A must-read

Krugman put up a must-read piece at the New York Times. I think it is slanted to the Keynesian school of thought, but it is also an excellent history of modern macroeconomics and how we got to where we are. There are a few paragraphs I want to quote and discuss, but please do read the article in full. It is particularly good for those who want a quick grounding in economic history.

Any emphasis in the quotes below is mine.

1. The birth of modern economics and the Efficient Market Hypothesis
"The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations” in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” — costs that people impose on others without paying the price, like traffic congestion or pollution. But the basic presumption of “neoclassical” economics ... was that we should have faith in the market system."
This is foundational. Note that it relies on rational individual decision-making.
"There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”"
Krugman details much more, but essentially, makes clear that the belief in Efficient Markets had taken hold to such a degree amongst mainstream thinkers and policy-makers, that any thought to the contrary was dismissed out of hand.
"By October of last year, however, Greenspan was admitting that he was in a state of “shocked disbelief,” because “the whole intellectual edifice” had “collapsed.” Since this collapse of the intellectual edifice was also a collapse of real-world markets, the result was a severe recession — the worst, by many measures, since the Great Depression."
I linked an Economist article on this a few days ago. I think what one can see here is the beginnings of a fundamental questioning of Milton Friedman's faith in rational markets. This is a very, very serious question, as a reversion back to Keynes would be greatly at odds with what we've been used to for nearly 20 years now (it's arguable that Bernanke's stimulus is Keynesian, but I do still think that the core belief system of key modern policy-makers leans towards deregulated markets). Also, this is why I have the blog The Mess That Greenspan Made in my list of favorite blogs. =)

2. The Stock Market
It is generally accepted that the goal of a public corporation is to maximize value for its shareholders. This is a principle that I, at least, have never questioned. I am beginning to, however:
"By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.”"
I find this very interesting. How did corporate leaders view the stock market prior to 1980? Was it simply a means to raise cash - in other words, allowing the stock to fund your activity and judge your value rather than forcing your activity so as to increase the stock price? The former seems far more rational to me.
My dad, Pramod Khargonekar, with whom I discussed parts of this article, brings up further points and questions on this topic:
There are some really fundamental questions: Consider a public company such as IBM.
Who owns the company? Legal answer: Stockholders (there are many classes of shares which makes this a little more nuanced. There are also debt holders who have a higher priority in terms of ownership which makes this answer even more complicated. Finally, taking into account externalities, society where the company operates have a legal and societal stake in the company. This is not always acknowledged.)
What is the role of mgt? Flip answer: maximize the value of the company. But what does this mean? Stock price in the next day, week, month, year, ...? Not all stockholders have the same view on this. BoD is supposed to represent the interests of the owners but they are often beholden to the management. Often CEO is also the Chairman of the BoD. The entire area of corporate governance is supposed to deal with this but has been quite dismal in this regard.
Where does the larger society fit into this? Flip answer -- no role. But then when the company creates toxic dumps, we the society pay for it and thus it becomes a subsidy from the nonowners to the owners. Unless the cost of externalities is fully reflected in the taxes paid, this is often in favor of the management of the company.
It is critical to realize that the corporate/government structure is constructed by us: it is not ordained by nature. It operates in the physical world and has humans as players. Behavioral finance, economics is probably the best direction for understanding how these things work and what to do about them for the long term good of the society.

3. Keynesian Economics
Back to quoting more Krugman:
"I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.
This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.
Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .
In short, the co-op fell into a recession."

4. No one could have predicted this!
"Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”
... there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”
Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified.
...In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place."

I leave the rest of the article to you. It makes for great reading.
The key points this article brings up:

• Lack of faith in the Efficient Market Hypothesis (I've brought this up before, and am wondering if we're beginning to see a more serious questioning).
• Too much belief in mathematical models that make for an ideal world rather than modeling the real world.
• A need to incorporate Behavioral Economics more strongly as the field moves forward.

I want to make a post later in further detail on the principle of maximizing shareholder value, how that's currently defined, and how it should be defined. I will quote my dad's note in that again, but expand on some points it makes brief note of (corporate governance and behavioral economics).