Larry Summers has dropped out of the race for Fed chair — and the stock market has rallied! The irony should be noted, of course, because Summers has come to exemplify the Panglossian Wall Street liberal of the Clinton era and, one would hope, with the rather dramatic capsize of his political boat amidst a storm of opposition such an archetypal figure is now fading into the dusk; a dinosaur, from more primitive and regretful years, now long since past.
I will not, however, engage in a screed against Summers’ questionable career trajectory, his dubious opinions of women or anything else which I’m sure more capable people than me are eulogising on today now that Summers has, in a sense, passed on. Rather I would prefer to turn to a paper that Summers co-wrote in 1990 entitled Noise Trader Risk in Financial Markets. This paper, I think, gives us insight into the mind of the Panglossian Wall Street liberal of the Clinton era as it was in the process of formation.
The paper, as the title suggests, is part of the “noise trader” literature and is generally associated with the so-called New Keynesian school. The noise trader literature builds on the well-known Efficient Markets Hypothesis (EMH) literature and, in characteristic New Keynesian style, adds some frictions. The idea of “noise” lying behind the noise traders’ views, commonly associated with the name Fischer Black whose bogus nonsense I have written on before (here and here), basically states that markets cannot exist without noise because otherwise nobody would trade. Here is Black from his characteristically poorly written paper Noise:
Noise makes financial markets possible, but also makes them imperfect. If there is no noise trading, there will be very little trading in individual assets. People will hold individual assets, directly or indirectly, but they will rarely trade them.
The noise trader theorists then build models in which those traders that are trading on noise — which is effectively “bad information” — get the upper hand and, through a sort of process of intimidation, drive the typical EMH trader out of the market causing all sorts of chaos. Thus we have a sort of Gresham’s Law dynamic: bad traders drive out the good. The moral overtones so typical of theories based on mainstream microeconomics should be noted, and noted well. (It is also pallid nonsense based on the poor use of metaphor, as I have pointed out before).
The noise trader theory, however, is only used to show frictions in otherwise harmonious markets. Although the paper in question does entertain the idea that noise traders might take over the market and even that “rational” investors might then spend their time trying to anticipate said noise traders, the story is still a goodies and baddies narrative in which it is only when the baddies win out entirely that the market can become unstable. The proof, of course, is in the pudding: Summers only a few years later became a zealous and infamous deregulator, crushing those who disagreed with him, thus proving beyond a shadow of a doubt that the noise trader theories were constructed to describe only minor deviations and “special cases”.
Thus, since the general case in financial markets, according to the New Keynesian Panglossians, is that they should be fit and healthy, it is assumed that noise is an exception that will not spread too far. One can clearly see this in the blog post Summers’ co-author of the paper in question Brad Delong published in the wake of 2008.
Among the things that Delong says that he was not expecting from the crisis were “the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn”; “the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one”; and “the panic flight from all risky assets – not just mortgages – upon the discovery of the problems in the mortgage market”.
Put simply, Delong assumed that were there noise in the financial markets, at the end of the day such noise was probably just a small ripple on an otherwise calm ocean. Even if housing did take a downturn in the late-00s the assumption that not just Delong but basically all New Keynesians made was that, since the rest of the components of the financial markets were efficient and thus robust, there would be no serious crisis. This would be forgivable perhaps, if one ignores the many crises that had arisen during the Clinton years — such as the East Asian crisis, the Russian debt crisis, and the implosion of Long Term Capital Management and the subsequent bailout.
Summers and many of his colleagues have, of course, had their Road to Damascus moment and have come to see the light — but only gradually, as Summers was the key figure in the Obama Administration blocking a larger and much needed bailout after the crisis. But in their conversion their legacy, as indicated by Summers’ fall from grace, may already be fading — and fast. Their contributions proved to be not merely irrelevant to real-world economic conditions, but potentially blinding myths responsible in part for the deregulatory zeal of the Clinton years — deregulation that is now proving so hard to reverse.
When Summers stands in front of those pearly gates I truly hope that St. Peter forgives him and lets him in, because it appears that us mere mortals here on earth have no such capacity to do so. Rest in peace, Lawrence Henry Summers.