Is the Need for Simple Stories Getting in the Way of Banking Reform?

Let’s acknowledge the obvious: there are a lot of not trivial impediments to reining in the banking industry: the deregulation policies that put a comparatively small number of firms in charge of infrastructure critical to commerce; the fact that said firms have done a very good job at disguising the rents they collect; that those rents have now become so high as to allow the financial services industry to pay for a sizable lobbying effort to keep those favorable rules in place.

So any reform effort is up against very well heeled, very well placed incumbents. That makes it imperative that the case against its bad practices be compelling.

But are opponents doing themselves a disservice by demanding simple narratives as the way to rally opposition? Unfortunately, that’s a well documented human way of organizing information. Studies of jury decision-making have found that they do not proceed by weighing evidence, but by storytelling: to see what account of events they find most plausible.

An interesting essay on the crisis by Moe Tkacik in the Baffler, based on a reading of thirteen (!) crisis books, highlights this issue (Completely self serving aside: I am in the peculiar position of having a story in the same magazine, which by virtue of it being of the ones NOT put on line, appears to have been read by all of one person not associated with The Baffler, namely Felix Salmon, who was a good enough sport to say he enjoyed it throughly. This puts me in the odd position of having more people in my Long Suffering Circle of PrePublication Sanity Checkers having seen it than actual target readers).

This part of Tkacik’s essay caught my attention:

The above paragraph is excerpted from one of the most widely read texts to emerge from the financial crisis: the October 2008 farewell letter of a hedge fund manager named Andrew Lahde. The letter opens, “Dear Investor,” and closes with the words “goodbye and good luck”; in the fifteen months prior to authoring it Lahde hadamassed a 1000 percent profit for his clients and increased his own net worth nearly a hundredfold by anticipating the foreclosure crisis.

The letter depicts Lahde’s success as a victory over a class of people variously termed the “Aristocracy,” “the low hanging fruit,” the “idiots whose parents paid for prep school, Yale, and then the Harvard MBA,” who “were (often) truly not worthy of the education they received (or supposedly received)” but rose to the commanding heights anyway because they “had all the advantages (rich parents) that I did not.” Condemning politicians for repeatedly rejecting legislation that “would have reigned [sic] in the predatory lending practices” and bemoaning “a dearth of worthy philosophers in this country,” the letter challenged George Soros and other great minds to convene a meeting to devise a new form of government devoted to fostering a genuine meritocracy. “Capitalism worked for two hundred years, but times change, and systems become corrupt,” Lahde wrote….

Like Lahde, [federal judge Richard] Posner is pessimistic about the nation’s financial future, and he blames the coming full-scale “depression” upon a neglectful regulatory structure and an academy that had been “asleep at the switch.” The chief difference between the two seems to be their esteem for other capitalists. Where Lahde saw a financial industry peopled with mediocre trust fund kids who had traded their souls for Crackberries and Wellbutrin, Posner defends bankers “whose IQs exceed my own” as “brilliant.”….

..the rationally self-interested John Galt clones who seem to inform Judge Posner’s views are decidedly less believable characters than the rich-kid conformists Lahde indicts. And in a way, Lahde’s mixture of sympathy and contempt for his fellow financiers bodes better for the future of the American economy than does Posner’s soft bigotry of subprime moral standards. This is not an ancillary concern. If capitalism has failed, and socialism has failed, and the only remaining option is some improved version of the drab “mixed economy” that currently exists, then we are living in a perilous ideological vacuum.

Yves here. In particular, Tkacik notes that Posner calls for:

….a concise, constructive, jargon and acronym-free, nontechnical, unsensational, light-on-anecdote, analytical examination of the major facts of the biggest U.S. economic disaster in my lifetime….

I think a lot of people would like to see that too. And the very desire for something that simple is a huge impediment to reform.

Of all the things Posner asked for, the red herring is “non-technical”. I submit it is not possible to have an adequate description of the crisis without digging into, exposing, and explaining matters that ARE technical. Now that can probably be broken down in a way to make it accessible to laypeople but it will require a willingness to learn a bit.

Let us put it another way: Would ANYONE with an operating brain cell have demanded a “nontechnical” explanation of the Challenger disaster? Rocket failures are actually not uncommon, but even though the terrain and the forensic methods were presumably familiar, no one would expect the investigation NOT to be technical. It had to have been a materials, mechanical, electronic, programming, or human failure (or a combination of the above). Investigators had to look at how the flight came apart to determine the precise nature of the failure.

The disaster that befell the global economy took place in a vastly more complex, less well charted system. Moreover, most people accept that looting took place, they just don’t know how, exactly (and they may not be able to articulate it as looting, but they get that big bonuses and big bailouts should not co-exist). How can probing the looting mechanisms NOT be a critical step? And that by nature IS going to be a technically-oriented exercise.

Moreover, the attempt to reduce complex phenomena to simple accounts can be misleading, even counter-productive. The Depression took place eighty years ago, and economists and financial historians are still debating its causes and what remedies were effective. What is disconcerting is that the dominant narratives seek to attribute the depth of the downturn and the halting progress out of it to either poor monetary policy or poor and later inconsistent fiscal policy (most people forget that there was a steep recovery before the second leg downwards in 1937, when fiscal stimulus was withdrawn).

But single factor explanations of complex phenomenon are dubious. That period also included considerable financial reform (deposit insurance, the securities laws of 1933 and 1934), and both debt destruction via default and bankruptcy, as well as via restructuring, the Home Owners Loan Corporation, which refunded mortgages that had been five year bullets (not sure how much principal amortization, but there was still a large balance after five years) into twenty to twenty-five year fixed rate. It should be noted that even though the HOLC was seen as a risky gimmick at the time, the maturity matching was a much better fit than the old loans, which were of much shorter maturity than typical ownership, and the five year bullet simply created considerable rollover risk. Perversely, now with society more mobile (both physically and materially) and with homeowners refinancing more often, we have a maturity mis-match the other way, with fifteen to thirty year mortgages when relatively few people occupy the same house long enough to pay their mortgages off (and let us not forget that transaction costs are high….).

So the desire for simple narratives has likely clouded our understanding of the Great Depression. It may be that a whole series of elements are necessary but not sufficient individually for a sustained recovery to take place. Or there may be a significant “time heals all wounds” component: that a certain amount of debt writeoff/restructuring needs to take place for other interventions to have sustained impact.

Humans find abstractions and models useful in separating noise out from underlying, durable relationship. But the desire to find patterns can lead observers to see ones where the support is tenuous, or focus on some at the expense of others which may be just as valid. I hope enough of the people seeking to understand the crisis avoid falling for seductive, but potentially incomplete, explanations.

Update 7:30 PM. I see in comments that a lot of readers are unhappy with the notion that Posner’s and most people’s desire for a “….a concise, constructive, jargon and acronym-free, nontechnical, unsensational, light-on-anecdote, analytical examination of the major facts of the biggest U.S. economic disaster in my lifetime….” might actually impede reform efforts. I probably erred in focusing on “nontechnical” in my discussion. Upon further reflection, the real issue with his (and most people’s desire) is wanting both “concise” and “nontechnical”.

In my view, the investigations of the crisis have not deleved sufficiently into the complex products, the related trading strategies, and the profit/bonus determination methods related to them. That is where the looting took place. Until someone goes there, no account will be sufficient, and the odds remain high that the mechanisms by which the chicanery took place will remain intact.

Paul Volcker correctly dismisses what the industry has touted as “innovation” as unproductive on balance, but they still remain free to “innovate”. Volcker’s skepticism, no matter how well founded, is not backed by a compelling indictment.

Now when the forensic work has been done, the process by which the looting occurred probably can be broken down in a nontechnical form. But it will not be concise, and it is unlikely to be a simple narrative. That is where my beef lies.

For instance, UBS was forced by its regulators to explain why it got itself in a mess. They provided a detailed report to the regulators, and a shorter, more accessible one to the public in the form of a shareholder report. It runs to a full 50 pages. And even then, it is FULL of acronyms, so getting those out would make it even longer.

I also note that some readers jumped on the Challenger example, saying, “Oh, but it was a simple explanation! It was the O-rings! And that can be explained in a non-technical manner.”

Reader John L reminds us, by e-mail, that the O-rings were the proximate cause of the rocket blowing up, but there were NOT the real reason the astronauts died. The real cause was compromised design that resulted from the choice to have a reusable shuttle. He contends that if a similar explosion had happened in an Apollo rocket, the crew would have survived:

The idea of a re-useable space shuttle is one only a contractor could come up with. Its retarded, but it looks cool, and costs a lot.

Rockets blow up. When a rocket is performing correctly is blows up under the rocket. When one of a billion things go wrong, the oxidation of the fuel no longer takes place where it should, under the rocket.

Because of this there are a few very simple things that can be done to protect the payload. One of them is to put the payload as far from where the explosion is supposed to happen, on top You still have to harden that payload, but putting it on top of the rocket will lessen the chances that something goes wrong and fries the payload. If the fuel oxidizes by accident early, there is also less cross sectional area facing the payload. I can hit you with a broom stick, or jab you with it (which do you think might be easier for me?)

Put the passengers next to the fuel, and you are going to have problems. So, you have to harden the compartment that they are housed in. Its too expensive (and too heavy) to harden the entire re-usable ship, so you focus your effort on the cabin. This leads to the falling tin can with a windshield if something goes wrong.

The Apollo rockets all had the ability to bail out the crew, for the reasons above. An explosion would force the passenger cabin up and away from the rest of the explosion, and then a built in parachute could deploy and return the capule to the earth safely.

There was no way to build a parachute into the shuttle, It would have been blown up by the explosion next to and around the passenger cabin.

You end up rebuilding the rocket each time anyway, through inspection or parts replacement. You aren’t really reusing anything, you are just forcing all of the contractors to work on top of each other, and to all have to come to one place. Modular construction is the way to go, the shuttle program proves it.

The lobby is just like the banks though. They know that the end of the shuttle means no more govt money. They have been fighting the redesign all along. Just like the banks.

So who does the incomplete but compelling O-ring story, with its focus on proximate, rather than underlying causes, favor? The shuttle contractors, who get to continue with an initiative that is not as advantageous from a cost standpoint as they would have us believe, and puts the crew at more risk than older, safer designs. But some readers maintain this example bears no resemblance to the crisis.