How an academic economist discovered a useful theory via trading in markets

John Geanakoplos, an economics professor at  Yale and has Greece origins. His grandfather migrated to US from Greece in search of a better life.

He explains in this speech how he became an economist and discovered the leverage cycle via trading in financial markets. In this theory he showed the importance of collateral in finance and how it amplifies the financial cycle both ways. In good times less collateral is required amplifying the boom and in bad times more collateral is demanded amplifying the bust.

Why he became an economist is interesting:

Together with his brother, my grandfather built the first Greek church in Minneapolis and was the first president of the Greek community of Minneapolis and for many years the treasurer of the church. Though he had gotten quite wealthy, he told his sons that they should look for a purer calling than business. One son became a high school history teacher in Minneapolis, another son (my godfather) became a professor of chemical engineering, and my father became a professor of Byzantine history.

My sister and I wanted to be even purer than our parents. She studied music at Julliard and philosophy at Yale and became a concert pianist, playing all over the world, including twice here in Athens many years ago. I studied pure mathematics at Yale and then got a masters in mathematics at Harvard. But along the way to my math degrees I also took courses from extraordinary teachers in economics, like James Tobin and Herbert Scarf at Yale, and then Kenneth Arrow at Harvard. I realized that mathematics played an essential and beautiful role in economics, but that economics also touched on so many other things, like political philosophy and even business, that despite my grandfather, I was also interested in. So I decided to get my PhD in economics, under Kenneth Arrow.

Purer calling? But if it leads to PhD under Arrow it was worth it..

Ok, now to how he discovered about his leverage cycle idea. He took a sabbatical in 1989 to work in Wall Street. The mortgage market was starting to boom then:

The mortgage market was a multi-trillion dollar a year operation and I realized, while I was there at Kidder Peabody, that this whole operation behind the scenes was invisible to everybody and was worth writing about. It was bringing great welfare gain to the country and nobody quite knew about it. So for me, it crystalized what the essence of finance is. The essence of finance is creating promises backed by collateral. The houses back the homeowner mortgage promises, the mortgages back the pools, the pools back the tranches. And the investors who buy the tranches are also borrowing money, using the tranches as collateral. Collateral is a very important to running a financial system. Yet collateral had never been mentioned in a single one of the many economics courses I took at Yale or at Harvard.

So I published my first paper on collateral equilibrium in 1997. And one of the questions I asked and answered was, how does supply and demand determine not only what interest rate people generally have to pay on loans, but also how much collateral they generally have to put up? That was a question that nobody seemed to have asked before. Even today you won’ find it in any textbook. It was a question that I could have asked out of pure logic, and the answer I gave was purely mathematical. Yet I never would have thought of the question if I had not worked in the business world of Kidder Peabody.

As financial markets were under stress during LTCM bust and then dot com crisis, he built his leverage cycle theory:

I decided that two such catastrophes could not be an accident. I decided to write about the crashes that could be caused by leverage and securitization, that is about what could go wrong. I developed a theory I called the leverage cycle. During periods of calm lenders ask for less and less collateral and leverage rises. Most importantly, because leverage raises asset prices rise. Hedge funds and other investors do well. Production increases. But when there is scary bad news that frightens lenders, they raise collateral requirements much more than interest rates. Because of the bad news, and because of the deleveraging, and because the optimists were leveraged so much before, asset prices not only fall, they crash.

Leveraged buyers go out of business. And with low asset prices, production grinds to a halt. Those who survive the crash do amazingly well when the cycle begins again and leverage and prices rise. The episodes of 1994 and 1998 were both leverage cycle crashes, the first in the government bond market and the second in the mortgage market (and actually more dramatically in emerging markets). The crash stages in both passed over in just a few months. But what if the next one was bigger and longer?

Well as we know, teh 2007 recession made John really popular. Now we see this idea of collateral and Repo markets much better than we did earlier.

He says unless  debt is forgiven Greece and US unlikely to recover:

The situation is of course reminiscent of what has happened to Greece and other sovereign borrowers. Lenders should never have lent so much money. Now that the situation has become bad, the borrowers cannot possibly pay it all back. Of course the borrowers must be forced to put their houses in order, and to pay as much as they reasonably can. But to ask the impossible will work against even the lenders. Eventually part of the Greek debt will have to be forgiven.

If Greece makes the needed reforms, mostly by collecting taxes from the rich who evade them, and reforming the business sector, and if the Eurozone is rational, part of the debt will be forgiven. Greece will get a fresh start. And in this global economy there will be no reason for you to abandon a country you love to find opportunity elsewhere as my grandparents had to.

🙂

Well, usually we find fin econs applying their ideas/theories in markets. Here is someone who discovers a new theory while working in Wall Street…

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2 Responses to “How an academic economist discovered a useful theory via trading in markets”

  1. Paul Buys Debt-Ridden Property in Sydney Says:

    Dear Mostlyeconomics,
    Interesting Post, NRO’s David Hogberg expounds thusly:

    Too many intellectuals believe they have a duty to make decisions for the rest of us.

    In his 1988 book Intellectuals: From Marx and Tolstoy to Sartre and Chomsky, Paul Johnson wrote that one of the lessons of the 20th century was “beware intellectuals. Not merely should they be kept well away from the levers of power, they should also be objects of suspicion when they seek to offer collective advice.”

    [In] Intellectuals and Society, [Thomas] Sowell has made good on a 20-year-old promise [that followed publication of Johnson’s book] to write about intellectuals.

    Sowell approaches his subject as an economist, analyzing the incentives and constraints intellectuals face. Sowell defines intellectuals as an occupation, as people whose “work begins and ends with ideas.” This includes academics, especially those in the humanities and social sciences, policy wonks, and, to a certain extent, journalists. This distinguishes them from occupations in which the work begins with ideas and ends with the application of ideas. Physicians or engineers usually start with ideas about how to approach their work, but eventually they have to put them into practice by treating patients or constructing bridges.

    As a result, intellectuals are free from one of the most rigorous constraints facing other occupations: external standards. An engineer will ultimately be judged on whether the structures he designs hold up, a businessman on whether he makes money, and so on. By contrast, the ultimate test of an intellectual’s ideas is whether other intellectuals “find those ideas interesting, original, persuasive, elegant, or ingenious. There is no external test.” If the intellectuals are like-minded, as they often are, then the validity of an idea depends on what those intellectuals already believe. This means that an intellectual’s ideas are tested only by internal criteria and “become sealed off from feedback from the external world of reality.”

    Members of other professions can achieve fame and fortune by finding ways to meet the demand for their end products. But for intellectuals to prosper they must create demand for their ideas by stepping outside their areas of expertise to offer “solutions” to “social problems” or “by raising alarms over some dire dangers which they claim to have discovered.”

    Sowell chronicles the disasters that occur when intellectuals succeed in getting politicians, judges, and other policymakers to impose their vision on society. In the section on crime, Sowell examines what happened to the U.S. when intellectuals imposed on the criminal-justice system their vision of crime as being as much the fault of society as of the individual. In the 1960s, the Warren Court made it more difficult to convict and imprison criminals with decisions such as Miranda and Mapp. Other judges and policymakers followed with an effort to alleviate the so-called “root causes” of crime, such as poverty and discrimination. Rehabilitation was emphasized over prolonged imprisonment. The result was a reversal of a decades-long improvement in the crime rate.

    Intellectuals take their beliefs as axiomatic truths rather than hypotheses to be tested. In the current health-care debate it is axiomatic among many intellectuals that a public plan will improve the health-insurance market. As one liberal blogger put it, “If the public plan works, then private insurance will work better as well. In this telling, the simple existence of the public plan forces a more honest insurance market.” But treating that claim as a hypothesis shows that the evidence points in the opposite direction. Medicare, the “public plan” for seniors, drove private insurance for the elderly out of the market.

    It “was part of a long-standing assumption among many intellectuals . . . that it is the role of third parties to bring meaning into the lives of the masses.” Many people were shocked when in early 2008 Michelle Obama proclaimed, “Barack Obama will require you to work. He is going to demand that you shed your cynicism. . . . That you push yourselves to be better. And that you engage. Barack will never allow you to go back to your lives as usual, uninvolved, uninformed.” Sowell probably just shook his head in knowing disgust.

    The intellectuals of today are continuing a long tradition going back at least to Rousseau, who dismissed the masses as “a stupid, pusillanimous invalid.” He was succeeded by John Stuart Mill, who said that intellectuals are “the best and wisest” and “those who have been in advance of society in thought and feeling.” If Mill were not long dead, it would be easy to conclude that he ghost-wrote George Clooney’s Academy Awards acceptance speech for Syriana.

    [ Excepted from http://article.nationalreview.com/?q=Mzc… ]
    Good Job!
    – Paul Harvey at Paul Buys Any Problem Properties

    We purchase difficult properties and run-down properties without needing a bank, so if you can be negotiable on the terms, we can offer you the price you desire, today.
    …When you don’t want it, we do!
    If you know of anyone who has to get rid of a hard-to-sell house, we give out a $500 referral fee for each home that we purchase.

  2. HaLin Says:

    Hyman Minsky propounded a credit boom-bust cycle a century ago, Walter Bagehot echoed similar words a century before Minsky!

    History is the only constant!

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