Greed and Stupidity

Last week, I had lunch with an old friend who told me that he was very upset because he had lost so much money on his investments. He said that he was of two minds about the people who caused his pain. On the one hand, he wanted to forgive them, but on the other hand, he wanted to get even. Both, perfectly natural feelings. Of course, the problem with the revenge approach is the he did not know exactly whom to blame. Like many people, he really didn’t understand how we got into this economic mess in the first place.

Well, as previous posts have discussed, it’s a complicated tale in that there are a lot of culprits and more than enough blame to go around, including lax government regulation, unscrupulous mortgage brokers and mortgage lenders, overoptimistic rating agencies and everyone who thought real estate prices could only go up. But focusing on the banking system tells a large part of the story.

Recently, David Brooks wrote a column, Greed and Stupidity, which references some very good articles and contrasts the two theories of why and how bankers screwed up. Here are some relevant quotes regarding the two explanations – greed and stupidity.

What happened to the global economy? We seemed to be chugging along, enjoying moderate business cycles and unprecedented global growth. All of a sudden, all hell broke loose.

There are many theories about what happened, but two general narratives seem to be gaining prominence, which we will call the greed narrative and the stupidity narrative. The two overlap, but they lead to different ways of thinking about where we go from here.

The best single encapsulation of the greed narrative is an essay called “The Quiet Coup,” by Simon Johnson in The Atlantic.

Johnson begins with a trend. Between 1973 and 1985, the U.S. financial sector accounted for about 16 percent of domestic corporate profits. In the 1990s, it ranged from 21 percent to 30 percent. This decade, it soared to 41 percent.

In other words, Wall Street got huge. As it got huge, its prestige grew. Its compensation packages grew. Its political power grew as well. Wall Street and Washington merged as a flow of investment bankers went down to the White House and the Treasury Department.

The result was a string of legislation designed to further enhance the freedom and power of finance. Regulations separating commercial and investment banking were repealed. There were major increases in the amount of leverage allowed to investment banks.

The second and, to me, more persuasive theory revolves around ignorance and uncertainty. The primary problem is not the greed of a giant oligarchy. It’s that overconfident bankers didn’t know what they were doing.

Many writers have described elements of this intellectual hubris. Amar Bhidé has described the fallacy of diversification. Bankers thought that if they bundled slices of many assets into giant packages then they didn’t have to perform due diligence on each one.

Benoit Mandelbrot and Nassim Taleb have explained why extreme events are much more likely to disrupt financial markets than most bankers understood.

To me, the most interesting factor is the way instant communications lead to unconscious conformity. …Global communications seem to have led people in the financial subculture to adopt homogenous viewpoints. They made the same one-way bets at the same time.

Jerry Z. Muller wrote an indispensable version of the stupidity narrative in an essay called “Our Epistemological Depression” in The American magazine. … Banks got too big to manage. Instruments got too complex to understand. Too many people were good at math but ignorant of history.

The Remedies

The greed narrative leads to the conclusion that government should aggressively restructure the financial sector. The stupidity narrative is suspicious of that sort of radicalism. We’d just be trading the hubris of Wall Street for the hubris of Washington. The stupidity narrative suggests we should preserve the essential market structures, but make them more transparent, straightforward and comprehensible. Instead of rushing off to nationalize the banks, we should nurture and recapitalize what’s left of functioning markets.

Both schools agree on one thing, however. Both believe that banks are too big. Both narratives suggest we should return to the day when banks were focused institutions — when savings banks, insurance companies, brokerages and investment banks lived separate lives.

We can agree on that reform. Still, one has to choose a guiding theory. To my mind, we didn’t get into this crisis because inbred oligarchs grabbed power. We got into it because arrogant traders around the world were playing a high-stakes game they didn’t understand.

Conclusion

I agree with Brooks’ belief that the main cause of our economic meltdown was stupidity – not understanding the real risks in using “outsized” leverage to buy risky assets. On the other hand, investment bank managers were receiving “outsized” bonuses based on short-term results, and the long term risks and ramifications was someone else’s problem.

Who says we have to choose between greed and stupidity?