Saturday, February 07, 2009

Cedar's digest guide to the financial crisis

Ok, so, I am trying to post something every week now.  We'll see how long that lasts.  This week, a collection of thoughts and links on our financial crisis, with a psychological approach.

For beginners, or people interested in seeing a quick visual way of looking at how things went down, take a look at the long flow chart over at FlowingData.  I like it that it is a timeline, which includes both events and quotes.  I am sure that it simplifies some complex issues, but it is overall pretty good introduction.  Another excellent introduction is, amazingly enough, from This American Life, on NPR.

Second, I have been thinking a lot about Jared Diamond's book, Collapse, in relation to the financial crisis.  The book tracks the collapse of different civilizations, from the Anasazi, to Easter Island, to the Scandanavians in Greenland, to modern day Rwanda.  One of the central themes of the book is that people do not plan ahead.  Period.  Across cultures, across times, climate, weather, whatever.  If there is a 5 year period of great rains and crops, people feel great, they have more children, then, when it is followed by a 10 year drought, thousands (if not millions) of people die, whether by starving, or by killing each other.  This same pattern is evident in the way that the financial industry calculated and assessed risk (see NYTimes Mag on risk and VAR).  In short, the complex statistical model that was used, only used a few years in the past, and had no way of predicting how big the risk was (it could predict with reasonable accuracy 95% of the time, but it had no way of predicting how big the gain or loss could be the other 5%).  The other problem with the model was that it became the industry standard.  For an industry that purports to solve problems with competition, no one seemed to see anything wrong with a monopoly of risk models.  If competition and diversity is good, they should be good there too.

What about the psychology in these economic events?  I think it is most useful to apply what we know about psychology to three particular phenomena.  First, the securitization and separation of the mortgages from a relationship between lender and borrower to one between a complex and dispersed network of investors and a borrower.  Second, the attack on "corporate greed" and executive bonuses.  Finally, what to do in the future.

When the mortgages started getting sliced and diced and sold as securities, and later more like bonds, it effectively transformed something that was long term and low risk into something short term, with varying levels of risk (the NYRB has a good review of the history of this: Jeff Madrick on "How We Were Ruined and What We Can Do").  Combined with all of the de-regulation of the 90's, form my perspective, the chief effect of doing this was that a long-term loan now became a short-term security.  In doing this, it was in everyone's best interest to prop up the housing market, and in no one's best interest to evaluate the long term.  I think psychology research (and Diamond's book too) show that people do not need help reacting to short term incentives (there are various cognitive biases which show how our memories are short, our decisions are based on more recent events far more than they should be, etc), but what we need government, or rules, or groups of reasonable people to do, is help us keep our long term interests in mind.    The financial system was in effect an echo chamber for our worst short term impulses. 
This leads me to attacks on corporate greed, and the hubbub over executive bonuses (and bonuses in general) on Wall Street.  I think to label it greed is counterproductive, and seeking to "punish" the leaders of these companies is distracting from the real issue.  Punishing the people, and ignoring the incentive structure that drove their decisions, will just get us into this same mess again.  So, what were their incentives?  The "efficient markets hypothesis" would say that the stock price is all the incentive a company needs, and that things will work themselves out.  This is clearly not the case.  So what was the problem?  Was it a few greedy nakers who took too much risk and got caught gambling with more money than their companies had?  No, it was an entire industry that was encouraged to gamble.  We should have realized this with Enron (and many did, despite the "no one could have seen this coming" attitude that Greenspan et al take now).  When everything that the company was evaluated on was tied to the stock price, the very smart Enron people (Andrew Skilling especialy) figured out how to effectively make the stock price go up (again, mostly in the short term) without actually doing much else (i.e. generating anything else of real value).  Saying that they got personally rich misses the point, just as it does in the current situation.  The bankers, and the companies they ran, were only looking in the short term, because that is what the system they were in supported, in addition to the fact that this is the way people think.  Rather than attack corporate greed, or 40,000 dollar toilets, or whatever, I would hope that we would realize that this isn't just a few bad apples, or even a bad tree or two, but bad soil we are talking about here.

So, the future.  I have tried to learn enough about our money system to figure out what the proposed solutions are, but I haven't heard enough talk about the above in stark terms; that what supported this mess was a massive reliance on short term strategies, and in the market's ability to police itself.  We don't just need more effective policeman (to prevent future Madoff's) but we need an enitrely different incentive structure.   I can accept that entirely nationalizing the whole financial system might not be optimal, but neither is a situation where we have individual banks and bankers taking risks that they know will be insured by the federal government if they fail, but if they win they get the profits.  It seems like when talk gets to the terms of some of these deals, there gets to be some concern that if the deal isn't good enough, if there aren't enough incentives for the companies to participate, they won't want to, so we need to make the terms good enough for them.  I have been disappointed in is that no one takes the next step and says, well, the current incentive structure has gotten us into this mess, why are we still acting as if it works?  This smart guy (Sal Khan, he has over 700 youtube videos explaining math, finance, physics, and programming) has proposed that maybe the entire financial system is corrupted, and it might be cheaper and easier to invent an entirely new one.  In other words, the point of the financial system is to move money from people who don't need it right then (savings, investments, etc), to people who do need it (startup businesses, building projects, etc).  Why not invent a new system, knowing what we do now?  Sounds crazy, but I think that is a good start.  Recognizing that the system is fundamentally bankrupt, not just a few bad apples.  Michael Lewis and David Einhorn in the NYTimes
have a good long op-ed that I think everyone should read.
So, this post is far too long, obviously, but I think approaching the financial crisis like a psychologist yields the following insights: A) the bankers were not greedy and evil, just acting according to the incentives that were in their situation, B) to fix the situation, we will have to change these incentives, not just the personel, and weeding out "good" banks from "bad" banks.

Some other random links that I have found interesting about this: What a modern depression would look like... from the Boston Globe.
A brief piece about why money has no value, from Patrick Rhone.  I have been thinking about this idea more and more too, and how the financial crisis makes it more apparent what things have real value including obvious things like food, shelter and family and friends, but also less obvious things such as skills of making stuff that people can actually use.  As things become more and more expensive to get from China, a lot of things that were once disposable (like, say, shoes) now need fixing.

Thanks for tuning in.  Next post will be a light one, about how to get more out of twitter, or, for those of you who would never join in a million years, what the big fuss is about.

3 comments:

Christian said...

Cedar, I would like to present an alternative theory to our current mess. Given your preference for government to solve this problem, you may find these theories crazy. However, I would ask that you take the time to study them. While you correctly name corporate greed as part of the problem you ignore the one entity which makes this robbery possible: the State.

You can find an introduction to the Austrian Theory of the Business Cycle at this link:
http://mises.org/story/3128

If you wish to learn more about the State, i.e., what it is, how it functions, and its purpose, I would recommend this article:
http://mises.org/easaran/chap3.asp

Sam said...

I thought that Cedar said that pointing at greed as part of the problem is missing the point. And I agree. You're right, people will act in a way that reaps rewards. Interesting suggestion to revamp the incentive system.

Cathy said...

Cedar,
I wonder if you have thought about applying a number of these theories to what is going on in education reform. The focus on less oversight,( here in DC Mayoral takeover of both state and local functions) fewer regulations,(emphasis on charter schools that have more freedoms) a narrower measure of success ie the test scores. In addition top dollar salaries for results on these test scores. There has been very little discussion about a larger vision. This is too simplistic but begins to get at what we are seeing as the business models are imposed.

Cathy