Thursday, September 25, 2008

Flunking the professor

Long ago, I was an economics major. I was good enough at it to be asked to participate in the departmental honors program. But I turned away from it for several reasons. One of them came back to me with a vengeance when I read, via Sully, how Harvard econ Prof Greg Mankiw argues against the push for warrants in the bailout:

This is essentially the assertion made in David Leonhart's column in the NY Times on Wednesday. And it again illustrates that we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again,assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant -- say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.

Now I didn't study the Modigliani-Miller theorem. But I knew, as soon as I read that passage, that Mankiw was wrong, and I knew why. And what I knew I can teach you in two minutes, after which you too can slam 90% of "markets are magic" economic claptrap.

So what is the Modigliani-Miller theorem? I wandered over to Wikipedia, and read the following.

The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.[1] It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.

Everything you need is in the first sentence, and you don't need to even understand what follows. This theory, like 99% of economic theory, assumes a state of the world that, in the immortal words of one of my economics profs, "is a special case." This magic theory assumes:

1. No taxes
2. No bankruptcy
3. No information asymmetries
4. An efficient market

See the problem yet?


So now the whole rationale for the plan is “price discovery”: we’re going to throw lots of taxpayer funds into the pot because that will let us find the true values of troubled assets, which are higher than the fire sale prices out there, and so balance sheet will improve, confidence will return, etc, etc..

Does that sound to you like information symmetry?

Krugman: assets are currently being sold at “fire-sale” prices, which don’t reflect their true, “hold to maturity” value; we’re going to pay true value — and that will make everyone’s balance sheet look better and restore confidence to the markets.

As I said, this is really a giant version of the slap-in-the-face theory: markets are getting hysterical, and the feds can calm them down by buying when everyone else is selling.

Does that sound to you like an efficient market?

Anbody seen a business deal lately that didn't have tax implications (most are DRIVEN by the tax impacts)? And don't get me started on the bankruptcy aspect, which is what got us here in the first place.

So, lessee.... that's at least two, and potentially four, out of four logical predicates violated. The whole reason we are in this mess is that the market failed. The government is stepping in because there are no other buyers -- a textbook non-efficient market situation. And our good professor wants to point to a theory that imposes very strict requirements for market dynamics in order to apply.

And THAT'S why I didn't become an economist. Because everyone carefully states those assumptions, but then ignores them in practice -- because if economists limit themselves to applying these theories to contexts where the assumptions are not violated, well, they don't get to talk so much.

What oughta be taught in high school, Professor, is that textbook economics tends not to map onto the real world so well.


Anonymous Anonymous said...

This comment has been removed by a blog administrator.

7:26 PM  
Anonymous Anonymous said...

I wonder whether the presence of a central bank with the power to control our currency has something to do with this.

I recently saw 2 videos on Google video:
The Money Masters
Money as Debt.

Very worrisome.

8:33 PM  
Anonymous Anonymous said...

This comment has been removed by a blog administrator.

12:53 AM  
Anonymous Anonymous said...

Dude, did you miss this part of Mankiw's post:

"A smart friend, who knows more about this topic than I do, emails me his response to the critics:"


9:05 PM  

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