The Value of Fear II

Let's start where the last post left off, with the words of Milton Friedman; That capitalism is a system of profit and loss and the latter is just as important as the former. The profit comes about because we are greedy, because wealth is relative, not only to what our peers have but also to what we ourselves have, most people do not consider themselves wealthy even though if you are reading this blog you are probably financially better off than 90% of the inhabitants of planet earth. Just as 90% of people think they are above average in terms of looks, intelligence and driving ability, we tend to thihnk of ourselves as less well off than we are and want more, all that stands in the way of this insatiable desire for more is fear. the fear that we may lose what we already have. This fear is powerful, in Nudge, Richard H. Thaler and Cass R. Sunstein show how we value what we have much more than an identical object we do not have. So surely this should stop us taking undue risks? It's what stops us putting our life savings on black 27 on the roulette wheel, stops us going all in when our odds of a flush are tiny. Regarless of the potential profit the fear gives us prudence. We are careful with our own money. 

The problem occurs when we are given an opportunity to gamble with other people's money, countless studies, some particularly good ones documented by Dan Ariely in his book "The Upside of Irrationality" demonstrate that giving an indidual money to gamble and telling them that it is theirs increases prudence, whereas if you tell them they are just gambling for you prudence goes out the window and that 100 to 1 shop becomes much more inviting because, after all, there is no downside. The work that best sums up the actions that governments and bankers used to allow investment banks to use more and more money, less and less of it being their money is one by Russel Roberts entitled "Gambling with Other People's Money: How Perverse Incentives Caused the Financial Crisis". Russ is the host of "Econtalk" a weekly economics podcast funded by the library of economics and liberty that I would recommend to anyone with even a passing interest in the way the world works.

In this paper Roberts uses the analogy of a poker player, but not in the way various economic correspondants and financial chiefs use it as trying to equate the economy with it's billions of unknowable factors influencing the probability of any single event occuring that is so lamented by Nassim Taleb, author of the recent "Antifragile", but instead to convey a compliated message in simple terms.

Imagine you are a poker player, a very good proffessional poker player, but you're having some cashflow problems. You want to enter a contest and it costs 100 dollars, and you come to me and tell me that you'll put in 3 dollars of the enterance fee if i put in the other 97. The conditions of this loan are that regardless of how much you win I'm just going to get my 97 dollars back, maybe with some negligible interest which we'll ignore for now.

This was the morgage market pre 2008 crash.

So why would I loan you the money? And why did the banks loan people money that meant they owned houses that were 32 times more than their deposit? Let's explore the possibilites.

1.  Maybe you're such a good poker player that you've never lost it (i.e. house prises are rising everywhere are steadily and they are projected to continue doing so) This is a classic example of greed. I see virtually no chance of you losing so why wouldn't I loan you the money?

2. Maybe I'm a huge fan of poker, I like to see it played and if I can facilitate it's playing in the same way that people buying houses is seen to be a "good thing" that banks want to support, and to be seen to support. Homeownership has been seen (for right or wrong and that's another blog post by itself) as part of what makes "the good life" and it's facilitation is seen as persuing a social good.

3. Maybe this isn't just a relationship between you and me. Maybe in addition to us and all the other player you're competing against and with there's another man in the corner of the room. Roberts calls him Uncle Sam, and most of the time he just sits there and watches the game because he, like me likes poker and likes to see it happening, occasionally he comments on how the tournament is going and that has an effect on how you and the other players play. His very prescence in the room changes the incentives for everyone, because there is a belief (the relative legitimacy of this belief both before and after the crisis will be the subject of future blog posts) that is shared by both all the players like you and all the people like me funding the players, that if everything goes pear shaped then Uncle Same will fix things, rescue everyone, bail people out. 

What is the effect of this? How does this change everyone's incentives? Let's have a look.

Without Uncle Sam you, the gambler, have so little to lose. 3 dollars. So if a 50:50 chance to win comes up, and you stand to either lose 3 dollars. or make 100 dollars (because after winning 200 you only have to give me back my 97 dollars), you're going to take it. Greed will outweigh what little fear you have, but I don't want you gamble like that, because it's my money you're going to lose, so I keep a close eye on the bets you make and make sure you arn't being too greedy, and if you don't listen to me then I'll just stop loaning you money. 

And this is what the banks should have been doing, monitoring who they were loaning money to especially people with low or no credit rating, they facilitated people that never should have gotten car loans to get mortgages! and all this based on one truism; that house prices would continue to rise and if the borrower couldn't keep up payments they could refinance based on the house's new worth, and if the worst came to the worst they would default and the bank would own the house which was still worth more than the original loan. Heads you win, Tails you win even bigger.

Uncle Sam's implicit prescence corrupted all this. No longer did banks care who they lent to. No longer did investors worry about the mortgages behind the bonds they were buying. Everyone knew that the government stood behind the banks. And with this betrayal of a fundamental free market principle the capitalist world imploded.