More on the Fischer Black Model
By Arnold Kling
Some more thoughts on Fischer Black’s model of business cycles, following up on my earlier post on Tyler Cowen’s piece.
1. Black thinks of us as living in a CAPM world. There is no reward for idiosyncratic risk (risk that could be diversified away). Instead, there is a diversified market portfolio, and there is a risk-free asset. When we have an appetite for risk, we hold more of the market portfolio and less of the risk-free asset. Good times are when we hold a lot of the market portfolio and conditions are right. (In my example, in an agricultural society we make large investments and the weather turns out to be good.) Bad times are when we hold a lot of the market portfolio and conditions are bad. (The weather is bad, and we wish we had just stored grain rather than making risky investments.)
2. The financial crisis appears to be idiosyncratic, rather than general. That is, it looks as if people did not buy the market portfolio. Instead, some people over-invested in houses, and some institutions over-invested in risky mortgage loans. One could argue that the risk was spread ex post by the government, with all the bailouts.
3. Cowen’s argument, however, is that this apparently idiosyncratic nature of the risk is deceptive. In fact, you should think of the crisis as, to a first approximation, bad times for the market portfolio. Everybody wishes, ex post, that they had put more into safe assets and less into the market portfolio.
I have a number of problems accepting this as a story for the current crisis. Among the problems I have is that I cannot pinpoint the real shock at work–the shock that would be analogous to bad weather in an agricultural economy.