posted Sep 29, 2008
in Politics

More bailout stuff, skip if that makes you unhappy.

How did we get here? The economy is fantastically complicated beyond human comprehension, so we are forced to use heuristics to comprehend it. No amount of education can overcome this fact, which is why every economy professor is proposing a different solution; the education doesn't mean you actually understand, it "just" changes the heuristics.

My favorite heuristic for understanding the economy (and also a lot of business in general) is that people will do what they believe is best for them, based on their local comprehension of the situation, and that what other people intended for their local situation counts for nothing. Like many of my heuristics, this may sound blindingly obvious when stated baldly, but people clearly do not make economic predictions based on this. (By "people", I mean people in general. I don't know what economic professors base their predictions on.)

How did we get here, in terms of incentives?

  1. People who couldn't afford houses were given incentives to own houses in the form of cheap loans on assets rising in value very swiftly. Why were the assets rising in value? Because people could get cheap loans they should get. There's a recursion here. Plus, in general, people want to own homes.
  2. Congress has incentives to give things to people, and in this case they gave people a law that made it easier to get these bad loans. Note that it isn't strictly speaking correct to blame the crisis on this, because the real problem is the instability (in the mathematical sense) in the previous point. This didn't help, it may have been the biggest and most visible factor, but in a runaway crisis like this all factors are important.
  3. The major financial houses as a whole had incentives to keep the good times rolling. Saying that perception is fact in the world of finance would be overstating it by a lot, but perception is certainly a big part of fact, and so nobody's going to go out and talk about the real problems that exist. You can only mandate away so much of this.
  4. The individual bits of the financial houses had incentives to make everything appear to be doing better than it was, because they get the most bonuses that way. The best thing about dealing so much with projections and valuation based on the future is that it is easy to fudge them. Figuring out how to stop that is an incredibly deep philosophical question.

The reason why I think we need to strike at the second point is that it is the thing we have the most control over. The next thing we have the most control over is #4, though I can't even imagine how we can regulate away improper optimism. A financial crash would do nicely for at least some period of time, though.... in actuality we're probably getting this one no matter what, "for free", although if Congress or the Secretary of the Treasury really work at it they can undo that too.

I italicized "local" because it's the most important word in my heuristic and the part that people often miss (and not just in the case at hand). People do not act with a global perspective, even if they have it, which nobody actually does. This is in fact rational behavior because the uncertainty of what you believe is your global perspective is simply too large.

Even if somebody knows that globally, sub-prime mortgages are a disaster, it may still seem like the best choice, locally. I passed on getting one, but that wasn't because my believed global perspective told me it would hurt the national economy, it was because I believed that sooner or later it would hurt me. (The idea that I might be bailed out never even crossed my mind, which just goes to show how my global perspective was incomplete.) Money managers may even know that the good times can't go forever and that their misreporting hurts the global economy, but the local incentives of performance-based bonuses override that, fueling the rationalization-away of the global view most likely too. (And what's the alternative to performance-based incentives that doesn't simply result in nobody being willing to do it?) And Congress, well, Congress buying votes unto oblivion is currently the most likely way our country will end as a world power, edging out nuclear warfare in the 90's and currently holding a very comfortable lead over terrorism. If they have any clue that there's an actual, factual global reality out there beyond their pork politics, if they have any clue that the American economy is not in fact a blank check signed over to them, I haven't seen it in a while.

(On that note, on the eve of spending about 700 billion dollars, which is about 1,750 Bridges to Nowhere, give or take a few hundred Bridges to Nowhere, where's the increased scrutiny of Congressional spending in the press? If this doesn't serve as a wakeup call to tighten spending in Congress, tighten spending a lot, what will? Nothing, probably.)

There's too many people with local incentives to cause increasing instability in the housing market. We don't have to fix all of them, and can't fix all of them, but if we fix none of them, and if we in fact make it even safer for people to get bad mortgages, to make bad mortgages, and to continue to see local benefits, regardless of the intention of any bailout, what's going to change? If we don't cut off #2, we will still lose.

 

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