October 24, 2008

Greenspan discovers human nature

Posted by johnmcquaid under government | Tags: , , |
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Alan Greenspan came out yesterday and, confronted by the obvious, admitted he was wrong about the markets’ capability to police themselves:

Oct. 19, 2004: “Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.”

Yesterday: “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.”

We’re in one of those “holy cow!” moments that, in retrospect, makes you wonder not just whether Greenspan himself had a lick of common sense, but how all the politicians, public and private institutions, and collective suppositions arrayed around him for so long could have been so spectacularly off-base.

For one, it should have been obvious to Greenspan, who coined the phrase “irrational exhuberance,” that markets are not perfect information-processing systems. They’re subject to bubbles, to panics, to general craziness. That goes double in this case, when the chain of ownership of mortgage-based securities grew very opaque, often deliberately so. There simply wasn’t enough information to evaluate the financial risks, and the hard information that existed was often deliberately downplayed or obscured. When everybody’s making money, the market incentives push participants to make even more; there’s not much to be gained by sussing out out information that may bring the whole edifice down.

In some ways what’s happened is a classic “tragedy of the commons” problem. In the original scenario, outlined in Garrett Hardin’s 1968 article, cowherders share pastureland. Each one believes it’s in his own short-term interest to expand his own herd, and none has an incentive to pay attention to the long-term consequences – a pasture without grass and a lot of starving cows:

Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit–in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.

In this case, the “commons” is the unregulated marketplace itself. This is a basic problem of human nature – one that Greenspan, Congress and successive presidents should have taken into account.

 

October 13, 2008

RIP Bedford Falls

Posted by johnmcquaid under environment, government, Uncategorized | Tags: , , , , |
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I read this Ross Douthat Washington Post piece on my cell phone while stuck in a traffic jam. That may have affected my response to it, but basically, the point seems to be that if ol’ man Potter in “It’s a Wonderful Life” had been running the banking industry this past decade, we’d all be a lot better off now. Two points: If Potter were around today, does anyone think he wouldn’t have been all over those unreliable financial instruments that have put us all in such hot water? And Dick Cheney, the closest real-life equivalent to Potter in public life today, has already been functionally in charge of the country for nearly eight years now.

Seriously, the piece is an interesting if not quite coherent elegy for and condemnation of American suburbia. The problem with it is that it links together disparate trends whose only common thread is their unsustainability – and to the degree they are connected, misidentifies the culprit.

Are unsustainable lending policies somehow equivalent to ecologically unsustainable land use policies? Suburbia has been on an ever-expanding arc for the past 60 years, with an ever-expanding carbon and ecological footprint, a trend driven by market forces most economists would consider unremarkable. And for most of that time, the mortgage industry has functioned reasonably well. In other words, when the market “worked” it led us down an unsustainable ecological path. In the mortgage meltdown the markets obviously “didn’t work,” but the ecological damage was already done.

The piece also locates the seeds of the lending crisis in George Bailey’s modest efforts to get people out of tenements and into tract housing in Bedford Falls. But having a reasonable policy that promotes homeownership need not inevitably lead to the wild profligacy of the recent bubble. This type of post-hoc reasoning can be used to condemn, or justify, just about anything.

Douthat is looking to blame government policies encouraging homeownership for various disastrous consequences of suburbanization. But the real problem is in the fetishization of free markets, which don’t account for environmental consequences and are prone to bubbles.

In other words, Potter’s slums might have been more ecologically sustainable than Bailey Park, but I don’t think that’s the message we should take away from our current troubles.

 

October 6, 2008

21st century government

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James Fallows notes that we are at an historic pass:

In the short term, a worldwide financial panic and crisis. Just beyond that, the real economic and social problems that come when large numbers of people lose their jobs, their businesses, their investments, their homes, and even larger numbers become fearful about what might happen to them. And then, when we get a minute to think, profound global energy and environmental challenges, security concerns that range from loose nukes to terrorist organizations, plus a couple of ongoing wars and ever-rising medical costs. Just as starters. The United States is still incredibly rich, powerful, and productive. But the current situation is no joke, for America or the world.

Fallows is critiquing John McCain’s choosing this moment to focus on Barack Obama’s past associations with William Ayers. And I have to say, for someone who sees himself as a man of history, it’s sad and ridiculous for McCain to ignore the world-changing events going on around us all in favor of these threadbare character attacks. It can be seen as a legacy of the Bush/Rove attempts to manipulate perceptions even as reality came crashing down around them. Except that McCain isn’t directly responsible for the banking crisis, his history of backing deregulation notwithstanding. He could have put some of the best minds together and come up with something, instead of just ceding the whole issue – and the election – to Obama. I guess he really isn’t a man of history after all. At least, not for this moment in history.

What this does mean, though, is that if he wins, Obama will have giant challenges ahead of him. And I think there will be an opportunity to recast the sluggish 20st century institutions that have gotten us into such trouble over the past eight years (partly through the mismatch of their capacities to emerging problems such as global finance or climate change, partly through misuse and abuse by the Bush White House). Government institutions need to be nimbler, more pro-active, and more transparent, so they can recognize potential catastrophes before things go downhill, effectively communicate the risks to the public, and act effectively without getting bogged down in special interest hell. Not easy. But we’re reaching a point where we really have no choice.

 

October 2, 2008

Anticipating (or at least not ignoring) catastrophe

Posted by johnmcquaid under natural disasters, science | Tags: , , , , |
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James G. Rickards has an interesting op-ed in today’s Washington Post on the role of financial risk modeling in the banking crisis. This is an important topic on its own, but also has sweeping implications for environmental policy, disaster preparation, and other issues. As he explains it, Wall Street’s financial risk models (known as “value at risk”) aggregate the day-to-day risks of various securities:

What’s left is “net” risk that is then considered in light of historical patterns. The model predicts with 99 percent probability that institutions cannot lose more than a certain amount of money. Institutions compare this “worst case” with their actual capital and, if the amount of capital is greater, sleep soundly at night. Regulators, knowing that the institutions used these models, also slept soundly. As long as capital was greater than the value at risk, institutions were considered sound — and there was no need for hands-on regulation.

But there’s a forest-for-the-trees problem here. Aggregating individual risks is fine in a relatively stable system. But what if the system itself becomes unstable? The risk model will not anticipate it. It’s a familiar problem from complexity science:

Think of a mountainside full of snow. A snowflake falls, an avalanche begins and a village is buried. What caused the catastrophe? The value-at-risk crowd focuses on each snowflake and resulting cause and effect. The complexity theorist studies the mountain. The arrangement of snow is a good example of a highly complex set of interdependent relationships; so complex it is impossible to model. If one snowflake did not set off the avalanche, the next one could, or the one after that. But it’s not about the snowflakes; it’s about the instability of the system. This is why ski patrols throw dynamite down the slopes each day before skiers arrive. They are “regulating” the system so that it does not become unstable.

The more enlightened among the value-at-risk practitioners understand that extreme events occur more frequently than their models predict. So they embellish their models with “fat tails” (upward bends on the wings of the bell curve) and model these tails on historical extremes such as the post-Sept. 11 market reaction. But complex systems are not confined to historical experience. Events of any size are possible, and limited only by the scale of the system itself. Since we have scaled the system to unprecedented size, we should expect catastrophes of unprecedented size as well. We’re in the middle of one such catastrophe, and complexity theory says it will get much worse.

This problem – a reliance on computer modeling that cannot accurately anticipate catastrophe – isn’t restricted to finance. Our society bases all of its policy and financial decisions on such “hard” forecasting numbers. Insurance companies employ risk models to gauge likely hurricane losses. Less sophisticated, but still highly trusted, models were used to construct the pre-Katrina New Orleans levees. They rendered the likelihood of a Katrina-sized storm surge relatively small. Often, models are built on datasets with short histories, put together in times of relative stability. But the capacity for a bigger, systemic event to sweep in and take place is always there – the fact that it is very hard to quantify doesn’t mean it’s not real.

The problem now is that the world – its financial, energy, and food systems and the physical environment itself – are changing rapidly. That means more unexpected events will occur – floods, droughts, shortages, gluts, crashes. Government and private institutions need to recognize that the future won’t be like the past, recognize the limits of their current numbers, and prepare accordingly.

Also: Here’s Nassim Taleb’s take on the same topic.

 

September 29, 2008

Things fall apart

Posted by johnmcquaid under George W. Bush, government | Tags: , , |
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I hope, and expect, that we will get a bailout bill out of Congress within a week. There’s simply too much at stake, the political and economic pressures too high, and the possibility of mass public backlash too great, for it not to happen. It’s easy to be against something when your constituents are angry and the consequences of voting no are vague. But when everybody’s 401K tanks, the political consequences become instantly concrete.

Having said that, though, who knows? With each passing day, the crisis deepens and Congress and the White House – abetted last week by John McCain – continue to fumble. Maybe we really are a banana republic. But this has to be seen as a logical consequence of the failures of the Bush presidency, a reductio ad absurdum of Bush-era GOP politics – government doesn’t work, so let the markets – which are always right – burn. And throw in some tax cuts.

The leadership vacuum in Washington right now has made it impossible for the government to act decisively. The president is supposed to step up, lay out the right thing to do, mobilize public support. And Bush has, ostensibly, been doing that. Except, not really, because nobody gives a damn what he says. Bush never really tried to lead the nation or Congress – he got what he wanted by coercion and manipulation. He spent most of his time in office not listening to anyone. Is it really surprising no one is listening to him now?

Executive power now lies not with Bush but in the technocracy headed by Hank Paulson – the professionals whom Bush did his best to marginalize and mock for most of his presidency. So it’s not surprising that they are very nearly a spent force as well.

Bush may have finally cast his lot with the realists. But his natural allies, the House Republicans, are still standing up for the kind of rigid, detached-from-reality approach – an increasingly incompatible mashup of blustery populism and pro-business policy hokum, capital gains taxes and such – that Bush pushed for most of the past eight years.

 

September 19, 2008

The end of the “ownership society”

Posted by johnmcquaid under George W. Bush, government | Tags: , , , , |
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During the 2004 presidential campaign, the White House was pushing the catchphrase “ownership society” to sum up its economic philosophy. The policies included limited privatization of various government-run programs including Medicare and Social Security, incentives to increase homeownership and, of course, tax cuts. This is mostly forgotten now, but it’s an interesting window into how George W. Bush and Karl Rove overlooked the brewing troubles facing the country and, more surprisingly, emerging political trends.

The ownership society had a composition similar to many Bush initiatives: about 50 percent giveaway to Republican interest groups, 30 percent campaign razzle-dazzle, 15 percent GOP anti-government shout-out and 5 percent functional policy proposal.

The underlying idea here was ambitious: to break the traditional alignment in many voter’s heads between the largest, most popular government social welfare programs and personal economic security. Playing on looming entitlement troubles, Bush was saying in so many words: the government won’t be there for you down the line. But the solution is not to fortify those programs but to begin dismantling them. You won’t need them because you’ll have ownership in your own private health care account, your home, and the stock market.

The ultimate aim was to break the back of the Democratic Party support by dismantling, or altering beyond recognition, its signature achievements and “brand.” It would be replaced by a Republican brand whose message was: you’re on your own, but that’s good, because you’ve got a stake in these robust markets. It had a kind of superficial appeal – the New Deal and Great Society are so 20th century, and the 21st is all about markets and globalization, etc.

But this was a radical and, it’s obvious today, crazy idea.

Markets are risky. Sometimes you lose your shirt. The whole idea of 20th century government social welfare programs is to cushion those blows, not say “bring ‘em on.” And today, the blows are raining down. “Ownership” is out – except when the government’s buying at the fire sale. And it’s not individuals the feds are bailing out, but the guys who helped bankroll the Bush campaigns and the “ownership society.”

 

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