From DealBook: Tech-Wary Buffett Shies Away From Facebook

Warren Buffett

While investors are salivating over the Web’s hottest start-ups, Warren E. Buffett of Berkshire Hathaway, long reticent of technology companies, has no plans to take the plunge into the social networking space.

“It’s not my game,” he said in an interview with DealBook at the Allen & Company conference here. “The world is changing, and I’m lagging behind.”

Mr. Buffett said he was not exactly sure what to make of the multibillion-dollar valuations of Facebook, Groupon, Zynga, LinkedIn and the like.

“A few of them will be worth enormous amounts,” he said. But “I don’t know which ones.”


10 Steps to Risk-Proofing our Economy


Nassim Taleb’s Financial Times op-ed recommends 10 fixes to our economy

Last week in the Financial Times, Nassim Taleb published an op-ed entitled, “Ten principles for a Black Swan-proof world.” In it, Taleb lays out a number of major economic reforms we could make to limit the likelihood of catastrophic risk in the future (expanded upon in the full FT article):

  • 1. What is fragile should break early while it is still small.
  • 2. No socialisation of losses and privatisation of gains.
  • 3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.
  • 4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.
  • 5. Counter-balance complexity with simplicity.
  • 6. Do not give children sticks of dynamite, even if they come with a warning.
  • 7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence.”
  • 8. Do not give an addict more drugs if he has withdrawal pains.
  • 9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
  • 10. Make an omelette with the broken eggs.

I have mentioned Taleb’s recommendations on rethinking on the economy before. He’s not always right, but he’s certainly worth understanding. In this case, his 10 principles are unlikely to be implemented, but maybe policy makers should give them some consideration.

Taleb is the author of the tremendously interesting (though somewhat disjointed) books “Fooled by Randomness” and “The Black Swan” and is also the subject of a great essay by Malcolm Gladwell. Check him out.

How Close Are We to an Economic Depression?

economic depression

Are we on the verge of a Second Great Depression?

There has been a lot of whispering lately that our current economic crisis may be leading to another Great Depression.

On Tuesday, the ultra-liberal Nation magazine proposed that we might already be in the midst of the Second Great Depression.

Though there is no universally-agreed-upon definition of the term “depression”, an op-ed in Wednesday’s Wall Street Journal proposed one common definition: a 10% decline in per capita GDP.

If we take the definition of “10% decline in per capita GDP” as our working definition, how close are we to this kind of economic depression?

For the sake of this analysis, we’ll equate real GDP with per capita GDP, since month-to-month national population changes are trivial. For the curious, the US Census does publish that data.

On Monday, the Associated Press reported:

“A Depression doesn’t have to be Great — bread lines, rampant unemployment, a wipeout in the stock market. The economy can sink into a milder depression, the kind spelled with a lowercase ‘d.’

“And it may be happening now.

“The trouble is, unlike recessions, which are easy to define, there are no firm rules for what makes a depression. Everyone at least seems to agree there hasn’t been one since the epic hardship of the 1930s.

“But with each new hard-times headline, most recently an alarming economic contraction of 6.2 percent in the fourth quarter, it seems more likely that the next depression is on its way.”

Government (and press) are inflating data to hype the economic crisis

Here’s the problem: the 6.2% decline that the AP cites doesn’t really exist. That piece of data comes from a Bureau of Economic Analysis report from last Friday that announced a 1.6% quarterly GDP decline estimate — with an annualized rate of 6.2%.

For those with quick brains: 1.6 x 4 = 6.4, not 6.2, the discrepancy is likely due to the rounding of both numbers for simplicity.

As the New York Times graph (above) demonstrates, the only actual decline in GDP, so far, has been the 1.6% of last quarter. Any annualized extrapolation beyond the current quarter’s data, is pure conjecture. This curve could turn up or down, we don’t yet know.

This is all to say that the government announcement, and the AP report on it, are hyping the data to indicate GDP declines four times worse than they actually are.

I’m perfectly willing to concede that the data for 2009 could be as bad as (or worse than) a 6.2% decline in the American economy, but let’s wait for the data. Hype and fear aren’t going to help anything.

Forget Iraq: Prepare for a “Space War”?

space war

Does Recent Satellite Collision Foreshadow Future Space Destruction?

You probably heard about the satellite collision two weeks ago, when a US communications and defense satellite was struck by a defunct Russian satellite.

The collision involved an amazing amount of force (two 700lb. objects, traveling towards each other at over 13,000 mph, apparently creates the impact energy of 5 tons of TNT)! The impact also created a huge cloud of shattered-satellite space debris about 500 miles large that could circle the Earth for the next 10,000 years.

This giant cloud of collision debris now, itself, may be putting other satellites and space flights at risk, as even a pebble of debris, cruising faster than a rifle bullet, can destroy anything in its path. For instance, shielding on the International Space Station is only designed to protect the station from debris less than 1 cm in diameter.

Before that massive debris cloud was created this month, there were already over half a million pieces of space debris over 1 cm in size in the Earth’s orbit (as illustrated below).

Though some effort has gone in to developing space equipment to mitigate the creation of space debris, there are few economical techniques for dealing with the huge amounts of small debris already surrounding the planet.

Considering that our televisions, internet, cell phones, defense systems, and other technological infrastructures rely in whole or part on orbiting satellites, it’s easy to see that the destructive power of these debris clouds could easily disrupt our lives in serious (maybe even crippling) ways.

Could Satellite and Space Debris Battles Be the Future of Warfare?

If these debris clouds can spell accidental near-doom for our technology infrastructure, what could happen if we had to worry about the creation of space debris deliberately designed to attack our satellites?

On Saturday, a Wall Street Journal op-ed raised concerns about the recent successful launch of Iran’s first satellite. Though the Iranian Safir rocket and satellite were rudimentary by U.S. standards, they spell a future in space for more and more countries — including more and more who disagree with each other.

The op-ed’s author, an Israeli defense official, argued:

“The Safir demonstrates a fair amount of sophistication for an initial launcher. The question remains whether this sophistication is indigenous and what features, if any, have been imported from abroad. Some of the Safir’s features bear the telltale signs of previous space launching experience, implying outside help. Such help could come from any country that possesses Soviet-era missile and space technology. Yet the Safir is far more advanced than North Korea’s space launcher. This fact — and the magnitude of the entire Iranian space enterprise — indicates that much of the success is homegrown.”

The “Star Wars”/SDI space-based weapons proposals of the 1980s have not yet reappeared, but we may be closer than we realize.

As Foreign Policy magazine notes:

“No one, including the United States, is likely to have actual weapons in space in the foreseeable future. Space control does not require such weapons. Ground-based, sea-based, and even air-based antisatellite weapons (ASATs) can do the trick. The United States has long been working on a variety of highly sophisticated ASAT programs — indeed, the infrastructure for missile defense is the sort of infrastructure needed for ASAT systems.

“When a country builds ever greater military capabilities, potential rivals react. China, in particular, is wary of the coercive possibilities of U.S. military power. The Middle Kingdom says it wants a space treaty, but in January 2007, it tested its own somewhat primitive ASAT — a kinetic-kill device that roughly replicated a test the United States carried out in 1985.

“Is a space-related arms race under way? Yes. But there is still time to ratchet it down, and the Obama administration has signaled that it might do so. That will be difficult, though. Exceptionalism is a major driver of foreign policy, and influential people and hard-line think tanks are comfortable with the idea that full-spectrum dominance in all things military is America’s right.”

That ratcheting-down may be even more difficult if Iran and Israel are two of the nations in this space-arms race together.

Foreign Policy continues with the nightmare “space war” scenario:

“The United States continues to work on its ‘defensive’ ASAT systems. China and Russia do the same to counter U.S. capabilities. India and Japan put together their own individual systems. Ditto for Pakistan, if it survives as a coherent country. Israel follows suit, as does Iran.

“In a time of high tension, someone preemptively smashes spy satellites in low-earth orbits, creating tens of thousands of metal chunks and shards. Debris-tracking systems are overwhelmed, and low-earth orbits become so cluttered with metal that new satellites cannot be safely launched. Satellites already in orbit die of old age or are killed by debris strikes.

“The global economy, which is greatly dependent on a variety of assets in space, collapses. The countries of the world head back to a 1950s-style way of life, but there are billions more people on the planet than in the 50s. That’s a recipe for malnutrition, starvation, and wars for resources.”

Is any of this likely to happen? Probably not. Is it something we should probably be spending some time and energy to get a handle on? I’d say so. Part of the solution is just normal foreign relations and diplomacy to develop agreements about space usage. Part of it is putting resources into figuring out how to clear the Earth’s orbit of all this garbage. Maybe we should cross our fingers a little too — just think if the US-Russian satellite collision of this month had occurred 40 years ago, would anyone have believed it was accidental then?

Will Banks Be Nationalized This Weekend?

bank nationalization

Calls for Bank Nationalization Are Increasing

This week both Senate Banking Chairman Christopher Dodd and former Federal Reserve Chairman Alan Greenspan indicated that some form of federal bank takeover may be necessary in the near future.

I wrote a few weeks ago that nationalization may be one important way to create accountability and stability in our financial system.

Others have suggested that nationalization has been the Obama Administration’s plan all along — which might indicate why their announced bank bailout plans have sounded confused.

I have no special knowledge as to whether or not this is the correct solution to our massive bank insolvencies, but lots of people seem to think it might be.

If Banks Are Nationalized, Will It Happen Soon?

If nationalization might be in the cards, when can we expect it to happen?

The trick is that if banks are nationalized, their stocks will become worthless.  That means any announcements of a nationalization plan would send those stocks plummeting.  This is one reason why many observers think the Administration might keep a nationalization plan under wraps until it is ready to be implemented.

Adam Davidson of NPR further indicates that a nationalization plan would likely be announced on a Sunday:

“This is why so much of the big government moves happen on a Sunday afternoon. They wait until the markets in NY close on Friday, then they pounce. They spend a sleepless weekend–when global markets are closed–putting everything together and then announce it on Sunday afternoon, NY time, before Tokyo’s stock market opens.

“If the economists who tell us that nationalization is inevitable are right, then we’ll probably see things happen just like that. We’ll get breathless, hurried rumors on a Friday evening followed by a Saturday of confusing, contradictory leaks and a Sunday news conference announcing that the U.S. government now owns and operates several of the world’s largest banks.”

Part of this prediction could already be happening as traders today apparently worried about an impending nationalization and sold many financial stocks.

Economist Nouriel Roubini, on the other hand, thinks Obama plans  to wait a few months before  nationalization:

“The savvy Geithner, this theory goes, has determined that seizing Citigroup (C) and Bank of America (BAC) now would trigger a run on the bank at JP Morgan (JPM) and Wells Fargo (WFC)–thus forcing the immediate seizure of those giants, too. JPM and WFC are also insolvent, so this wouldn’t be irrational, but Geithner and his bosses might get blamed for destroying them.

“In 6-12 months, meanwhile, the market will gradually have realized that JPM and WFC are insolvent, so nationalization will no longer be a startling alternative (and Obama and Geithner won’t get blamed).”

My guess is that the odds of nationalization are probably very slim and that it would probably happen in weeks, not days, from now. But if it does happen this Sunday, I guess I can say I told you so.

Why Don’t We Hold “Experts” Accountable?


When Media “Experts” Assist in Ruining Our Economy, Why Aren’t They Fired?

Yesterday I wrote about a depressing appearance by Nouriel Roubini and Nassim Taleb on CNBC, where the show’s hosts were demonstrably incapable of engaging in a serious discussion about the structural problems in our economy. A few days ago, I also wrote about how one of the problems with our current economic crisis is that we aren’t making a point of holding financial leaders accountable for harming our economy.

I can understand that it’s politically and logistically difficult to fire all of the regulatory and financial industry leaders who played a part in getting us into this situation. What I have a harder time understanding is the 24-news stations (CNN, Fox News and, most notably, CNBC) who for years have held out financial “experts” to predict for us which stocks were “buys” and which were “sells”. Of course, none of these “experts” have any particular prescience (because nobody does) and all of them have had their specific predictions fail more often than not. Most importantly, these so-called “experts” didn’t see our crisis coming, didn’t prepare anyone for it, and yet are still on TV, pretending to predict hot and cold stocks for us. Why do these worthless “experts” still have jobs?

Can We At Least Agree to Boycott the “Experts”?

A number of financial bloggers recently participated in International Boycott CNBC Day, heeding the call:

“We are boycotting CNBC because of what we perceive as a gross lack of accountability and editorial judgment.

“We are boycotting CNBC because they produce shows with personalities who take zero responsibility for stock picks and markets calls which misinform viewers and distort the severity of the economic crisis.

“We are boycotting CNBC because they trot out so called expert guests who have cost investors millions without warning viewers and allow these guests to pump themselves up without demanding the disclosure of performance.

“We are boycotting CNBC because we want to send a message that such asshat behavior is unacceptable to us, their viewers.”

Now, I’m sad to admit that I didn’t learn about International Boycott CNBC Day until it was too late (the boycott was on February 3). Then again, it would be hard for me to “boycott” something I’ve never voluntarily watched [I do regularly watch it, involuntarily, as it is the station of choice in my gym lockerroom].

The saddest part is that not only are most people not dismissing these clowns, CNBC’s ratings are actually UP since the financial crisis started.

Don’t Believe (All) the Hype About the Stimulus Plan

US Capitol

Nancy Pelosi Wants You to Think This Is the Current State of American Unemployment

Last Friday, Speaker Nancy Pelosi released a graph showing the number of unemployed Americans from each of the last three recessions:

“This chart compares the job loss so far in this recession to job losses in the 1990-1991 recession and the 2001 recession – showing how dramatic and unprecedented the job loss over the last 13 months has been. Over the last 13 months, our economy has lost a total of 3.6 million jobs – and continuing job losses in the next few months are predicted.

“By comparison, we lost a total of 1.6 million jobs in the 1990-1991 recession, before the economy began turning around and jobs began increasing; and we lost a total of 2.7 million jobs in the 2001 recession, before the economy began turning around and jobs began increasing. [Emphasis mine].”

The explicit purpose of this graph is to support the Speaker’s view that a stimulus package of some kind — any kind — needs to be passed immediately to do something about this “unprecedented” precipitous fall in employment numbers. From the data presented, this seems quite persuasive. But it’s not the whole story.

A Better Way to Think About American Unemployment — In Context

Jim Manzi at “The American Scene” created this graph in response to the Speaker’s graph, adding two pieces of context:

“Of course there are a couple of odd things about this. First, it shows absolute job numbers, rather than unemployment rate (that is, job losses per capita). This matters, because the U.S. labor force is a lot bigger now than in prior recessions. Second, it ignores the recession of 1981 – 1982, which was by far the most serious of recent recessions.”

He also apologizes in the blog post for using such an ugly Excel spreadsheet to present his new data.

Some Observations on the Stimulus Plan — From the Addition of Context

The American Scene” draws two observations from its additional data:

1. What seems to matter in getting to really bad job losses is the duration of the recession. So, speed in passing a stimulus bill is probably a lot less important than getting our countermeasures right. This is, of course, diametrically opposed to the natural conclusion one would reach in looking at the first chart.

2. The structural work on the economy is at least as important as how we deal with the recession. The stagflation of the 1970s meant that we started the ’81-82 recession at about the unemployment level that we have taken more than a year of recession to reach today. Doing something, anything, to stop the pain of the current recession, no matter what its structural effects on the economy, might seem practical, but it is not.

I think the two graphs also beg a question (which I don’t have the data to answer):

What does this picture look like when given lots of extra data — say all worldwide recessions of the past 100 years? Or even easier: If this job loss is really “unprecedented”, then how does it stack up against even just the 7 U.S. recessions from 1900-1980? If the picture continued to be consistent, or showed some other trending with LOTS of data, then I might feel comfortable drawing conclusions from it about policy solutions.

As it stands, the Speaker does her position a major disservice by withholding the context needed to interpret her data.

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?

Bernard Madoff Even Scammed Other Scammers

Bernie Madoff Auction

One More Reason Bernard Madoff Succeeded: Investigators Didn’t Investigate

Now that Bernard Madoff is being investigated for allegedly running the biggest ponzi scheme fraud in history, lots of people are trying to figure out how he was able to get away with it for so long.

One clue as to how he got away with it and what little oversight or critical analysis goes in to vetting major investment advisors can be found in the example of hedge fund Access International Advisors (AIA).

AIA’s founder lost $1.4 billion in client money through his investments with Bernard Madoff before commiting suicide in December.

How does a major hedge fund get tricked into losing $1.4 billion? By having an already-useless investigation and due diligence process – and then not even using it.

The AIA hedge fund had a due diligence process for vetting potential investments. This due diligence process included handwriting analysis, also known as “graphology,” to investigate whether investment advisors were skilled and trustworthy enough to handle large investments. However, because of Madoff’s strong reputation on Wall Street, AIA decided it didn’t need to perform its standard investigation before investing with him.

As Risk Magazine reports: “[I]t’s not even that they used graphology… in order to assess investment prospects… It’s that they didn’t even bother to use graphology when they thought someone was an nice guy. Their due diligence process was, essentially, ‘are you a decent chap? If not, do you at least write with the letters all sort of wiggly?’”

But what if they had followed their standard practice of performing handwriting analysis on Bernard Madoff?

Handwriting Analysis Is Not an Investigative Technique or a Science – It’s Pseudoscience and Fraud

Let’s be clear here: in common language there are two types of “handwriting analysis.”

The first, otherwise known as “forensic handwriting analysis,” or “questioned document examination” is a scientific discipline, used regularly in courts of law, whereby experts examine documents to detect forgeries or to try to match handwriting examples to identify people. This is a valid – though still occasionally inaccurate – profession.

Expert forgery analysis should not be confused with its insidious step-child, otherwise known as “graphology,” which is a form of pseudoscience (a practice that claims to have scientific merit, but fails to demonstrate scientific verifiability).

Graphologists claim to be able to draw conclusions about a person’s personality based on characteristics of that person’s handwriting. Based on the size, shape, slant, loops, and compactness of one’s handwriting, “handwriting analysts” claim to know whether someone is confident, introverted, risk-taking, injured, mean, or hard-working. Peer-reviewed studies of graphology have concluded that it lacks validity.

Yet major corporations continue to use “handwriting analysis” as part of their HR hiring practices and, as in the Bernard Madoff example, to determine whether someone can be trusted to invest billions of dollars for them. Think of what’s happening here: a job applicant (or hedge fund manager) could be selected or rejected because her sloppy handwriting convinced a “handwriting expert” that she was an “extreme extrovert”, or a very “risk-averse” person.

Don’t believe me yet?

“Michael Shermer Explores Graphology” Videos

Watch this series of two short videos as Michael Shermer, the editor of Skeptic Magazine and author of “Why People Believe Weird Things“, tests the abilities of a professional graphologist:

The Michael Shermer handwriting analysis investigation continues in this second short video:

Graphologists Exist Because Graphology Triggers Our Confirmation Bias

After watching these videos, I think it’s reasonable to say that you could be left unconvinced that Shermer had done a thorough job of debunking graphology. Every test subject seemed somewhat pleased with their readings, and at least one thought the reading was quite accurate.

So doesn’t that mean that graphology might actually work?

Remember the example at the beginning of the first video of the employee who was going to “blow up” because of a medical condition, and it turned out to be true? That’s seems pretty convincing that graphology can work.

Here’s the problem with that line of thinking: The graphologists makes broad, generalized statements (”likes to do things sequentially”, “embarrassed if other people see her get emotional”, “man of action”, “learns best by reading and studying”, “not sure of his place in the world”) that could apply to just about anybody – which is why people saw accuracy even in readings about other people. An “analysis” that tends to draw broad conclusions that are accurate for most people, isn’t really a useful analysis.

But there’s a bigger problem: The graphologist also always makes a large number of predictions, some of which were accurate, some of which were not. The first woman in the video is told that her handwriting indicated that she grew up with an absent parent and that her mother had died. It turned out that her father had been “absent” while she was growing up – in that he worked a lot – but that it was her father – not her mother – who was dead. The woman interpreted the “absent parent” comment to fit the facts, and decided the other prediction was close, even though the identity of the parent wrong. [Note: A prediction of an “absent parent” is one that is vague enough to fit almost any person’s childhood and a large percentage of middle-aged people will have at least one parent who has died].

Graphology “works” because of what’s called a “confirmation bias” – the tendency of people to focus on facts that confirm their predictions, and discount facts that contradict their beliefs.

This is the same method psychics use in their readings.

First, we are told to believe that the “expert” has a special skill. Then the “expert” provides a large number of “cold” statements, which could be generally applicable to most people. The “expert” follows with “warm” statements – specific predictions – which are altered to fit the facts (”Your mother died?” “No, it was my father.” “I knew I was seeing that a parent had died.”) The “expert” always makes sure we direct our focus on the statements that we accurate, but doesn’t mention – or changes – the predictions that were false.

My conclusions:

1. No wonder people can commit fraud for billions of dollars when prospective investors choose to skip their due diligence if someone just seems trustworthy.

2. No wonder our economy is in crisis when major American corporate hiring and investment decisions are based on the “predictive” whims of charlatans.