Random as a Coin Toss
When I hear people say ‘It is different this time.’ I usually try to think -- what is the contrarian bet? For example, if everybody is saying we are in the early phase of the Japanese style deflation, as a contrarian, I might suggest we might be on the verge a new productivity cycle instigated by Internet 3.0 and the integration of a huge quantity of highly educated labor from emerging market nations. Who really knows? I think such a prediction is as random as a coin toss.
The New Economy
In the late 1990s, people said we were in a ‘new economy’, free from the boom and bust of the business cycle that plagued the ‘rust economy’. In the new ‘information economy’, just-in-time manufacturing and real-time logistics had solved the dilemma of inventory cycles that led so often to the boom and bust of business cycles. The new economy would ride smoothly as omnipotent central bankers like Alan Greenspan, referred to as the Maestro, would engineer soft landing after soft landing. We now know this kind of thinking was horse manure. It is true that advances in manufacturing enhanced the profitability of firms, but it did not make them immune to the business cycle.
Move On
In meetings with clients, I often say that most people will remember 2008/2009 like they remember the Crash of ’87 (1987), the S&L Bailout (1989), the Bond Crash of ’94 (1994), the Asian Contagion (1998); or the Tech Crash (2000), or the housing busts of 1979/1980, 1989/1990, and 2006/2007. Or O.J. Simpson’s murder trial, or Janet Jackson’s wardrobe malfunction, or Brittany Spear’s tribulations or Tiger Woods’s indiscretions. While the media may want to exploit these events in order extrapolate broader implications about society or the economy -- life simply moves on. People’s attentions move on. The economy moves on.
The Education
In college, I spent a whole semester studying an autobiographical book called the Education of Henry Adams. Intercollegiate Review ranked it the best book of the 20th century and Modern Library (a division of Random House) ranked it #1 in its list of Top 100 Non-Fiction books. Adams released the book privately in 1907 to his friends and it was eventually published after his death. To give some color on his station in life, his great grandfather and grandfather were the 2nd and 6th Presidents of the United States.
Henry Adams was born in 1838 and died in 1918. He was an American intellectual and represented himself as a journalist, historian and writer. During his lifetime he observed significant changes in society and technology. He witnessed the rise of steam powered rail transportation (1830s), electric light (1880s), motion pictures (1890s), and the automobile (1900s) – just to name a few of things that impacted the world he lived in.
In the latter part of Adam’s life he explored the idea of applying the laws of nature (Newtonian physics) to explain or even predict the course of human affairs. But eventually, by the end of his life, he decided this was a futile exercise as life unfolded in ways that were truly unpredictable, or at least that is what I thought he was trying to impress. The Education was one of those books that had a profound impact on my understanding of the world and history.
Maybe A Couple Paragraphs
While the Financial Panic of 2008/2009 has been an important event in terms of affecting millions of people all over the world, it is not, in my opinion, some watershed moment, or one of the more important events in history. It will get a paragraph or two in a history book, and perhaps a few pages in an economics textbook, maybe a chapter. The economics profession will likely have to integrate more ideas from behavioral economics to provide a more robust understanding of how financials markets really work. But has this event torn asunder the idea of the efficient market hypothesis, the idea that markets are made up of participants acting rationally on all known information, public and non-public? No. This financial panic has only demonstrated, once again, our limited understanding of the world around us.
Rational Until Panicked
Humans are rational, until they are panicked. Panic is born from truly unpredictable and random events, and that is why humans become panicked in response to those events. In our attempt to master everything, to predict every possible outcome or reaction to every set of inputs is truly a futile exercise. There will always be a set of circumstances in financial markets that will lead to financial panic despite the fancy risk models of the quants[i], or the best efforts of policy makers and politicians to create a more perfect order.
Enforcing Common Sense
We can make our financial system more stable by enforcing the rules we already have; we can limit excessive risk-taking by curbing the amount of leverage in the system (or clearly segregating highly leveraged entities and providing transparency so markets can assess the risk), we can minimize bad debts by employing prudent lending standards – these are not new ideas or rules – it is common sense. We have had laws in place to prevent such calamities, some born out of the experience of the Crash of ’29 and S&L Crisis of the 80s and early 90s. Financial institutions have simply gone around these rules by developing new kinds of entities or new kinds financial instruments -- all under the guise of financial innovation (driven by greed and hubris). We simply need our old rules to adapt to these new innovations and we move on – until the next financial -- crisis which I am sure will be unprecedented.
[i] See http://en.wikipedia.org/wiki/Quantitative_analyst
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