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« Shadow Congress | Main | Thugs, criminals exhale »

Jun 01, 2010


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I think the Cold War is an example of a time that presented a risk that was too awful, too incredible, for ordinary people to fully comprehend the catastrophe that, conceivably, awaited them.

Full-scale nuclear war was between East and West would have rendered the majority of the northern hemisphere uninhabitable radioactive rubble. The prospect that the conflict would have triggered climatic changes ending higher forms of life on Earth was, and still is, a very real possibility.

But, yet, fictional accounts of struggling survivors of a nuclear holecause are abundant, and often popular. American version of this cliche often show the survivors as functioning in a latter day version of the American frontier, with characters compelled to be free, independent and self-reliant. I've mostly thought they'd be dead.

Of course, although the U.S. and Russia are reducing their nuclear stockpile, both nations retain stockpiles sufficient to effectively end life on this planet as we know it. Several other nations -- Britain, France, China, Israel, India, Pakistan -- have enough weapons to create hell on earth.

It is sobering to understand that the only thing that prevented nuclear war during the Cold War was the will and good sense of a very few presidents and a very few general secretaries. Personally, I find that a very scary state of affairs.

These days, I've seen more than one commentary describing the terrorist threat as existential, as threatening the existing of the United States. That represents a gross exaggeration of the threat terror poses. Terrorism, in a very real sense, threatens individual Americans, but it does not threaten America. For four decades in the 20th century, this county and the Soviets engaged in policies that, ultimately, threatened the physicial existence of their respective countries. Perhaps we can be forgiven for questioning the abilities of leaders who put us in such a position.

Jim Caserta

Those two categories miss the cost element. People didn't want to think about a housing bubble because they enjoyed the free money, the pick-a-payment loans, free tax free heloc-income. Realtors enjoyed the increased fees from massive churn, as did the loan originators who made more the more often people bought, sold or refinanced. Bear, Lehman & Merrill booked massive profits in 2006. People were blinded by the money they were making, not by any psychological underestimation.

People can be making long-term bad decisions, but as long as the short-term looks rosy, it is very hard to convince them of the error of their ways. That is something that people need to understand about markets - they do not act instantly, they often take time for their presence to be felt.

BP underestimated a spill and its effects because it benefited them financially (short-term) to hold that idea. If there was not a massive financial upside to the underestimation, it would have been more realistically considered.


People who try to interject reality into risky situations are not treated kindly.
It is much more exalted to be a hero (saving foolish people by way of money or reconstruction) than it is to be a Cassandra. Party on.

Ed Cone

Another element -- politics that congeal into faith and bad policy. See: Greenspan, Alan, "shocked."

Jim Caserta

I'm not the only person who thinks Leonhardt might be limited in the two types of mistakes he lists.

However he gets the story of the housing bubble and the budget deficit almost completely wrong. He argues that Greenspan and Bernanke missed the fact that the economy faced a nationwide housing bubble because we had never seen one before. While that may be partially true, this comment also ignores the incentives facing the Fed chairs.


In short, the problem was not that they underestimated risk. The problem is that they face an entirely assymetric tradeoff structure. Clamping down on financial speculation was sure to have serious consequences for their careers, even if they were right. By contrast, failing to regulate properly did not seem to damage either man's wealth or stature in any major way even though it led to just about the most distrous possible outcome.


Ed Cone

And, as noted in an earlier comment, Greenspan was deeply invested in a belief system that made inaccurate assumptions about risk. The great empiricist turned out to be a credulous acolyte of a childish philosophy.

Jim Caserta

The point I was trying to make is the difference between philosophical 'investment' and financial 'investment'. If your firm's profits (short-term) are predicated on ignoring a certain risk - home prices falling - you ignore that risk. I have linked to this before, maybe not here, "Absence of Fear":

My associate asked several questions. “What are the key drivers of your rating model?” They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years. My associate then asked, “What if HPA was flat for an extended period of time?” They responded that their model would start to break down. He then asked, “What if HPA were to decline 1% to 2% for an extended period of time?” They responded that their models would break down completely. He then asked, “With 2% depreciation, how far up the rating’s scale would it harm?” They responded that it might go as high as the AA or AAA tranches.
This also goes along with Chuck Prince's infamous "if the music's playing, we're dancing". Greenspan could have been motivated by more than just philosophy. The banks that were making tons of money on the run-up of the housing bubble held a huge amount of sway. Had there not been huge profits in the ignoring of the risk, the risk probably would not have been ignored. But the corollary is that without the ignored risk there wouldn't have been the profits.

When the philosophy lines up with the profits, it's easy to stick to and rationalize. Balancing short & long-term profits and the idea of limited corporate liability are necessary to consider when discussing how people think about risk.

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