Grunion Moon (grunionmoon) wrote,
Grunion Moon

Catchup entry 2: Understanding uncertainty and the Basic Problem

Did anyone go see Let The Right One In? I'm telling you... :o)


This is going to be one of those things that's trite and obvious except that it has teeth. ---> Living in a complex society, writing randomly online, and living in a complex society that is undergoing a complex crisis period all have one thing in common: There is a tremendous temptation to pretend that we understand and are sure of more than we actually do or even can understand or be sure of.

The problem with that is if it gets in the way of real looking-around or really figure-outing.

When I saw the following in the paper I promised myself that I would mention it in OD. In this story, Analysis: stimulus bill that's not all stimulating, there's this curious sentence:
As it is, most of the money in the bill for road building, water projects and mass transit probably won't be spent until the economy has turned around and is back on a recovery path.
That conclusion isn't sourced or anything. All that can be seen by us is that it bubbled out of the writer's pen. It may have just come from the writer. But whether it came from the writer's own inner float-gauge or was suggested by a background source doesn't change much.

That "probably won't" must really have emerged from the need to maintain psychological security. Whether that be security about the general situation or security about the point the writer was constructing doesn't matter. Because: "Probably won't"? That's a thumb on the scales. "May", or "it is possible that", would have been limited to what we can know.

Ladies and gentlemen, the truth is that no one in the world - absolutely no one - really knows, or has odds worth a damn, about a timetable for this specific set of troubles under these specific circumstances based on these specific screwups. Nobody knows when the economy will have turned around, or how this will play out or how long it will go. It is simply not possible to look forward and know something like that. Welcome to the present. The naked feeling means you understand. (Certainly Japan's experience after its own real estate bubble went shows that long-period trouble is possible.)

Thinking like that sentence above gives a more reassuring feeling about the slump - but you notice how in the present it's acting as a premise in an argument that some of the projects being considered positively won't help and would be mistaken, at least would be if that's the only reason for them, because "we know that the trouble will largely be over by then." Steering like this makes problems.

I don't care how much "we need confidence" - we need to know what we don't know, for our figuring

A second table-banging thing here shrivelled in the light of my speculum when I went into it to write about it. I have a point about something, maybe, but it might really be something else; I don't think I can quite draw up the connections I was thinking of and make it stick.

I'll go into something else instead, since I mentioned confidence.

There has been something in my mind when I have been harping on the incentive problem that happened with mortgage loans with the banking system using Credit Default Swaps.

Specifically, there has been a reason - that I have not mentioned - why I have thought that everyone should understand this and that the government should specifically focus on and fix the arrangements.

Cliff's Notes version of my understanding of this: Once lending institutions could "sell the risk downstream" using Credit Default Swaps - and successive holders could likewise "sell it downstream" (in fact coming to trade them like stocks through the derivatives system, so that they were eagerly distributed onward and everywhere) - each player in the game only got the profit involved and not the risk involved. Thus all the incentive was simply to go ahead. A crucial part of this was on the mortgage lending end, because the lenders had every reason to lend more and more and no reason to restrict lending because of risk that the mortgages might go south - thus they had incentive to do more and more risky loans, any way the rules allowed, and beyond that, any way they could. For that reason, more and more of the risk being passed downstream was bad. And then lots and lots of resulting unsound loans began to go south - with a huge amount of financial assets now based on them nationwide and worldwide.

You may want to read through this piece on how Credit Default Swaps came to be before going on.

Wide-view context: the incentive problem here is similar to the working of the "tragedy of the commons" described by Garrett Hardin.


Right now the banks don't want to risk lending... people aren't spending... businesses can't do anything until they know what's going to happen, and their business is going down, and they're laying off, thus depressing buying power from there.

And the thing is, I'm not seeing where an understanding of exactly why things went swirling down the toilet is widespread.

That is a problem.

Amidst lots of blurred and blurring loose talk about lots of players having been greedy. (YES. But people have ALWAYS been greedy. The system largely assumes that and runs as a result. That hasn't changed, so it explains nothing. The incentives arrangement that I just described is what made the greed matter. The same goes for talk of gullible people who believed the lenders that their mortgage was a viable deal. Historically the banks HAVE been careful pocket-watch-carrying types wary of making loans that were too risky. Why wouldn't one be reassured by such professionals?) And also other things, like reporters apparently too used to reporting on Wall Street reporting too much on the Wall Street high financial capitalism end, like it was something that happened there, and not making clear the whole sequence. Etc.

The following is why people - not just the experts, a lot of people, everywhere - actually need to understand that stuff I wrote in the Cliff's Notes:

Look, this is not an argument against Keynesian spending-stimulus like they are trying to do, at all. But they want to make the players in the economy confident enough to go ahead and start playing again, in unison so that the players are able to do so. So, the idea is to have people definitely working and definitely spending money. The other players will see sales start to pick up, and get the impression that the stimulus is working, and ... That's the idea.

Sure. But the thing is: confidence is not a one-level psychological affair. It includes the higher brain functions; it includes reason.

And, reasonably, people just saw the entire vaunted proud system go kerphlooey and the high experts of American capitalism were either clueless or were helping it make it happen or couldn't do squat about it. And now the bigwigs are mostly deep into talk of bailouts and stimuluses, how to stand the busted system back up, which is not talking about how or why all of this could have happened.

People need to know, rationally and verifiably and understand it, what the problem was and that the problem has been isolated and removed and solved and that the system will now be on a sound basis and is NOT going to crash like that again, and here's why.

THAT is part of again believing and feeling that you will be able to plan on a sound basis, and acting accordingly.

WITHOUT that... well, without that, even all sorts of new spending projects, short- and long-term, are going to be sort of like putting sugar and amphetamine in every town water supply. You may drink some yourself, or you may just know that, hey, lots of your customers have gotten a dose of sugar and amphetamine. It'll do something. It won't do nothing.

But if that's ALL it is, yes, people will sell products to any additional customers that show up, and some businesses will be able to not fold, but there'll be a ... lot... of... standing... pat... and... waiting. Because people also need rational confidence - and rational feeds back into irrational.

People need to understand the way this basically simple incentive problem worked. And it needs to be actually and specifically and visibly fixed. I think a very sharp look needs to be taken as to whether the problem with Credit Default Swaps is something that is inherently unsound and can't adequately be fixed by "regulation" or "oversight" (WHICH WOULD BE FAR TOO EASY TO FALL INTO, BECAUSE IT'S FAMILIAR TALK)- simply because it is a basic incentive problem. Because, and to the extent that, no one has reason to watch the risk and everyone has reason not to, or to sluff watching it. It is almost an arrangement geared to seek out and maximize trouble (how many things involve loans?). Unless I am missing something, I think we'd better go back to either a pre-1994 system where the banks must once again hold big capital reserves themselves to cover their loan risks - and therefore must worry about and gauge their risks - or to a system where the banks can at most transfer their debt one step away to a debt-insurance company (and then the DEBT-INSURANCE COMPANY will worry about and gauge the risks and require that the banks do so.) It would be stable; that's the point. If loans were harder to get, balance that against the value to the economy of stability - and of confidence.


(Addendum to the last paragraph - To further illustrate the problem I see with keeping Credit Default Swaps "but regulating them": Well, if and to the extent that banks and loan institutions and their officers have no incentive to warily gauge risks and big incentives not to, if this is supposed to be safe, then either the government must enforce the banks' evaluation policies fantastically well, not just by making rules but by lots and lots of agents enforcing it, everywhere, working against people who will make a fortune if they skate by those rules ... or the government must itself examine and gauge and monitor and specify the riskiness of every part of every activity - just in the nation, or everywhere - that might conceivably have a loan made connected to it. Ummmm... not exactly a small-government approach... and bankers simply worrying about their own money would be better at it... Surely the pre-1994 system was not worse than this would be?)
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