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