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.