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.

It is not Obama’s fault that home sales are dropping, though it is his fault that they did not drop sooner.  Why is it bad that the sales of home and home prices are dropping?

Yes, it eats up bank collateral and destroys individual’s home equity values.  But that is exactly what happens when a bubble bursts and it is what should happen.  To move forward from a financial collapse we need to clear away the debris.

Instead of propping up inflated values we need adjust to the fact that home value appreciation near 10% is not normal.  What we got used to was an induced high.  What we are experiencing is financial sobriety.

We are seeing that even our huge national government cannot keep a fake market alive forever.

We should instead create a market where housing has to compete fairly with other investment alternatives without the subsidies, tax breaks, and political meddling.

Housing will not drop to zero. At some point they will reach a point where the industry will recover. For every dollar one person loses on a home another will gain.  For a president so keen on redistribution this should be welcomed.

We are living in interesting times.  While the professional economists are trying to figure out what happened we have all become economists of sorts just to try and understand the events that greet us every day.

With huge deficits many would expect inflation as another weak willed government resorts to the printing press to solve its problems.  In response we are saturated with ads to buy gold, the default inflation hedge.  Yet I well remember the inevitability of inflation in the 1970’s as gold passed $800 an ounce; only to hit the Reagan/ Volcker wall.  Inflation fell as did the price of gold.  In inflation adjusted dollars gold has yet to recover over 25 years later.

Retired economist Scott Grannis, in his excellent blog, Calafia Beach Pundit, explains how we can be looking at record low bond yields and interest rates while the deficit hits and record levels and  inflation remains tame.  It is a subject that has puzzled me. Read A bond bubble?

Excerpts:

So perhaps there is, in addition to weak growth expectations, an inordinate fear of the future: a fear of big tax hikes, and of a prolonged economic malaise caused by an overbearing state that absorbs the fruits of and smothers the private sector. Japan comes to mind, with its massive deficits, a debt/GDP ratio that has been well into triple digits for years, and sluggish growth. Perhaps it’s the case that as debt approaches and exceeds 90% of GDP the economy simply loses much of its forward momentum, a thesis supported by the findings of a recent research paper by Rogoff and Reinhart. There’s even some support for this thesis in our own history—muddled of course, by WWII—when federal debt surged to 120% in the early 1940s, even as 10-yr yields traded at 2% or so.

If the market is scrambling to buy bonds yielding 2.5% or less, it only makes sense if market participants hold little or no hope for a better alternative in the foreseeable future on a risk-adjusted basis.

It also makes sense that today’s almost-zero yields on cash, extremely low yields on risk-free bonds, and massive debt sales become in a sense a self-fulfilling prophecy. Low yields represent very low hopes and aspirations on the part of the private sector, while the bonds being sold and the money absorbed from the private sector by our federal deficit are being used to fund a level of spending and wealth redistribution such as we have never seen before.

We’re not witnessing a bond bubble in the making, we’re living in a statist nightmare.

By pushing more people into housing through incentives the Federal government may be aggravating the unemployment problem.

In good markets housing is illiquid. In a real estate depression a house is like a heavy anchor.  The inability to be mobile restricts job opportunities by forcing homeowners to remain in a single location. Renting allows mobility and the flexibility to respond to better job opportunities quickly.

With so many homeowners underwater there is a further incentive not to sell a house in order to avoid the recognition of the capital loss. Many would want to avoid the pain of coming up with cash at a closing.

The housing crash has destroyed home equity values even for those who can afford the homes they occupy, and it puts pressures even on them to avoid moving to better jobs in distant locations.

In a New York Times Article Paul Krugman took exception to another who laid blame for the financial crisis on Fannie Mae.  In Contending with Paul Krugman, part II, Charles Lane takes exception to Krugman. An excerpt:

What is the point of trying to absolve Fan-Fred in the first place? To the extent that Krugman is merely trying to show that the real culprits are to be found elsewhere — on Wall Street — then I suppose this is a worthy exercise in some academic sense. But apportioning blame for the Great Panic of 2008 is a bit like trying to figure out “the” cause of World War I. If ever there was an overdetermined historical event, this was it. There’s more than enough blame to go around; everyone should be held accountable.

I can understand why a liberal would want the government to support housing opportunity for low-income people. But I cannot understand why a conscientious liberal would support Fan-Fred. What is “progressive” about a couple of megacorporations populated by highly-paid executives who enriched their shareholders and themselves by exploiting a boatload of special government breaks — from an implicit federal debt guarantee to exemption from state and local taxation? When anyone proposed tighter regulation, such as raising their capital requirements, limiting their product line or anything else, pretty much, Fannie and Freddie mobilized an immense and widely feared Washington lobbying operation, greased with campaign cash.

No, Fannie and Freddie, or their congressional enablers, did not “cause” our current predicament. But they were definitely part of the problem. Over many years, they directly and indirectly encouraged over-investment in single-family housing; and their activities during the bubble contributed to making the bust, when it came, both bigger and more costly to taxpayers than it might have otherwise been.

Fannie Mae alone was not responsible, but it is equally dangerous to absolve its roll.  The more we seek demons and partisan blame the more we miss the systemic causes that need correction, and the more we risk a repeat shortly down the road.