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November 04, 2009

The Clever Sillies Strike Again

leverage.gif

Last Fall, the pitfalls of trying to solve the "problem" of low home ownership by making it easier and cheaper to buy homes on credit were graphically illustrated. The interesting observation is here:

... when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them "natural buyers."

Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.

"It was evident to me that there was a cycle going on, not just in my little market, but all over the world," says Mr. Geanakoplos, who is still a partner at Ellington Capital. The "leverage cycle," he called it.

This idea had big implications for policy makers. For decades, they thought of interest rates as the most important indicator of supply and demand in credit markets, and the only variable they needed to adjust to achieve a desired economic result. Now, Mr. Geanakoplos was saying that something else -- lenders' collateral or margin demands -- could be even more important.

And yet the entire health care reform house of cards rests on the frankly ludicrous assumption that if government artificially holds down the cost of medical treatment, consumers of medical care won't consume more of it. Since demand is very much a function of price, this assumption defies common sense. But even if they were right; even if consumers demanded exactly the same amount of care under a government subsidized system, the addition of millions of new consumers would cause aggregate demand to rise.

What on earth do they expect to happen to prices when the number of consumers suddenly exceeds the capacity of existing medical professionals to provide care?

Prices are signals. They convey important information about which goods and services are in demand and the quantities desired. Government can certainly try to hold down prices, but they cannot change the underlying forces that cause prices to rise and fall. The only thing price manipulation does is hide information from those who need it most: producers and consumers.

In a sane world, the experience of just having watched "the smart people" nearly bring the global economy to its knees might have induced the more reflective among us to revisit the wisdom of giving them license to redesign the American economy along more "intelligent" and "equitable" lines:

... I have written about the absent-minded and socially-inept ‘nutty professor’ stereotype in science, and the phenomenon of ‘psychological neoteny’ whereby intelligent modern people (including scientists) decline to grow-up and instead remain in a state of perpetual novelty-seeking adolescence. These can be seen as specific examples of the general phenomenon of ‘clever sillies’ whereby intelligent people with high levels of technical ability are seen (by the majority of the rest of the population) as having foolish ideas and behaviours outside the realm of their professional expertise. In short, it has often been observed that high IQ types are lacking in ‘common sense’ – and especially when it comes to dealing with other human beings. General intelligence is not just a cognitive ability; it is also a cognitive disposition. So, the greater cognitive abilities of higher IQ tend also to be accompanied by a distinctive high IQ personality type including the trait of ‘Openness to experience’, ‘enlightened’ or progressive left-wing political values, and atheism. Drawing on the ideas of Kanazawa, my suggested explanation for this association between intelligence and personality is that an increasing relative level of IQ brings with it a tendency differentially to over-use general intelligence in problem-solving, and to over-ride those instinctive and spontaneous forms of evolved behaviour which could be termed common sense. Preferential use of abstract analysis is often useful when dealing with the many evolutionary novelties to be found in modernizing societies; but is not usually useful for dealing with social and psychological problems for which humans have evolved ‘domain-specific’ adaptive behaviours. And since evolved common sense usually produces the right answers in the social domain; this implies that, when it comes to solving social problems, the most intelligent people are more likely than those of average intelligence to have novel but silly ideas, and therefore to believe and behave maladaptively.

Sadly, I believe the clever sillies are about to strike again. No good can come from this. But as we survey the wreckage of a once robust economy, it will no doubt come as a great comfort that we were led over the cliff by the very best minds.

Posted by Cassandra at November 4, 2009 08:10 AM

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Comments

"...we were led over the cliff by the very best minds that money can buy.


You forgot that part.
0>;~}

Posted by: DL Sly at November 4, 2009 11:23 AM

Very interesting writeup. Looking at the housing market vs. mortgage leverage chart, it's actually a bit remarkable that house prices have not, on average, fallen a lot further then they have. I'm thinking this may be because most of the worst examples are concentrated in a few geographic areas that were already atypical of the country as a whole, and that tended to contain the damage somewhat.

However, the most interesting bit to me was the writeup about psychological neoteny. It's no secret that the post-modern academy, in general, discourages its adherents from interacting with what we might call "the real world". (This is one reason we see more conservatism among the professors of engineering and the hard sciences. They often get them involved in research partnerships where they are exposed to people who work in industry, and to the actual workings of the industry itself.)

However, I think it's also giving at least some of the pointy-heads more credit than they actually deserve. It's been my observation that a good bit of the self-styled intellectual elite of today, particularly on the liberal arts side, are really not inherently smarter than the average Joe. They may be good at sounding smart and striking the pose, but when you start digging, you find there's not much substance there. A true intellectual would realize that common-sense behaviors and beliefs evolved for a reason, and ignoring that is, well, not smart. There's actually quite a bit of intellectual laziness among many of the people who fancy themselves as the great thinkers of today. So I'm less inclined to think of this form of neoteny as a psychological disorder, and more along the lines of what we call, in plain English, spoiled brats.

Posted by: Cousin Dave at November 4, 2009 03:19 PM

Wow! Two excellent points nicely tied together. The explanation that banks needed to find a way to loan more money in the WSJ article is a very clever - and simple - way to look at what happened. And I loved the point about bright people over-thinking situations that don't really respond to analysis. (Is there a link for that?) It reminds me of those old Jim Kaat baseball aphorisms like: You study long, you study wrong.

Posted by: Elise at November 4, 2009 03:30 PM

Sorry - I added it in. I was in such a hurry this morning that I forgot. It's only the abstract of the article, though. I have it somewhere on another pc but since I have 5 in my office it's anyone's guess which one!

Posted by: Cassandra at November 4, 2009 03:42 PM

Orwell said something to the effect of
" only the intelligentsia could believe something so stupid" Hasn't changed much

Posted by: reg at November 4, 2009 07:46 PM

I find it extremely ironic that the Dems are trumpeting the financial crisis as "proof" that laissez faire capitalism doesn't work when excess regulation contributed to the problem in the first place.

Posted by: Cassandra at November 4, 2009 08:41 PM

What on earth do they expect to happen to prices when the number of consumers suddenly exceeds the capacity of existing medical professionals to provide care?

They'll declare that it is proof of their assertion that the American people *needed* it, then pat themselves on the back incessantly.

Then they'll blame the insurance industry for everything else.

Posted by: BillT at November 4, 2009 11:58 PM

GREED!

Those failed greedahness of the Bush years must come to an end. We must eliminate greedy corporations that seek to make a profit at the expense of the downtrodden proletariat so we can return to full employment!

Posted by: Barack Will *Work* You! at November 5, 2009 12:08 AM

...when excess regulation contributed to the problem in the first place.

Then add zero actual oversight from the regulation writers (or their surrogates) and you've got the *cause* of the problem.

Posted by: BillT at November 5, 2009 03:27 AM

The health care reform issue is actually several related issues, with the insurance industry being just one. I invite and strongly encourage everyone to read this article from the New Yorker about why health care costs so much:

McAllen, Texas and the high cost of health care.

It is apolitical and a really great article.

Posted by: MikeH at November 5, 2009 09:41 AM

"I find it extremely ironic that the Dems are trumpeting the financial crisis as 'proof' that laissez faire capitalism doesn't work when excess regulation contributed to the problem in the first place."

That's not stupidity. That's malice. They may not understand much about economics, but they know good and darn well that government was manipulating the market. But their ideology doesn't allow them to admit where the problem is, so they have to blame the victim.

Posted by: Cousin Dave at November 5, 2009 10:48 AM

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