Felix Batista, an anti-kidnap specialist who has been credited with ensuring the freedom of hundreds of hostages was abducted as he stepped outside a restaurant to answer a phone call.

The increase in crime in Mexico, especially kidnapping, will have a very chilling effect on the relocation of America manufacturing and other businesses across the border.  American executives and managers are just not willing to take the risks to visit their plants there.

News of capital crimes in tourist areas will not help their tourist industry either. The recent story of dozens of gunmen storming a Holiday Inn in Monterrey and taking six hostages will cause a lot of vacancies throughout the country.

Failure to control the crime in Mexico will have a devastating effect on their economy. As it spills over our borders our citizens will demand increasingly stronger response.

We mortals pride ourselves as rational beings, but we act emotionally. We get attached to previous positions, and will discount or filter evidence rather than change our minds. We read the news for confirmation rather than information.  We are so inundated with information that we rely on emotional instincts to make quick decisions.

Our first instincts are emotional and we tend to then, and only then, rationalize our first decisions. I call this emotional rationalism. Marketers understand this very well.

When you add risk into our thought process we can become even more irrational. Risk is probability plus outrage or fear. Thus the chance of a 911 attack may be small but the outrage of that act may lead us to take extreme measures to prevent such an occurrence from happening again. We spend far more political capital to prevent gun deaths than deaths from swimming pools, which are far more common.

The Age of Reason did not stop wars and hatred; it just changed the institutions that expressed them. Anti-Semitism of the church simply became anti-Semitism in the halls of education and government. Hatred towards those who opposed established faith became even more bitter when it was applied to those who opposed established norms of reason.

Academic credentialism, as distinct from intellectual depth, is not immune to emotional rationalism. Academics will become attached to their theories even when they conflict with the realities of the world they attempt to explain. The world of experience will translate to the world of theory much better than the reverse. Once someone gets a theory in their head it is hard to get them to see the world objectively again.

Thus academics descended on Wall Street with sophisticated models to explain investment behavior. Long Term Capital, a hedge fund from the 1990’s was held in awe because of two PhD Nobel Prize winning economists on its board. Its first few years showed impressive results and helped it attract billions of dollars of capital. But Long Term Capital made bets on Russian bonds and went from a net worth of billions to bankrupt in a matter of a few months. In typical academic fashion the quants explained that the move on Russian bonds was a ‘25 standard deviation event’, so far outside the realm of a rational model that it could not be predicted.

A 25 standard deviation event is a way of saying the odds of this were as remote as getting hit by a meteor while playing the back nine at Augusta National. It is another way of saying that no rational person could be expected to have foreseen this. This is what happens when theory trumps experience. Our world is filled with the outcomes of ‘25 standard deviation events’.

But these same theories brought down a bigger house of cards only ten years later. Debt pools were assembled that were so complicated that when the underlying assets such as a mass of very crappy mortgages collapsed, the credit markets froze because nobody could figure out what any of these pools were worth. The reason these toxic assets are so hard to clean up is because our brightest accounting and financial minds cannot figure out what they are worth.

We still fail to understand the principles of probability and how our emotions filter and distort our reality. As Nassim Taleb notes in his book by the same name we are “fooled by randomness.”

We can discern the various probabilities of a specific outcome of a roll of a pair of dice, because the universe of outcomes is clearly limited and knowable. The same is true of guessing the chance of any combination of cards from one or multiple decks. Cards and dice are a world on known unknowns.

But making bets on the outcomes in the world of global finance is something wholly different. There is no limit to the combinations and outcome of hundreds of national policies, billions of investors, with millions of financial products, subject to the fears and exuberance brought by wars, inflation, and old fashion human greed. This is the world of infinite possibilities, the world of unknown unknowns. This is a world better served by a philosophical understanding of risk embedded in a world of experience than a delusional faith in theoretical models proposed by credentialed academics.

Yet we have still failed to understand this fundamental reason for our recent credit collapse and we are making the very same mistakes, only this time in the government sector. We still swoon for the sound of intelligence over experience.

A car ‘czar’ brags that he has no experience in the automobile business, but “business is business”. Steve Jobs at Apple was replaced by an executive from the soft drink business; Jobs was brought back- you can now Google the story on your iPhone.

In a subject as massive and as filled with unknown unknowns as global climates we are making bets with familiar delusional certainty and even declaring that the “debate is over”. I may not know which end of the test tube the cork goes into, but I would feel a bit better about reordering our entire economy and social structure based on a fifty year climate prediction if we could predict the weather next week.

Many blame the financial collapse on greed and capitalism, but these flaws have been with us forever.  As Thomas Sowell noted, blaming the financial collapse on greed is like blaming a plane crash on gravity; it is true but not a very useful description.

With some months to now reflect and study the causes of the credit collapse, we cannot hide the central role the government played in the disaster. Had Fannie Mae not guaranteed the crappy mortgages they could not have been assembled into vehicles earning AAA ratings and become acceptable to global investors on such a grand scale. We have been fleeced at the gaming table but the casino owners , the dealers, and the pit boss were all government bureaucrats. They just reserved the high roller tables for Wall Street.

As we watch and hope the government will reform the excess of Wall Street, we should be more concerned who will reform the excesses of government. We should ask how they plan to solve a problem by repeating the very same mistakes that caused it.

From StumblingOnTruth
Keep the Casinos Open
by Clifford S. Asness, Ph.D.

Excerpt:

Stepping back, nowadays the popular narrative is that this economic crisis was caused by Wall Street and derivatives. It was not. It was a real estate bubble caused by government, countless individual people, indeed Wall Street, and a bevy of other economic agents like mortgage and real estate brokers and a government-created oligopoly of underperforming rating agencies. Government was a prime culprit through the creation of disastrous GSEs, implementing politically correct social policy that warped the housing market, enacting land use restrictions in the bubble’s worst epicenters and, of course, promoting 20+ years of too-big-too-fail when it was not at all needed, including pursuing exceptionally easy monetary policy for years after the “dot com” bubble. Individuals contributed mightily through a get-rich-quick mentality (who doesn’t know somebody who quit a real job to flip houses?), over-spending, and short-sightedness. Financial firms of all types clearly pitched in as they tried to ride the bubble until it burst all over them.

Had Wall Street acted more soberly we would still have had a bubble (but maybe a smaller one, which I agree would’ve been better!). But had government not built a bonfire and thrown gasoline on it, I’m not sure we’d have had any problem at all. This can be argued in a circle forever and, admittedly, rational people can disagree how to apportion blame. But, to solely blame Wall Street, as has become the popular narrative, and use that as an excuse to bring yet more of the economy under the federal thumb, is sordid. Government is using a disaster it had a primary role in creating as cover for further takeovers in a cloud of class warfare and lies. That just sounds wrong to me

To review, government, including many of the same legislators who brought us Fannie Mae and took VIP loans from Countrywide, is pinning the full blame for this mess on Wall Street, and concluding we should give government much more power going forward. Its idea of reform is not to commit to ending too-big-to-fail, but to plan for it in perpetuity. Its idea of reform is to give government unspecified but exceptionally puissant abilities to prevent and to fix all problems in the future through bureaucrat-determined arbitrary taxes, open-ended takeover powers, and unprecedented resolution powers that ignore a century of well-developed bankruptcy law (making the corruption carried out in the Chrysler bankruptcy now the law of the land). I’ve exhausted even my ability to be sarcastic here. Please ridicule government amongst yourselves.

IBM, Johnson and Johnson,  and McDonalds are issuing debt with rates comparable to US government debt and at lower rates than that offered by many foreign governments. What does this mean?  That bond buyers consider blue chip corporations as safe as the government which has the power to print money.  That is profound: we have greater faith in the power to create and produce than we have in the power in government.  The secret to surviving and prospering in a country with the government gone wild is to somehow insulate your life from the ill effects of a looter mentality; to make government as irrelevant as you can.

While our current regime is as anti-business as any seen in some time, stocks may be the preferred investment choice. Real estate is still rocky.  With interest rates so low, they only have one way to go, and that makes bonds a risky investment.  Gold is so popular that the contrarian in me hesitates, and few remember how gold collapsed from $800 an ounce to nearly $200 from the 1970’s to the 1980’s.

While many near retirement fear the low interest rates will strongly impact their retirement income, this low interest rate may not be so bad if we do incur any deflation.  A 1% yield against a 3% decline in prices (deflation) is a real 4% gain in purchasing power.

The impact of the huge national debt may be offset by the eradication of wealth in the real estate collapse. This may explain how we have so much debt, yet prices are stagnant.

The federal stimulus is negated by the cuts in state spending and the unwinding of the credit bubble.  The stimulus is unable to counteract the lack of confidence and trust. People are saving instead of spending because of the combination of fear and the collapse of credit. The government and the fed  is trying to stimulate a demand that may not exist. They are fighting the last recession. This one is different.

Corporate earnings are improving, but unemployment remains high.  These are not unrelated. As the weak economy has held down wage increases, this alone will translate into lower costs and better profits. But this is true only if high competitive pressures have not squeezed margins, which has occurred and if volume remains healthy which varies based on industry.  Demands for technology are solid; demands for housing and construction and related banking services are not.

With tax increases on the horizon investors and business managers are using whatever tools are available to push earnings into 2010 and expenses into 2011.  This will make the current year look better, but it will make 2011 look worse. Business people know this and this is why they are reluctant to make long term investments. For example there is a growth in Rolph IRAs and 401k’s which allows investors to convert current retirement plans and pay taxes this year and get tax free distributions later.

The insistence on class warfare and only increasing taxes on the rich plays well to those seeking social justice, but the reality is that this class will change their behavior the most in response to higher taxes.  They will swap labor for leisure, which they can more easily afford to do, and they will swap tangible assets for financial assets.  They do not have pay tax on the enjoyment of a second home or a new boat. This will drain investable assets that are desperately needed to create new jobs.

Complicated laws measured in thousands of pages have two distressing effects.  They increase the need and function of lobbyists who seek to carve out special advantages for their representatives.  A president who campaigned on the malignancy of lobbyists will cause them to proliferate.

These laws put a burden on the smaller businesses who often lack the political power to influence the legislation that controls them or the counsel to advise them on minimizing their impact.  These small businesses are the backbone of the middle class, and the complex regulations will hurt the middle class and small business much more than the rich who are more adept at managing political risk.

The destruction of the middle class is more destructive to our social fabric than all of the excesses of Wall Street, both real and imagined.

Business is frozen from radical and uncertain legislation and clear anti-business jawboning from the presidential pulpit. Nobody wants to play a rigged game. As some retire early they will not likely re-enter the business world until confidence is restored and they just do not trust the administration as Neil Cavuto so appropriately put it. There is some cost to the loss of the most experienced business people; their wisdom is needed to avoid mistakes they learned from.

All of this keeps unemployment high.  Higher minimum wages and longer unemployment benefits make hiring both more expensive for businesses and less desirable for workers. I have never had a worker ask to be laid off… until this recession.

The only thing keeping unemployment as low as it is has been is the number of workers just exiting the workforce.  Those who are not actively looking are not counted. But at some point these people will return to the workforce. Perhaps they run out of money or their brother in law just tires of them sleeping on the couch.

Ironically the very thing that may push them to re-enter the workforce may be the renewed optimism that may accompany a sharp political reversal in November. We can thus expect an increase in unemployment if the Republicans make significant gains. This will be short lived if the Republicans can make the proper policy changes that we desperately need.

If the Republicans do not make the material political gains so many expect then this terrible business climate and the related unemployment will be with us for some time.