This weekend I watched The Big Short. The movie makes a big deal, as does the book, about the odd personalities of the investors who saw the financial crisis coming more clearly than others. Some thoughts on that:
1. If the typical normal person (or normal investor or normal regulator) saw a financial crisis coming, then it would not occur.
2. At any one time, there are lots of outsiders forecasting extreme events. If you bet on outsiders all the time, most of the time you will lose.
3. The challenge for insiders is to filter out the noise from outsiders without filtering out the signal.
4. You filter out signal when you hold as sacred hypotheses beliefs that really should be questioned. As the movie points out, the hypothesis that AAA-rated securities are safe was sacred. The hypothesis that house prices never go down in more than a few locations at the same time was sacred. The hypothesis that new risk management techniques made old-fashioned mortgage underwriting standards obsolete was sacred.
5. People with outsider personalities are less likely to fall into the trap of holding hypotheses as sacred. If you don’t need to get along with the insiders, then you question them. You question them when they are right and you question them when they turn out to be wrong.
6. As you know, I think that MIT economics has produced a set of insiders who hold sacred hypotheses. Math equals rigor. AS-AD. Market failure always justifies government intervention. Etc. The Book of Arnold is an attempt to call them out on it.
“4. You filter out signal when you hold as sacred hypotheses beliefs that really should be questioned. As the movie points out, the hypothesis that AAA-rated securities are safe was sacred. The hypothesis that house prices never go down in more than a few locations at the same time was sacred. The hypothesis that new risk management techniques made old-fashioned mortgage underwriting standards obsolete was sacred.”
I can think of one other sacred hypothesis related to the financial crisis that you don’t mention here. Not that I blame you for not mentioning it.
Also, I’m not sure why the guys who saw the crisis coming don’t qualify as insiders. Does disagreement with the reigning insider consensus make you an outsider even if you work inside the system and have deep inside knowledge?
An additional point is that, while outsider personalities may be less likely to hold hypotheses sacred in general, some of them hold their pet hypotheses sacred and use the exact same language as the truly skeptical ones to convince insiders that it’s the insiders who have sacred beliefs. This makes it harder still to separate signal from noise.
I agree absolutely with the analysis, but I need to come out and say more broadly, I think the idea of “those who saw it coming” and “those who did not” is largely absurd. First, because you need pretty good timing to come out ahead–you might “see it coming” but one year too early, and you’re wiped out. Second, because you need enough funds to survive until it happens.
But most important, in a price bubble (as I think we can agree this was), people can rationally hold long positions in overvalued assets because they believe values will continue to climb “long enough” for them to cash out. So it is entirely possible that many insiders also saw it coming, but believed they had just enough time to ride the gravy train a little longer before cashing out.
FWIW, 2005 seems to be the turning point where the mortgages were going to default at above-average levels.
And we’re more or less back up to where we were back in 2007 in terms of nominal prices.
So unless you got wiped out by the actual collapse, buying in the mid-2000’s was a good choice. You’re still up. It just took a bit to get there.
Re: 2. “there are lots of outsiders forecasting extreme events.” If, after the event, you go looking for someone who had forecast it, you will find someone. You have not necessarily discovered unusual prescience. You have discovered a law of probability.
My personal experience is that faith in a hypothesis is less relevant than the work politics. It is nearly impossible to be in a firm that is making fast money and to go around telling everyone to pull back, that serious trouble is around the corner, and that they should willingly make less money and play it safe.
Physicists have given mathematics a good name. It seems that equations can predict everything because they predict so much about the physical world. But, this is a shallow understanding of math and physics. Physicists have carefully investigated the predictions made by their equations and have thrown out all of the “non-physical” results. Math predicts physics only because physicists have thrown away all of the math and interpretations which turned out to be wrong.
In particular, equations do not care about cause and effect, and it is easy to manipulate equations and then interpret them as saying that the effect produces the cause.
This is common in economics, where biased economists compute some result and then proclaim that it must be correct because the equations say so. The worst offender is Keynesian economics. The Kenesian spending multiplier comes from reversing cause and effect.
In reality, the more complicated the math and the more factors which go into it, the more likely that it is wrong.
The failure of any macroeconomic theory to predict makes all of those theories useless. It is laughable that support for some theories comes from what supposedly didn’t happen. The US government spent $800 billion in “economic stimulus”, and proof of its good effect is supposedly that the recession wasn’t worse. There remains no official prediction of the following dismal unemployment rate or slow growth in GDP. All we have are possible explanations of the past given after the fact. That is narrative, story telling, apology, not science.
Some economists spin theories which would supposedly help if government executed the resulting policies, but they defend themselves by noting that governments don’t do it the right way. They fail to predict in detail the result of the bad policies, except that some good result supposedly didn’t happen.
The real purpose of macroeconomics seems to be to give politicians a justification to spend more money on the projects of their cronies and supporters. Is there a macro theory which calls for less government spending and lower taxes?
Frank J. Tipler is Professor of Mathematical Physics at Tulane University. He writes that macroeconomists are not scientific. They are guessing and encouraging experiments on the public. Tipler wrote the following article, although the byline is “Original Content”
Macroeconomics ‘Experts’ Apply Astrology, Not Science
http://www.realclearmarkets.com/articles/2009/01/macro_experts_apply_astrology.html
“4. You filter out signal when you hold as sacred hypotheses beliefs that really should be questioned. As the movie points out, the hypothesis that AAA-rated securities are safe was sacred.”
Actually, senior-tranche, AAA-rated mortgage and asset-backed securities paid off at par, by and large. AA, A, BBB subordinated securities defaulted.
“…by and large. ”
There is a lot of slop in that caveat when you have a system that may fail catastrophically at any default rate whatsoever.
“The hypothesis that house prices never go down in more than a few locations at the same time was sacred.”
This is OT from your broader point, but what % of home values in the country in 2005 were in the four Sand States of CA, FL, AZ, and NV? California homes were triple the national average and the other three states were about twice, so I’m guessing that about half the value of homes in the country were in four states, with CA/AZ/NV being something like one or two interconnected markets. If you include Las Vegas and Phoenix in Greater Los Angeles, which for Bubble purposes seems reasonable, how much of the pre-9/15/08 plunge was in just a single if vast local market?
Late in 2008, somebody calculated that 7/8ths of the decline in home values were in those four states. (Sure, Greater Detroit was hit hard by the subprime collapse in 2007, but it’s home prices were already low.) After that, the recession drove down home prices just about everywhere, but the initial shock came from a fairly isolated bubble.
I recently watched the movie. There is one aspect of the movie narrative that is lacking in this discussion.
The “heros” of the story were not merely “outsiders” who questioned conventional wisdom. Importantly, they combined this with their own superior empirical work. They de-constructed those mortgage pools to find out what was in them, did surveys “on the ground” to get a better idea of what was actually happening and drew the proper conclusions. Per the movie, that was something nobody else bothered to do. They were not just being contrarians for the sake of being contrary, nor were they “lucky”: they actually had to go out and create a vehicle that would enable them to short MBS’s in order to capitalise on their research.
Of course, “if the narrative is to be believed” is a big “if”, particularly in the movie business. I viewed the movie as a broadside against the EMH. I don’t think the story disproves the EMH (depending on which version you choose), but it does seem to demonstrate that it is possible for those with superior knowledge and effort to “beat the market” and this should be an asterisked footnote to any EMH story.