Never Again! Really? The Devil You Say.

The forthcoming adoption of a financial reform bill in Congress prompted me to republish an Observation I made at the height of the financial crisis.  Here is my Observation:

Last week [the week of September 29, 2008] I was asked to explain one comment in my latest Observation. That comment was that “we all had a hand in it.”  By “it” of course I meant the present economic conundrum.  By “we” I meant to include the population at large.

I was then asked to explain my reasoning and I gave the following explanation:

We are all subject to certain cognitive imperfections.  One of them directly impacted us when the real estate bubble burst and that same imperfection impacted us when the tech bubble burst. The imperfection is:

People have an irrational, compulsive and subconscious belief that a trend will continue far beyond what would be justified by a historical statistical analysis.  They are then unpleasantly surprised when the “trend” ends and things revert to the mean.  Hence the following previous Observation I made over a year ago (when the market was still hot):

·        Yes but this time it’s different

It never is.

Why do you think they named it the “mean?”

Maybe because of the harsh way you can be re-taught an old lesson when something reverts to it.

-          06/18/2007

Ok how does all of the foregoing apply to our present situation [October 2008]?  When real estate began to “take off” (late 90’s) and that market condition continued until the general public perceived it as a trend this “cognitive bias”, called “recency” or trend continuance, took over. People began to buy real estate with the conviction that values would continue to go up. They simply reasoned that if the property turned out to be more than they could afford they could sell it at a profit. That outlook changed the way they perceived the risk of borrowing money (remember that I said in an Observation that when the “possibility” of making a large profit comes in the room a cognitive bias causes “probability” to head for an exit -05/27/2008).

Ordinary everyday people began to take risks that they simply did not perceive as real. What began as a trickle became a torrent the longer real estate continued to appreciate. People began to believe that it was ok to, shall we say, fib on loan applications. They also saw logic in NINJA loans.  Yes that’s how far logic strayed. All of us were aware of what was transpiring.¹   We simply did not perceive how short the trend would last and how far and extensive the damage would be.

Then the trend ended and now -

          We know how mean the mean is.

Of course the lending and financial industries had a hand in it - they encouraged and facilitated this to go on.

People say that we should learn from this and never let it happen again.  Well I am all for that but my hope is balanced by the simple fact that contrary to a precept of classic economic theory we are not “rational” when it comes to economic decisions.  Our shortcomings are embedded in our DNA. 

The best strategy in my view is to remember our shortcomings and do our best with those in mind to avoid repeating our economic mistakes.

In 1991 I read an article by Chris Argyrs in the Harvard Business Review, Teaching Smart People How to Learn.  The upshot of this article is that when events turn out badly we tend to engage in “defensive reasoning”, i.e. blame others for the outcome.² This very effectively keeps us from learning from past experience.  In order to keep history “repetition” to an absolute minimum we need to avoid the onset of defensive reasoning and instead focus on the one thing we had and will have control over which is, our own conduct.  That is why in my previous Observation I said “Whining that it was someone else’s fault isn’t going to help.”

Regulate yes, but don’t be foolish enough to think it will never happen again. Lewis Black, the satirist (03/20/2007 Observation), is no doubt going to have a field day with these peccadilloes.

1. Even those of us that owned property but did not refinance, take out a second mortgage, line of credit or trade up were yelling “run, baby, run – who cares if the kids can’t buy a home.”

2. The more intelligent the individual the more pronounced the onset of defensive reasoning – blaming someone else for a negative outcome. As observers, it is not uncommon for us to be surprised when we observe people we consider to be extremely intelligent, well educated and experienced in the matter at hand to fail to “get it” and insist on proclaiming an argument that no one else is buying.  This I believe explains the reaction many have had to the denials coming from some on Wall Street.

            -10/06/2008