The Map and The Territory - Alan Greenspan Book

The latest issue of the Central Banking Journal includes my review of the latest book from Alan Greenspan.  It is an interesting book with insights about economics and about the man.  You can read the review here or below.

Book review of ‘The Map and The Territory. Risk, Human Nature and the Future of Forecasting’ by Alan Greenspan, Allen Lane, 2013

‘The Map and the Territory’ is an enigmatic title for a book written by a former Chairman of the US Federal Reserve, which also seeks to cover ‘risk, human nature and the future of forecasting’.  I set out to review the book thinking how long it will take me to understand the rationale for the title. 

The introduction made an impression.  A reasonable acknowledgement that economic forecasting failed in the lead up to the crisis and of the need “to understand how we all got it so wrong”.  I use the word ‘reasonable’ judiciously.  Given the author’s position as Chairman of the US Federal Reserve before the crisis, I was not expecting an acknowledgement that the Fed or the US authorities fell asleep under Greenspan’s watch so “we all got it so wrong” – my emphasis.   Equally, I am not sure if other central bankers have acknowledged that much.  The assessment is usually about bankers going bonkers. 

One of the issues that Greenspan tackles in the book is the extent to which it is appropriate to rely on rationality assumptions for forecasting economic behaviour.   One of the challenges that Greenspan identifies for forecasters is that behavioural responses are unlikely to be symmetric.  For example, the collapse of asset prices would be sharp and, probably, deep while recovery would be gradual.  Overall, Greenspan concludes that economic behaviour is not random and that most economic choices are stable over the long run.  In his own words, ‘we are driven by a whole array of propensities ... but, ultimately, our intuitions are subject to reasoned confirmation.’

This does not mean that errors would not occur.  Greenspan singles out the secular underestimation of tail risks based on the last quarter century of observations.   As for the ability to eradicate those propensities that can give rise to the tail risks, Greenspan dryly note that ‘there was no irrational exuberance in the Soviet Union and none in today’s North Korea’.

It is difficult not to read the book seeking to understand the man – the musician, the economist (or is he a forecaster), the businessman and the economic technician.   Greenspan uses the term economist and forecaster in ways that seem fully synonyms.  I can only wonder how many people in his position would see things that way.  Typically, I guess they don’t but I found it an honest recognition of the main economic role of leading a central bank. 

For Greenspan, there is also small gap between the forecaster and the businessman.  His business, Townsend-Greenspan & Co, was industry forecasting so he had to delve into the details of markets such as oil, natural gas, coal, pharmaceuticals.  I remember learning about price elasticity of demand and about the challenge of estimating it.  As I recall it, the example that Samuelson’s textbook mentioned was the elasticity of the global demand for oil.  Here is someone who saw that challenge from the first row.  Greenspan admits getting his estimates about the oil consumption after the rapid escalation of oil prices in 1973 off the mark.

The interest in the detail of the economic forecaster is evident through the book.  There is a fair amount of slicing and dicing of US statistics to understand the underlying reality.  I was particularly interested on (I believe) his development of an indicator of a time series of maturity of GDP and his use to measure the degree of risk aversion in the economy.  Another example that caught my attention was the use of patent data to measure productivity.  The examples could be particularly useful to any Central Bank analyst looking for innovative ways to analyse the economy.

In terms of banking regulation, Greenspan acknowledges – not surprisingly – that regulatory capital requirements were too low before the crisis.   His analysis suggests an increase of regulatory capital from 10% before the crisis in terms of book value to 13% and 14% in 2015.  Greenspan is also clear that designating banks as “systemic” is simply enhancing their ability to fund themselves at a lower cost.  Greenspan quotes IMF estimates of 40 to 80 basis points funding advantage, which, as he also points out, is a significant advantage in a competitive financial market.

The books also looks beyond financial regulation to wider economic issues around productivity and the rise of entitlements culture, which makes for an interesting reading.  I would recommend it to post-graduates that want to develop an appreciation of the breadth of economic thinking and analytical skills that can be accumulated over a lifetime, even if you do not necessarily share every idea or conclusion.

As I completed reading the book, I still had not found an explanation for the rationale of the ‘map and the territory’.  I had a few hypotheses but nothing.  I was worried that I might have missed something fundamental about the book.   I was reassured to find references to maps in the inside cover of the book. 

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The Godfather of Freakonomics has passed away

Last week it was announced that Gary Becker had passed away.  He formulated his economic career around the application of the tools of economic analysis to broader social issues like human capital, crime, racial discrimination and family.  This wider application of economic analysis makes him the godfather of Freakonomics.  As a recognition for his research contribution, he received the Nobel Prize in Economics in 1992.

Becker’s Nobel lecture provides a good overview of his work and how he extended the traditional analysis of individual rational choice by incorporating a much richer class of attitudes, preferences, and calculations.  In this lecture, he also shared his inspiration to apply the tools of economic analysis to crime.  He was driving to an examination and was late.   He realised that to arrive on time, he would need to park his car and risk a parking fine.  He knew that enforcement was patchy so there was a chance of not getting a fine.   He made a decision to risk a fine.  The private benefits exceeded the costs!     

Understanding these cost-benefit considerations and non-market interactions matters to economic and social policy.   As he aptly said in one of the speeches at the Nobel Prize award:  “the widespread poverty, misery and crises in many parts of the world, much of it unnecessary, are strong reminders that understanding economic and social laws can make an enormous contribution to the welfare of people.” 

Daniel Finkelstein wrote an interesting article in The Times in which he stressed Becker’s contribution to the world of economics, by emphasising that economics is much broader than understanding how money moves in the economy and that it’s about: “understanding people’s incentives, and structuring social institutions in response to them”.  

When I studied economics, I don't think I appreciated the extent of this imbalance. Furthermore, there is a lot to be done and said to address it beyond the scope of this post.  Though I am with Becker that this is not about re-inventing economics and abandoning rationality, or as he put it eloquently: "no approach of comparable generality has yet been developed that offers serious competition to rational choice theory".  The key test is the generality of the predictions that arise from rational choice.   

So the Godfather of Freakonomics is not with us anymore.  Finkelstein summed it up much better:  “The world has lost one of its great thinkers.  Fortunately, we still have the power of his thoughts.”

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More on the ‘C-factor’ in Regulation: Business Model Analysis

Business model analysis (BMA) is one of those terms that are becoming common currency in regulatory discussions, hence the reference to a ‘c-factor’ or common factor in an earlier post (here).  

The PRA published a useful article in the Bank of England March Quarterly Bulletin setting out how they intend to apply BMA to insurance.  It suggests that there are two aspects to a BMA.

Firstly, there is a company dimension, which is obviously not spelt out in great detail for the obvious confidentiality reasons.  In general terms, this would recognise that:

• there is an ‘inverse production function’ in insurance – the fact that insurers collect premium before the service has been delivered and can earn an investment return until claims are paid; and
• insurers must price the product without full knowledge of production costs – hence the ‘experience analysis’ of reserves.

Secondly, there is a market dimension, which recognises that a business model is not static and will respond to changes in regulation, culture, society and technology.  This is evidenced in the article by reference to two developments:

• price comparison web-sites in the UK motor industry; and
• non-standard annuities.

Overall, the PRA sets out a helpful and clear vision about BMA:

‘The PRA’s capital requirements help to make insurers resilient against short-term shocks.  But to be confident that insurers will remain viable over the longer term, the PRA needs to know whether an insurer’s profits are sustainable.  In other words, the PRA will need to analyse the risks of an insurer’s particular business model.’

I found quite remarkable and refreshing to see this level of clarity from supervisors. 

The recent UK budget announcement about removing the requirement for compulsory annuitisation will provide wide ground to test the practice of BMA from a regulatory perspective and, probably, from a company perspective as well.

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Risk and Compliance Management: Horizons for 2014/15

The UK’s FCA published recently its Risk Outlook and its Business Plan for 2014/15.  They provide a useful indication of the breadth of the regulatory challenges and evidence of a top-down approach to address them. 

The structure of the Risk Outlook is similar to last year’s.  The inherent risk factors such as information asymmetries, do not change overnight unlike the economic and market environment.  The main aspects of the changing market environment that caught my attention were:

1.    the continuing household indebtedness reflecting the growth of unsecured lending, mainly credit card, and forecast increasing household leverage (Figures 6, 18 and 19 of the paper);

2.     lenders’ forbearance in the mortgage market, supported by low interest rates; and the FCA concerns about the cost to consumers (fees and accrued interest);

3.     the stable and risky profile of mortgage lending; about 40% of mortgages have high-risk features – LTV in excess of 90%, loan to income ratios in excess of 3.5 and terms in excess of 25 years (Figure 22);   

4.     the differential impact of increasing interest rates (mortgage customers, those accumulating wealth and near retirement and those considering an annuity purchase).

The FCA then translates these observations into statement about risks.  Again, the ones that caught my attention were:

1.     the challenge of making ‘appropriate’ profits; for example, making profits from non-core activities could undermine fair treatment of consumers or financial crime responsibilities; for insurers, this could manifest itself in the response to the Retail Distribution Review and moves to direct sales;

2.     the implications of short term cost-cutting strategies materialise as demand starts to grow and could result in poor management of firms’ back book;

3.     the adoption of technology may not be supported by adequate systems and controls or expertise; this could manifest itself on insufficient spending on existing technology or the use of big data without appropriate controls;

4.     plans to mitigate the risk of failures do not give adequate consideration to conduct implications such as in respect of the changes to terms and conditions in stress conditions.

The Business Plan then identifies priorities for the key sectors.  For life insurance, the priorities appear to be:

1.       suitability of products and services sold;

2.       fair treatment of the back book;

3.       the governance of with-profits funds.  

Interestingly, the FCA business plan also reflects new responsibilities which include supervising 50,000 firms in respect of consumer credit, enforcing competition law, implementing changes to the approved persons regime and the establishing a new payment systems regulator.   

All in all, it’s going to be a busy 2014/15 for everyone.

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