Finance is in shambles. It has remained until now under the close supervision of economic and financial theory. In recent years, due to the overbearing dominance of views developed under the umbrella of the “Chicago School” of economics, finance has been regarded as explainable through the combination of a very simplified version of psychology: that of the “homo oeconomicus“, and of physics. The physics in question is supposed to have risen all-armoured Minerva-like out of the embarrassingly simplified psychology hitherto mentioned. This is the tenet of methodological individualism presiding nowadays over mainstream economics and financial theory.
Human nature, in the guise of the homo oeconomicus displays a number of qualities such as utilitarianism, ultimate rationality and – somewhat paradoxically combined to the two aforementioned – a pervasive herd instinct. Why this particular version of psychology? For no better reason than having been dominant at the end of the nineteenth century when a supposedly “scientific” economics emerged. This is why homo oeconomicus is so conveniently transparent to himself or herself, working out with clockwork precision in all circumstances the most rational approach that the precise quantity of information available allows – that is, unless the herd instinct prevails. Not for him the murky hesitations and self-delusion that unconscious motives convey.
Back in the nineteenth century, physics were stressing how important it was to remove subjectivity from scientific methodology, meaning the uncontrolled interaction of human beings with the subject of their inquiry. The difficulty here for economics is that when you remove from the economy the uncontrolled interaction of human beings, what is left to study is of not much interest. Here an example: price formation which economists explain as the meeting of a curve representing demand with another representing supply. Now tell me: has any anthropologist ever encountered circumstances where the status of buyer and seller is indifferent to the settling of price? Aristotle knew that reciprocal status determines price and this makes him on the contrary the anthropologist’s friend (1).
So, let us say this bluntly: human nature as envisioned by economics holds but a frightfully tenuous relationship with the type of human nature which anthropologists are familiar with.
What are then the traits of human nature which the current crisis has most prominently emphasized?
Greed is noticeably absent from the catalogue of traits pertaining to the homo oeconomicus unless it should be regarded as an inflated version of “utilitarianism”. I’m mentioning this only in passing as greed is so perspicuously at the forefront as an explanatory factor of human behaviour – especially in finance – that it hardly requires theoretical elaboration. Let’s thus concentrate instead on two other features, less blatant no doubt but most prominently at work in the current crisis: the unwarranted optimism of all agents involved and an unconscionable trust in our capacity at predicting the future.
Unwarranted optimism has made sure that the thesis holding that “things are fortunately no longer as they were in the past” has been raised to the status of dogma and subscribed to with no hint of reservation. It rests on the premise that humankind is making progress faster than the speed of light and that, despite the 1929 crisis having taken place a mere eighty years ago, the erring behaviour of the human race displayed in those days is as distant today as the Palaeolithic times. Should the current crisis turn out – God forbid! – to be worse than 1929, our belief in the indefectible progress of the human race would no doubt be compromised for at least… a full five years! Such is the spirit of the species!
Mr. Alan Greenspan, formerly head of the Federal Reserve Bank of the United States, and currently a key partner of the Paulson Credit Opportunities Fund, a hedge fund having astonishingly benefited from the American bubble popping, has been a prominent promoter of the “new economy / new finance” view where prior mishaps pertain necessarily to a distant past. “Hedging” is the financial term applying to Mr. Greenspan’s method: a financial strategy where one protects oneself against excessive exposure to risk by adopting two positions in reverse directions. In this instance, developing a particular policy based on throwing one’s arms in the air at the thought that financial bubbles could be prevented and one joining subsequently a company betting that one’s policy will fail. Here in his own words: “After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world’s central banks could do to temper this most recent surge in human euphoria…” (2). So why not be philosophical indeed and benefit from those very unbeatable bubbles?
Mathematical models underpinning the operation of the Asset-Backed Security provide another example for overbearing optimism: we’re talking here of the infamous financial instrument backed in some unfortunate circumstances by subprime loans. What I will say here relies heavily on field notes taken in the years 1999-2007.
Briefly said, Asset-Backed Securities are debt instruments created by pooling several thousands of consumer loans in the likeness of a traditional bond. ABS may be backed by credit card debt, mortgages, student loans, aircraft leases, and so on. Literally speaking, Mortgage-Backed Securities (MBS) are asset-backed securities; historically though, MBS refer only to securities backed by “prime” mortgages, the less risky ones with high level of collateral (low Loan To Value) and high borrower credit score (3).
Models used to represent ABS’ behaviour were known to be inadequate, being in particular deprived of tools allowing simulating the impact of “triggers”, triggers being a setup allowing when the instrument is distressed to divert cash flows to locations where they are more urgently needed. Models used back in 2007 at Countrywide, the top institution in the United States granting mortgages, ergo the top institution of that type in the world at large, were deprived of the capacity of simulating “triggers”. This was not regarded though as an issue to be taken in earnest as Countrywide‘s accounting advisor – backed in this by the United States government regulator of thrifts, the OTS – regarded that lack of understanding of the products sold to trusting patrons as “industry standard,” i.e. all right. My own insistence, in my capacity of “model validator” within the Risk Management team, that such “triggers” be added to our models explains no doubt why I belonged to the first load of Countrywide employees allowed to join back the job market in October 2007. Here was at work one well-advertised dimension of the subprime crisis: the sales by investment bankers of financial products whereof they had very little understanding.
Turning now to our unconscionable trust in our capacity at predicting the future I will content myself with mentioning the way so-called “forward rates” are being used all across the financial world for making forecasts regarded as good as true about future values of interest rates. Mathematical demonstration as well as empirical data confirm that the best forecast for a “floating” interest rate, i.e. a rate for a particular maturity the value of which is determined by market forces, is its current value. This fails however to be very exciting and does not justify by itself the high wages granted until recently to “quants.” So the “industry standard” has become instead that one can derive very accurate forecasts for interest rates from the forward rates‘ curve.
A “yield curve” is a broken line connecting the current interest rates corresponding to various maturities. So you look for the current floating rates applying to borrowing for three, six, nine months, one year, three year, etc. and then connect the dots. From that curve, one can calculate – through an algorithmic technique called “bootstrapping” – some intermediary rates, implied within the current yield curve. For instance: “what rate applies if I borrow for three years in nine months from now?” The value obtained results straightforwardly from a mathematical calculation. Now, much more power is being assigned to these “forward” rates than being simply “forward”, i.e. the rate you are charged now for contracting a forward loan, such as, in our example, a promise to let you borrow for three years in nine months. Forward rates are regarded as actual predictions, and very accurate ones for that matter, of what will apply in the future.
Financial engineers with mathematical degrees from reputable higher education institutions will tell you that the current forward rate for a three year loan taken in nine months is a very good forecast for what the three year interest rate will be in nine months. It doesn’t make any mathematical or any other sense. But mind you, the fate of whole Wall Street or City institutions has been built on that basis.
What’s the explanation? My own hypothesis is that that belief derives from a special combination of arithmetic and optimism. I was once expounding to the late Professor Meyer Fortes my dismay that some of the sayings of fishermen I had lived with in Brittany seemed to be very reliable and based on empirical observation while others added to nothing more than superstition. A smile came upon his face, betraying his unswerving trust in human nature: “Paul, what would we be without hope?”
More would need to be said about the economy and finance of a more general nature, such as: “Why do business teams need to be modelled after the military type of hierarchy?” or “Why are companies built in the likeness of Sahlins’ ‘predatory lineage’? (4), i.e. as an opportunistic and colonizing entity that knows no limits? But however important, these questions go way beyond the specifics of the subprime crisis.
More relevant, although no less general, is the structure itself of the system currently undergoing a crisis: the market organisation of the economy. Little noticed is the fact that its processes have been left to the spontaneous organisation – or should one say, lack of organisation – of nature when left to its own devices: the survival of the fittest within a competitive environment. The human species has, through its own industry, brought relative peace within its political setup in the shape of democracy. The rise of democracy can be located and precisely dated. Nothing of the kind has as yet taken place with the economy. Some attempts have been made to regulate – one should say “regiment” – the economy through a simpleminded transpose of an authoritarian state structure. As one could have expected, the results were dismal but no other attempt has ever been made in earnest.
Johann Friedrich Blumenbach (1752-1840) is remembered as the true founder of Völkerkunde, usually translated as “ethnology.” Blumenbach was a fastidious classifier of human races on the evidence of their bones in the true line opened up by his forebears Linné, Tournefort and Adanson. The method turned out to be of little avail. We still owe him though the term “Caucasian” still used in the New World when referring to human beings of fair complexion. Less known are Blumenbach’s studies on domestication, detailing the changes in appearance and behaviour of species domesticated by Man. His astute observation revealed to him that Man subjected himself to the same treatment, resulting in self-domestication. Through such process we’ve managed to pacify our mutual dealings, fighting off to some extent our aggressive inclinations towards each other. Democracy displays our progress in that direction in the political realm while in the economic sphere we’ve left human nature unfettered, still short of domestication. The suffering to come from the subprime crisis will be pervasive: a strong incitement no doubt for bringing to completion that process of self-domestication.
(1) Polanyi, K., “Aristotle discovers the economy”, , in G. Dalton (ed.), Primitive, Archaic and Modern Economies. Essays of Karl Polanyi, Boston: Beacon Press, 1968, 78-115; Jorion, Paul, “Aristotle’s theory of price revisited”, Dialectical Anthropology, Vol. 23, N°3 1998, 247-280.
(2) Greenspan, Alan, “The Roots of the Mortgage Crisis”, The Wall Street Journal, December 12th, 2007.
(3) There is a technical difference in the structure of MBS and ABS: the former’s credit enhancement method is subordination of junior certificates to senior certificates, the latter’s is over-collateralization (see for a more detailed explanation: The ABS and Uncle Sam.
(4) Sahlins, Marshall D., , “The Segmentary Lineage: An Organization of Predatory Expansion”, American Anthropologist, Vol. 63(2) 1961: 322-344.