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Global Crisis Blog

Dear Ben, Yes You SHOULD Have Seen It Coming,

And Yes, You CAN Prevent the Next One

By Shlomo Maital


NASA Rocket:  Here comes the next bubble!!

Memo:  to Prof. Ben Bernanke, Chairman, Board of Governors, U.S. Federal Reserve:

From: Shlomo Maital

Prof. Bernanke, I’m an over-the-hill former economics professor, who spent 20 summers teaching economics at the place you got your Ph.D.,  M.I.T.     I admire the quality job you’ve done, battling to limit the consequences of the Crisis.  What good fortune the Fed head is a scholar who knows what massive destruction a Depression can cause, and why we need to use everything we have, and then some, to forestall it.

But Ben, may I call you that?  I still find your statement made on Monday Nov. 16, 2009, rankling. You said, exact quote, “It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value.”   In other words:  We can’t predict bubbles, we can’t tell when a bubble is happening, hence, we can’t take vigorous action to prick them.

I know what you mean.  In the end, there IS no fundamental value of an asset.  Its value is based on supply and demand, and demand is based on perception, including irrational exuberance, which at the time seems highly rational.

But Ben, it is neither extraordinarily, nor inherently, nor difficult, to detect a bubble.  What about a new paper by Prof. Jerome Stein, like me an emeritus economics professor, who makes the following case worthy of your close attention: [1]

The FED, IMF, Treasury and the market (including AIG and Citigroup) lacked the appropriate tools of analysis to answer this question:  what is an optimal leverage of capital requirements that at the moment balances expected growth against risk?  In other words, when are banks and other financial institutions over their heads in debt and in danger of collapse?   Stein uses a technique used to guide NASA rockets, known as  SOC stochastic optimal control (it optimizes the path of the rocket every milli-second, taking into account random disturbances and deviations).  Rocket trajectories are not unlike trajectories of banks and financial institutions like Lehman Brothers — subject to unexpected buffets, always checking if the capital structure is over-stretched or okay, always re-optimizing and re-evaluating.  (Goldman Sachs did this procedure, re-evaluating risk, every week or 10 days, and emerged more or less unscathed as a result).

Using SOC,  a strong warning signal is generated, showing when the optimal debt ratio (leverage) exceeds (or greatly exceeds) the actual debt ratio.  This is how to tell when a bubble exists.  Stein notes that “the excess debt starting from 2004-5 indicated that a crisis was most likely”,  using his tool.   In other words:  there were warning signals as early as 2004-5.   No wonder the Queen of England asked,  in Nov. 2008,  “Why did no one (i.e. no economist) see this coming?”.

Can we use SOC so that next time, economists will not embarrass themselves and their profession, and so that I need not go outdoors in disguise?


[1] A critique of Alan Greenspan’s Retrospective on the Crisis.   Applied Math dept., Brown University,  Jerome_Stein@brown.edu

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Blog entries written by Prof. Shlomo Maital

Shlomo Maital
July 2010
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