Nov 29 2008

The role of "scientific" theories in the financial crisis

Published in Trustscientific researchresearcheropportunismmarketsinvestorsinstitutionsgovernancefinancial services industryfinanceeconomicsBlogacademic research by Jaakko Aspara  

The academic world is often considered to be isolated from the real world. However, now that the world is struggling with an unprecedented financial crisis, one must (at last) pay attention to the role that academic theories may have in the real-world developments.

 

The very serious problem to be identified is that economists and finance scholars typically have excessive trust in their own theories -- trust that often approaches outright naiveté. This blind trust has tremendous implications to our economic system; at worst it contributes to crises like the one we are experiencing now.

 

Let me present a few illustrations. (Note that related comments on the "blind trust" can be found also in entries by Tuomas Kuronen and Henri Schildt)

 

Perhaps the best-known finance theory in the validity of which most academicians blindly believe is the one that states that the financial markets are efficient. This implies that the market values of securities, such as stocks, always reflect all the information that is relevant to their fundamental values.

 

Based on this theory one often concludes that "markets are always right" in their pricing of securities -- and also rightly price the risks related to the security values. 

 

Now, to the extent that people have without a slightest doubt believed in this "scientific" conclusion, the theory in question has evidently been the underlying primus motor of the current crisis.

 

Another recent theory in the assumptions of which one trusts beyond reasonable doubt prescribes that firms should disgorge their "free cash flows" to their shareholders. A further theoretical prescription is that firms should disgorge their cash flows by buying back their own shares from the stock market (rather than by just paying dividends).

 

One blindly believes in these theoretical norms despite the fact that no one has ever been able to unambiguously define "free cash flows". And even less adequately has anyone been able to explain how a firm could -- in case it disgorges away its "free" cash flows -- maintain a reasonable level of investments in development of innovative products. Or, for that matter, a reasonable cash reserve for the rainy day, or September-October.

 

Also, one blindly believes that a firm should disgorge its cash flows by repurchasing its own shares from the market - even though no real-life evidence whatsoever exists that would prove that such buybacks would maximize the long-term market value of (or payments from) a firm to investors (beyond the short-term push-up to stock price).

 

Indeed, from the perspective of the financial crisis, it is illustrative to look a bit further into the stock buybacks that the largest US financial institutions made before the culmination of the crisis. (The figures come mostly from a study by William Lazonick of UMass Lowell.)

 

For instance, Lehman Brothers spent 17 billion dollars on buying back its own shares from the market during 2000-2007, and Bear Stearns 8.4 billion. As late as in 2007, the year preceding their collapses, these banks still spent 2.6 billion and 1.7 billion on stock buybacks, respectively.

 

And the other financial giants were not worse (or better) than that. In total, Bank of America, Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and JP Morgan Chase spent a tremendous 175 billion dollars on stock buybacks in 2000-2007. As late as in 2007, the year before the crisis culminated, the banks still had 28 billion dollars of "free" cash to spend on stock repurchases!

 

Moreover -- if the absolute figures do not say enough to you --  the figures appear even more insane when you relate them to the firms' net incomes. For instance, the money spent on stock buybacks at Lehman Brothers was about 92 percent of the firm's net after-tax income during 2000-2007. Add to this the dividends that the firm paid (which in themselves were rather moderate) and you can see that the firm disgorged away a sum of money equivalent of over 100 percent of its net income during the years leading to the crisis.

 

It is really quite obvious that if the banks had left part of these immense amounts of money into their cash reserves, they would have been able to better dampen down the crisis -- or even prevent its culmination altogether.

 

 The cash reserves were disgorged, however, and eventually the stock buybacks only benefited the corporate executives who were early enough to sell their personal stock options in 2007 or before -- with stock prices that had been manipulated temporarily upwards with the very stock repurchases.

 

There is a multitude of theories similar to "markets are able to price risks rightly" and "using free cash flows on stock buybacks maximizes shareholder value" in the science of finance. (A few others can be found here.) These are theories in the truth value of which the scholars blindly believe, for which they eagerly speak, and which the persuasively teach to students -- but which just aren't very wise in terms of how the real world works.

 

To end with, perhaps the most tragicomic theory is one that some academic textbooks in the USA have until lately been claiming. It goes: "Securities based on mortgages are in fact risk-free". Right.

 

All in all, people's trust in the truth value of the "scientific" theories of finance has long ago gone over the top. This blind trust is unquestionably a partial cause to the current crisis.

 

 As a final remark, it must also be noted that the academic theories -- in which way too many people trust -- are at their most hazardous when corporate insiders cunningly exploit that trust. These insiders will always play their cards right so as to maximize their personal income -- while conning the greater fools who trust in the "scientific" theories with even brighter blue eyes.  The greater fools are: their own shareowners and investors as well as the politicians, media, and government officials.

 

Unfortunately, the problem is aggravated by the fact that there are so few academic scholars that would be straightforward enough to stand up and exclaim: "Many of our theories just suck. Big time."

 

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Interesting analogies from history
written by Jaakko Aspara, December 23, 2008, 13:10
One person who commented the above blog entry to me saw that finance practitioners' blind trust in their theories has interesting analogies in history.

One analogy comes from the "obedience studies" by the late Yale University psychologist Stanley Milgram. In a study à la Milgram, volunteers administer what they believe are increasingly powerful electric shocks to another person in a separate room. The volunteers are told that the shock experiment is actually a learning study, destined to address the effects of shocks and pain on people's learning.

An "authority figure" -- the experimental scientist who is present with the volunteer -- prods the volunteer to shock the person in the other room. (Note that the other person is actually just an actor who plays the role of "learner" -- a fact that the volunteer is, however, not aware of.) Each time the learner gives an incorrect answer to a question posed to him/her, the volunteer is urged to press a switch, seemingly increasing the electricity voltage over time.

Now, the main finding of Milgram experiments is that the majority of the volunteers are prepared to raise the voltage of the electrical shocks to fatal levels -- even if the targeted person is screaming of pain. The interpretation of this is that people can have such a high level of reliance on authority that they often disregard their own common sense in dealing with an issue and blindly follow the lead of an authority (or that of others or hierarchy in general). Additionally, the volunteers no longer see themselves as responsible for their own actions -- rather, the instructor-authority is seen as accountable.

The analogy of Milgram's obedience study to the financial world becomes clear when one views the "scientific" theories of finance as playing the role of the authority. Indeed, it seems that legions of finance practitioners around the world have in recent years just ignored all common sense and blindly relied on the assumptions of certain authoritarian theories. An what is more, the finance practitioners seem to have continued to rely and act upon those theories even if they have seen the increasing stress and pain that they are inflicting upon the system, their own employer firms and shareholders, their co-workers, and eventually even themselves.

Another analogy comes from 1930s Germany. Most of us are familiar with this "nightmare decade". In any case, consider how the Swiss theologian-intellectual Karl Barth views the decade (see the reference to Barth by the Archbishop of Canterbury, http://www.telegraph.co.uk/com...-love.html). What Barth saw beginning to take its grip on Germany in 1931 was a system of "principle" that worked quite effectively once one accepted that quite a lot of people that one might have thought mattered as human beings actually didn't. As the nightmare decade unfolded, the implications of this became clearer and clearer. What Barth was warning against was the temptation of unconditional loyalty to a system, a programme, a "cause" which was essentially about "me and people like me". It's about "our needs", the programme of this particular group, its safety and prosperity.

Now, consider that community of finance practitioners. These people have unquestionably have had a very strong sense of community, high awareness of their own prosperity needs and rights -- and systematic programs to achieve the prosperity by ignoring or manipulating the world outside. And like in the decade of its historical analogy, the unconditional loyalty by finance practitioners towards their own system and principles eventually had truly nightmareish consequences.

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