G20 summit: How the bandwagon wrecked the wisdom of market crowds
James Surowiecki
The Guardian
Politicians, take note: the answer may not be to use markets less, but to make sure the players are many and the opinions diverse
On the eve of the G20 summit there is one question that everyone is thinking about the financial crisis: how could we have been so stupid? To be sure, there is one explanation of the crisis that insists that people weren't stupid, that instead they were responding rationally to a flood of cheap money from the US Federal Reserve and China. But while there's something to this, it's ultimately not enough of an explanation. Even if money was cheap, all (or nearly all) of it didn't have to flow into housing. It could have gone into other, more productive investment. And while you expect borrowing to expand when money is cheap, you also expect there to be some connection between the risks people take and the rewards they reap. Yet looking back on the bubble and the crash, it's hard to argue that risk and reward were in sync.
Bubbles always have at their heart some big idea, and in this case, obviously, that idea was twofold: housing prices could keep going up indefinitely, and our new instruments for managing risk meant that investing in housing was effectively risk-free. But while this veneration of real estate was central to the bubble, its effects were amplified by specific institutional and cultural factors that led the financial industry to make what amounted, ultimately, to the worst bet in history. In the US, at least, most big financial institutions in effect wagered the value of their entire companies on the housing market. It's when those bets started going bad that the current crisis began.
So what drove these bets? First, at most companies the link between pay and performance, risk and reward, was severed - or, to be more accurate, the link between pay and long-term performance was nonexistent. Crowds are wise when the individuals in them have an incentive to get the right answer. On Wall Street, though, the enormous amounts of money that one could make in the short term meant that the long-term consequences of failure mattered much less than they once did. Similarly, the fact that mortgages were packaged and sold as securities to outside investors changed incentives dramatically. Mortgage brokers were rewarded not on the ultimate performance of the mortgages, but on how many deals they made. As a result, it's not surprising they were not interested in meaningfully evaluating potential borrowers' riskiness.
(More here.)
The Guardian
Politicians, take note: the answer may not be to use markets less, but to make sure the players are many and the opinions diverse
On the eve of the G20 summit there is one question that everyone is thinking about the financial crisis: how could we have been so stupid? To be sure, there is one explanation of the crisis that insists that people weren't stupid, that instead they were responding rationally to a flood of cheap money from the US Federal Reserve and China. But while there's something to this, it's ultimately not enough of an explanation. Even if money was cheap, all (or nearly all) of it didn't have to flow into housing. It could have gone into other, more productive investment. And while you expect borrowing to expand when money is cheap, you also expect there to be some connection between the risks people take and the rewards they reap. Yet looking back on the bubble and the crash, it's hard to argue that risk and reward were in sync.
Bubbles always have at their heart some big idea, and in this case, obviously, that idea was twofold: housing prices could keep going up indefinitely, and our new instruments for managing risk meant that investing in housing was effectively risk-free. But while this veneration of real estate was central to the bubble, its effects were amplified by specific institutional and cultural factors that led the financial industry to make what amounted, ultimately, to the worst bet in history. In the US, at least, most big financial institutions in effect wagered the value of their entire companies on the housing market. It's when those bets started going bad that the current crisis began.
So what drove these bets? First, at most companies the link between pay and performance, risk and reward, was severed - or, to be more accurate, the link between pay and long-term performance was nonexistent. Crowds are wise when the individuals in them have an incentive to get the right answer. On Wall Street, though, the enormous amounts of money that one could make in the short term meant that the long-term consequences of failure mattered much less than they once did. Similarly, the fact that mortgages were packaged and sold as securities to outside investors changed incentives dramatically. Mortgage brokers were rewarded not on the ultimate performance of the mortgages, but on how many deals they made. As a result, it's not surprising they were not interested in meaningfully evaluating potential borrowers' riskiness.
(More here.)
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