short term and delay any reckoning as long and as completely as possible. Further, it was designed by the legislature with woefully simplistic measures for risk and utterly naive means of enforcement. The entire premise was the vain search for a free lunch.
Not only does the Chicago School not shoulder any of the blame for this travesty, but even the most basic student of the Chicago School and neoclassical pricing theory could have predicted it without breaking a sweat.
I’m no PhD candidate, but I was musing about the liquidity surge and its likely effects, twice as far back as March, 2007, and again in August, 2007 (I even quoted a comment left by a The Big Picture reader in that piece) and yet again in September, 2007:
These two effects drive liquidity seeking the same level or returns into increasingly risky assets. These effects are, as I pointed out, complicated by the structural need for particular risk tranches to service structured products or the issuance of instruments in securitization transactions (CDOs and such) that depend on efficiency frontier portfolio design. These instruments can, therefore, create an "artificial" need for high risk assets and drive these asset prices up, even as their quality diminishes.
In the present example, and in the words of a CDO manager I quoted before: "I gotta keep accumulating collateral, and I gotta issue the liability against that collateral." This, in turn, drives loan origination into overdrive and so reduces the oversight and loan standards that less than qualified borrowers are given a pass where they otherwise never would have.
I closed the August piece with this:
Again, I don't make the case here that I am some genius investor. Merely that even a young girl with a newly minted MBA, a student of the Chicago School writing a private equity blog in her spare time could see what was happening.
Clever investors (e.g. Paulson & Co.) took the time to dig deep into the structures and made small fortunes allocating capital effectively as a result of the crisis. Of course, these investors, the only ones actually exercising any intellectual calories, are now symbols of the evil profiteering of otherwise innocent market actors.
Now, what sort of myopic intellectual arrogance does it take to blame the results of this borderline criminal bit of statism on the facts that Moodys, Standard and Poor’s and Fitch used Gaussian distributions and correlation modeling to assign their ratings, and that these ratings were the crux of regulatory requirements on institutions? Well, I submit, the kind of myopic intellectual arrogance that Mr. Ritholtz’ piece displays. At the heart of it is the conceit that we (the United States) can tame the cycles of the market with the force of our will. That if only we had the right leaders, these crises would be avoided. If only we hadn’t deregulated so far. Of course, no proponent of these positions seems to have any real grasp of how regulated and artificial mortgage markets were at this point- but that takes some work to uncover through the miasma that is today's political rhetoric on the subject. That, in short, is too much work to try and understand.
The belief that we can reject the cold hard reality described in neoclasical price theory and therefore the Chicago School for a much warmer, fuzzier world is a very appealing one. We would love a world where we can spike low-end home ownership at will. Where anyone can enjoy the two car garage stuffed with a pair of new SUVs, and the adjoining macmansion adorned with numerous flat screen TVs, unlimited cable and a perfectly manicured lawn. Where everyone can live outside their means indefinitely. Where everyone has a right to insurance. Cheap insurance. Where everyone can build inside the bounds of a 50 year floodplain, demand “affordable” insurance for their delusional misunderstanding of their place in the natural world and look to the rest of society to compensate them if the insurer’s premiums (regulated by state mandated risk models to keep them low) are insufficient to cover the rebuilding bills. A world where 30 minutes study is all that’s required to invest your life savings in a single instrument you selected after reading a glossy brochure on the premise that it is your god given right to make 14% annual returns, and where making a poor selection in that due diligence process is cause for your immediate bailout.
And this is the world that the anti-Chicago School desperately needs. The world where investing isn’t hard. Where there is an entitlement to returns. Where, rather than do painful fundamental analysis, we can rely on simple models that tell us with flawless precision to invest every single dime of our capital in the care of the greatest Sharpe ratio known to man (Bernie Madoff). Or on three-letter ratings from this or that agency. In short, a life that rewards intellectual laziness lavishly. After all, if the world is cruel and cold, and humans are powerless to sway the tide, then what role is there for great leaders? Great leaders to bring us limitless and effortless prosperity. Great leaders to punish the evil-doers who gave us imperfect models with fines, perp-walks and, yes, prison.
And this is the ultimate danger of these lines of thoughts. To adopt a theory that central control of economies is effective, one must believe in omniscient central controllers. This leads nowhere other than to a cult of personality and unfaltering belief in a perfect leader who will tame markets, be he named Marx, Reagan, Greenspan or Obama.
It is the dogged skepticism of the Chicago School that results in its opposition to such notions. But, like other criticisms of homocentric thinking, it is doomed to be attacked and decried with the sort of criticism that populists often take advantage of: It is cold-hearted and unmoving. It requires of us real work. It requires us to admit that capitalism is hard. That there are no free lunches. That merely voting for the right leader and hoping for the best is not sufficient. And, like the Copernican model, which should have put forever to rest the notion that mankind is the center of the cosmos, it fails to give mankind’s vanity its due. Copernicus was infinitely lucky not to live to see the publication of his works as he no doubt would have been killed for them. It would be a pity if the same might be said of Friedman in twenty years.
Our need to remake Cook, rather than face the baser reality of the time in which he lived, and the fact that his conquests, and those of adventurers like him, most likely resulted in more efficient allocations of resources and in large measure the historically remarkable prosperity we now enjoy, is both understandable and dangerous. The same can be said of the propensity to demonize models in a vain attempt to soften the world.
When I was learning about Gaussian distributions my professor admonished us after every example he gave. “Do not use this blindly in the real world. It will turn around and bite you.” Gaussian distributions were useful much of the time, he warned, often enough to lull you into a false sense of security. The real world, he cautioned, looks far more like hydrodynamics, and wave theory. Guided most often by Gaussian distributions, enough so to allow prediction accuracy 99% of the time, until chaotic seas make nonlinear Schrodinger equations more apt and (out of "nowhere") a rogue wave sinks your 99th percentile hull design as easy as you crack an egg for breakfast. The world was likely overlaid by more than one model, he suggested. One, which rules most of the time, calmly predictable and familiar, and one (or many) that lurked just beneath, waiting to show itself in all its fury when conditions were right. Woe to the practitioner who failed to heed this warning, one he echoed for the nth time, sternly before the final (one of my last). That practitioner is doomed.
That professor, by the way, was Eugene Fama.
Art Credit: John Cleveley the Younger "Death of Cook," (1784) National Maritime Museum, London. (Discovered, 2004 in private British collection).