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Exclusive: Harvard Economists Prove that Bankruptcy is Mythical

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This document was leaked to Naked Capitalism by a university economics student who has asked to remain anonymous

Background

Mixed reactions have followed the recent brilliant demonstration by a pair of young Harvard economists that bankruptcy cannot occur. While the community of economists has generally affirmed the correctness of the reasoning at issue, various individuals already distinguished for their carping attitudes have willfully misunderstood the theorem; for example, the controversial blogger Yves Smith has publicly labeled the proof ‘yet another demonstration that economics is the ugly stepsister of astrology.’

This sort of obscurantism is hardly surprising – as Ludwig von Mises pointed out in 1956 in The Anti-Capitalistic Mentality, ‘economics is so different from the natural sciences and technology on the one hand, and history and jurisprudence on the other hand, that it seems strange and repulsive to the beginner.’ Ms. Smith is evidently one of the people who experienced as a student this natural but irrational feeling of aversion, and has since refused to make the effort to think with true economic rigor.

The insight incorporated in the recent theorem is not difficult to explain, although for a full understanding, knowledge of the relevant mathematical techniques is, of course, essential.

Axioms

As has been recognized since at least the 70s, proving appropriately deep theorems in economics requires assuming that all individuals and corporations can borrow unlimited amounts of money at the risk-free rate. This assumption was essential in proving the Black-Scholes Theorem (the foundation of option pricing), the Modigliani-Miller Theorem (the cornerstone of modern understanding of capital structure), and more generally it underpins CAPM (the model for pricing securities and portfolios of securities).

Enemies of modern economics have complained that the borrowing assumption is unrealistic, pointing to companies undergoing LBOs in the 2000s – following Modigliani-Miller, these companies did not consider the extent of their debt levels important. Such ideologues charge that during the recent unexpected downturn, many of these companies were unable to continue to borrow and so went bankrupt.

Such ‘criticism’ ignores Milton Friedman’s devastating rejoinder: all theories are based on unrealistic assumptions, and so a theory should be judged not on its assumptions, but on the power of its conclusions. Following Friedman’s criterion, the value of assuming unlimited borrowing at the risk-free rate is incontestable, given the tremendous influence enjoyed by Black-Scholes, Modigliani-Miller, and CAPM. Would these obscurantist ‘critics’ prefer that we simply throw away the massive human achievement that is modern theoretical economics?

The Theorem

The recent work begins with the axiom that all individuals and companies can borrow unlimited amounts at the risk-free rate; however, the authors then take this axiom and reason from it in a new and unexpected direction. They ask us to imagine a profit-maximizing firm, or individual trader, called X, and to consider how X will respond if faced by economic adversity. They assume, credibly, that X will be failure-averse, and so will try to avoid failure by any legal means necessary. As a result, X will borrow at the risk-free rate in order to avoid bankruptcy. Presumably the economic adversity will not last forever, and X will eventually be able to pay off his or her loan. In the case that the adversity continues, X will continue to borrow, thereby following what is in effect a martingale strategy, and never going bankrupt.

At this point, the prescientific musings of Hyman Minsky might lead to worries that a sustained period of adversity could cause X to contract spiraling obligations that could destroy the global economic system. However, as the young Harvard economists point out, such an eventuality would contradict the first fundamental theorem of welfare economics, which proves that a modern economic system is constantly in a state of Pareto optimality (see, e.g., the classic proofs by Arrow and Debreu). The economists therefore conclude, reasonably enough, that the nightmare scenario of exponentially growing debt is logically impossible, and so, as already concluded, X will never go bankrupt.

Evidence

Empirical support for the theorem is provided by a close analysis of events during recent decades. In the early 90s, a trader for Barings Bank named Nicholas Leeson experienced market adversity while trading futures and, true to the theorem, dealt with this problem by steadily increasing the amount he was putting at risk. Undoubtedly his strategy would have succeeded at some point, but there was interference in market processes on the part of Barings’ auditors; massive losses for Barings resulted. Despite this unfortunate turn of events, the world financial system was not shaken, and Barings itself continued existence as a part of ING, although admittedly at an acquisition price that was rather low.

If any conjunction of unpredictable events had been capable of shaking our faith in the theorem, it would certainly have been the recent financial crisis. Yet although at the time there was a certain degree of turbulence, and some of the top financial firms consolidated, by and large all of the major players survived. ‘Critics’ of the theorem point to the bankruptcy of Lehman Brothers; but these ‘critics’ ignore the fact that all results in the social sciences are necessarily approximative. Despite occasional deviations from the model like the bankruptcy of Lehman, the model’s prediction that no financial companies would go bankrupt fits very closely with observed reality.

The point has also been made that during the recent crisis many individuals and small businesses did in fact go bankrupt. Of course this slight inaccuracy takes nothing away from the theoretical brilliance and general predictive power of the Harvard economists’ model; but undoubtedly future Nobel Prizes will be earned by other economists who succeed in putting together even more comprehensive theories. Such theories will doubtless succeed in modeling exceptional scenarios in which transaction costs and state interference can lead to occasional bankruptcies.

Policy implications

The first clear consequence of the Mythical Bankruptcy Theorem (MBT) is that to the extent that the financial system has experienced problems lately, these problems have resulted from the failure of policy to ensure that the assumptions of a perfect market are realized, viz., due to regulatory and other constraints on unlimited borrowing by market participants. Important steps towards remedying these market frictions have already been taken by prudent government officials, including the removal of arbitrary barriers on the use of various types of liquidity facilities – but more remains to be done.

Just as important, however, is the task of making sure that in these benighted times, the laws of economic progress are not obfuscated by confused people like the aforementioned Ms. Smith and Mr. Minsky. Here constant and patient effort is required – and I believe that there is also room for improvement in our tactics.

By virtue of our respect for logical reasoning, I believe that we economists are too quick to underestimate the impact of less logical modes of persuasion on other people. In this case, we must consider carefully the names that are applied to economic phenomena in public discourse. It is instructive in this regard to examine the actions of the New York Fed, which in its paper on shadow banking noted that the very term shadow banking creates the impression that the activities in question have little purpose outside of regulatory capital arbitrage. The authors of the paper prefer the felicitous coinage “parallel banking system.”

In this regard, we must become much more critical towards uninformed efforts to label phenomena of temporarily spiraling credit obligations with non-rigorous and pejorative names such as “Ponzi finance.” In light of the Mythical Bankruptcy Theorem, we should employ a less ideologically charged vocabulary: I propose the term liquidity-enhancing finance.

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108 comments

  1. MyLessThanPrimeBeef

    I wonder if a liviing being can borrow unlimited amounts of time from its creator at some sort of risk free rate, he, she or it will never die?

      1. Mel

        Your creditors can borrow to stay afloat until they make the money back, someday.

        Reminiscent somehow of the professor in Lewis Carroll’s _Sylvie and Bruno_ who never paid his tailor — just refinanced with a promise of double the money next year.

  2. Kiste

    “economics is so different from the natural sciences and technology on the one hand, and history and jurisprudence on the other hand, that it seems strange and repulsive to the beginner”
    ——————–

    So Mises disavows principles of empiricism and historicism in one fell swoop as far as the field of economics is concerned. Really? Then economics really IS the ugly stepsister of astrology.

    1. Kiste

      “Empirical support for the theorem is provided by a close analysis of events during recent decades. In the early 90s, a trader for Barings Bank named Nicholas Leeson experienced market adversity [...] Despite this unfortunate turn of events, the world financial system was not shaken [...]”
      —————————

      Now he’s calling an anecdote “empirical support”. Is this the quality of academic work at Harvard these days?

        1. DownSouth

          If only it were a brilliant piece of satire, then perhaps this sort of “thinking” would not be so dangerous. But unfortunately, these people are dead serious.

          Mises, as well as his acolytes Hayek and Friedman, were a product of the same philosophical tradition that spawned the Bolsheviks. The only difference is that for Mises, Hayek and Friedman, the road to paradise was state capitalism, whereas for the Bolsheviks, the road to paradise was state socialism. As Michael Allen Gillespie explains in Nihilism before Nietzsche:

          In Trotsky’s Promethean vision, we see a further unfolding of Fitche’s dream of absolute freedom. The attempt to make this dream a reality, however, produced a nightmare from which we have only recently awakened.

          As Gillespie goes on to explain:

          This Promethean element is particularly evident in a Bolshevik pamphlet of 1906 which argued that man is destined to “take possession of the universe and extend his species into distant cosmic regions, taking over the whole solar system. Human beings will become immortal.

          On the flip side perhaps it is Ayn Rand’s disciples who give us the most concise distillation of the Promethean element, evident in statements such as this one cited by David Sloan Wilson from the Ayn Rand web site:

          Those who have read the “Fountainhead” or “Atlas Shrugged” know that the sunlit universe Ayn Rand depicts in her novels is unlike the world that they see around them. How can one achieve the clarity of vision and joyous existence that her fictional heroes achieve?

          1. Jessica

            “In Trotsky’s Promethean vision, we see a further unfolding of Fitche’s dream of absolute freedom. The attempt to make this dream a reality, however, produced a nightmare from which we have only recently awakened.”

            The Promethean vision failed for two main reasons. Those holding it did not examine or understand what they are socially, who they really represented or might wind up being used by. Second, those holding this vision did not examine who they are as individuals. Thinking alone is not enough. Meditation, psychological exploration, etc. are needed for this.

            Most economics is actually a mild (mediocre) version of Promethean vision. It too fails to examine its social roots (in part because it is funded to obscure them) and assumes a fantasy image of humans rather than explore how we actually behave.

          2. Pixy Dust

            What else can we expect from free-marketeers’ obsession with Ayn Rand or von Mises as faith-based gospel truth? Economics is not a provable “hard” science. It is a social consensus – cooperatively accepted, or imposed. From my limited understanding, von Mises ideology seems to value money and assets of the individual, regardless of the diminishment of humanity – a feudal-state throwback (Libertarian paradise). After all, free-markets can’t be free if they’re restrained by societal accountability. Of course, history proves laissez-faire capitalism never seems to end well for the vast majority of citizens. But not to worry – government is always a handy whipping boy.

  3. Abc

    Yves, please enlighten us whether this document is a (very good) hoax, or whether the authors really believe what they have written there.

    1. Yves Smith Post author

      This is a hoax. The tipoff should have been the references to me. No one in the real world would bother singling me out as a critic of an academic paper.

        1. oliverks

          “Such ‘criticism’ ignores Milton Friedman’s devastating rejoinder: all theories are based on unrealistic assumptions, and so a theory should be judged not on its assumptions, but on the power of its conclusions.”

          Did he ever say such a thing? That line was brilliant, I’ll start quoting it all the time.

          1. CaitlinO

            Maybe Friedman should have taken a Philosophy of Science class or three.

            http://philosophy.wisc.edu/hausman/papers/38.htm

            Friedman rejects a standard instrumentalist concern with all the predictions of a theory. A good tool need not be an all-purpose tool. Friedman holds that the goal of economics is “narrow predictive success”–correct prediction only for “the class of phenomena the hypothesis is designed to explain.” Lester’s surveys are irrelevant because their results are not among the phenomena that the theory of the firm was designed to explain. On just these grounds, many economists dismiss any inquiry into whether the claims of the theory of consumer choice are true of individuals.

            I suggest that Friedman uses this view that science aims at narrow predictive success as a premise in the following implicit argument:

            1. A good hypothesis provides valid and meaningful predictions concerning the class of phenomena it is intended to explain. (premise)

            2. The only test of whether an hypothesis is a good hypothesis is whether it provides valid and meaningful predictions concerning the class of phenomena it is intended to explain.2 (invalidly from 1)

            3. Any other facts about an hypothesis, including whether its assumptions are realistic, are irrelevant to its scientific assessment. (trivially from 2)>

            If (1) the criterion of a good theory is narrow predictive success, then surely (2) the test of a good theory is narrow predictive success, and Friedman’s claim that the realism of assumptions is irrelevant follows trivially. This is a tempting and persuasive argument.

            But it is fallcious. (2) is not true, and it does not follow from (1). To see why, consider the following analogous argument.

            1′. A good used car drives safely, economically and comfortably. (oversimplified premise)
            2′. The only test of whether a used car is a good used car is to check whether it drives safely, economically and comfortably. (invalidly from 1′)
            3′. Anything one discovers by opening the hood and checking the separate components of a used car is irrelevant to its assessment. (trivially from 2′)

            Presumably nobody believes 3′.3 What is wrong with the argument? It assumes that a road test is a conclusive test of a car’s future performance.

      1. Deus-DJ

        Damnit, I thought it was a hoax because of how utterly ridiculous some of the references were but I didn’t think you would actually trick us:( It took a professor here at UMKC to also point out that it’s a hoax for me to realize it…..

      2. Dan G

        The paper sounds like the bible of the Fed. and our goverment. Just keep throwing money at problems and eventually you will get lucky. It is kind of the antithesis of time/labor/money foundation of capitalism. They want to extend the time to infinity,have a never ending supply of capital, and lastly not offer any concrete productive outcome or product to society except theft from someone else.

  4. Expat

    Kevin Bacon once acted in a movie in Hollywood.
    Hollywood is part of Los Angeles
    Los Angeles is the largest city in California.
    The governor of California used to be Arnold Schwarzenagger.
    Arnold Schwarzenagger has lots and lots of money.
    Money is printed by Ben Bernanke, Fed Chairman.

    I think that pretty much confirms what this Harvard paper is getting at, which is that Federal Reserve notes are actually Bacon. Mmmm, crispy and chewy at the same time, salty and tasty. And bad for your health.

  5. Edmundo Braverman

    “Ms. Smith is evidently one of the people who experienced as a student this natural but irrational feeling of aversion, and has since refused to make the effort to think with true economic rigor.”
    ——————————–

    A douchebag says what?

    1. LeeAnne

      Near as I can see, armed with an education in economics, the convert proceeds to communicate interminable hypotheses and unresolvable argument with graphs and formulas that only another economist can suffer. The sufferer is like a drug addict; the stuff may not work all that well after awhile, but it just hurts too much to withdraw.

      It is a total fraud.

  6. David

    So we have idiots on the Harvard faculty, no surprise.
    I like the way they explicitly throw empiricism out the window with:

    “…all theories are based on unrealistic assumptions, and so a theory should be judged not on its assumptions, but on the power of its conclusions.”

    Yves, these clowns are actually agreeing with you that economics is like astrology for the latter certainly also makes powerful conclusions based on unrealistic assumptions.
    unrealistic assumptions

    Then they criticize Herman Minsky for being “pre-scientific”. Hah, too funny.

  7. KnotRP

    These guys are right of course, but they shouldn’t
    plagiarize Krugman like that. Externalized costs are
    left as an exercise for the student. Economics is
    hard.

    Oh, and if you pull your bootlaces upward without quiting, you
    can fly into outer space….lol, excellent paper.

  8. Daniel Plainview

    This is just a very bad takeoff, (and I mean BAD takeoff) on Oliver Wyman’s mythological 2015. The author of this “satire”…….Yves??

    1. Yves Smith Post author

      Other readers seemed to think it was a good hoax. I think you just don’t like this sort of thing.

      The “topics” list has this flagged as a guest post, plus this is not my writing style.

      And it makes a serious point.

      The writer read a lot of the critical underlying papers, including Arrow Debreu (and he has the math skills to understand it). I actually wanted him to put more of the wonky details in since he had done the work. He started by noting how many seminal papers made bankruptcy impossible via providing as an assumption that firms can borrow unlimited amounts at the same rate, which is either explicitly the risk-free rate or is some non-specified private sector rate (per CAPM, individuals and firms all borrow at the same rate). As he noted on Arrow Debreu:

      The role of time displacement in A-D is complicated, so I didn’t include it explicitly. Basically A-D assumes that commodities have time stamps on them, so you can always trade a current commodity for a future commodity. But in any case, everyone’s utility constantly increases, so bankruptcy is axiomatically precluded.

      1. Ina Deaver

        Wait wait – individuals and firms borrow at the same rate? That is the most astounding piece of idiocy since “rational consumers.” Is it really the same rate if the risk of failure for the individual is personal bankruptcy, but the firm just dissolves and moves on to plunder again in another form — even if the nominal rate is the same?

        It was a lovely piece of snark. But I had just never focused on the underlying assumptions since deciding back in 1992 to leave the study of economics because the assumptions were crazy (and necessary). You had to assume that the other variables hold constant, or that the elasticity was infinite, or some other piece of insanity because otherwise the theories just couldn’t wrap around the complexity of the problem.

        Yikes.

      2. alex

        In all fairness I believe Arrow-Debreu was intended as nothing more than proof of the _possibility_ of certain solutions under a certain set of assumptions. There’s nothing wrong with that so long as one takes it in the intended spirit. It does not demonstrate that such solutions will occur in the real world, if for no other reason than it doesn’t show that the assumptions are valid.

        The problem is geniuses who don’t see the difference, and mistake a simple (if mathematically esoteric) model for a description of reality. Or worse, they don’t care about the difference, and are content with wasting time on an academic circle jerk instead of doing science. In the physical sciences or engineering such people would be laughed out of the business.

        Arrow at least is not one of the people to make such an elementary mistake. Amongst his later work is a study of information asymmetry (same area as Stiglitz’s claim to fame).

        1. Deus-DJ

          Technically, STIGLER, the guy who wrote “The Economic Theory of Regulation” or something to that effect(which is THE advocacy piece against regulation and for the public choice theory of regulation) also studied information asymmetry as his other major contribution. You don’t want to give him credit though, do you? :)

          Arrow merely wrote an academic piece as you described it, he wasn’t the ideologue that Stigler was.

          1. Deus-DJ

            Yes, Stigler and Stiglitz are two different people. Stigler was one of the founders of the Public Choice theory of regulation. You should look him up.

        2. DownSouth

          alex said:

          In all fairness I believe Arrow-Debreu was intended as nothing more than proof of the _possibility_ of certain solutions under a certain set of assumptions. There’s nothing wrong with that so long as one takes it in the intended spirit….

          The problem is geniuses who don’t see the difference, and mistake a simple (if mathematically esoteric) model for a description of reality.

          The problem is that once a model has been thrown out there, regardless of how many warnings are placed on the package, the “geniuses” always seem to find it and ignore the warnings.

          For example, let’s take two abstract works of art.

          Consider first Malevich’s painting subtitled “Woman in Two Dimensions” which can be seen here.

          Now obviously this work of art is abstract and was never billed as anything but abstract. It exemplifies Walter Benjamin’s strictures about the need for the radical Communist intellectual to “denature” his work if necessary.

          Next consider Arno Brecker’s sculpture Readiness which can be seen here.

          This work is not so obviously an abstraction and was promoted by the Nazis as “realism.” But regardless of its billing, it is every bit as much of a reductionist abstraction as is Malevich’s “Woman in two Dimensions.” Here’s how Peter Adam explains Brecker’s sculptures in Art of the Third Reich:

          [They] encapsulated the basic aesthetic Hitler demanded from this art form. They were also supposed to express a longing for eternity. They were to inspire admiration and legitimize the system. Everything about them is idealized: their hair, lips, bodies. It is the faultless picture of man modeled on antiquity. Everything is noble, even the material, and yet they look hollow and totally artificial. The statues do not breathe, do not live.

          The title of Brecker’s “Readiness” of 1939 implies that this is man ready for battle, an impression emphasized by the half-drawn sword. The muscles of the legs and arms are overemphasized. The hand is forceful, designed to grasp. The interplay between stillness and movement in the pose creates a deliberate tension that is the result of the contrast between reflection and aggression. As I many art works of this period, the function of this piece was to divert people’s attention from reality and lead them into a dream world in which work and love, battle and achievement were formed into a new popular myth.

          The National Socialists hoped the extreme details of rendering and its enforced realism would seduce the onlooker to identify himself with the figures and what they stood for. And yet we have no idea what they feel or think, only what they represent. If we look at a figure of antiquity we can see the living image of a person; individuality is clearly visible. The gesture is natural. The National Socialist figures strike a pose. A gesture is personal, a pose is synthetic, imposed form the outside. The frozen pose became the ideal treatment of political indoctrination, the elimination of personal freedom. It explains the feeling of unreality and deceit which we experience when we look at these statues. How could people have thought that these figures represented real persons, real living beings?

          But here’s the rub. Despite the fact that “Woman in Two Dimensions,” unlike “Readiness,” is so obviously an abstraction, people took it for a representation of a real person, a real living being. The artist Vladimir Maiakovskii was so despondent when he discovered this abstraction was not obtainable in real life that he committed suicide. As Paul Wood explains in “The Politics of the Avant-Garde,” Maiakovskii had worked for Mossel’prom and other state enterprises in an attempt to make new values fundamental to the daily life of the socialist society. By 1930, he saw that all had been a mirage. Maiakovskii’s recognition was bleak: “So, the thing you’ve been fighting against for twenty years has now won.” The “twenty years work,” as well as the October Revolution, which had given that work practical focus, taken it out of the realm of the avant-garde cenacle, and appeared to offer it a world to work with, were all an illusion.

          But, as Paul goes on to point out:

          Not everyone was possessed of Maiakovskii’s insight. The ideological power of the dictatorship was colossal. And the Five-Year Plans were, seemingly, successful: the Soviet Union built while the capitalist world largely stagnated. Designers still had an important place, and were presumably gratified to serve what Lissitzky in 1930 still saw as the development of “a Socialistic society.”

          1. alex

            The bottom line is that you can’t make anything idiot proof.

            The theory of evolution was perverted by some into “social Darwinism”. IIRC Darwin himself specifically repudiated social Darwinism as a perversion of his ideas. What else could he do. Should he not have published his theories because it’s possible to pervert them?

          2. Pixy Dust

            Nicely explained. If I understand correctly, your art examples imply, on the one hand, an abstract world of “the possible” through participatory consensus. In Hitler’s examples we find subjective, rigid, soulless presumption and expectation.

            No wonder Adolf was a frustrated mediocre artist. But he got the marketing thing down pat.

        3. JustAnObserver

          I’ve always read Arrow-Debreu as one of the greatest reductio ad absurdum proofs of all time. It *should* have been taken as a fully-fledged attempt to kill off the toxic nonsense called “equilibrium theory” that’s poisoned economics for 200 (?) years.

          FWIW my view is the – increasingly – desperate attempts tp “prove” the existence of an equilibrium is (have been), at base, a desire to return to a Feudal system where everyone knows their place … a reaction to the hierarchy disrupting consequences of capitalism.

          1. alex

            ‘desperate attempts to “prove” the existence of an equilibrium is (have been), at base, a desire to return to a Feudal system’

            Never ascribe to conspiracy what can be explained by mere incompetence. Steve Keen’s take is that you have an army of economists who know nothing but statics, and have no desire to learn/develop the far more complex area of dynamics. Waah, it’s hard!

            As an engineer I especially get a laugh out of that. In many areas of engineering static analysis is considered the “baby stuff” that you learn before tackling the far more difficult questions of dynamic systems.

  9. mannfm11

    I am beginning to wonder about Harvard? I note a high number of the shady people in government seem to be educated there. At what point do you take the loaded gun out of the hand of the baby? Clearly Leeson would have made out, but at what point would the bank be empty first? The entire system has to balance on the books. Also, there is a limit to how much interest one can extract from the economy.

    If this works so well, why not go to Greece and solve the debt problem? I’m sure they can rake together enough money to open an account. 10 bp on a few hundred billion should be fair compensation for such a gig. By the time everyone finds out, the country will owe the entire world supply of debt.

    There is a prohibition of titles of nobility. Setting one up to never have to pay their bills is such a title and the supposed practice, if possible, should be prohibited in the United States and banking companies in the country should be prohibited from engaging in the practice anywhere around the world. The entire idea is criminal and the authors of this paper should be watched as such.

  10. attempter

    Undoubtedly his strategy would have succeeded at some point, but there was interference in market processes on the part of Barings’ auditors; massive losses for Barings resulted.

    Very true, according to the criminals called “economists”.

    The only part that wasn’t clear to me is whether the Mises quote is authentic. It certainly can be – Hayek flatly said if his theories are applied and the results turn out differently from what he predicted, that can only be because the prescription wasn’t applied with sufficient rigor.

    As I said a few days ago describing the prescriptions of the IMF, “A human being is burning to death? Apply more flame.”

  11. craazyman

    MBT sounds like MMT.

    bowahaha aahaha hahahahahaha!!!!

    seriusly that was very good paper. I study economics grad with lots of math. I have math prove social optimality achieved when 10 rich guys all have 48888888 billion in wealth from deriviatves trade. All markets everywhere reach lowest possible price 24 hours each day. everybody socially optimal happy everywhere.

    sincerely yours

    Dum Fuk, PhD
    Institue for Econonmic Effishensee

  12. sid_finster

    Funny stuff. If liquidity does not matter, then the Martingale must be an optimal betting strategy….

  13. financial matters

    Nassim Nicholas Taleb has developed the Black swan theory where there is no distinction between any different kinds of uncertainty.

    In his book The Black Swan, in the section subtitled “The uncertainty of the nerd”, he writes:

    In real life you do not know the odds; you need to discover them, and the sources of uncertainty are not defined. Economists, who do not consider what was found by noneconomists worthwhile, draw an artificial distinction between Knightian risk (which you can compute) and Knightian uncertainty (which you cannot compute), after one Frank Knight, who rediscovered the notion of unknown uncertainty and did a lot of thinking but perhaps never took risks, or perhaps lived in the vicinity of a casino. Had he taken financial or economic risk he would have realized that these “computable” risks are largely absent from real life! They are laboratory contraptions

  14. But What Do I Know?

    Well, Yves, you must be getting somewhere if they’re disparaging you by name. . .

    In any case, the proof of the thesis that you can’t go bankrupt if you can borrow unlimited amounts of money is nothing new–I have some in-laws who worked this out year ago :>)

  15. Squeeky Fromm

    Well of course this is satire, because the whole point is that while one could use econobabble to to show bankruptcy was impossible, one would likely end up like Alan Greenspan, who underestimated the appeal of making hay while the sun shines.

    Squeeky Fromm
    Girl Reporter

  16. Thomas Williams

    Sophomoric from start to finish.

    Might have been a useful academic exercise for the students had they been instructed to refrain from ad-hominum attacks.

    Yawn

  17. avgJohn

    I have to side with the young Harvard economists on this one.

    I think we are good to go, as long as we don’t run out of zeros (assuming exponential growth in computer power, of course).

    But just wondering, does anyone know what number comes after a gazillion?

  18. AK

    Aaarghh.. nearly religious experience. I saw for a moment the Almighty of all market transactions. He was in palankeen carried by few chicago boys and I saw His eyes.. These eyes.. Full with squared CDО’s, floating over ocean of unlimited amount of money at risk-free depth. And then – bang! Some bastards siphoned the liquidity-enhancing dream into their caymanian accounts.

  19. Tadit Anderson

    It is a great piece of satire, with the caveat that under the paradigm that is already disconnected from real world and the common weal, most of professional and professorial economics is a fiction already. The corporatist capture of governance is the left hand of the continuing peril. Post Keynesian economics, in the technical sense, is in contrast an advocate for function, not dysfunction. The romance of the bling be the thing, though as a fiat franchised fiction it is just a sting. Pass the ponzi, please.

  20. Walker

    This has to be a hoax.

    There is no way that section on Axioms was written by anyone who has any clear understanding of how mathematical modeling works.

    1. Yves Smith Post author

      Um, the author has a PhD from one of the very few uber elite pure math programs in the US. That guarantees his command of math skills are better than that of any economist. Very few people have the chops to do pure mathematics in a serious way.

      And this is not presented as a faux econ paper, but a concerned discussion about an econ paper.

  21. ella

    Yesterday during Bernanke’s testimony he virtually affirmed the occurrence of bankruptcy of the SSA trust fund. When asked about Congress’s prioritization of treasury debt, he said that the only problem with move to prioritize the debt payment would be a computer problem. Recall that the R’s want to prioritize debt payments to China before SS (SSA invests its surplus in US treasuries with roughly a 2T current investment).

    Does he not understand that once prioritization occurs for one class of US creditors it can happen to other classes at the will of Congress? If the debt is not repaid to SSA then the SSA will likely be bankrupt. Of course maybe this is the plan, and it does not fit with the leaked paper that there can be no bankruptcy. No bankruptcy in law but in fact can occur, if there is an insolvency.

    Now why would anyone buy treasuries and risk being included in the class that is paid last or not paid at all? Will this scheme also filter down to the states? Which class is next?

    Watch out China your treasuries could be next. And then maybe the treasuries that Uncle Be holds. No that will never happen will it?

  22. Philip Pilkington

    Has anyone actually read Von Mises’ book (The Anti-Capitalist Mentality)? I’d recommend it – not all of it, but skim it – its very funny, in a paranoid, pathetic sort of way… a bit like watching an Alex Jones clip on YouTube.

    He basically says that everyone who disagrees even slightly with, well… Von Mises himself, has self-esteem problems and is a resounding failure at life. It is a fascinating work of psychology – specifically, the personal, grandiose and rather pathological psychology of Herr Von Mises himself.

  23. mark

    I thought it was very witty,and the satire was indeed obvious. However, I think the lesson is less an ideological one, and more a professional one, than some of the commenters think.

  24. PJ

    “As has been recognized since at least the 70s, proving appropriately deep theorems in economics requires assuming that all individuals and corporations can borrow unlimited amounts of money at the risk-free rate. This assumption was essential in proving the Black-Scholes Theorem (the foundation of option pricing), the Modigliani-Miller Theorem (the cornerstone of modern understanding of capital structure), and more generally it underpins CAPM (the model for pricing securities and portfolios of securities).”

    To the extent that economics has any relationship to the Universe in which we live, matter and energy are finite. No one can borrow, use or create “unlimited amounts” of anything in any factual way; nonsense like this ”research” traps people and policies in foolishness.

  25. Jennifer A. Hill

    This kind of work is basic rationalization for the corrupt system that the beneficiaries intend to continue with as long as they are allowed.
    It also embodies the misogynistic patriarchal stance of the western world view, which still supports men over women as decision makers at almost every level. When making reference to Yves there is a clear subtext in the commonly used attacks on intellectual and reformer women, that we women are irrational and unable to appropriately comprehend the due to some intellectual or educational deficiency. Listen to this “carping attitudes have willfully misunderstood the theorem,” first lets think about carping it means nagging, who nags women, next lets look at the word willful – it carries the notion that the individual is immature and unable to follow appropriate rules or reasoning, something women are often accused of when they come close to dismantling power constructs (think Alice Paul). So even before they mention Yves by name they trash her with the common oppressive language of men in power.
    But at this point in the document they have not identified her by gender – which would have made my points less damning but they can’t stop themselves and by the second paragraph refer to her as Ms. Smith. Then you get the full blown attack; she only has the understanding of a rebellious student and is resisting the truth of our sublime construct crap. The language smacks of cultspeak, authoritarian drivel, and the attack is quite cutting, “Ms. Smith is evidently one of the people who experienced as a student this natural but irrational feeling of aversion, and has since refused to make the effort to think with true economic rigor.The insight incorporated in the recent theorem is not difficult to explain, although for a full understanding, knowledge of the relevant mathematical techniques is, of course, essential.”
    There are so many negative assumptions about Yves in this part I scarce know where to begin. 1. On the level of an economics student 2.Not mature enough to understand the complex and correct nature of the theory
    3. More talk about being willful 4.And the coup de grace – Yves does not have the requisite mathematical skill to see the truth in the theory
    So remember in this battle for an economic system that will better serve the people and common good women are a necessary evil. Yes women are needed to care for the young and old for free and do other jobs for men as necessary but our constant guard over the common good is really a threat. We must keep speaking truth to power – no matter how many Harvard dolts try to discredit us.

    1. craazyman

      Is it true that 8 out of 10 women don’t have a sense of humor?

      bowaha ha ahahaha ahahaha hahaha

      This excellent paper is the underpinning for the entire notion of “bankruptcy remoteness” which supports that entire securitization process. Who really has gone bankrupt, except for a few patsys? Everyone else was floated like a turd in the bowl. This form of financial innovation would not be possible without the insights of these Harvard theorists — who may or may not be male or female (or even human, ho ho).

      It’s easy to discredit pathbreaking work with off-topic diatribes about male and female sykologie. But it’s harder to really loot and fleece the ignorant public. Yes, it is. It takes a special talent for that.

    2. Cedric Regula

      I think women have the potential to be better financial mathematicians than men. We did math modeling in engineering, and we knew that if we tried to fool Mother Nature, we were in deep doodoo.

    3. Martin Lipow

      Jennifer Hill turns Alice Paul on her head. Paul was among the generation of women who first hit the glass ceiling, who had the education, abilities and contacts to aspire to managerial positions and found themselves discriminated against by employers in favor of men. Paul and her allies aimed to advance themselves on the backs of the vast majority of their “sisters” by wiping out protective legislation for women, which as a practical matter also benefited large numbers of poorly paid men. For example, facing the prospect of paying overtime pay for overtime worked to women but not to men, ask yourself who an employer would hire. As leader of the National Woman’s Party, Paul pushed for a version of the Equal Rights Amendment embodying an abstract concept of equality which concealed a concrete aim of an equality of the lowest common denominator. “We don’t want any special privileges” was a constant refrain, which translates to “If somebody’s made a gain which interferes with our individual advancement then drag them down into the mud where we are.” The labor women opponents of Paul supported an amended ERA embodying an equality of the highest common denominator and preserving protective legislation. Instead of resenting or seeing as a barrier to advancement the gains made by others elsewhere, the supporters of this approach saw them as benchmarks to be applauded and aspired to. An even better approach would have been to apply the language of the 14th Amendment to women, but that’s another story. Alice Paul and her ilk were and are a threat to the common good.

  26. ep3

    yves, what about simmons beautyrest? they had been a strong company for 100 years. Then they were bought out by private equity, then leveraged to the hilt, with finally their employee pension plan was raided to keep them afloat. All the while the private equity fund walked away after making millions while the employees no longer have a pension.
    That is wrong. And Obama supports things like that.

    1. Yves Smith Post author

      I was in the office of the guy who did that deal the day they won the bid. He came in and proudly pronounced their success. The price was so high there was no way it was gonna work. It was later called “the burning bed.” If it’s any consolation, it singed the reputation of the players involved.

  27. Cedric Regula

    “Would these obscurantist ‘critics’ prefer that we simply throw away the massive human achievement that is modern theoretical economics?”

    I wasn’t completely sure before, but after reading that gobbledygook, yes, I’m sure.

    But that leaves the task of fixing Harvard’s econ school. I propose we have Milken lead an LBO. He gets short term risk free cash from TBTF Land to do the hostile takeover. Then cuts salary and bennies 30% to pretty up the income statement for a year and then issues 15% junk bonds and pays off his short term free money. To pay the interest on the junk bonds, he raises tuition, replaces all the books in the book store with comic books and sets their selling price at $200 each. Then he hires Larry Summers to run the Harvard endowment SPV whom then assigns cash flows from the scholarship fund to interest payments on the junk bonds.

    We then cross our fingers that there is no noticeable decline in product quality, tuition revenue remains intact, and bankruptcy just isn’t possible.

  28. Joe Rebholz

    Yes. Very amusing. Fooled some of you too for bit didn’t it.

    But the sad thing is, this kind of silly assumption — that anyone can always borrow more money — was actually used by real, live, respected, academic economists — Scholes, Black, Modigliani, Miller, Mises, and the others listed, but also by many other economists for the last couple hundred years and much of the rest of the world has taken economics seriously.

    You can prove anything from false assumptions. Milon Friedman’s assertion that the axioms don’t matter, but only the conclusions that you can deduce from them, is absurd, silly, and stupid. Why bother deducing anything. Just assume the answer you want. Effectively that is what you are doing when you claim the axioms don’t matter. If the axioms and deduction don’t matter so then what are they there for? They are then just a trick to try to make economics look like a science because it supposedly uses logic and mathematics. In mathemaics we sometimes say a variable goes to infinity, but we are very careful in what we mean when we talk of infinity or indefinitely large quantities. In the real world it seems no variables can go to infinity. In the real world they crash.

    It wouldn’t be worth going on about this except for the fact that similar false assumptions, absurd axioms, and many mathematical mistakes permeate both modern and historical economics. Worse, considering this, we have no way of sorting out which of the so called economic truths that economists and the rest of us use in our thinking about the real world are correct and which are illusions. So as far as I am concerned, ALL of economic reasoning is suspect. I don’t know enough to be able to sort through all of historical and present day economics to separate truth from illusion. I doubt if any living economist could do it either, but as a field they need to do it. Yet they keep teaching the same old crap. And they call themselves academics. I have little respect for most of them.

    The Mythical Bankruptcy Theorem is a beautiful spoof of the whole corrupt, incoherent, baseless, epistemically closed, unscientific field called economics.

    The Mythical Bankruptcy Theorem paper should be requited reading for every economist everywhere, and its authors should get the next Nobel prize.

  29. Doug Terpstra

    If only Bernie Madoff had understood these immutable economic proofs. He might still be enjoying private showers while his victims enjoyed a dignified and comfortable retirement.

    BTW, can anyone provide a link to the discount window where “individuals and corporations can borrow unlimited amounts of money at the risk-free rate,” preferrably for an indefinite period of time? I would gladly pay you Tuesday for a hamburger today.

    1. Cedric Regula

      Sometimes during my paranoid moments I begin thinking that Wall Street may still be innovating and creating more financial products that we haven’t heard about yet.

      They have names like the “Humpty Dumpty Straddle” and the “Cheshire Cat Bounce Swap”. These spawn a rich set of structured synthetic derivatives, like the “Cheshire Cats Bouncing” product which is composed of a wrapper around multiple Cheshire Cat Bounce Swaps with tranches we can select from based on our precise appetite for risk or our exacting hedging needs.

      Then I get more paranoid and believe that at some point in the future a disheveled Janet Yellen, wearing a wig because her real hair fell out, appears on CNBC and announces that it is imperative that the Federal Reserve initiate QE9 and purchase all Humpty Dumpty Straddles, Cheshire Cat Bounce Swaps and Cheshire Cats Bouncing instruments in the marketplace over the next 24 hours. The dire consequences of the Fed failing to act would result in the ozone layer being repo’ed and the entire human race will be exposed to a lethal dose of Alpha wave radiation and also the lower risk, but still lethal, Beta wave radiation.

      Then I get depressed and decide I shouldn’t think about things like that.

    2. Pixy Dust

      I think you’ll find the window behind the thatched roof hut where the pretty brown girl lives. Somewhere in the Cayman Islands I’m told.

  30. nowhereman

    If nothing else this little exercise should lead us to examine the axioms under which we all operate, most often without our explicit awareness.
    For example, can someone explain to me the inevitable popularity of Maury Povich, and Jerry Springer and the stratum of society they present? I only ask, because according to economists they don’t exist. Yet there they are every day without fail.

    1. Bob Falfa

      1. Nothing is so firmly believed as that which is least known.

      2. Gotta admit that paternity test show concept that Maury came up with is gold, pure gold.

    1. Cedric Regula

      We should define “hoax” vs. “satire”. A hoax is something that didn’t happened, like when those Martians invaded us.

      A satire is a play on something that did happen.

  31. Bruce Cohen

    “Consider a spherical economy of constant infinite density whose surface is compact and closed …”

  32. john bougearel

    So, Ms. Smith,

    Just what do you make of the accusation that you are: “evidently one of the people who experienced an… irrational feeling of aversion [to economics], and has since refused to make the effort to think with true economic rigor?”

    The question is a bit tongue and cheek, but I certainly do not appreciate the subtle ad hominen attack intended to undermine your credibility. I have seen PHD professors resort to this ugly tactic before, where the intended results hit their mark.

    Now onto the claim that adopting a martingale strategy of borrowing ad infinitum by trader X under adversity until said crises subsides will allow trader X to avoid bankruptcy in perpetuity:

    The author offers up as dubious proof the most recent financial crisis as a case in point: “If any conjunction of unpredictable events had been capable of shaking our faith in the theorem, it would certainly have been the recent financial crisis. Yet although at the time there was a certain degree of turbulence, and some of the top financial firms consolidated, by and large all of the major players survived….The economists therefore conclude, reasonably enough, that the nightmare scenario of exponentially growing debt is logically impossible, and so, as already concluded, X will never go bankrupt….the model’s prediction that no financial companies would go bankrupt fits very closely with observed reality….”

    It is clear that the author has clearly enjoyed his little intellectual exercise playing games with economic theory, as well as his or her tete a tete dismissing Yves Smith’s own intellectual rigor.

    Several flaws in the author’s line of reasoning come to mind regarding his or her constructs of what “fits very closely with observed reality.” But I will only address one. Namely, that a modern modern economic system is [not] constantly in a state of Pareto optimality as assumed in the “classic” proofs offered by Arrow and Debreu and as also assumed and offered up by this author.

    Arrow and Debreu’s proofs are flawed in a myriad of ways. Quoting Yves Smith in Econned: “The conditions of the Arrow-Debreu theorem are highly restrictive. For instance, Arrow and Debreu assum perfectly competitive markets [where] all buyers and sellers have perfect information, [where] no buyer or seller is big enough to influence prices… [and where] everyone has perfect foreknowledge of all futures periods.

    In other words, the model bears perilous little resemblance to any world of commerce we will ever see. What follows from Arrow-Debreu is absolutely nothing. Arrow Debreu leaves you just as in the dark about whether marekts clear in real life as you were before reading Arrow Debreu.

    “And remember” says Yves Smith, “this [Arrow-Debreu] paper is celebrated as one of the crowning achievements of economics.”

    Milton Friedman actually defended what Yves calls the “credulity-straining axioms” of economic theories.

    From a 1953 Friedman paper: “Truly significant hypotheses will be found to have assumptions that are wildly inaccurate descriptive representations of reality, and in general, the more significant the theory the more unrealistic the assumptions…The relevant question to ask about the ‘assumptions’ of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximations for the purpose at hand.”

    Yves Smith poignantly observes that “Friedman’s statement that ‘unrealistic assumptions’ prove the best is willfully false. In the absence of any evidence to the contrary, unrealistic assumptions are worse than realistic ones. An unrealistic assumption is one directly contradicted by evidence. This amounts to a ‘get out of reality free’ card.”

    The study of modern economics is like living in Plato’s Cave where economic students are imprisoned to an illusion watching shadows projected onto the wall of the cave. The shadows are as close as economic students will ever hope to get to viewing reality.

    What were to happen if these imprisoned economic students were released from their Cave of illusions? What if these students of modern economic theory were forcibly dragged out of their cave and into the sunlight where cockroaches fear to tread, wouldn’t they be angry? Wouldn’t they be distressed and unable to see?

    Socrates postulated that the freed prisoners exposed to the light of day would at some point in time “acclimate.”

    However, thus far, lashing out at Ms. Smith as having an “irrational feeling of aversion” towards modern economics suggests these Harvard students are still pretty uncomfortable with Ms Smith dragging them out of their dark and dismal caves.

    However, Ms. Smith has escaped the binding chains of the cave’s illusions and acclimated to the real world. Socrates further speculated on what were to happen to the acclimated person (to the world of reality) if he/she were to return to the cave. “Were he [she] to return there, wouldn’t he [she] be rather bad at their game, no longer being accustomed to the darkness? Wouldn’t it be said of him [her] that he [she] went up and came back with his eyes corrupted?”

    So, this is Ms. Smith’s return to the cave, and those still inhabiting the darkness of the cave are claiming she has an
    “irrational feeling of aversion” to the cave’s constructs of illusion.

    If this is all we have come to in advancing the school of economics since this past financial crisis, then indeed, this if further evidence that we haven’t even passed go yet.

    How long, O, Lord? How long, O, Lord will the ardent supporters of modern economic theory remain imprisoned in their caves?

  33. john bougearel

    Wow,

    I’ve been duped by this satire. And, Yves you are right, the tipoff should have been the ad hominen references to you. Well, the joke’s on me!

    But Alex’s observation that “It says a lot about the credibility of economics that many people didn’t realize this was a satire.”

    So, they are making some forward progress at Harvard, after all, encouraging news!

  34. RSDallas

    This, most certainly, is a joke isn’t it? It sounds like a theory developed by some Las Vegas gaming executive. I kept reading just to see if the Harvard flunky was going to site that the source of additional loans came from a money tree planted somewhere on the Harvard campus. Presumably by the Economics building.

  35. Paul Repstock

    Wow! Yves must finally have achieved ‘critical mass’ with her readership…:) Bravo!

    Probing nerves to stimulate such extreme reactions usually requires exceptional skill. I think most of us will credit Ms. Smith wth that.

    Here is a side note to gladden F Beard’s heart, we are so behind the curve on this side of the pond. Have no doubt; the gloves are coming off in this fight.

    http://arcticcompass.blogspot.com:80/2009/12/better-way-barter-system-vs-national.html

  36. PDC

    Really funny… somehow reminds me of Orwell’s NewSpeak and, in a more subtle way, of Swift’s “Modest Proposal”.

  37. djinn

    This doesn’t strike me as satire, so much. The author is describing, totally straight-faced, how the basic underlying assumptions of the way banks and others handle and hedge risk is seriously fucked. Very interesting.

  38. propertius

    It’s nice to know that I still have the job I lost as a result of the Barings Bank “noncollapse”. 16 years of back pay will come in very handy. I must remember to send Nicholas Leeson a thank-you note.

  39. stevelaudig

    as a former criminal defense lawyer, whose only background is “home economics” I knew it was “effed-up” when I read it and since much of the blathering of status-quo defending “experts” is “Carrollian” anyway I didn’t spot the hoax but I did spot the “Walrus” and “Carpenter” argument and know that they [the Masters of the Universe] do view us all as mere oysters.

  40. Michael

    You would think economists at Harvard would be a little smarter than to declare something like Bankruptcy is a myth but this is precisely the reason I hate the study of economics in its modern state. These economists are supposedly brilliant and i’m sure they are very smart but the problem with economists is that their theories and themselves are so detached from reality that common sense and real experiences are completely missing.

    How does this guy say that all theories are based on unrealistic assumptions?? If that were true, then no theory would be true and you wouldn’t be able to prove it.

    Here are the assumptions I see: 1) unlimited source of credit 2) always positive return on investment 3) the only thing that exists is the market; other events do not have an impact.

    Obviously there’s a limit to how much any individual or firm can borrow; there’s only so many bonds you can issue, stock you can issue or debt you can hold up. Second, whoever said that the money borrowed was going to be invested wisely and have a positive rate of return? it is possible (and often happens) that companies LOSE money either from betting on the wrong horse, misappropriation of resources, corruption etc. So if you lose money on the capital you borrowed, how would you pay that back? Unless the solution is to continue borrowing more money to pay off the debt you had earlier, which is clearly unsustainable. Third and lastly, are economists so self centered around the free market that other events have no impact or meaning in their life? Political, social, natural events can cause immense disruptions (i.e. North Korea and WMDs, Egypt, hurricanes etc) which can affect supply lines, resources, etc etc.

    This is why I don’t like the discipline of Economics; it’s too theoretical, divorced from the real world and tries to mathematically rationalize human society when clearly individuals are NOT always rational and not everything is neatly written into a thesis paper. A much more enlightening and realistic discipline to study this would be political economy, which is a holistic approach to how real economics works, not how economics works in a professor’s textbook. Economists seriously need to wake up and see that their discipline is flawed and at least incorporate other disciplines like history, psychology, political science and more as well as actually use the real world experiences as a basis for their theories.

  41. jane hay

    this is hysterical !! Who wrote this? My snark meter has pegged. The line about astrology was smack on target.

  42. ChrisPacific

    Very nice. I’m almost done with ‘Debunking Economics’ (Keen) so I was able to recognise the neoclassical tropes. I couldn’t believe the Friedman quote when I read it. How these people have ended up with the keys to the kingdom is beyond me.

    1. Doug Terpstra

      I thought the same thing listening to Mubarak and later Suleiman’s speech today. That those dry-rot, termite-riddle ancient stumps could possibly have risen to the great Pharaoh and Grand Vizier of one of Earth’s greatest civilizations is a cosmic mystery.

  43. skippy

    I didn’t even comment last night upon reading, needed ice to compensate for the pummeling my face took from knee jerks.

  44. 60sradical

    Erudite economists living in ivory towers babble esoteric chunks of nothing. Perhaps they cause a little head- scratching epidemic among .000000002% of the masses. Dumb-ass bankstaz, on the other hand, cause millions to lose their homes and millions more to die a slow death. The world of finance totally trumps self-absorbed and over-paid academic mutants called “economists.” In the same way realpolitik trumps the crap on the MSM.

  45. psychohistorian

    Nice snark. Economics, without including politics is, has been and ever will be be propaganda as cover for the rich in control of our society.

    Too bad it can’t be used as a study in critical thinking for the masses.

  46. Jon Cloke

    I think you’re being gamed here on the mythical bankruptcy crap… this reads like someone who’s familiar with your blog and (forgive me) your self-awareness and they’ve written a fairly clumsy piece of satire pulling all your strings!

  47. TC

    Liquidity-enhancing finance?

    Then we should all look forward to the added pressure on the drain this enhancement creates when panic hits…

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