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The Evolution of Bad Ideas

Posted by plektix in Economics, Evolution, Incentives, Uncategorized on August 3rd, 2009 | View Comments

It is by now common wisdom that our current financial crisis is due in large part to misplaced incentives in our financial system. Analysts and fund managers were rewarded for short-term thinking and risk-taking. If we can rework our financial system to reward long-term, careful planning, it is often argued, we can avoid collapses like this in the future. While I agree that misplaced incentives were a fundamental problem, the question of how to change this is rather more deep and complex than I think many people realize. Our economy is, of course, an evolutionary system. Successful businesses grow in size and their practices are imitated by others; unsuccessful businesses vanish. This process has led to many good business practices, even in the financial sector. However, evolution does not always yield the best outcomes, in biology or in economics. Our recent crisis illustrates two key limitations of evolutionary systems, limitations which allow bad ideas to evolve over good ones. The first problem has to do with time lags. Suppose Financial Company A comes up with an idea that will yield huge sums of money for five years and then drive the company to bankruptcy. They implement the idea, obfuscating the downside, and soon the company is rolling in cash. Investors line up to give them money, magazines laud them, and other companies begin imitating them. Not so Company B. Company B believes in long-term thinking, and can see this idea for the sham it is. They persue a quiet, sound strategy, even when their investors begin pulling money out to invest in A. We would like to think that in the end, Company B will be left standing and reap them benefits of their foresight. But there is a fundamental problem of time-scales here: by the time A folds, B may already be out of business, due to lack of interest from investors. In theoretical terms, there is a fundamental problem when the evolutionary process proceeds faster than the unfolding of negative consequences. In these situations, good ideas never have a chance to be rewarded, evolutionarily speaking. One might argue that investors, not to mention government regulators and ratings agencies, should have forseen the flaw in A's plan. But this highlights a second limitation of the evolutionary process: it favors complexity. Simple bad ideas can be detected by intelligent agents, but complex ones have a chance to really stick. If Company A's idea was so complicated that no one aside from a few physicists could figure it out, investors and regulators could easily be fooled. It's not clear to me how to patch these flaws in the evolutionary system. Increased transparency and oversight will help, but unless we can somehow cap the complexity of financial instruments (difficult) or slow down the evolutionary process (impossible), I'm not sure how we'll avoid similar crashes in the future.

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Alex Golubev

from Marginal Revolution. Very long but very interesting!
For new technology, is it the progression of the inevitable?
http://www.kk.org/thetechnium/archives/2009/08/progression_of.php
rafefurst

@Rick, it makes sense from the individual's self-interest standpoint, but not for society as a whole. It's a tragedy of the commons when your defaulting on a debt to someone else affects me. It's society's job to stop tragedies of the commons.

The issue is, as you say, a shortage of collateral. With derivatives on debt the collateral gets spread more than 1 to 1 (which is where it needs to be to stop systemic risk). In the past, unsecured bad debt was punished by sending the debtor to prison. Usury was also a form of recourse that is unacceptable. Bankruptcy and government bailouts have taken us too far in the other direction. Some sort of balance must be struck.

Here's a proposal, what's wrong with it? Other than education, no loans are allowed that are unsecured 1 to 1. Eliminate bankruptcy law entirely (personal and corporate).

The only reason bankruptcy laws are necessary is if you have debt you cannot reasonably pay. But if there's no unsecured debt, there's no need for bankruptcy law. All risk-funding should be equity-based only.

If you are an equity shareholder in a fallow company, you can either find a fire-sale buyer for your stock so you can take the write-off, or you just have to wait until management decides to close the doors. Remember, the company has no debt, no lines of credit and thus does not have a need to declare bankruptcy. Everything had been funded entirely by venture capital. It's way more fair to the investors anyway since equity holders share in the upside and are thus compensated for the risk of ruin (which is the same whether the investment is debt or equity).
Wamplerr

Mandatory or not, there are still every day situations where it just makes sense.

I own a car, I want to make the $2500 worth of bets (could be on one game or on 25), why sell my car before the games? Presumably I'll win more often than I lose. When things go bad (something about shit flying into fans), that's what the car is for. Why liquidate up front?

Same with an education loan to an 18 year old, it's really an advance on a positive EV bet (Income|College > Incoming|High School) without Mom and Dad having to liquidate the house up front. Everyone seems to win. Throw in some life insurance in case the kid dies?

Excessive leverage can only exist if there's a shortage of collateral. Maybe the market will learn a lesson?
Alex Golubev

It's not that i want to throw good money after bad, it's that we're not guaranteed to get even back to this point if we rebalance everyone's balance sheet through financial collapse (Fight Club style). The resulting anarchy is not worth it in my opinion. We can just settle into a stagnations of anywhere from 3-200 years, waiting for a discover of the next "engine". But that's strictly in the real world. i'm just agreeing with the conclusion of the original post. it's a very unjust world, yet we somehow need to find happiness in the fact that this is as just as it's ever been (ignoring the minor wealth redistribution).

Education should be paid for, but i'm afraid to be overly confident on this, because absolutes lead to "american dream" labels, which lead to irrational pricing ("what do you mean it's already priced in?! College education has never gone down in price") :)

Derivatives on leverage are much tougher to justify. I totally agree - the same asset should never be leveraged more than once, except in Utah.
rafefurst

Alex, your points are well-taken.

The one category I would consider indispensable in a developed economy is education loans (I hadn't thought of that one, so thanks). OTOH, you could say that educating citizens is a social good and should be paid for.

I'm not sure why leverage needs to continue just because it has been allowed in the past. Something about good money after bad :-)

In practical terms, I think it could easily be mandated that derivatives on leverage are not allowed. Meaning you can loan any amount to anyone you want for any reason, but you can't parcel out or otherwise sell any part of that loan or use it as collateral for anything else. This would go for developing economies as well.
Alex Golubev

there is no mandatory reason for any activity and i dont' want to make this about semantics, cause that's pointless.

I'd say that there is an argument for leverage, because we dont' exist for the economy (developed or not), we exist for ourselves and engaging in trade is a way to increase the usefullness of resources. So is it mandatory to have leverage? No. But does it make sense for the individual and society to borrow money for education and all kinds or resources while a kid - yes. you're a "developing" agent in a sense. Same goes for old people, who need to extend their assets as much as possible - they should be allowed to lend if they wish to do so. Same goes for life insurance, which is straight up gambling, but it's useful.

I already stated my second argument is that leverage IS mandatory, because it's already in the system and outside theoretical economics everythign is path dependent. we are in a crab trap that is leverage. If our system is crumbling because we're too leveraged, it is suicidal to remove it all right now. Right?
rafefurst

The problem is as the world gets more complex and the so-called "externalities" become internalized in the economic dynamics, there is no such thing as independence and market neutrality. While it is probably harmless to use small amounts of leverage on relatively small bets, there is no *mandatory* reasons for doing so. And since the slope is getting more and more slippery, it would actually be better for the world to disallow leverage entirely than to try to contain its use.

I realize this is a strong statement, and I do qualify that there are mandatory uses in a developing economy. But I challenge anyone to come up with a mandatory use in the global developed economy today.
Alex Golubev

Right, but 3-5x is based on history and the point is that we need a more dynamic leverage constraint, which is inversely proportional to the volatility of 3 years. Now some cliche about crossing a river based on average depth.

My concern is that this or any policy which is inversely proportional to the majority's desire (votes, money, etc...), will only be implemented when it is not needed and is very likely to be repealed or loopholed when it's needed the most. It's an equivalent of the three branches of gov't in order to curb their power in the long run. However, we've done plenty to undo that safeguard - terrorist prisons without due process, spying, torturing etc... So, that's why i think we're destined to go through more volatile booms and busts than need be.

Then there's all the talk about creating fallible networks instead of concentrated institutions that put the entire system at risk. I absolutely agree, but the whole path dependent thing is a huge "roadblock". The only ways of getting there are by either letting institutions fail (missed that chance) or by using antitrust laws to break them down once the credit/economic environment improves. Fat chance.

So instead of working on these two issues (leverage and fallibility) our glorious leaders seem more concerned with redistributing wealth and finding witches. bread and circuses?
Wamplerr

Agree with both points, but there are simple places where leverage is sensible.

Even in the realm of #3, a portfolio of enough stocks that is market neutral should be able to use 3x to 5x leverage safely. I see that as pretty comparable to betting the 25 college football games.

Massive leverage on directional bets, not so sensible.

Now some cliche about a baby and bathwater...
Alex Golubev

Precisely. There are different ways of betting ont he future.

I think it breaks down into at least three categories based on whether the range of outcomes in known in advance and whether the payoffs are a function of people's perceptions.

1. Known, not a funtion - casino, lottery. Probability theory and normal curves apply
2. Known, is a function - horses, sports. Some probability models can still be used.
3. Not known, is a function - finance. The range of outcomes is function of leverage and perceptions, so the distribution is highly volatile.

I don't know if i'm definining this correctly, but this would be the first step in deciding how much leverage would be allowed for different types of bets. #1-2 are pretty much under control and don't pose any systemic risks. Although it would be pretty interesting to see a casino extend credit based on people's winnings!! Still this is the sole area where probability theory can be fully applied, so risk management and Var would actually work.

#3 is f*d for life. seems like we need some sort of mechanisms that is inversely proportional to the popularity of the investment, which is so anti-democratic it makes me seriously doubt whether such a safeguard can ever exist or be supported by any politican when it's of the utmost importance.
plektix

Are the outcomes of these games independent? Because that sure wasn't the case for all the financial betting that went on.
Wamplerr

Leverage makes sense in it's simplest form.

If I want to bet 25 college football games at a Sportsbook for $100 each, why should I have to bring $2,500?
Alex Golubev

It's a tradeoff between potential growth and (in)stability. Higher potential growth cannot be mandatory in any way, but i think everythign is path dependent, so we cannot ignore the fact that we do have leverage and a lot of it.

Theoretically we probably shouldn't deny people the desire to lend their money out anyways, but we need to always remember that our world is going to become more and more interconnected (globalization + internet), so if anything, we should use less and less leverage, because we are more likely to experience long periods of stability followed by wilder panics.

In the real world, it will be the opposite - increased length of stable times is used as an argument for more leverage by businesses AND regulators. This is where it all breaks down. there's a reinforcing feedback loop between money and power that prevents us from reaching an optimum solution.

The optimist in me would argue that the use of any new technology also resembles a bubble. I was pretty late in getting a cell phone, but a fad/luxury turned into a necessity. So yes, regulators cannot really call out and prevent bubbles, but the same cannot be said about credit and leverage. I cannot think of any example where credit/leverage didn't go through a bust after going through a boom (unlike new technology, which CAN go through a boom without a bust). So i'm optimistic on asset bubbles (they're not THAT bad), but pessimistic if increasing leverage/credit is involved.

What's even worse than leverage is when the bad guys are given another life and bailed out. I mean we DO want to save the system, but this isn't going to end well. There IS reality and the right incentives are key. Misallocation of resources cannot be constantly saved by reinflation. Even if the system survives and there is no ultimate crash, the incentives for hard work and prudent investing disappear, so we'll be stuck in a gambling world where a lot less real progress is made (than could be made). It IS an equilibrium of sorts, but don't count on me on working very hard. I guess if the system can still "trick" people into working hard, then all is well, but we can do so much better. The reinforcing money/power loop is scarier than leverage. Talk about tangents!
rafefurst

I agree that leverage is the number one culprit for the social hazards of the economy. I can't think of one mandatory reason to allow leverage in a developed economy, can you?
Alex Golubev

Great Post!
1. I spent countless hours arguing with Mr Sumner that he is too focused on inflating the agregate economy and while that is our only way out of this mess, it doesn't mean that it is the most fair outcome. Economits should focus on the efficiency of resource allocation FIRST and growth second. Try this one with Scott, cause I got tired of his reinflation at any cost. He didn't seem to devote nearly enough attention to fairness.

2. Absolutely. Evolution leads to dead ends all the fittest is only clear in hindisght and only for a limited period of time until the next ice age or so. BUT

3. I would argue that mistakes don't kill people, guns and leverage do :) The dotcom bubble involved a much more creative and useful invention and was just as speculative as the housing bubble, but i think the biggest driver of the SEVERITY of resource misallocation and subsequent blowup was LEVERAGE. It's human to make mistakes. It's not human to live on 3-10% margin. 10% we MIGHT be able to get away with. Everything else is lethal.

4. Corporate incentives. not as important for survival of the system (as long as we remove excessive leverage), but hugely unfair. 1-3 yr bonus compensation packages need to go away. introduce vesting and clawbacks.

Simple as that. BUT, #3 is being adressed naturally through the credit cycle; if and when leverage is removed through regulation, you can rest assured that it will be brought back in a different form (instrument) or generation (say 70 years later). if we are lucky that is.