Feeds:
Posts
Comments

Posts Tagged ‘John Cassidy’

I ended Friday’s post with the point that, contrary to what John Cassidy and Barry Ritzholtz assume in their arguments, what is rational is not necessarily good. The blurring of the line between reason and goodness comes, ultimately, from the ascendancy of atheism and, hence, materialism among intellectuals. In place of fundamental and eternally-established goods present in a theistic worldview, materialism turns to reason as capable of determining what’s good. I don’t know where Cassidy and Ritzholtz stand on the existence of God, but they both argue from materialist assumptions. To illustrate the difficulty that causes in seeing how to deal with the sources of the financial crisis, let’s take a look at a few quotations from Cassidy’s arguments.

In explaining the problems with getting cooperative behavior in a prisoner’s dilemma, Cassidy writes:

Attempts to act responsibly and achieve a coöperative solution cannot be sustained, because they leave you vulnerable to exploitation by others. If Citigroup had sat out the credit boom while its rivals made huge profits, Prince would probably have been out of a job earlier. The same goes for individual traders at Wall Street firms. If a trader has one bad quarter, perhaps because he refused to participate in a bubble, the results can be career-threatening.

In these two examples, Cassidy assumes that, at base, the good is self-interest. He notes that Prince would have been out of a job if he did not lead Citigroup into the credit boom and that individual traders who do not participate in bubbles stand to lose their job or see their career prospects damaged. All of those things may be true, but we can see fairly easily that, although the decision of a trader to participate in a bubble may be rational if he has the end of keeping his trading job, it would be irrational if he has the goal of only earning a living through activity that did not lead to long-term harm to himself and others. Indeed, if he has the second goal, his behavior in participating in the bubble would be illogical.

Let’s take another example. Writing about the subprime mortgage boom, Cassidy notes that

…many mortgage companies extended home loans to low- and middle-income applicants who couldn’t afford to repay them. In hindsight, that looks like reckless lending. It didn’t at the time. In most cases, lenders had no intention of holding on to the mortgages they issued. After taking a generous fee for originating the loans, they planned to sell them to Wall Street banks, such as Merrill Lynch and Goldman Sachs, which were in the business of pooling mortgages and using the monthly payments they generated to issue mortgage bonds. When a borrower whose home loan has been “securitized” in this way defaults on his payments, it is the buyer of the mortgage bond who suffers a loss, not the issuer of the mortgage.

Here, Cassidy gives the basic logic of companies giving home loans to people who cannot afford them. (For a first-person account of this logic in action, listen to This American Life, Episode #390, Return to the Giant Pool of Money. The whole episode, really the whole series of episodes about the economic crisis, is great, but the relevant section starts at about 17:05 on my podcast version.) Again, we can call the logic rational, but only if the goal of the mortgage company is to make money on a product that doesn’t have intrinsic value. If we assume that a mortgage company’s goal is to make money by providing loans to people who have a good likelihood of paying them back, then the mortgage companies Cassidy describes were acting completely irrationally.

So, if we cannot judge the goodness of an action by its rationality, we need to have another way of determining whether an action is good. This is where externally-established standards come into play. In a column in last Monday’s New York Times, David Brooks wrote about such standards and the role they have played in American national history. After quoting several statistics about ballooning personal and public debt in the U.S., Brooks makes the following observation and recommendation:

These may seem like dry numbers, mostly of concern to budget wonks. But these numbers are the outward sign of a values shift. If there is to be a correction, it will require a moral and cultural movement.

Our current cultural politics are organized by the obsolete culture war, which has put secular liberals on one side and religious conservatives on the other. But the slide in economic morality afflicted Red and Blue America equally.

If there is to be a movement to restore economic values, it will have to cut across the current taxonomies. Its goal will be to make the U.S. again a producer economy, not a consumer economy. It will champion a return to financial self-restraint, large and small.

In the broad strokes, Brooks is exactly right. We do need a “moral and cultural movement” to confront the shift in values away from discipline and rectitude, and it must be broadly-based. Whoever would like to be a part of that movement would do well to consider these two exhortations from The Hidden Words of Baha’u’llah:

O MY SERVANT! The basest of men are they that yield no fruit on earth. Such men are verily counted as among the dead, nay better are the dead in the sight of God than those idle and worthless souls.

O MY SERVANT! The best of men are they that earn a livelihood by their calling and spend upon themselves and upon their kindred for the love of God, the Lord of all worlds.

Only with such standards in mind can we use rationality to determine which actions are good and which are not.

Read Full Post »

John Cassidy at The New Yorker has a post at his new blog, Rational Irrationality, defending his position from an article last week that the financial crisis was caused by individuals making completely rational decisions that, when aggregated at the collective level, turned out to be completely irrational. In the original article, Cassidy explains that the Prisoner’s Dilemma is at the root of the financial crisis, and he’s certainly right about that. Cassidy’s explanation of the basic dynamics of the Prisoner’s Dilemma and their application to business and finance is as good as you’ll find, so I’ll quote it in full here. (Note: Charles Prince was the Citigroup CEO when Citigroup got into the business of CDOs.)

Because financial markets consist of individuals who react to what others are doing, the theories of free-market economics are often less illuminating than the Prisoner’s Dilemma, an analysis of strategic behavior that game theorists associated with the RAND Corporation developed during the early nineteen-fifties. Much of the work done at RAND was initially applied to the logic of nuclear warfare, but it has proved extremely useful in understanding another explosion-prone arena: Wall Street.
Imagine that you and another armed man have been arrested and charged with jointly carrying out a robbery. The two of you are being held and questioned separately, with no means of communicating. You know that, if you both confess, each of you will get ten years in jail, whereas if you both deny the crime you will be charged only with the lesser offense of gun possession, which carries a sentence of just three years in jail. The best scenario for you is if you confess and your partner doesn’t: you’ll be rewarded for your betrayal by being released, and he’ll get a sentence of fifteen years. The worst scenario, accordingly, is if you keep quiet and he confesses.
What should you do? The optimal joint result would require the two of you to keep quiet, so that you both got a light sentence, amounting to a combined six years of jail time. Any other strategy means more collective jail time. But you know that you’re risking the maximum penalty if you keep quiet, because your partner could seize a chance for freedom and betray you. And you know that your partner is bound to be making the same calculation. Hence, the rational strategy, for both of you, is to confess, and serve ten years in jail. In the language of game theory, confessing is a “dominant strategy,” even though it leads to a disastrous outcome.
In a situation like this, what I do affects your welfare; what you do affects mine. The same applies in business…. If Merrill Lynch sets up a hedge fund to invest in collateralized debt obligations, or some other shiny new kind of security, Morgan Stanley will feel obliged to launch a similar fund to keep its wealthy clients from defecting. A hedge fund that eschews an overinflated sector can lag behind its rivals, and lose its major clients. So you can go bust by avoiding a bubble. As Charles Prince and others discovered, there’s no good way out of this dilemma. Attempts to act responsibly and achieve a coöperative solution cannot be sustained, because they leave you vulnerable to exploitation by others. If Citigroup had sat out the credit boom while its rivals made huge profits, Prince would probably have been out of a job earlier. The same goes for individual traders at Wall Street firms. If a trader has one bad quarter, perhaps because he refused to participate in a bubble, the results can be career-threatening.

Following the argument in this last paragraph, Cassidy argues that the situation should be dubbed “rational irrationality,” as the rational behaviors of individual traders or firms leads to irrationality at the collective level. In other words, what’s good for all these individuals ends up being bad for the collective of which they’re a part. In this case, that collective happens to include the rest of us, too.

As Cassidy notes in his follow-up blog post, Barry Ritzholtz disagrees that the individual behavior Cassidy describes is rational. Quoting Cassidy:

Ritholtz writes: “ ‘Rational Irrationality’ asks us to ignore the repercussions of our behaviors. We can rationalize short term gains at the expense of long term losses, because we need to obtain quarterly profits regardless. Apparently, when it bankrupts the company, only then with the benefit of hindsight can we see what went wrong. I am terribly sorry, but that is precisely the sort of thinking that led to the crisis in the first place. Making loans to people who cannot pay them back is not rational when its profitable—its NEVER rational.”

As I mentioned, Cassidy defends himself against Ritzholtz’s argument, and at the risk of having this post be overly long, I’d like to quote the defense at length.

From a macro point of view, Ritholtz is right. Directing capital to people or firms who can’t afford to service it amounts to misallocating resources, and it is a form of market failure. But from a micro point of view, things are very different. Most of the people issuing sub-prime loans were loan officers at mortgage lending firms, such as Ameriquest and New Century, who were paid on commission. Neither they nor their bosses had much interest in whether the borrowers could repay the loans, and for good reason. They were intending to sell them on to Wall Street firms for securitization. If the default rates turned out to be higher than expected, it was the purchasers of sub-prime securities that stood to lose out, not the loan originators.
Now, this was certainly myopic thinking, but it wasn’t irrational. During the good years, some of these brokers racked up seven-figure commissions and bonuses. (See, for example, the excellent account of subprime and Alt-A lending in “Chain of Blame,” by Paul Muolo and Mathew Padila.) To be sure, some (many) of them ended up losing their jobs when the bubble burst, but that doesn’t invalidate the point: pushing sub-prime mortgages onto folks that couldn’t afford them was a lucrative business, and the people who were involved in it it were simply reacting to the price signals that the market was providing to them.
Ritholtz focuses on the role of the Wall Street firms. He writes: “On a risk adjusted basis, the behaviors of Citi, Bear, Lehman, New Century and others was hardly rational. Call it whatever you want, but do not forget this simple fact: It was the sort of narrow, risk-ignoring thinking that is ALWAYS rewarded in the short term, and ALWAYS punished in the long term.”
Sadly, this isn’t true either. During a bubble, the risks are rarely evident. If they were evident, asset prices would adjust and the bubble would pop. From the point of view of a trader, or a CEO, the bigger risk is missing out on the easy money that is to be made. In such an environment, the rational thing to do is surf the bubble.

After reading through this argument, it becomes clear that, at root, Cassidy and Ritzholtz disagree about what the word “rational” means. It’s here that we should step back. Both Cassidy and Ritzholtz think that, for any individual, “rational” means whatever is in that individual’s interests. It’s just that they apply different time frames to the interest. Cassidy thinks that short-term interests often outweigh long-term interests because a person looking at the long term to determine his short-term actions may guarantee that he’s not around for the long term. Ritzholtz, on the other hand, thinks that long-term interests can be seen, at least if one has a sense of history, and must be taken into account in the short term. Hence they disagree about what’s “rational”.

I’d like to suggest that they’re both missing part of the picture. They both assume that to declare something “rational” is to declare it morally good. Because something is rational, however, does not mean it is good. To determine whether a practice — selling CDOs, say — is good, I must have a set of criteria about what constitutes goodness. I may then use rational thought to determine whether a particular practice meets those criteria. But if the criteria are flawed, the practice may be rational — i.e. it may follow logically from or be consistent with the criteria — but it will not be good.

Rather than stretch your post-length tolerance any further, I’ll turn to this point in my next post. If you’d like a hint of what’s to come, you might like to read this op-ed from David Brooks at The New York Times earlier this week.

Read Full Post »