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April 10, 2011
David Warsh, Proprietor


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Learning How to Push Back Against the Bankers

We all invoke past successes in hopes of illuminating the way ahead. Hedge fund magnate George Soros rented the Mt. Washington Hotel, in Bretton Woods, N.H., over the weekend for a gathering of his Institute for New Economic Thinking. In its inaugural meeting last year, the INET crew assembled in John Maynard Keynes’ old college in Cambridge, England.  The idea is to bring history, philosophy, financial acumen and other forms of non-traditional analysis to bear on economic problems.

A very different sort of meeting took place this weekend in Cambridge, Mass. Some 75 invited economists gathered for the annual Conference on Macroeconomics of the National Bureau of Economic Research. The NBER, which is approaching its hundredth anniversary (it was founded in 1920), is the United States’ premier economics research collaborative.

For twenty-six years, conference organizers have selected the half-dozen new papers they deemed most promising and published them, with elaborate discussion, in a widely circulated volume. The Macroeconomics Annual has proven to be a reliable guide to where the best university economists have thought their science was going, year after year.

The papers this year included a shrewd new approach to describing the formation of expectations around events, a pioneering empirical investigation of the way that lobbying was deployed in the financial crisis (a phenomenon previously much illuminated anecdotally by journalists), and an examination of how the housing bubble may have been transmitted from one industrial democracy to another following the fall in interest rates at the turn of the century.  .

In certain ways, however, the most novel paper was the one which proposed a new measure of aggregate financial risk and called for economic theorists to become more deeply involved with the Treasury Department’s newly-created Office of Financial Research.

The names of sainted NBER researchers were invoked – Wesley Clair Mitchell and Arthur Burns, Simon Kuznets, Milton Friedman and Anna Schwartz.  The origins of various now-familiar systems of financial instrumentation were recalled  – bank call reports in the nineteenth century; national income accounts and flow-of-funds data in the twentieth – by way of explaining what might be gained from new measures of risk that go beyond traditional balance-sheet accounting.

In Risk Topography, Markus Brunnermaier (of Princeton University), Gary Gorton (of Yale University), and Arvind Krishnamurthy (of Northwestern University) demonstrated in no uncertain terms why traditional accounting data, including profit and loss statements and balance sheets,  may be inadequate to the task of alerting regulators when dangerous stresses are developing.

By way of illustration, the authors offer four examples, of steadily escalating complexity, of what a clever banker might be expected to do with $100 in the present age.  These range from “plain vanilla” (with $20 of equity and $80 of debt, he loans $50 to two different firms, just like an old-fashioned bank) to the joys of  synthetic leverage (with  $20 of equity and $80 of debt, half of which is overnight repo financing, he buys $100 of Treasury securities and writes protection, using credit default swaps, on a diversified portfolio of 1,000 investment grade corporate bonds, each with a notional value of $10, in hopes of making 5 percent on his $1,000 worth of swaps).

Then, in each case, too, they analyze what can go wrong

The result is the broad outline of something the authors call a “liquidity mismatch index.” It’s not impossible to understand.  If you puzzled through House of Cards or The Greatest Trade, or if you are curious about how those bank stress tests work, you may find it worthwhile to read the paper.

There are alternative approaches, or course.  Darrell Duffie, of Stanford University (a consultant to various hedge funds), in discussing the paper, described his 10x10x10 approach to measuring systemic risk. Others pointed out that accounting data upon which any system will be based must be dependable, as well – firms must value their assets and liabilities accurately.

Jeremy Stein, of Harvard University, who worked as an adviser to the Treasury Department in 2008, described at one point in the conference the experience of crisis. Inevitably, he said, it comes to a point at which industry experts are brought in to explain and explore various options for coping.

“There are two hours to decide. These guys tell you that things are incredibly complicated. They wear incredibly beautiful suits.  They are incredibly knowledgeable. And they are incredibly self-interested.

“The kind of data [envisaged by the authors] may or may not enable us to see around corners.  But having done the analysis, it will give us quite an ability to push back against the other form of argument.”

The stakes are high.  The Office of Financial Research, having been established by the Dodd-Frank Act, is going to do something.  Some have proposed that it should simply require financial firms to submit all their position data, and all their transaction data – in which case OFR will have to develop summary measures on its own, with relatively little input from the theorists who will depend on their data to understand and defuse future crises.

In the worst case, the OFR could become a little like the Internal Revenue Service, whose primary data on income distribution are largely inaccessible to researchers interested in trends in income inequality. There was a time when the NBER was well equipped to take on such measurement projects on its own.  But unless some serious scholar steps up to the responsibilities entailed by the need for systemic risk assessment, we are in danger of having to continue to navigate in the dark.

.                                     xxxx

The Michael Porter controversy bubbled to the surface last week, thanks to Harry Lewis, computer science professor and former dean of Harvard College.  He brought the matter up at a meeting of Harvard’s Faculty of Arts and Sciences.

Porter, a distinguished Harvard Business School professor, had held out high hopes for Libya under Gadhafi in a report prepared (with Daniel Yergin’s Cambridge Energy Research Associates) for the Libyan government in 2006. (“Libya’s popular democracy system supports the bottom-up approach critical to building competitiveness. … Libya has the only functioning example of direct democracy on a national level.”)

“To put it simply,” said Lewis, “a tyrant was willing to pay for a Crimson-tinged report that he was running a democracy, and a Harvard expert obliged in spite of all evidence to the contrary.”

“Shouldn’t Harvard acknowledge its embarrassment?” Lewis asked Harvard president Drew Faust, “and might you remind us that when we parlay our status as Harvard professors for personal profit, we can hurt both the university and all of its members?”

Faculty meetings are private. Faust apparently replied to Lewis that she didn’t want to be “scold in chief.” She distributed a written statement. Lewis added a little on his blog. Porter sent an email to the Harvard Crimson, the student newspaper. Former Kennedy School dean Joseph Nye responded to criticism of his involvement, both in The New Republic and in the Huffington Post.

Bloomberg BusinessWeek, which in 2007 had trumpeted the Porter project, followed up last week with a pithy survey of the situation (“Flattery for hire has no place on the CV of a serious academic”).

The really interesting questions have to do with channels of influence.  Heretofore stories have tended to blame Monitor, the Cambridge, Mass., consulting group founded by Porter and seven other Harvard Business School professors. The reputations of Joseph Nye and Robert Putnam, both former deans of Harvard’s Kennedy School, and political scientist Benjamin Barber, have been bruised.

But it was Porter’s personal project from the beginning.  It was he who somewhat breathlessly broke the news of his engagement in the Financial Times, in 2006, which reported it on its front page. ”I have gotten to know Saif quite well,” he explained the next year to BusinessWeek, referring to the dictator’s son. “He was a doctoral candidate at the London School of Economics, where he studied with some of the best professors. He’s very much oriented towards making Libya a member of the modern world community.”

That was shortly before Porter says he ended his involvement, after he learned that the wrong man was put in charge of the project he had devised.  But Monitor continued to collect.

And a year after Porter quit, the Libyan dictator’s reincarnation as “a mainstream, more responsible member of the world community” was intact. The FT noted in an advertising supplement “the procession of world leaders to Gadhafi’s door” (but not that many of the stream of visitors had been paid by Monitor).

Moreover, this time the FT didn’t consult Porter. He appeared in the story only as another button on Gadhafi’s sleeve, “the Harvard management guru… once an adviser to Ronald Reagan as US president, [who] helped to produce a 200 page document that called for prioritizing tourism, agriculture and construction to diversify an economy in which oil and gas account for 70 percent of gross domestic product.”

Say this then for Michael Porter. When he’s bought, he stays bought. He has had a remarkable career as a master explicator of industrial strategies, a consultant to corporations and governments alike. What he thought there was to gain from becoming public relations councilor to a madman and his son remains a real mystery,

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