5 Ways to Rethink America’s Current Economic Crisis

economic insurance

Nassim Taleb and Daniel Kahneman Explain the Real Roots of the Economic Crisis

Check out this hour-long video of a panel discussion between Nassim Taleb and Daniel Kahneman reflecting on the current economic crisis:

Unfortunately the beginning of the discussion is a little disorganized, but it gets better at around 12 minutes.

Nassim Taleb is a financial trader and scholar and the author of the books “Fooled by Randomness” and “The Black Swan.”

Daniel Kahneman is a psychology professor at Princeton, Nobel Prize winner in economics, and the author of the seminal book on cognitive biases “Judgment Under Uncertainty.”

Five Ways to Think Differently About America’s Financial Crisis

Listening to this discussion, I draw five major points regarding the causes of Wall Street’s economic crisis and the problems with Washington’s response:

1. Banks and Politicians Misunderstand the Risks of Rare Events

Nassim Taleb and Daniel Kahneman argue that the true cause of our current economic crisis was not just the nation’s “housing bubble” or the derivative investments based on it, but Wall Street bankers’ and Washington politicians’ fundamental long-term misunderstanding of the concept of risk.

In Taleb’s book “The Black Swan” he develops the metaphor of the life of a turkey to describe the problem of trying to make future predictions based on the data of past events when faced with rare, but catastrophic, risk:

Taleb’s Turkey Metaphor: “A Turkey is fed for a 1000 days—every day confirms to its statistical department that the human race cares about its welfare ‘with increased statistical significance.’ On the 1001st day, the turkey has a surprise.”

The Fate of Today’s Banks: “The graph above shows the fate of close to 1000 financial institutions…The banking system (betting AGAINST rare events) just lost…trillion[s of] dollars…on a single error, more than was ever earned in the history of banking. Yet bankers kept their previous bonuses and it looks like citizens have to foot the bills. And one Professor Ben Bernanke pronounced right before the blowup that we live in an era of stability and ‘great moderation’ (he is now piloting a plane and we all are passengers on it).”

The problem with this misunderstanding of risk is that the fundamental economic principles underlying America’s banking industry were to make steady profits day after day by placing large, highly-leveraged bets against the possibility that rare, catastrophic events would ever occur.  Our banking and investing infrastructure (including public policies and regulations) supported the idea of consistently making money in the short term, because the risk of long-term collapse was unlikely.

The primary problems with this line of thinking are (1) no one can know when the collapse will come; (2) given enough time, rare events do eventually occur; and (3) big bets against rare events DO WORK day after day after day, until one day they blow up.

Experimental psychology has shown that humans prefer small gains over time to one big payday and conversely prefer one big loss to a series of losses over time.  This psychological inconsistency reinforces people’s beliefs in the theories underlying our current financial system.  Taleb calls this the phenomenon of “bleeds versus blowups.”  Society prefers people who are successful most of the time, even if they occasionally lose big, to people who are consistently losers, but occasionally win big — even if the net gains and losses for each are the same.

The cause of our economic crisis was not the housing bubble or even the complicated derivative instruments, but the fact that their risks were misunderstood by the banks and regulators that created them.

2. Wall Street and Washington Created a Dangerous Financial Monoculture

A second problem is that Wall Street and Washington have created a financial “monoculture” — an entire economic infrastructure built almost entirely on the same sources of risk: more and more money held by fewer, larger banks, all highly-leveraged on the exact same set of derivative investments.  When an entire system is built around a single idea (or single source of risk) — and that idea turns out to be exactly wrong — the system collapses.

The concept of monoculture comes from the idea that a farm planted with all the same variety of crop is at risk of complete collapse if a disease catches that crop.  This same problem of monoculture effects things like software viruses (when a single Windows virus can put almost all computers at risk) and manufacturing (as seen in the current peanut butter recall where products all over the country are sourced from a single facility).

Here the problem was that every major investment bank had taken the exact same risk against a specific rare event.

They did this primarily for two reasons: (1) almost all economic “experts” and investment bankers were schooled in the same theories and models; and (2) the incentive structures consistently in place throughout the market encouraged investment managers to seek high short-term gains, with little incentive toward long-term stability. (For an example of these two issues at play, see Taleb’s favorite case study: Long-Term Capital Management).

Washington regulators — especially Federal Reserve Chairmen Alan Greenspan and Ben Bernanke — helped to make this system more fragile by encouraging major bank consolidations — thus creating this monoculture.

We saw a major turning-point in the last few months when Alan Greenspan confessed that his theory of the world was wrong: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”  The problem is that financial institutions are simply collections of individual agents all operating with short-term incentives.

3. Financial Systems Need Redundancies

This financial monoculture has created another industry-wide problem.  Because large, publicly-trade banks had to compete with each other for analyst recommendations, every bank had short-term profitability as its primary motivation.  This narrowly-focused incentive structure discouraged investment managers from hedging their long-term risks through the use of insurance or redundancy.

Banks could have used a small percentage of their short-term profits to purchase options or other hedges on the rare possibility of extreme loss, but such a move would have made them comparatively less profitable than competitors.

In this case, the extreme competition among a small number of nearly-identical entities created a “race to the bottom” whereby any insurance or redundancy would have driven away investors – all of whom wanted short-term profit maximization.  This race to the bottom, did create extremely efficient short-term investment vehicles, but at the cost of extreme fragility and risk.

4. Bankers Keep Their Profits, We Pay Their Losses

The existing financial system has created a  “moral hazard” problem.  Moral hazard is the idea that a person tends to behave less carefully if they are insulated from the risks of their decisions than they do if they know they will have to bear the consequences of their actions.

In the current system, bankers were (and are) rewarded with huge bonuses for meeting or exceeding their short-term annual profit goals, but when it turned out that those short-term profits were derived from placing big, risky bets, and the system collapsed, the banks (and bankers) were bailed out by the Federal Government (on behalf of regular taxpayers).

These financial institutions didn’t have to bear the marginal cost of insuring against extreme risk because of this moral hazard — they could act recklessly, knowing full-well that catastrophe would be insured by the general public.

As Taleb describes it, this created a system of “capitalism for gains, socialism for losses” — when bankers MAKE money, they get paid (big), but when they LOSE money, we pay (big).  This incentive system creates perverse incentives related to short-term reward derived from long-term risk.

It is worth noting that — Obama’s temporary limits on executive pay aside — this short-term incentives payment structure continues to exist in America’s financial services industry.  For instance, we have not yet learned the ramifications of the broken hedge fund 2+20  incentives structure.

The main problem with the moral hazard of bank bailouts is that since bankers and investment managers don’t bear personal consequences from placing money at extreme risk, they are actually acting RATIONALLY as individuals when they do so.

For example, check out Taleb’s Facebook Group: “Make Bankers Accountable” accusing Citibank executive (and former Clinton Treasury Secretary) Robert Rubin of making over $100 million by putting the world’s largest bank in extreme risk — and then being bailed out by taxpayers.  It’s hard to say that a guy making $100 million should feel like he did anything wrong — he did what the system encouraged him to do.

5. When a System Breaks, Change It

Taleb concludes his discussion with two pleas: (1) financial services executives and regulators should all be fired — to actually face consequences for their actions, and (2) business schools should reassess their curricula, most of which teach a set of economic theories that created our financial monoculture.

When the people running our financial system have failed and their theories have been proven wrong, the people and their theories must be replaced.

Taleb argues that the American banking system should be nationalized, so that regular people’s savings and retirement accounts aren’t leveraged against risky investments.  He argues that simple savings-and-loan banking should be run by the Federal government, with no profit or competition incentives. He suggests that risky, leveraged investing should be done through private hedge funds — but then NEVER bailed out.  The idea is to separate most people’s desires for long-term stability from the minority of investors seeking riskier short-term gains.

Regardless of a bank nationalization plan, all the regulators and executives (Geithner, Bernanke, Summers, etc.) involved in the recent crisis need to be fired.  We have had a system run by people with a certain set of economic theories.  Their theories have been proven wrong.  Yet they continue to run our economic system.  Worst of all: because their economic theories do indeed result in day after day of short term profits, we are easily lulled into letting them remain in charge.  Their theories WILL look stable for a long time, until one day it again BLOWS UP.

Similarly, Taleb argues that business schools should pause their teaching and reassess their theories before graduating another class of students steeped in the economic theories that created this mess.  Taleb has called for a boycott of any business school that teaches modern portfolio theory. His argument is that no business school is better than a destructive business school – theories only have value if they outperform no theory.

Where Does Our Economy Go From Here?

I am glad to see that some of these ideas are beginning to gain acceptance in mainstream thinking about the American financial crisis.  If ever there was a time to reassess our ways of doing things, now is that time.  When Kahneman and Taleb find themselves at the elite Davos World Economic Forum, arguing their viewpoint before world leaders, it makes me optimistic that maybe we can find our way.

Here’s my recommendation.  As you hear about upcoming bailouts and stimulus packages, assess whether these issues are addressed:

1. Does the plan acknowledge the existence of FUTURE catastrophic risk? Or does it create a system where this same problem could arise again?

2. Does the plan provide for DIVERSITY in (1) recovery methods, (2) financial institution types, and (3) economic theories? Or does it perpetuate a few small institutions driving our economy with a single philosophy and a narrow set of investments?

3. Does the plan call for INSURANCE and redundancy – requiring that future investments are hedged against extreme risk? Or does it put all of our proverbial eggs in a single basket?

4. Does the plan create an appropriate system of rewards and consequences, making decision-makers ACCOUNTABLE for the risks that they take? Or does it create a situation where firms could be bailed-out again if (when) they fail?

5. Does the plan CHANGE the people and theories that have been running the economy? Or does it allow those who crashed our economy to keep driving our economy?

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