Arnold Kling  

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The Case for Profits... Good Luck, Jeremy Stein...

Justin Wolfers writes,

there are about three papers written on monetary policy for each paper mentioning fiscal policy. And there are only a few dozen papers written on the multiplier each year.

He has more data.

Jerry Muller writes,

a large role was played by the failure of the private and corporate actors to understand what they were doing. Most heads of ailing or deceased financial institutions did not comprehend the degree of risk and exposure entailed by the dealings of their underlings

As a high-falutin' academic, he calls this an "epistemological recession." As you know, I call it the suits vs. geeks divide.

Finally, David Leonhardt has a big piece coming up in the NYT Magazine. So far, I've only read the first page, and he mentions Mancur Olson, which is cool.

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COMMENTS (4 to date)
Don the libertarian Democrat writes:

"a large role was played by the failure of the private and corporate actors to understand what they were doing. Most heads of ailing or deceased financial institutions did not comprehend the degree of risk and exposure entailed by the dealings of their underlings"

I'm wondering why you buy this explanation. Did you feel the same way about the people running Enron? Those were pretty complicated investments.

There is nothing complicated about a CDS or CDO. Explaining and understanding their risk is easy. What's hard to understand is the math used to determine default rates for mortgages and tranches. But is not terribly hard to understand graphically. Most people can understand a Bell Curve and the idea of tails graphically, for example. I learned about Godel's proof from Prof. Chihara when I was a freshman in college. I didn't understand everything, but, because he knew what he was talking about, he helped me understand the basics of it.

CDSs and CDOs were chosen because they needed lower capital requirements. If it wouldn't have been these, it would have been some other investment created to suit the need. Such a need is inherently risky. Everyone knows that. Higher capital standards are in place to lessen risk.

There are a number of papers on the internet from 2005 and earlier that detail, for anyone interested, how and why the math models were risky. Can a CEO use the internet? They do not entail the need of great mathematical acumen to understand.

When I was in college and graduate school, I did pretty well in logic and math. I'm terrible at them and they bore me. But I always managed to find someone who could help me for free. Are you telling me millionaires couldn't find skeptics or third parties to inform them of the problems?

Not understanding risk is not an epistemological problem. It is a problem of competence. Epistemology often deals with justification. How do you know something? Why do you believe something? That's why Wittgenstein and Austin, who wrote( both were actually edited from notes ) the two best books on the subject in the last 75 years, On Certainty and Sense And Sensibilia, spend so much time on how we justify beliefs and knowledge. They both stress context and presuppositions.

The question is what are the beliefs and suppositions that justified these business decisions? I say that it was a context of implicit government guarantees to intervene in the case of a financial crisis, and lax prosecution dating back to the S & L crisis.

I'm don't doubt that the magnitude of the debacle stunned the bankers and investors acting on these beliefs. Sadly, they trusted, based on the S & L Crisis and the Fed's actions in recent years, in the efficacy of government to limit a crisis should one occur. But I believe that they all knew that they were taking very large risks for very large payoffs.

When Lehman collapsed, the market and investors panicked. Not in five minutes as Prof. Taylor seems to believe, but during the following weeks. That's because they were counting on government intervention. They had no Plan B.They do not believe in nor want a financial system free of government aid. As Wittgenstein wrote, "If a lion could speak, we could not understand it". I say "If a free market existed, our investor class could not compete in it".

Grant Gould writes:


The ability to maintain a definite course of action while giving a fair and unbiased hearing to the evidence against that course of action is practically the definition of good organizational leadership. If the heads of these organizations couldn't do that, they were bad leaders, and the directors who hired them were bad choosers of leaders; that there were CDOs and CDSs and whatnot involved is almost secondary; they might as well have been widgets and sprockets. Call this the Kling Hypothesis.

If on the other hand the heads of those organizations chose their courses rationally, weighing a rational assessment of the risks against a rational expectation of a bailout with other peoples' money, then they were good leaders who simply lacked any moral sense whatsoever. Call this the Moral Hazard Hypothesis.

Finally, it may be that the heads of those organizations made rational and informed decisions not for the good of their companies but based on their own specific incentives -- compensation schemes, personal preferences, social approbation, whatever. They rationally preferred risk profiles that matched their incentives rather than those facing their organization, and in the resulting princple-agent problem their organizations died. Call this the William Black hypothesis.

Of course these are not mutually exclusive, and it is virtually certain that some of the bad decisions involved were motivated by each (in particular, given the strength of social incentives, if enough people fall into categories 1 and 2, everyone else is going to feel a strong temptation toward category 3 if only to stay friends with their drinking buddies...). Any attempt to prevent such problems in the future is going to have to deal with all three, in rough proportion to how much each contributed to the failure.

Floccina writes:

I agree with you Don that there is nothing complicated about a CDS or CDO but I have seen first hand where some mangers seem to think that they need to nothing but to pay based on simplistic performance criteria. So one person will do a poor job but luck and keep his job and another does a good job but is unlucky and loses his job. They did not know because they were convinced that they did not need to know.

Russell writes:

Sorry Don but not understanding risk is an epistemological problem; it is called epistemological arrogance.

Here's Taleb and Kahneman discussing the problem - utterly brilliant:

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