Some food for thought

Rather than blog today about Middle East developments, I'd like to flag some ideas that I think can and should serve as useful frameworks in understanding the economic universe as we go forward through this crisis:

The FT ran an excellent synopsis of "what went wrong" in financial markets in yesterday's paper. It's a bit funny but a bit sad that many of the best economists have spent more time trying to understand what the past few months really means or how much worse things can get (if you are Roubini) rather than trying to understand how we get out of this. They leave that, I guess, to the bureaucrats.

But the FT article raises some concepts that I think should apply not only to banking and investment but also to how everyday analysts like myself look at the world. The article lays out the concept of disaster myopia, or, as defined by the article, the tendency to underestimate the probability of disastrous outcomes, especially for low frequency events last experienced in the distant past. The author then goes on to explain that the markets' over-reliance on "the wisdom of crowds," ratings agencies, and econometric models led to what was fundamentally a lack of independent thinking, or for a better term, creativity. No one was able to see the fundamental errors in the investment styles that predominated the market from 1998-2008.

Untangling that web will be the work of economists for decades and while the FT article attempts to start to unravel some of the multi-layered issues that lead to the current crisis, it simply cannot account for everything. But the issue of a lack of creativity when it comes to economic analysis seems to be absolutely correct. In a less charitable mood, I would almost call it a lack of common sense rather than creativity. Inevitably, it seems, economists, financial gurus, and bankers are hard wired to dismiss contrary evidence. I would say this is true as much on the upside as it is on the downside. When noted geniuses like Warren Buffet can admit to not seeing the downside risk on oil prices last year and losing billions of dollars as a result, you know you have a problem. Why is it then that we cannot recognize changes in paradigms before they get too extreme? Why does a bubble have to burst before anyone recognizes that a bubble existed in the first place? And why do economists persist on believing that the laws of nature (what goes up must come down) do not apply to economics?

I think there may be a few large issues that need to be addressed if economics is to become more flexible and dynamic a discipline as it can be. Despite the discipline's dismal record of forecasting, economists persist on seeing themselves as quasi-scientists. The more hard data we have, the better. We rely on macro statistics to determine what's happening and what's likely to happen. The problem is that macro statistics are always historic. They tell you what's happened not what's going on currently. And econometric models more often than not forecast based on a straight line from those macro indicators. They are fundamentally unable to anticipate the discontinuous event.

But signs of the discontinuous events are always out there if you are able to keep an open mind. In September 2007 I listened to a trader warn of an impending disaster on Wall Street. He talked about the collusion of ratings agencies in rating CDOs, talked about the toxic assets that banks were hiding, and predicted the problem was going to grow much, much larger since those toxic assets were going to become even more toxic as sub-prime mortgages reset. The macro data did not support such analysis at the time, so his forecasts were largely dismissed. (We'll leave aside here that the data didn't support the analysis because the banks had not yet owned up to their looming balance sheet troubles.) Again, in June of last year, I heard commodities traders talk about how inflated the price of oil had become and predict that the collapse would be less likely to come from a disruption in the physical market but more from a disruption in financial markets. But, once again, despite the seemingly inexplicable run up in prices, analysts still argued that it was the fundamentals market and Chinese oil demand that were keeping prices up. That prices collapsed rapidly a few months later was something that analysts dealt with later.

A very smart and insightful colleague has for years argued that the devil is in the details. If you want to understand how the world works, there is little use to studying the macro numbers. Look for the micro stories instead. Because micro trends can add up to macro tsunami. If you need proof of that, think about how one speculator in Las Vegas, betting on the price of real estate continuing to rise, made up a market and a market took down a global financial system.

It's something to think about...