[Non-Family Topic] My Take on the Financial Crisis

Date October 20, 2008

I’ve been thinking quite a bit about the financial crisis, as well as reading up on various economists’ takes and listening to some podcasts that have covered the subject. There is a lot of energy being devoted to arguing about who should be blamed. I suppose that’s no surprise as we approach the biennial (or quadrennial, really, when it comes to a real fever pitch) rhetoric-heightened period of American political consciousness. 

So…here’s my take.

Warning: The conclusion blames no specific people, no specific political parties, no broad classifications of a subset of the population (“Wall Street fat cats,” “the liberal elite,” etc.), and no overall indictment of the United States or the free market system. 

Quite a bit of my thinking is tied to what I learned from three professors at The University of Texas between 2000 and 2002: Dr. C. Courtland Huber (ostensibly teaching Financial Accounting, but teaching a libertarian economist’s view of the free market and many, many other things), Dr. Bob Mettlen (Macroeconomics), and Dr. Stephen Magee (Microeconomics — get a sense of him in this video). My thoughts are driven as much by the content (and some very specific anecdotes) from that experience as the fact that, given three intense classes, how qualified I am (or…am not) to assess what went wrong and who is to blame.

What I Had Learned (And Hadn’t) after a Semester of Macroeconomics

On January 3, 2001, the Fed surprised everyone with 0.5 percent cut in interest rates. This was an effort by Alan Greenspan to stave off a recession as the economy was in the final bumps of the bursting technology bubble that ran through most of 2000. I had just completed a semester of macroeconomics; I was arguably at the peak of my understanding of the subject. I sat down and posted on my class’s discussion board my interpretation — given the knowledge I had gained over the previous three months — of what had happened and why as both the lead-up to that cut and the ensuing fallout. This launched a thread with other students chiming in, and we were all feeling like very bright little MBAs with what we came up with. As the thread petered out, I sent Dr. Mettlen an e-mail asking him to take a look at the analysis and let us know what he thought. It took him a couple of weeks to respond, as he was in Europe on vacation, but, when he did, his response was something to the effect of, “Everything you and your classmates put in your analysis is technically correct. But, you have the benefit of hindsight, and you haven’t taken into account dozens of other factors.” He then pointed me to a page from our textbook that illustrated many of the different factors at play in our economy. This was somewhat humbling. 

What this taught me: There is a reason that people spend their entire careers trying to understand and model the economy — it’s ridiculously complex.

For that reason, I get a little frustrated by politicians and pundits who keep trying to dumb down into sound bites both the underlying causes of the crisis as well as the proposed fixes. The truth is, the overwhelming majority of the population is years and years of education away from being able to understand what happened or to legitimately chime in with a fix. And, by overwhelming, I mean well north of 99%. Which leads me to… 

An Analogy…

I hatched an analogy a week or so ago, and it seems to continue to hold up (assuming my take on the economy is somewhat valid). Put simply, the evolution of the economy is analogous to the evolution of the automobile. 

Here’s how:

When automobiles first hit the mainstream, largely due to Henry Ford, their mechanics were relatively straightforward. They had a simple internal combustion engine that was firing off little explosions inside cylinders that drove pistons that, through some basic mechanical connections, turned the wheels. Many of the people who owned a car, out of necessity, had to be able to troubleshoot problems and perform most fixes.

The economy in the early days was the same way. It wasn’t long after society moved from a barter-based system to the introduction of currency that “banking” cropped up (which happened at various times in different societies) — people found ways to use their excess cash to their benefit, while people who were short on cash/assets were able to borrow for their own needs. Like the early days of the automobile, the people who were using cash — all of them — understood pretty much everything that was going on.

Back to the automobile. As soon as it went mainstream, as manufacturers looked for a competitive edge, they began rolling out enhancements, which lead to air conditioning, power steering, power windows, engines with more horsepower, engines with better gas mileage, and so on. With each enhancement, the car became more complex. And, the number of people who could pop the hood and truly understand what was going on started to diminish. That (along with the explosion of the number of cars in existence) led to the rise of the auto mechanic as a full-time profession. Mechanics went through training and then through 40 hours a week of practice. They gained the experience needed to understand what was going on under the hood, to identify and fix problems with the car, and even to see early warnings of trouble and take corrective action. As the automobile became more complex, the number of shade-tree mechanics, or at least the scope of work they could reliably perform, decreased. For me, the introduction of electronic fuel injection as a replacement for the carburetor marked the point where I realized the evolution of my understanding wasn’t going to keep up with the evolution of the technology. For my dad, I think the point occurred the first time my mother’s mid-1990s Mazda Miata needed it’s one-year annual maintenance, which involved hooking it up to a diagnostic computer that ran a bunch of tests. And now, we’re at the point of hybrids coming on strong…but let’s get back to the economy for a minute.

The field of economics evolved in a similar way. In that case, though, competition was between financial institutions (in the broadest sense) rather than simply between manufacturers of tangible goods. Competition was driven by two things: 1) Making as much money as possible in the financial markets, while 2) managing risk effectively. Economics 101: higher risk –> higher reward, right? Financial derivatives were invented to hedge risk without dramatically decreasing the reward. This was good. Free markets and competition were driving innovation so that both pure financial institutions, as well as the finance people at companies, as well as personal financial managers, could all work together in a fair manner so that money sat truly idle as little as possible. Like the automobile industry, this added complexity quickly moved to a point where a steadily decreasing number of people truly understood how all of the moving parts fit together and affected each other. As a matter of fact, even the people who were recognized as being the most brilliant economists had fundamentally different philosophies as to what was going on — thus, the rise of the “classical economists vs. Keynesian economist” structure.

Now we’re at a point where the automobile and the economy have moved well beyond where casual dabblers can legitimately claim to understand what is going on. Even the experts have trouble wrapping their heads around all of moving parts. In both cases there are:

  • The systems (“the car” or “the economy”)
  • The components of the systems (car: drive train, transmission, cooling system, etc.; economy: stock market, bond market, foreign exchange market, etc.)
  • All of the moving parts within each component

And, here’s where things have changed. In both cases, we look at the components as black boxes that perform some function — they have some form of input and some form of output. In some cases, we may understand the inner workings of one component or another, but things are just too complex to really understand the inner workings of all of them. This, I believe, is a fundamental change from 50-100 years ago.

In the case of automobiles, this is okay. There are “system designers” and “system tests” that focus on the inputs/outputs of each component and how the components tie together. The system designer puts forth detailed specifications as to how each component needs to behave from an input/output perspective (as well as from a size, shape, and cost perspective). The component designers then work to build a “system” that meets those specifications. And, their testing is “unit testing” of the component — does it perform to the component’s specifications, and, if not, then how does the design need to be changed? Many of the people who work on these components don’t actually have a fundamental understanding of “the system” overall — they just know their part.

With the economy, it’s the same thing, but the specifications are both murkier and clearer. The financial markets in a free market system operate on the premise that there are inefficiencies in “the system.” Finding those inefficiencies and exploiting them is a way to make money. But, the more people there are exploiting those inefficiencies, the less money can be made. That feeds a continual search for new inefficiencies and friction points to exploit. From a macro level, this is generally a good thing — it drives efficiency. But, like the car example, it also means that we have been developing increasing specialization in the subsets of the economy and financial markets — people and computer models that are adding complexity to their “component” while assuming/expecting the other components to continue to function as they always have, and for some universal truths about “the market” to remain true (e.g., companies can always issue commercial paper to raise money, although the terms they get for it will vary; credit default swaps can use leverage and, if used correctly, still provide minimal risk; if you bundle up enough risky mortgages, the overall risk of the investment will do down, etc.). When it turns out that various components do get pushed too far, and their interaction with each other does break some of those universal truths, you get a meltdown.

Like the automobile, the system/component hierarchy continues to grow deeper and more complex. Each component is its own system comprised of complex components, which, in and of themselves, are systems comprised of complex components. Who doesn’t know of a case where a car started experiencing mechanical problems because of a “bad chip” buried somewhere in the engine that only a diagnostic computer could identify? My parent’s first-generation Prius broke down earlier this year and was borderline totalled. It wasn’t because of the way it had been driven, nor due to a lack of maintenance (although my dad grumbled every time he took it in to the Toyota dealership because of the price of the work, he took it in religiously). It was largely a case of an underlying weakness in the overall system design that Toyota was not able to identify until it started cropping up five years into production. In the economy, the equivalent situation comes from financial derivatives that are built on other financial derivatives that are built on other financial derivatives — many levels down until you get to a basic financial instrument. The solution isn’t — and, really, cannot be — “don’t allow that complexity.” 

As I was flipping through my old Finance textbook, I caught a sidebar about the Great Depression. The source of the sidebar was a paper by Ben Bernanke, which, on the one hand, was not a surprise, as there has been a lot of press about how the Great Depression was Bernanke’s specific area of expertise. On the other hand, it had not really struck me that there are so many complexities in the economy that, when someone is a “recognized expert,” that there is a good chance that he would be the person referenced on the subject in a run-of-the-mill college textbook.

So, that’s really my take. It’s not Barney Frank’s fault. It’s not Hank Paulson’s. It’s not Ben Bernanke’s. It’s not Alan Greenspan’s. It’s not George Bush’s. It’s not the Republicans’. it’s not the Democrats’. It’s the system. Or, rather, our approach to the system and how it can/should evolve over time. It’s a system built on a pretty good underlying premise — incentivize people to find inefficiencies, and the system will improve. That same macroeconomics professor I mentioned earlier once made a comment to the effect of how we would never have another Great Depression, because we’ve analyzed where the government took missteps and won’t make the same mistakes again. In 30 years, I have no doubt that we will look back and say we won’t make the same mistakes again that led to this crisis. And, we probably won’t.

I actually think McCain was on the right track at one point during the second debate: get the brightest economic minds in a room and let them try to come up with a plan. The kicker? Time is short, and Bush isn’t going to take that approach. I don’t have the answer. Neither does Obama, nor McCain, nor Nader, nor Barr. Nor anyone at an Obama or a McCain rally. Nor you. It’s going to take some good hard work with some serious computer models from people in academia, government, and industry who are looking at this full-time. The rest of us ought to stay the hell out of it.

15 Responses to “[Non-Family Topic] My Take on the Financial Crisis”

  1. Shawn said:

    Tim,

    While your argument that the world economy is so complex, that the meltdown could have been the result of a butterfly flapping its wings is probably more accurate, I do find a trail of mistakes that helped contribute to this. I think our world view would color the types of things we uncover – our own personal – “I told you so” that we find fault in policies we don’t agree with and try to malign them into causes of our misfortune. Not terribly productive, but kinda fun to make an argument and soothing in a weird way. I think what you are meaning is that it doesn’t matter how we got here (for blame) other than to find out how to get away from here (for a solution). :-) .

    As the 99% of the population that doesn’t really know how this came to be, they are looking for someone to tell them who to blame. While this is not immediately productive – my 401K languishes no matter who is at fault – it will have an economic impact of its own – consumer confidence index. If we can’t find what was at fault, then we can’t deter it from happening again (even though it won’t happen again as the complexities will shift anyway). People want to hear that something happened, that we can blame someone so that the new President can fix it. People need to believe something so they are confident consumers.

    The thing we should all do is to evaluate the leader we want to handle this type of matter. Someone that is thoughtful, that has the capacity to change their opinion, can ask meaningful questions, can form their own opinions, articulate their own vision.

    As was probably the case in your dad’s Prius, we need deep diagnostics and subtle redesigns or changes in the affected component and interactions in an otherwise elegant system.

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