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.

In a world of uncertainty it is more important to know the odds than to know the facts.

In a business bet, if you have a thirty percent chance of winning one hundred dollars or a seventy percent chance of winning forty dollars (with return of principal guaranteed) the better bet is the 30% chance.  (30% of $100= $30 vs 70% of $40= $28.) What is pertinent is not just the chance of winning but the pay off or, conversely, the risk.

But risk is rarely known so precisely. In real life decisions risk is a combination of probability plus outrage. This is why we are more concerned with the threat of terrorism than swimming pools, which kill more people.

We all know that there is a chance we will die before our time. That is a known unknown. We can assess what the potential costs of that known unknown is with payroll and investment information, and make a prudent investment in life insurance.

In the financial world (as well as the world of politics, public policy, and foreign affairs) we are faced with unknown unknowns; not only are risks present that we are unaware of but the potential outcome is often unmeasurable.  This uncertainty is multiplied by the global extension of our financial institutions, where matters such as the likelihood of repayment of bond principle and interest is subject to cultural differences, religious tribalism, diplomatic shifts, political frailty, and economic amateurism.

Small banks in Iceland and German villages took large positions in the American mortgage market with poor understanding of the risks, the interconnectedness of financial assets and institutions and with a false sense of security in the professionalism of our financial leaders.  They did not know what they did not know.

Our financial professionals, rational and highly educated, were not immune to this uncertainty and were more blinded than enlightened by their intellect. With complicated mathematical models they deluded themselves with a false sense of certainty; they thought they had considered all the risk factors, but one never knows ALL of the risk factors.  The one risk factor they did miss was a decline in real estate and home prices; it seems obvious only in retrospect. Both regulators and law makers grossly misjudged the risk of the vast interconnectedness of our financial institutions.  What we thought was a market rich with competitors, was really just a giant company with redundant and interconnected divisions.

We valued math when we needed history. We replaced a philosophical understanding of risk with a delusional mathematical certainty.  This emboldened excessive risk taking and leverage, and convinced the financial titans that they had discovered financial alchemy.  The huge profits they enjoyed for a while only convinced them of their own genius, and encouraged them to take even bigger risks.  They thought they could ignore the risks of poor underlying junk assets and convert them into investment grade securities with mortgage backed securities, credit default swaps, and other derivative securities. They thought they could turn tin into gold.

But as John Galbraith noted, “genius is before the fall.” Every bubble in history has been built on delusional certainty, excessive leverage, and the mistaken association of money with intelligence.

This bubble would have been contained were it not for the political and tax policy that inflated the housing market, going back for several decades.  The mortgage tax deduction gives preference to housing over other investments. When Reagan eliminated deductions for consumer interest, it made housing interest even more valuable and equity lines of credit were tapped for boats and vacations.

Franklin Roosevelt opposed the FDIC (Federal deposit Insurance Corporation) because it would penalize prudent banks and encourage excess risk taking.  He capitulated in a compromise in 1934 and it grew from the original $2,500 to the $250,000 we have today. The implied government guarantees of Fannie Mae and Freddie Mac was  a moral hazard on steroids compared to the FDIC.

The Community Reinvestment Act, championed by Jimmy Carter, Bill Clinton and George W. Bush (as ‘Compassionate Conservatism’) put these moral hazards to political use and eschewed prudent financial policy to gain political favor. Wall Street thought they could make risk disappear with complex mathematical models; Washington thought they could make risk disappear by pretending they did not exist.

The absurd mark to market rules enforced on the banking system by the government regulators only served to accentuate extremes in market behavior, and could not have been imposed at a worse possible time.

Economics is not a science and the intellectuals and elites who pretend it is keep wreaking havoc.  Though not a science, there are principles that have stood for centuries and are ignored at our own risk.  There is no better teacher of these principles than to watch the results when they are ignored or violated.

Economists are realizing that each successive recession and recovery takes longer to regain the employment level before the contraction.

The depth of the recession may have something to do with this and the perception of the recession may also have an effect.  The more severe the beginning of the recession the more stunned and reluctant businesses may be to regain confidence in hiring.

Political uncertainty may delay recovery. Radical legislation as we now face has left many businesses shocked and uncertain what the rules of the game are.  This administration’s intrusion into bankruptcy law (GM and Chrysler) , contract law (mortgage cramdowns) and legal recovery (BP) leaves businesses reluctant to operate under conditions more like that of a third world country than the economic powerhouse that used to be America.

But the more likely explanation is the combination of a higher minimum wage and more generous and extended unemployment benefits. It is economic common sense that higher minimum wages will negatively impact employment but the impact is muted when enacted during a growing economy with low unemployment. The effect is amplified in a recession where radical new laws like the health care bill or the attempt at a card check bill makes any new employee a serious liability.

This is not to accuse everyone drawing unemployment of preferring it, but I have never had an employee ASK me to lay him off if it becomes necessary to reduce workforce…. until this recession.

Drawing unemployment for two years reduces the incentive to seek work, and a higher minimum wage reduces the incentive to hire.  It is a combination that will keep our unemployment levels high for some time to come.