Over at Naked Capitalism, there has been a lot of talk about the risk of default in Fannie Mae and Freddie Mac. As someone without a mortgage or a home part of me is kind of enjoying the whole debacle since I rather foolishly half-believe that I can sit on the sidelines and watch this slow-motion wreck wind its way across America and, increasingly, Britain. However, the implosion of either of these two companies would make Bear Stearns look like a minor blip on the financial radar.
The thing that I am still struggling with is how so many purportedly smart people can be so unbelievably stupid. I have never had a mortgage or been a sophisticated investor but even I could tell that this whole boom was going to come to a very ugly end at some point in the decade. Obviously, in some cases mortgages were deliberately mis-sold to people in no real position to know better, but there are a lot of people without this excuse and I’m especially curious about what was happening in the minds of the brokers/investment bankers/fund managers.
I can only see it as a particularly expensive example of the same sort of groupthink that led Wired to predict that the Dow would hit 20,000 shortly before it did something very, very different. Unless there has been a persistent, largely-unexamined dimension to this: you put a bunch of hyper-competitive/hyper-smart people in a room where they can make and move around such large amounts of money that the sums no longer have any kind of tie to the real world. These people ‘inspire’ each other to more and more risk-taking in order to ‘beat the other guy’ and people lose sight completely of the fact that there is a big downside to getting it all wrong.
Except that thanks to the 2 and 20, or 4 and 40 rule the downside looks a lot smaller than the upside to taking on all that risk. Basically, if you’re not completely incompetent then you make shedloads of money when the money is easy and when it all falls apart you’re still doing fairly well as long as you haven’t spent every penny you were pulling in. If you really do hit rock bottom, then I guess you’ll have to sell the Renoir.
Taking a broader view, my friend Dave is (if I can describe it correctly) doing his PhD in economics on how thinking by analogy affects decision-making. I’m glad to see that there are serious, smart people thinking about this because economics really needs to get out of the rationality trap. I don’t know why we haven’t done away with this idea completely because we so clearly aren’t rational in so many areas of our lives, but I guess rationality makes it easy to predict what people will do. Except when it doesn’t.
This is kind of a continuation on my thoughts about commuting — what creates those ‘tipping points’ where behaviour starts to change in measurable ways?