Friday, October 17, 2008

"Who Will Guard The Guardians?" 2: Revenge of the Mule

In previous posts I discussed the “good intentions” that can sometimes have bad unintended consequences, such as the drive to make home ownership more available to low income Americans (in respect to the current financial crisis). In the last post, I indicated that I will be discussing other activities in this disaster that seem dodgy on their face (in the specific context of the rating of the sub-prime-mortgaged backed securities). What I’d like to discuss, as a bridge, is the idea of making mistakes and the Biblical injunction to humility.It’s clear even if you separate out people with good intentions, and even if you also separate out clearly venal behavior, that a lot of what went wrong in the subprime disaster can still be classified as many people being seriously, magnificently wrong … wrong specifically about the valuations and riskiness of many of these securities. I will discuss later some of the evidence as to whether any of this was deliberately misleading, but assume for a moment it wasn’t. The fundamental toxins that crept into the financial system were mortgage-backed securities that were a lot riskier (and hence worth a lot less) than people thought they were. This meant that many other financial transactions, including things like the credit default swaps, were based on fundamental bad information.

Economists looking at this wreckage might be tempted to say “I told you so” because of the highly publicized role played by “quants” whose mathematical models were behind the bad valuations --- "quants" are people with backgrounds in things like mathematics or physics or specialized finance who believed that the price of the securities could be valued almost without any reference to the economics of the actual markets supporting them. One incredible story from the Bloomberg series I referenced in my last post is of a West-cost banker, skeptical of these securities, who tried unsuccessfully to get securities industry analysts to take a “bus tour” of the actual neighborhoods and homes supporting the securities. He apparently got no takers.

However, it is incorrect to suggest that economists can shift all of the blame to the quants, because the statistical modeling of future economic valuations is our sandbox. Some of these folks had to have had some economics training along the way. And, it was a Nobel prize-winning economist who co-authored a report (appearing in “Fannie Mae Papers”) which predicted:

“The paper concludes that the risk of default of the GSEs [Fannie Mar and Freddie Mac] is extremely small.”

Or, in historical context:

“As far as it is possible to do, these two ships [the Olympic and the Titanic] are designed to be unsinkable.” ---- a White Star promotion quoted in

“An absurd delusion” ---- Meteorologist Isaac Cline about the possibility of a major hurricane devastating Galveston, Texas, quoted by biographer Erik Larson.

So what does the Bible say about this? Is it a sin to be wrong? I don’t think so, but there’s no doubt that anything that sets up false gods is a sin, and a pride or arrogance in which we worship our own knowledge certainly fits the bill.

The Old Testament clearly distinguishes between knowledge and wisdom (Proverbs being the most obvious, but not only, example). There was a lot of knowledge in the sub-prime mortgage industry that was not backed up by wisdom. I strongly suspect, from his many teachings about the “last” and the “least among you”, that Jesus would have not spoken kindly of anyone in love with their own intellect, particularly if they (using a very apt idiom) “lorded it over” other people. And Paul warns (in the letter to the Philippians) against vanity and conceit. Doug has always been quick to point out that these warnings are particularly important to those of us whose vocation is one in which knowledge and prediction are our stock-in-trade.

If an engineer can be wrong about a ship or a bridge, or a meteorologist can be wrong about the path or severity of a storm, how much more humble should we economists be when what we are attempting to model are not physical forces but the behavior of human beings. I’m not saying we can’t try, and I’ll be happy to stand by my predictions about what would happen if the government imposed a $1.25 price ceiling on gasoline. But I always recall my favorite part of Asimov’s Foundation series when the spectacular scientific success of the Seldon model was upended by the behavior of a single person, the aberrant Mule.

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