If you need more reasons to dislike former Bear Stearns CEO Jimmy Cayne, apparently William Cohan’s new book about the fall of Bear gives you plenty more. I’m just judging from the excerpts in Malcolm Gladwell’s new article in The New Yorker, which is really about the tendency toward overconfidence among the people who rise to the top on Wall Street, but also quotes Cayne saying that people he doesn’t like are gay – and he doesn’t mean it in a nice way.

Gladwell tries to position psychology as an alternate explanation of the financial crisis:

Since the beginning of the financial crisis, there have been two principal explanations for why so many banks made such disastrous decisions. The first is structural. Regulators did not regulate. Institutions failed to function as they should. Rules and guidelines were either inadequate or ignored. The second explanation is that Wall Street was incompetent, that the traders and investors didn’t know enough, that they made extravagant bets without understanding the consequences. But the first wave of postmortems on the crash suggests a third possibility: that the roots of Wall Street’s crisis were not structural or cognitive so much as they were psychological.

I think this is a bit much. The fact that some Wall Street actors were megalomaniacs does not change the facts that regulators did not regulate, or that rules and guidelines were inadequate. Nor is overconfidence inconsistent with incompetence.

But Gladwell is probably right that overconfidence was a factor in the terrible decisions made by so many people. The problem, Gladwell argues, is that overconfidence is a useful trait to have in many settings – perhaps even an evolutionary adaptation. But then we fall into the trap:

“I’m good at that. I must be good at this, too,” we tell ourselves, forgetting that in wars and on Wall Street there is no such thing as absolute expertise.

In addition, the business world tends to breed overconfidence in CEOs. There is dumb luck in everything. But people who are successful tend to think that their success is a product of their own abilities, which leads them to overestimate those abilities. The sycophantic nature of the corporate culture at most large companies only reinforces this delusion. Then there is the insistence by the media, analysts, and institutional investors that CEOs project constant, Herculean confidence. If a CEO were to say the truth on an earnings call – “I’m pretty happy about how we did last quarter; we got lucky and closed a couple of big deals we might not have won; if things go well next quarter we’ll meet our targets, but any number of things could go wrong” – investors would fall over themselves trying to dump his or her stock.

But all of these problems are endemic to modern American capitalism, not just Wall Street banks (although Wall Street trading floors are particularly fertile breeding grounds for overconfidence, given the nature of trading gains and losses, and the amount of money being made). I would tend to put it more in the category of problems that will always be with us than the category of specific causes of the financial crisis. Maybe the specific problem here was that megalomaniacs ascended to be head of systemically important banks that could bring down the entire financial system, rather than running airlines, telecom companies, private equity firms, high-tech companies, baseball teams, or other organizations whose collapse would not have such dire consequences.

By James Kwak

Or, why human beings are bad investors.

Free Exchange has Anthony Gottlieb’s recollections of interviewing Bernie Madoff about financial regulation:

at the time he came across merely as calm, strikingly rational, devoid of ego, and the last person you would expect to make your wealth vanish. I certainly would have trusted him with my money. I cannot say the same of other financial superstars I interviewed. . . . Perhaps it is the most confidence-inspiring ones that you have to look out for.

I couldn’t agree more. We human beings have this completely misplaced confidence in our ability to judge people by “looking them in the eye.” I recall reading about one study (sorry, I don’t remember anything else about it) which showed that hiring managers were more likely to make good hires by selecting solely on the basis of resumes than by interviewing people – because using resumes is completely objective, while interviews allow you to interject your own erroneous beliefs. (I do believe that if you use interviews well – that is, to obtain factual information, like how well someone can actually write a computer program – you can do better than just using resumes; but maybe I’m just fooling myself.)

There are a couple of ways to look at this phenomenon. One is to think about motivations. There are people who are trying to rip you off and people who aren’t. The latter have no motivation to try to seem trustworthy, so they don’t bother. The former do have that motivation, so they try. Some are bad at it; some, however, are very good at it.

More broadly, what does it mean to appear trustworthy? “Trustworthiness” is just a set of signifiers that are generated by one person and that enter the brain of another person, like a firm handshake or a steady gaze. It’s like those luxury car manufacturers who expend effort and cost engineering the sound of the car door closing, because that sound is a signifier for quality. There is some evolutionary process whereby these signifiers got attached to the concept of trustworthiness in our brain over the history of the species, and maybe the connection was valid at some point. But now that people can reverse-engineer the connection and replicate the signifiers whether or not they are actually trustworthy, our instincts aren’t much use anymore.

The only way not to be fooled by your instincts is to rely solely on objective facts. Now, in the Bernie Madoff case, one can object that the only visible “facts” were themselves cooked, and that is true. But that just means we need better policing of things that are presented as facts. And I think the overall point still holds.

This is the second in my new occasional series of reflections on some of the root causes of the global economic crisis. As is probably evident from the first one, I’m not going to try to identify the cause of the crisis, or even render particularly analytical judgments about the relative importance of various contributing factors. Instead, I’m more just presenting and thinking about some of the forces that were at work.

One of the singular features of the last decade was the U.S. housing bubble (replicated elsewhere, such as the U.K. and Spain, but nowhere on such a grand scale), which was accompanied by a broader though not quite as frothy bubble in asset prices overall, including the stock market. One of the standard explanations is that bubbles are created when greed takes over from fear: people see prices rising, and at first their fear of getting burned keeps them on the sidelines, but as the bubble continues and other people get rich their own greed increases until it wins out over fear, and they buy into the bubble as well. As a result, some say, we are bound to have bubbles periodically, especially when new investors (young people), who have never experienced a crash, come into the market.

There is psychological research that not only backs all of this up, but goes even further and says that bubbles are a virtual certainty. Virginia Postrel has an article in The Atlantic that centers on experimental economics research by people such as Vernon Smith and Charles Noussair. In one experiment, investors trade a security that pays a dividend in each of 15 periods and then vanishes; the dividend in each period will be 0, 8, 28, or 60 cents with equal probability, so the expected dividend is 24 cents, and there is no time value of money (the whole experiment takes an hour). Despite the fact that the fundamental value of the security is absolutely, completely, easily knowable, bubbles develop in these markets . . . 90% of the time. When the same people repeat the same experiment, the bubbles get gradually smaller; but simply change the spread of dividends and the scarcity of the asset, and the bubbles come back with full force (so much for experienced investors).

Continue reading “Causes: Maybe People Are Just Like That” →