Wednesday, January 6, 2010

"naive extrapolation and collective magical thinking"

To continue the theme of our (cultural?) inability to learn from past mistakes, I think it is important to remember that we learn in order to get on successfully in a world that initially strikes us as the "blooming, buzzing confusion" described in Chapter XIII of William James' The Principles of Psychology. From this point of view, we are best informed by that sentence in Henry Miller's Tropic of Capricorn: "Confusion is a word we have invented for an order which is not understood." Ever since James we have tried to deal with how our mind deals with confusion by seeking patterns through which it may "understand," in Miller's sense of the word, an order that must be present.

An excellent example of such pattern-seeking behavior may be found in the column John Kay wrote yesterday for the Financial Times under the title "The Cause of our Crises has not Gone Away." Given where the column was published, one quickly recognizes that the "crises" he has in mind are economic, rather than matters of ethics or "homeland security." The logical strategy of his article involved situating current conditions in a historical context and then seeking out patterns in that broader historical view. His results are, to say the least, striking:

The credit crunch of 2007-08 was the third phase of a larger and longer financial crisis. The first phase was the emerging market defaults of the 1990s. The second was the new economy boom and bust at the turn of the century. The third was the collapse of markets for structured debt products, which had grown so rapidly in the five years up to 2007.

The manifestation of the problem in each phase was different – first emerging markets, then stock markets, then debt. But the mechanics were essentially the same. Financial institutions identified a genuine economic change – the assimilation of some poor countries into the global economy, the opportunities offered to business by new information technology, and the development of opportunities to manage risk and maturity mismatch more effectively through markets. Competition to sell products led to wild exaggeration of the pace and scope of these trends. The resulting herd enthusiasm led to mispricing – particularly in asset markets, which yielded large, and largely illusory, profits, of which a substantial fraction was paid to employees.

Eventually, at the end of each phase, reality impinged. The activities that once seemed so profitable – funding the financial systems of emerging economies, promoting start-up internet businesses, trading in structured debt products – turned out, in fact, to have been a source of losses. Lenders had to make write-offs, most of the new economy stocks proved valueless and many structured products became unmarketable. Governments, and particularly the US government, reacted on each occasion by pumping money into the financial system in the hope of staving off wider collapse, with some degree of success. At the end of each phase, regulators and financial institutions declared that lessons had been learnt. While measures were implemented which, if they had been introduced five years earlier, might have prevented the most recent crisis from taking the particular form it did, these responses addressed the particular problem that had just occurred, rather than the underlying generic problems of skewed incentives and dysfunctional institutional structures.

The public support of markets provided on each occasion the fuel needed to stoke the next crisis. Each boom and bust is larger than the last. Since the alleviating action is also larger, the pattern is one of cycles of increasing amplitude.

There are two important conclusions to draw from these findings. The first is that, informed by a historical view, Kay concluded that the pattern resides not in the structure of the crises themselves but in "mechanics" that were repeated from one crisis to the next. The second is that each iteration of those "mechanics" leads to a crisis whose amplitude is greater than its predecessor.

Kay's conclusion is likely to aggravate just about everyone trying to make a living in the financial sector, with the possible exception of those who sail under the flag of what I have called "the Grameen School of thought," whose fundamental premise is that the financial sector should be based on a non-profit business model. His final sentence packs a real wallop:

In the name of free markets, we created a monster that threatens to destroy the very free markets we extol.

The nature of that monster is best captured by his brief speculation on how the next crisis might surface:

I do not know what the epicentre of the next crisis will be, except that it is unlikely to involve structured debt products. I do know that unless human nature changes or there is fundamental change in the structure of the financial services industry – equally improbable – there will be another manifestation once again based on naive extrapolation and collective magical thinking.

In other words the entire financial sector rests on a foundation of illusion; and, while Niall Ferguson argued that case that such illusion was a necessary prerequisite for progress, Robert Skidelsky saw it as a sign of regress in the development of a society more ingenious at making money than at making things. To bring this distinction to Main Street, the very fact that our financial institutions have, for all intents and purposes, "recovered" from the crisis while the resulting unemployment crisis shows no similar signs of recovery can be attributed to the proposition that ours is no longer a country with a significant commitment to "making things." Furthermore, we cannot expect either the Executive or Legislative branches of government to confront this problem, because ours is an age in which those who make money have radically more influence than those who make things. From this point of view, the financial sector may very well barrel its way into its next crisis before the rest of the country has recovered from the present one!

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