Paul Romer wants to make sure that we understand the importance of Elinor Ostrom’s “work on one of the deepest issues in economics”:
Skyhooks versus Cranes: The Nobel Prize for Elinor Ostrom. by Paul Romer: Most economists think that they are building cranes that suspend important theoretical structures from a base that is firmly grounded in first principles. In fact, they almost always invoke a skyhook, some unexplained result without which the entire structure collapses. Elinor Ostrom won the Nobel Prize in Economics because she works from the ground up, building a crane that can support the full range of economic behavior.
When I started studying economics in graduate school, the standard operating procedure was to introduce both technology and rules as skyhooks. If we assumed a particular set of rules and technologies,… then we economists could describe what people would do. Sometimes we compared different sets of rules that a “social planner” might impose… Crucially, we never even bothered to check that people would actually follow the rules we imposed.
A typical conclusion was that rules that assign property rights and rules that let people trade lead to good outcomes. What’s the skyhook? That people will follow the rules. Why would they respect the property rights of someone else? … We might have had in mind something like this: police officers will arrest people who don’t follow the rules. But this is just another skyhook. Who are these police officers? Why do they follow rules? … Elinor showed that there are lots of important cases where people follow rules about ownership without police officers. One of the central challenges in understanding failures of economic development is that in many places, police officers don’t follow the rules they are meant to enforce.
Elinor’s fieldwork, followed up by her experimental work, pointed us in exactly the right direction. To understand BOTH why we don’t need police officers in some cases AND why police officers don’t follow the rules in other cases, we have to expand models of human preferences to include a contingent taste for punishing others. In reaching this conclusion, she … spelled out the program that economists should follow. To make the rules … emerge as an equilibrium outcome instead of a skyhook, economists must extend our models of preferences and gather field and experimental evidence on the nature of these preferences.
Economists who have become addicted to skyhooks … think that they are doing deep theory but are really just assuming their conclusions… If we fail to explore rules in greater depth, economists will have little to say about the most pressing issues facing humans today – how to improve the quality of bad rules that cause needless waste, harm, and suffering.
Cheers to the Nobel committee for recognizing work on one of the deepest issues in economics. Bravo to the political scientist who showed that she was a better economist than the economic imperialists who can’t tell the difference between assuming and understanding.
Related Article:
Ostrom & Williamson Win “Ironic” Nobel in Economics by Barry Ritholtz
Unintended Consequences
Before I knew anything about the finance industry, if someone had thrown out the name “Blackrock” I would have conjured up a scene from the Wild West, a cattle rancher hiring a gunslinger to roust out the sheep farmers and take control of the town. But now, of course, I know that BlackRock is a financial behemoth with $1.5 trillion in assets under management — soon to be over $2 trillion due to its purchase of Barclay’s asset management business. But of more note than its asset footprint is the mantle BlackRock is gradually assuming as the arbiter of value.
BlackRock won a set of contracts to provide analytics for the New York Fed’s trillion dollar mortgage-backed purchase program. Now, BlackRock may end up with an NAIC contract to analyze the mortgage-backed securities in insurers’ portfolios.
I do not mean to diminish BlackRock’s laudable role in assisting in many ways with the financial crisis – coming forward when a number of other large firms demurred. But as one contract is piled on another, their models will become the standard for pricing mortgages, complex derivatives and structured products. Unlike the money management business, which is competitive and relatively transparent, this is a monopoly ready for the making. A monopoly because the more institutions, industry associations and regulatory bodies that employ their services, the more they become the de facto standard. Over time, auditors, clients and equity holders – perhaps even regulators – will start saying, “Well, it is nice to see what your internal models have to say about your portfolio value, but we want your portfolio benchmarked using the BlackRock model.” A BlackRock seal of approval; BlackRock, the JD Powers of portfolio quality.
Here are the problems with this:
First, of course, is the well-known issue of allowing a private enterprise to have monopoly control of a utility – in this case a de facto replacement of the rating agencies (not a bad thing in itself) by putting one firm in the position of providing the benchmark pricing of financial products. Second, there are natural conflicts of interest given that BlackRock is also the asset manager for the New York Fed’s Maiden Lane portfolios and has raised over half a billion in private capital to purchase legacy securities as part of PPIP. (Though I should add that BlackRock is aware of this issue and has stated the firm has strict internal controls preventing any valuation services from being gamed by its investment arm. Which should make us all feel a lot better).
But the most critical problem is that its approach is at variance with the broadly held view that we need to have transparency in the derivatives markets because, unlike, say, RiskMetrics, BlackRock does not share the specifications of the models it employs. We don’t really know what these models are doing. Valuations based on a black-box BlackRock model, or, for that matter, anyone else’s black box model, do not get us the transparency we need. I don’t care what a trading desk uses for its decision making, but when it comes to valuations that carry beyond the firm, we need to be able to see and critique the models that are being used. If a model is to become a standard, if it is going to be used for regulatory or other benchmarking purposes, it should be transparent and subject to peer review.
Which gets to a simple point: If we want to go down the path of standardized valuation and comparability in these complex portfolios, we need open derivatives models. One thing we should have learned from the rating agency debacle is that even if we put aside the issues of monopoly power and conflict of interest, we cannot stop with having the proprietor of such models say, “Trust me, I know what I’m doing.”
Originally published at Rick Bookstaber’s Blog