financial crisis

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Looks like Nudge has made it into the Indian Fed. Talking about global financial turmoil, Shyamala Gopinath, Deputy Governor at the Reserve Bank of India (the country’s Central Bank), cited the book in a speech last week, and asked if Indian financial policymakers could “take a cue” from behavioral economics and the concept of choice architecture.

Lastly, on the issue of selling of complex products, we have to collectively work towards a viable framework. What is the solution? In this context I would like to recount the application of a surprisingly simple idea to the realm of public policy that has received tremendous attention after being advocated by Richard Thaler and Cass Sunstein in their international bestseller “Nudge.”

Amol Agrawal, who first noticed this speech, is pleased by Gopinath’s question about the adaptability of choice architecture. Nudge enthusiasts everywhere may be able to find a new audience for their insights.

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Here is how the standard economic experiment in trading works: A group of a dozen people are given money and shares to trade in isolation from behind a computer terminal. Each share pays some dividend, which averages 24 cents, paid at the end of a trading round (the actual dividend for different shares vary, just like real stocks). The fundamental value of each stock can be easily calculated by an Econ. Heck, by a Human too. It is just the expected value of a future dividend stream at any time. So if there are 15 trading rounds and the dividend is 24 cents, the expected value is 15*.24 or $3.60. This simple calculation ignores capital gain, which is unknown, and depreciation, which is zero in this case because all the rounds are finished in an afternoon. So do stock prices follow fundamental values? Of course not.

Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, (Charles Noussair, a professor at Tilburg University) emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.

From the Atlantic.

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By Richard Thaler and Cass Sunstein

(Originally published in the Financial Times, November 11, 2008, under the headline “Human frailty caused this crisis”.)

Mea culpas are rare these days. In a debate with John Kerry in 2004, President George W. Bush fa­mously could not name a single mistake he had made in his first term. So it is both noteworthy and commend­able that Alan Greenspan, the former US Federal Reserve chairman, fessed up that he had failed to anticipate the financial crisis.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief,” he said. Mr Greenspan had faith that banks were prudent enough to make sure they were not lending money cheaply to people who could not pay it back. Yet that is what happened. As Mr Greenspan says of securities based on subprime mortgages: “To the most sophisticated investors in the world, they were wrongly viewed as a ‘steal’.”

Continue reading the post here.

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Mostly Economics points to this passage from Euro Intelligence that says not in Germany.

The money market is still frozen…the biggest mistake of the German plan had been the voluntary nature of bank rescues, which has led to the perverse situation that so far only one state-owned bank, BayernLB, has asked for new funds. Lucas Zeise says the German government made the mistake to ask the banks to co-draft the rescue plan, rather than forcing banks into recapitalisation, as the British and French have done.

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In response to the financial crisis, a number of countries have sought to boost liquidity and confidence by guaranteeing bank debt and consumer deposits. Eagle-eyed Amol Agrawal notices that New Zealand did so with a behavioral economics twist: It used an opt-in strategy for participation in the government program. (Australia used a similar approach.) Agrawal argues that the opt-in strategy is a signal to investors about the relative health of the New Zealand banking system.

(New Zealand’s Ministry of Finance) believes its financial system is safe and hence has used opt-in. In fact, (the New Zealand government) is trying to signal the same to the markets. If the risks from financial system were higher, it would have instead used a opt-out strategy.

That may true, but the opt-in approach is also a signal about the relative health of individual banks. Contrast it with the U.S. FDIC program to guarantee bank debt, which was “voluntary” in name only – at least for the nine major banks that initially participated. The U.S. government’s argument against true voluntary participation was that banks that did take part would be considered weak by investors and other lending institutions. New Zealand banks that choose to opt-in will face this very dilemma. So while New Zealand sought to showcase the health of its financial system at the expense of a few weak banks, the U.S. sought to shelter the extent of the damage to its financial system at the risk of undermining some of its strongest performers (ie. Wells Fargo and JPMorgan Chase).

So far, the New Zealand government has not announced which banks are participating in its opt-in program, but stay tuned.

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Some of the most interesting work in modern economic theory explores a pervasive social phenomenon: the informational cascade. The concept, first elaborated in a brilliant 1992 paper by Sushil Bikhchandani, David Hirshleifer, and Ivo Welch, illuminates countless social and economic surprises. It is impossible to understand the real estate bubble, or the current financial crisis, without exploring the dynamics of informational cascades. Policymakers should consider its implications in seeking ways to respond to today’s economic chaos.

From Wall Street’s Lemmings, in the New Republic:

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A video from the Newshour with Jim Lehrer.

Q: But what about the mentality of the investors, the markets that need to gain confidence? What do we know about what drives that on a given day or what it takes to turn it around?

Thaler: Well, I think we don’t know much. I think one thing that should be stressed is that we don’t really know whether there is a panic here. We have lots of uncertainty. And when there’s lots of uncertainty, we expect volatility. People can’t really make sense of this.

The other thing I would say is that whatever is going on is primarily being driven by professionals. This is not a retail panic. And I’m not sure that there is a panic.

People are reacting to very real things. The credit crunch is quite real. And people in the money management side are worried about people withdrawing their money. They’re having trouble borrowing. And so they have to reduce leverage, and all of that drives prices of risky assets down.

A radio interview on The World. “There’s a tendency to talk about this as a panic, and maybe there’s a panic, but frankly there’s an even scarier interpretation of what’s going on, which is this isn’t a panic, it’s actually quite real. Things are as bad as we’re fearing, and that we’re just going to have to suck it up and live a bit more frugally.”

And a CNN clip on Nudge. The reporter is tempted by french fries.

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