Jordan Ellenberg

[digg-reddit-me]The bankers – whose enormous salaries were earned based on their skills at judging risk and making money – caused a financial cataclysm because they disastrously misjudged the riskiness of the complex financial instruments they created and sold.

This was the lesson I learned in the immediate days after the financial crisis – and it still explains a great deal of what happened. (Of course, there was also a good deal of outright fraud and the perversity of short-term incentives in which bankers could profit exorbitantly if they made profits regardless of how their investments turned out over the long-term.)

Cognitive errors may have contributed to the misjudging of risk. Megan McCardle for example gave a compelling description of different cognitive errors which contributed to the financial crisis – including the recency effect which she describes:

People tend to overweight recent events in considering the probability of future events. In 2001, I would have rated the risk of another big terrorist attack on the US in the next two years as pretty high. Now I rate it as much lower. Yet the probability of a major terrorist attack is not really very dependent on whether there has been a recent successful one; it’s much more dependent on things like the availability of suicidal terrorists, and their ability to formulate a clever plan. My current assessment is not necessarily any more accurate than my 2001 assessment, but I nonetheless worry much less about terrorism than I did then.

These cognitive errors were so damaging because they were programmed into the models for minimizing risk that the “quants” created to divvy up mortgages and just about everything else that could be bought and sold.

Michael Osininski tried to claim some share of the blame in a recent New York magazine article – as one of the top “quants.” Osininski described how he had an inkling of the disaster ahead:

[T]he world I had helped create started falling apart. I hadn’t anticipated it, but at the same time, nothing about it surprised me.

Last month, my neighbor, a retired schoolteacher, offered to deliver my oysters into the city. He had lost half his savings, and his pension had been cut by 30 percent. The chain of events from my computer to this guy’s pension is lengthy and intricate. But it’s there, somewhere. Buried like a keel in the sand. If you dive deep enough, you’ll see it. To know that a dozen years of diligent work somehow soured, and instead of benefiting society unhinged it, is humbling. I was never a player, a big swinger. I was behind the scenes, inside the boxes. My hard work, in its time and place, merited a reward, but it also contributed to what has become a massive, ever-expanding failure.

Jordan Ellenberg described how these models that purported to minimize risk actually just compressed the risk into “one improbable but hideous situation” in a manner similar to that of the 400 year old sucker bet, the Martingale. For example, Wall Street bankers combined hundreds of mortgages into securities in the belief that while some of the mortgages might default – most would not. The more mortgages you combined, the safer the investment was – as only a small percentage of mortgages typically defaulted. Unless something went very wrong. Comparing Wall Street bets to the Martingale, Ellenberg described the bet Wall Street was making:

(0.99) x ($100) + (0.01) x (catastrophic outcome) = 0

Wall Street bankers thought that the collective assets they were trading were worth $99 each in this estimate – rather than $50 as they would be if each asset were judged individually.

One of the few people who saw this misjudging of risk as the inevitable cause of a financial crisis was Nassim Nicholas Taleb who wrote that Wall Street had consistently ignored the possibility of what he called “Black Swans” and what Ellenberg described as an “improbable but hideous situation.” Taleb has placed a great deal of blame on the mathematical models used by the quants and on the hubris of the bankers and traders who believed that they were created wealth when they were instead building an elaborate house of cards.

While he was running his own hedge fund in the 1990s, he turned his own knowledge of his lack of knowledge – and others’ lack of knowledge – into enormous profits. It came at the expense of losing a little money 364 days of the year – but making enormous profits in that one remaining day. He would bet on market volatility – which he understood financial firms repeatedly underestimated.

Taleb was castigating Wall Street barons for years as they hubristically bet greater and greater sums of money – making leveraged bets that the market would continue to rise.

Taleb’s key insight is that we know very little of the world itself – and will be more often fundamentally wrong than right. The example he uses is the Black Swan as described by David Hume:

No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.

This fundamental unknowability of the world must inform our actions, and perhaps points to some solutions. Taleb himself recently wrote a list of steps we should take to create a world more resistant to Black Swans. But his overall philosophy insists that we must attempt to resolve this crisis by tinkering with different solutions, and seeing what works, while being mindful that our actions will inevitably have consequences we do not imagine. And remember – at any point – a black swan could come around and reshape our world suddenly – as 9/11 did, as the assassination of the Archduke Ferdinand to start World War I, as did the invention of the personal computer, as has this financial crisis. The solution will not come from our determined application of fixed ideas, but by our openness to the possibility that we may be wrong, even as we are determined to act. We must see the shades of gray and acknowledge that we do not fully understand the world, yet still act – tinker, if you will.

In this, Taleb seems to have reached a philosophical end point similar to the famous libertarian economist Friedrich Hayek who in his Nobel Prize speech explained that “we needed to think of the world more as gardeners tending a garden and less as architects trying to build some system.”

To tinker, to garden, to nudge – all of this points to a more modest liberalism, a market-state liberalism.

[Image courtesy of robokow licensed under Creative Commons.]

[digg-reddit-me]Like a lot of people, I’ve been struggling to understand this financial crisis over the past few weeks. I don’t pretend to be an economic expert – I’ve always been more interested in foreign policy, politics and history – but the issue of this crisis is obviously so important, it seems that it is everyone’s responsibility to find out what went on, what caused this.

I also feel that this is an issue which is confusing our politics, our partisan impulses. Both the right and the left have many reasons to hate the bailout – yet the pragmatists on both sides agree that something must be done. Everyone is angry. Very few predicted this. I only came across a few who prominently warned about a crisis such as this – subscribers to the Austrian school of economics such as Ron Paul; liberal capitalists such as Warren Buffet and George Soros; and economists like Nassim Nicholas Taleb.

This crisis has succeeded in confusing ideological categories – which is probably part of the reason it has spwarned so many interesting and non-ideological takes, as people struggle to understand these momentous events in terms they are familiar with. (Here’s one ingenious example.) On the whole, Republican politicians instinctively trusted the market and although some attempted to reign in Fannie Mae and Freddie Mac, they saw no imminent threat to the financial system. A few Democrats saw the need for more oversight to prevent excessive risk-taking that might endanger the financial system; many more Democrats (especially as the party in Washington is dominated by neo-liberals), didn’t see the profit in warning of an unknowable future catastrophe. Those financial firms whose main purpose was to minimize risk and maximize profit accomplished this by reducing the risk of any individual transaction while placing greater and greater stress on the system – trading many small risks for a giant catastrophic risk. But theyse firms didn’t know this because the entire system was opaque and oversight was minimal. As long as things were going well, there was no reason to figure out what was going on.

Now, here we are today.

I don’t pretend to understand the cause or the cure of this crisis. But here are 10 things I’ve learned, 10 things worth sharing, in my attempts to figure out what’s going on:

The “real” Great Depression of 1873: “[T]he current economic woes look a lot like what my 96-year-old grandmother still calls ‘the real Great Depression.’ She pinched pennies in the 1930s, but she says that times were not nearly so bad as the depression her grandparents went through. That crash came in 1873 and lasted more than four years. It looks much more like our current crisis.” This depression also featured mortgage issues, a housing bubble, an emerging economy undercutting global prices (America instead of China), amd a lack of transparency leading banks to refrain from lending. From Scott Reynolds Nelson in the Chronicle of Higher Education.
The Martingale. Wall Street fell for a 400 year old sucker bet, the martingale. You always win in this betting game – as long as you can cover your losses. But once your losses are too great, this “double-or-nothing” game leads to catastrophe. The formula to understand this is simplified as:

(0.99) x ($100) + (0.01) x (catastrophic outcome) = 0

In other words, playing for $100, there is a 99% chance that you will make at least $100 dollars playing this game. But there is a 1% chance of a catastrophic outcome. If you never stop betting, the catastrophic outcome is inevitable.
April 28, 2004. Stephen Labaton of the New York Times examines the SEC decision to relax regulations and create an exemption for the biggest investment banks (those with assets over $5 billion) that would allow them increase their leverage ratio, and borrow as much as 33 times their assets as Bear Stearns did. This made the big investment banks especially susceptible to any downturns, as if their overall investments declined by even 3%, they would lose all their assets.
Goldman Sachs always wins. David Weidner of MarketWatch explains how Goldman Sachs looks to come out of this crisis stronger – and why their political connections had nothing to do with it. (Really. It’s just a coincidence that their main competitors have been ruined, the institution they relied on most was bailed out, and the Treasury Secretary is a former CEO.)
Financial Interdependence. Which means that if one bank trips, the entire financial system falls down. Why? Because the key innovations of the past thirty years in the financial markets have been geared towards reducing risk. Often this was accomplished by spreading risk among many actors. An investor would borrow money to invest in some security; to hedge in case the investment went south, an investor would buy insurance; to hedge against the insurance company not being able to pay, they would purchase a credit default swap. Mark Buchanan described in a New York Times editorial how some economists had begun to create models of markets which projected the actions of many agents acting independently. As the economists allowed greater interdependence in these models: “The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a ‘phase transition’ akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.”
The American System. The American economic system is not and has never been pure capitalism. As Robert J. Schiller wrote:

No, our economy is not a shining example of pure unfettered market forces. It never has been. In his farewell address back in 1796, 20 years after the publication of Adam Smith’s “The Wealth of Nations,” George Washington defined the new republic’s own distinctive national economic sensibility: “Our commercial policy should hold an equal and impartial hand; neither seeking nor granting exclusive favors or preferences; consulting the natural course of things; diffusing and diversifying by gentle means the streams of commerce, but forcing nothing.” From the outset, Washington envisioned some government involvement in the commercial system, even as he recognized that commerce should belong to the people.

Capitalism is not really the best word to describe this arrangement. (The term was coined in the late 19th century as a way to describe the ideological opposite of communism.) Some decades later, people began to use a better term, “the American system,” in which the government involved itself in the economy primarily to develop what we would now call infrastructure — highways, canals, railroads — but otherwise let economic liberty prevail. I prefer to call this spectacularly successful arrangement “financial democracy” — a largely free system in which the U.S. government’s role is to help citizens achieve their best potential, using all the economic weapons that our financial arsenal can provide.

Americans may assume that the basics of capitalism have been firmly established here since time immemorial, but historical cataclysms such as the Great Depression strongly suggest otherwise. Simply put, capitalism evolves. And we need to understand its trajectory if we are to bring our economic system into greater accord with the other great source of American strength: the best principles of our democracy.
The Shadow Banking System. Existing alongside the regulated banking system is what is called a shadow financial system – including money market accounts, hedge funds, investment banks, and countless other financial creatures. This system was invented in order to avoid government regulation of various sorts. This crisis has been mainly but certainly not exclusively in this shadow system – and those regulated banks have been the big winners in all of this (aside from Goldman Sachs.) Even the remaining independent investment banks – Goldman Sachs and Morgan Stanley have chosen to be subject to greater regulation. Nouri Roubini speaking at the Council on Foreign Relations explained that the shadow banking system is on the verge of collapse because of their lack of transparency and because they took risks they would not have been able to if they were subject to regulation.
Market Fundamentalism. I am a person suspicious of fundamentalism of any kind – and perhaps that makes me more prone to see reflections of the true believers in Communism during the collapse of the Soviet Union in the true believers in capitalism during the current crisis. The difference of course is that we today are not in a pure capitalist system – which is at least part of what has prevented this crisis from destroying our economic system so far. The government shored up essential institutions and is taking various measures now to restore liquidity to the markets – from the bailout to the Federal Reserve’s unprecedented actions. But what is evident to most observers – that the market failed to regulate itself, that the market mispriced risk, that short term profits were prioritized over long-term value, that the actions of thousands of individual actors acting for their own best interest created a systematic risk – is not clear to market fundamentalists. They insist that it was the fact that the government was involved in the market at all that led to these risks – specifically in the form of Fannie Mae and Freddie Mac. They have a point – in that Fannie Mae and Freddie Mac were only lightly regulated in recent years, and that though they got into the subprime lending market late and were forced out by regulators early, they underwrote a significant amount of these loans during that time, and that these institutions were able to overleverage themselves because of an assumed implicit government guarantee. All of this is to say that Fannie Mae and Freddie Mac were part of the problem. They weren’t the first companies to be hit by the crisis; and other companies came quickly afterward. Perhaps it is because of my limited experience, but I haven’t heard any serious economists on the right or left pushing forward the theory that this was all Fannie and Freddie’s fault – only right-wing partisans trying to throw some political blame the Democrats’ way. What these market fundamentalists want to insist is that though even the remaining investment banks have taken themselves out of the shadow banking system and voluntarily subjected themselves to regulation, what we really need is less government intervention in the market. All this is based on the distinction between economic activities of the government as decided in a democracy by the people, which in market fundamentalism are inherently oppressive, and economic activities of private individuals and corporations, which are free. Which means that a single individual controlling hundreds of billions of dollars is freedom while a government of the people controlling a similar amount is oppressive.
Cognitive errors. Megan McCardle of The Atlantic has compiled a useful list of cognitive errors that seem to have played a role in the crisis – both in creating the conditions that led to it and in compounding it. For example, she discusses the recency effect:

People tend to overweight recent events in considering the probability of future events. In 2001, I would have rated the risk of another big terrorist attack on the US in the next two years as pretty high. Now I rate it as much lower. Yet the probability of a major terrorist attack is not really very dependent on whether there has been a recent successful one; it’s much more dependent on things like the availability of suicidal terrorists, and their ability to formulate a clever plan. My current assessment is not necessarily any more accurate than my 2001 assessment, but I nonetheless worry much less about terrorism than I did then.
The Black Swan. Nassim Nicholas Taleb is my kind of economist. The basis of his philosophy is that, “The world we live in is vastly different from the world we think we live in.” He advocates “tinkering” as our best mean to change the world – and his theory of the markets take into account many of the previous points. While he was running his own hedge fund in the 1990s, he turned his own knowledge of his lack of knowledge – and others’ lack of knowledge – into enormous profits. It came at the expense of losing a little money 364 days of the year – but making enormous profits in that one remaining day. He would bet on market volatility – which he understood financial firms repeatedly underestimated. Taleb’s key insight is that we know very little of the world itself – and will be more often fundamentally wrong than right. The example he uses is the Black Swan as described by David Hume:

No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.

This fundamental unknowability of the world must inform our actions, and perhaps points to some solutions. We must attempt to resolve this crisis by tinkering with different solutions, and seeing what works, while being mindful that our actions will inevitably have consequences we do not imagine. And remember – at any point – a black swan could come around and reshape our world suddenly – as 9/11 did, as the assassination of the Archduke Ferdinand to start World War I, as did the invention of the personal computer, as has this financial crisis. The solution will not come from our determined application of fixed ideas, but by our openness to the possibility that we may be wrong, even as we are determined to act. We must see the shades of gray and acknowledge that we do not fully understand the world, yet still act – tinker, if you will.
“Damn, it feels good to be a banksta!“