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.

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.

Studying the financial bubbles we can see several common characteristics.

During the bubble inflation we see markets taken to an extreme by financial greed, but as Walter Sowell so appropriately metaphored on the housing bubble, “blaming the crash on greed is like blaming an airplane crash on gravity”; it is accurate but not very useful. We have had greed with us since the Garden of Eden.  Why does it only seem to rear its head to an extreme only every few years?

We see common sense dissolved in ‘new paradigms’, ‘permanently high plateaus’, ‘irreversible trends’, and ‘progressive thinking.’  Motivated by financial gain we believe whatever will support our belief in the unsupportable.

During the dot.com bubble we accepted billion dollar valuations of companies with no customers, no available products and only promising markets.  As 25 year old entrepreneurs became billionaires we believed that they were smart. There is this common aspect of bubbles that equates wealth with intelligence.  We want to believe that our new wealth is a reflection of our superior insight rather than mere luck.

When these bubbles burst and reality restores common sense we do not want to accept our own foolishness for buying into the speculative fever, we want to blame someone.  The geniuses who adorned the magazine covers as the faces of the bubbles either become villains or fade to obscurity.

In the distant past bubbles were fueled by individual greed buying into bad ideas, or at least good ideas taken to an extreme. But more recently bubbles have been enlarged by government policy.  Beyond just misguided monetary policy, the recent housing bubble was fueled by government policy that added to the demand for housing by pushing programs to help people buy homes who could not afford them.  By eliminating down payments and guaranteeing otherwise obviously risky loans the Government through Fannie Mae and Freddie Mac created one of the biggest bubbles seen to date.

The cover of Newsweek with the picture of Al Gore as “The Thinking Man’s Thinking Man” strikes me as a sign of a new bubble inflating. The subtitle “Al Gore’s new plan for the planet” is the hubris of bubbles.

We never seem to recognize bubbles when we are in the middle of them. They only seem visible when they burst.  Yet the new green industrial complex is growing with massive investments that seem guided more by wishful thinking and paranoia than common sense and reason.

From the administration’s stated belief that green energy will provide the jobs that will lift us out of massive unemployment and recession to the policies that will create the drive to capitalize on the new government direction, we now see massive investment into irrational markets.

Al Gore is the chairman of Generation Investment Management, an investment firm making capital investments in firms with potential to capitalize on the green movement and policies. He is also founder and chairman of the Alliance for Climate Protection, an outfit promoting the green economy. With money from people interested in promoting the public interest of environmentalism, the Alliance for Climate Protection is spending $300 million to promote the lifestyle that will benefit the investments of Al’s firm.

To be sure others besides Al Gore are on Capitol Hill promoting climate bills that will financially benefit their own interests.  Members of the Bush administration were chastised for their oil interests and criticized for letting it influence their policy decisions.  But we are assured that those now promoting their financial interests in their preferred energy sector are altruistic.

Gore is the face of the green industrial complex, but there are many seeking to profit from their foresight and concern to help save the planet. Gore is a genius for getting public policy firms to advertise heavily to support the market for his investments. The best entrepreneurs from the previous bubbles were never able to get $175,000 to make speeches promoting their industry. Gore may be the first green billionaire.

As in previous bubbles skeptics are marginalized, often demonized. As in so many previous bubbles delusional certainty is hurled at skepticism and reason more like an offensive than a defensive weapon . Gore boldly claims, “The debate is over.”

Believers who do not know which end of the test tube the cork goes into post scientific articles to confirm their belief. Confirmation, not information, is the object of their reading.

As I read about the genius of Al Gore on the cover of Newsweek,  I recall the prophetic words of John Kenneth Galbraith in his book , “A Short History of Financial Bubbles,” .

“Genius is before the fall.”

To blame the mere shortage of cash for the evils caused by incompetence and corruption is the favorite lie of socialists and crony capitalists everywhere. Socialists always say there is no problem of inequality or poverty that can’t be solved with cash.  It is cash alone that separates the rich from the poor- not talent or skill or hard work or thrift. Similarly, in the socialist view it is only access to capital that separates “greedy” and “monopolistic” (read “successful”) firms from the thousand flowers that would bloom if only the government would create a “level playing field” and “enforce competition.”

After the socialists becpme the government and begin evolving into crony capitalists, their favored beneficiaries- Soviet state-owned factories, Japanese banks, Fannie and Freddie in the United States- are always described as faultlessly devoted, idealistic, and hardworking, or at least essential.  If they underperform (and they always underperform), it is only because they are short of cash- which the government then always provides in some form or another.

From Panic by Andrew Redleaf and Richard Vigilante