DeLong’s Hilarious Admission
Longtime reader Von Pepe urges me to referee the dispute on Cato Unbound between Larry White and Brad DeLong. I just spent several hours this morning writing up an analysis for Mises.org, which presumably will run in the next couple of weeks. In the meantime, let me say that I think Larry White is spot-on, while I think DeLong is spot-off.
DeLong’s approach is to list several possible causes of the financial crisis, rule out all but one, and then conclude that it “must be” the last remaining thing on his list. As Casey Mulligan notes, this approach is dangerous because DeLong might have left something important out of his list (which he did).
Anyway, check out this excerpt from DeLong’s original essay:
Things are even worse as far as the risk discount is concerned. Our models predict that in normal times, with the ability to diversify portfolios that exists today, the risk discount on assets like corporate equities should be around 1% per year. It is more like 5% per year in normal times — and more like 10% per year today. And our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level but that has led to ten times the total losses in financial wealth of the impulse.
Got that? “Our” models of risk discount on stocks are off by 400% in normal times, and 900% right now. So while I appreciate DeLong’s candor, you would think he might be a bit more humble. It’s one thing for him to shoot holes in everybody else’s explanation, and say after it all, “I’m sorry fellas, but I don’t think any of us knows what is going on here.” But he seems pretty sure he knows the way to fix the economy.**
* People like Nassim Taleb and Benoit Mandelbrot think the problem is in the normal distributions used in standard financial markets models. If you instead model stock prices that are subject to error terms with “fat tails,” then the “equity premium puzzle” disappears. Thomas Bundt and I have a forthcoming paper on this in the Review of Austrian Economics. Let me also admit I am dumbing down the analysis in this little footnote; we cross our Ts in the academic paper.
** I checked his blog to give a good example, but it’s just full of Keynes loving at the moment. But that in itself should give you a hint that DeLong is confident on how to fix things, and it doesn’t involve more freedom for individuals to structure their own “recoveries.”
