Bad economics

I like sound analysis and sound reasoning. I dislike "sound economic policies" as they usually refer to dogmas.

I like discussions in which good arguments are explained if needed, and I dislike discussions in which good arguments are dismissed (usually by economists vested with power) without considering them seriously.

I like simplicity where possible, and I dislike simplicity when complex analysis is needed.

With this, I would like to introduce Avinash Persaud, whom I see as a sound thinker whose thoughts should be taken more seriously by policymakers.

Avinash Persaud has written an article, “Financial Regulation: Sending the Herd over the Cliff. Again”, that he sent to me saying it will appear in the June 2008 issue of the IMF's Finance & Development. Its basic argument is that risk models of banks create a false sense of safety and make crises worse when they emerge. In 1998, when the Asian financial crisis unfolded, and Avinash still worked with J.P. Morgan, he “learned first hand that whereas risk-sensitive systems may help banks manage their risk during quiet times, they are not crisis-prevention measures: they make crises worse.”

In 1999, Avinash wrote a Prize winning essay, “Sending the Herd off the Cliff Edge: The Disturbing Interaction of Herding Behaviour and Market-Sensitive Risk Management Practices”, and noticed it was dismissed by regulators as “too theoretical or extreme”.

In his recent article, Avinash disagrees with the regulators’ charm with market risk models that banks use and their proposal to incorporate these models in the new rules of Basel II.. “The reason we regulate markets over and above normal corporate law,” says Avinash, “is that markets fail from time to time, with devastating systemic consequences. If the purpose of regulation is to avoid market failures, we cannot then use risk models that rely on market prices as the instruments of financial regulation. (…) Risk sensitivity as a regulatory principle sounds sensible only until you think about it.”

Avinash stresses that market failure relates to the economic cycle. Banks and markets underestimate risk in the up cycle and overestimate risk in the down cycle. “In an up cycle, market participants always see some new paradigm that tells them the cycle is dead or that it’s ‘different’ this time. (…) At the top of a boom, the risk models prescribed in Pillar 1 of Basel II, whether using market prices or the ratings of credit-rating agencies, will be telling banks that they are running less risk and are better capitalized than they will in fact turn out to be when the credit cycle turns.”

In Avinash’s view, Basel II is bad economics. “It tries to use market prices to predict market failures and destroys the natural, liquidity-inducing diversity in risk assessments. What it ends up doing is precisely what regulation should be designed to avoid: acting procyclically.”