Here are some things to remember about the present financial crisis. If you keep them in mind, it won’t help you much, but you’ll be right.
1. Stay ignorant. Finance in general, and sophisticated financial instruments in particular, are designed for the purpose of being hard to understand. The first person to understand them makes a ton of money, and a lot of other people lose. (Sometimes the economy collapses too, but, you know.) Finance is like a big puzzle contest with a few winners and a lot of losers.
The point is this: once you try to figure out what’s going on you risk getting sucked into the game. You’ll think you’ve got the game figured out, and the guy sitting across the table from you will let you win a few hands, but in the end BOOM! you’ve lost everything.
Unfortunately I haven’t figured out a way of staying out of the game.
UPDATE: I can’t believe how right I was:
George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.” Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”
And Warren E. Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
More:
“I was in this game for money,” Lahde, 37, wrote in a two-page letter today in which he said he had come to hate the hedge-fund business. “The low-hanging fruit, i.e. idiots whose parents paid for prep school, Yale and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other sides of my trades. God Bless America.”
2. Tranches are bundles of loans mysteriously sorted and packaged according to how risky they are. Large corporations buy tranches and use them as collateral to borrow money from other large corporations. These corporations are owned partly by individuals, but mostly by still other large corporations, which themselves might very well also be owned by more large corporations yet. In the end you have millions of actual home loans at one end and millions of actual individual investors at the other, with an undecipherable maze of legal entities and financial instruments linking them. (You might as well discuss quantum theory, it’s easier). Few or none of the flesh and blood owners have any idea what’s going on, until finally one day they wake up and BOOM! their money is all gone. (If anyone knows what happened, it’s probably the managers hired to manage these various legal entities, but they have just voted themselves enormous bonuses and never have cared to socialize or communicate with the pitiful rabble who own the stock anyway.)
Economists don’t worry about these things, though. (Nader does, but Nader isn’t an economist and he’s crazy too.) Economists worry about welfare Cadillacs, transfer payments, and waste in Democratic budgets. Government, in sharp contrast to the free market, is inefficient and corrupt and can never do anything right.
3. The way to handle economists and financiers is to let them fight it out among themselves until there’s only one left alive, and then kill him or her. That isn’t always enough, however – if you read the papers, you know that J. P. Morgan still controls us from beyond the grave (presumably with the help of the Templars, the Bavarian Illuminati, Hassan ibn Sabbah, and the Elders of Zion.)
4. The two biggest political decisions of the last 30 years or more were made in panic mode on the basis of misinformation and/or scanty information. If Bush and Cheney are counted as elected officials, they’re the only ones who had any significant input on these decisions. In the same way that Scalia rigorously follows his legal philosophy except when something serious comes up (e.g., Bush-Gore 2000), our system of government is democratic and strictly follows proper legal procedures except when an important decision needs to be made.
Despite the fact that they’re almost certain to have control the executive and both houses of Congress three months form now, there’s considerable doubt as to whether the Democrats actually exist.
5. Greenspan was a genius until he wasn’t, but he may still be a genius who’s just decided to burn us. He apparently did his best to throw one or two Presidential elections to the Republicans, but he’s non-partisan because the Republicans are too liberal for him. During his unelected tenure, if he wasn’t the second most important official in American government it was because he was the most important. The creative destruction and immiserization we’re about to see will bring joy to his heart.
6. Likewise, economics is a powerful science until it isn’t — i.e., until the bubble pops. Bubbles are psychological in origin (and thus of no concern to economists), so it’s up to the psychologists to explain them. They can’t do it, though, because they’re losers and only slightly less worthless than sociologists. Economists are the only real social scientists, but they have to rely on those other guys who always fuck everything up. (Like lawyers, though, economists still do have some useful knowledge, and if you can afford one, at times he or she can get the job done for you.)
In short, no one knows WTF is going to happen. Praise the Lord, we’re all brothers and sisters in ignorance! (And you needn’t fear the economists – they’re as frightened as you are, and only the Chicago School economists have a taste for human flesh).
7. Obama and the Democrats are fortunate enough to have been chosen to preside over the collapse of Western civilization. Keep an eye out for the seven-headed dragon rising from the sea.
October 7, 2008 at 4:21 pm
Bulls and Bears make money, pigs and chickens don’t. Unless those pigs are Emerson’s hogs. Emerson charges admission to watch “feeding time”. Soon he will run out of the coffee cans where he hides his cash.
October 7, 2008 at 10:00 pm
Obama and the Democrats are fortunate enough to have been chosen to preside over the collapse of Western civilization.
Congratulations on winning the 2008 election Obama! Or as it’s sometimes known as, “Who Wants to be Herbert Hoover II?”
October 8, 2008 at 3:03 pm
Nassim Taleb seems to be saying that the peasants are right.
October 9, 2008 at 3:15 pm
BTW, can we send everyone employed by AIG (say with a salary of 6 figures or more) to the pig farm?
October 9, 2008 at 8:01 pm
Come one, come all. Please schedule visits in advance so that we have sufficient hogs ready to go.
October 12, 2008 at 11:33 am
Are you saying that it’s not useful to try to understand finance economics? I’m a bit struck by the thought that: suppose vulcanologists were largely employed by, the profession dominated by, the interests of housing developers who want to build on mountains. Then they’d not be trustworthy in the same sort of structural way as economists. But back in the real world, vulcanologists aren’t like that – they get kudos and benefit from getting things somewhat right on the dangers of living near volcanoes, and they get to be largely forgiven their mistakes. What would the structure of an economics profession have to look like for economists to be like this? how could they be made independent of those interests? I can’t see it but it has to be possible, and it’s not like the underlying questions aren’t interesting.
October 12, 2008 at 4:25 pm
My point about finance economics is that it’s when you think you know how to play poker that you get skinned, and the same for finance. The best way not to think you understand finance is to not know anything about finance. That way you won’t be tempted to play.
Of course, you still are in trouble if the roof crashes down on everyone’s head the way it just did, but understanding finance won’t help you in that case either.
I think that the disinterested, objective, purely scientific model of economics is impossible. There are no disinterested people or institutions in any possible world. The scientific model tends to allow people to hide their interests under ritualistic scientific behavior.
One thing that I’ve found recently is that technocratic liberals seem to be especially dedicated to the scientific model. The critics of that model are either leftists, or rightists such as James Buchanan and F.H. Knight.
October 14, 2008 at 6:08 am
The problem with that article is that author would lead the reader to believe that all derivatives are bad. Which in reality, derivatives all companies and traders to reduce their risk. The problem is that derivatives also allow traders to take risky positions. If you don’t believe me, please educate yourself.
October 14, 2008 at 11:02 am
Absolutely not, BP! I already explained why.
Someone at Crooked Timber said exactly the same thing as you just did. Merton and Scholes had a creative brilliant scientific idea, but unfortunately people didn’t realize its limits!
Their idea worked wonderfully until it didn’t. So we had a different financial disaster (LTCM), albeit a cute little teentsy one of only 4 or 5 billion dollars. (Fortunately Merton and Scholes had already received their Nobel Prizes by the time the scheme collapsed. It would have been a pity if their careers had been impacted by something as petty as this.)
With all due respect, I think I’ll get my advice about shit from someone other than you.
October 16, 2008 at 2:12 pm
This article can do with a few more BOOM!’s. It is the only word which can capture the quickness of bankruptcy by derivatives.
October 16, 2008 at 9:24 pm
I think BP was on to something when he was talking about “reducing risk for companies and traders”.
Unfortunately, that appears to really mean “handing risk off to Washington”. Which is an old and fun game, but appears to have had the unforeseen consequence of tempting Washington into just buying out the bastards like London did.
October 18, 2008 at 9:57 am
Yes, that’s exactly what I meant. Ever heard of hedging with futures or options?
October 25, 2008 at 8:06 am
…described derivatives as potential “hydrogen bombs.”
…derivatives were “financial weapons of mass destruction, …potentially lethal.”
This kinda stuff sounds even sillier than Greenspan’s ’smart’ ’self-regulated’ markets. In fact, Greenspan’s bullshit sounds a bit less insane to me.
Derivatives are just pieces of paper, silly bets, how can they do a mass-destruction? You bet, and you lose, and someone else wins.
In a universe with 100,000 small banks and zero banking giants derivatives are completely (oh, OK, almost completely) harmless; in this universe with a few banking giants anything, any mistake is a “hydrogen bomb”.
October 25, 2008 at 1:05 pm
ABB1, the “somebody else wins” part is the weak spot in your argument. Your own theory that banking itself is the problem is a pretty blunt instrument. The people holding the silly position seem to have come out of this all right, if I’m not mistaken.
I was first introduced to derivatives almost ten years ago by the Andrew Wiederhorn case in Oregon. Wiederhorn was a seminal, cutting-edge finance whiz kid who used derivatives to leverage a moderate investment into tens or hundreds of millions. (He borrowed money to buy bad debt, contracted it out to debt collection agencies, borrowed more money against the bad debt, and went on from there). There was a downturn and he went bankrupt, but not before engaging in various kinds of fraud and destroying a union’s pension fund.
By the grace of God, a local weekly published a long worshipful article about him a couple of months before everything fell apart. The premise seems to have been that, since the journalist couldn’t understand how Wiederhorn did it, Wiederhorn must have been a genius like Einstein. I also didn’t understand it, but my interpretation was that something fishy was going on.
And it turned out that Wiederhorn didn’t understand what was happening either. He had never really planned to be a crook, he just believed in magic and believed in himself. In interviews immediately after the crash, he was explaining that there never had been anything wrong at all, and that someone else (New York bankers, I think) had ruined everything.
I’m sticking with my theory that at a certain level of complexity and unintelligibility, sophisticated financial instruments are time bombs because no one really knows how they work. I’m not terribly embarrassed to be on the same page as dummies like Soros, Rohatyn, and Buffet, rather than you.
(A universe with 100,000 small banks would be unstable too — it’s been tried. Did you know that in Minnesota during the Depression, the small local banks were in such bad shape that for a time they were in political alliance with the Communist Party? Fact.)
October 25, 2008 at 6:21 pm
It’s not my theory that (assuming capitalist or mixed economy) banking itself is the problem.
It is my theory that concentration of banking is the problem, Minnesota local banks’ cooperating with the commies notwithstanding.
Soros and Buffet are correct in this sense: in this current banking system derivatives are extremely dangerous, yes. But for this sort of structure – so massively centralized and concentrated, yet without any rules or clear objectives – pretty much any deviation or mistake can be deadly.
In a more decentralized system you would have some small banks controlled by Buffet and Soros, others by Greenspan and Schwartz. They could experiment and screw up all they want, get rich or go under, nobody would care.
It’s better to have (if possible) some sort of holistic environment, than to follow these leaders-geniuses like Buffet and Soros. They can be right today and wrong tomorrow.
October 25, 2008 at 6:31 pm
Before the Federal Reserve we had that kind of decentralized system, and we still had what were called “panics”. Economists always blame psychology (”irrational exuberance”, “panic”, “animal spirits”) when their system collapses.
At CT I’ve proposed a simple fix: abolish the federal reserve and go on the gold standard. Complete bullshit, AFAIK, and mutually contradictory I think, but people get tired of my unremitting negativity.
The Gold Standard Greenback Party cannot be defeated.
October 25, 2008 at 9:40 pm
No, I think federal reserve is fine. Isn’t it possible to simultaneously have federal reserve and more or less diffused banking system?
In fact, it should be a function of the federal reserve (if it isn’t already) to prevent unhealthy concentration.
October 26, 2008 at 1:09 am
Well, the reason that local Minnesota banks were communist-allied was that they were at the mercy of larger banks, but you need large banks for projects of any size — the small town banks made loans to farmers and small businessmen.
November 2, 2008 at 4:13 pm
Hey John, Scarlett Johansson says “Hi.” She was at the Obama office in Lakewood signing autographs and rallying the troops and was kind enough to give you a shout out.
November 3, 2008 at 1:04 am
Thank you, Helpy. This may push me over the edge, though. It will be your fault. What’s her philosophy of relationships?
She’s getting married, right — what’s her marriage cycle been to date?
November 17, 2008 at 2:42 am
“Reducing risk” through derivatives works if individual risk is uncorrelated. Which, by the way, is precisely the assumption of Black and Scholes. Correlation of risk *increases* the overall risk, as is clearly demonstrated by current events. People who believe theories based on flimsy, unrealistic and downright silly assumptions, over actual empirical evidence should not be taken seriously (and this clearly includes a lot of economists).
I agree that “ignorance is bliss” when it comes to derivatives and other esoteric instruments. It was pretty obvious to a lot of ordinary (non financial types) that there was a massive housing bubble that was going to crash. Of course, many of these people were probably in no position to do anything about it, or if they weren’t too greedy, they quit the market when the bubble had not completely collapsed.
November 18, 2008 at 2:58 pm
you need large banks for projects of any size
Why? Why can’t you borrow from a lot of little guys at once? With the aid of computers I don’t think the bookkeeping would be *that* complicated.
In fact, doesn’t the Treasury already do this and call it “bonds”? And the bookkeeping is even more simplified by fixing the maturity value and letting the sale value fluctuate; everyone knows exactly when the bond matures and what it’s going to be worth, if the issuer is solvent.
Maybe I shouldn’t try to understand the issue; but I think trying for some understanding is harmless as long as you don’t try to make money off it.
November 18, 2008 at 3:25 pm
Something that issues a lot of bonds to a lot of little guys would be a large banklike financial organization with all the problems and benefits that come from that.