Monday, March 24, 2008

Keeping the Garbage in the Public OODA Loop

Barry Ritzholtz at the Big Picture raised an interesting question this weekend that I think it vital --- why do we tolerate or even encourage a Garbage In-Garbage Out OODA loop. He raised it in the context of investing, but I think this goes beyond the economy:

 Why have we as a nation been increasingly reluctant to confront objective reality? What is it about the present social mood, political leadership, and economic envrionment that has so totally led us to a world of denial. Up is down, black is white, good is bad --- its all very Orwellian..

There are multiple reasons here, and I just want to look at two. The first is a structural economic argument that our society has become more of a jackpot society than a steady-gainer society. The second is we have a series of perverse incentives set up to encourage bad decision making and discourage good decision making.

Earlier today I analyzed why the Clinton campaign is engaging in a very low probability bid to win the Democratic nomination as I rejected the set-up for 2012 option. I zeroed in on structure of the contest and the lack of viable agreement enforcement mechanisms.

We live in a jackpot society where the winner takes all and the loser has very little recourse. The nomination process is the ultimate jackpot.....

the traditional response to a single iteration jackpot, single winner, complete losers game is to go all in for as long as one has the resources to play in the hopes that something shakes the right way for you just as the jackpot is declared. The odds suck, but bad odds are better than zero odds. So I don't think Clinton is playing for 2012 as that scenario does not make a whole lot of sense, she is playing for now with a good strategy given a horrendous prospect of success

We are a jackpot society today in which a single big score is all one needs to be set for life. Marginal differences in initial endowment of skills, combined with luck, combined with much higher levels of  intergenerational income correlation  means that two very similiar people will have very different income paths. Furthermore, the jackpots (unless you can hit a curve) keep changing locations, encouraging chasing behavior. We saw this with the tech bubble as got funded, and then we saw it again in 2004-2006 with speculative flippers entering the market with the hope that if they could just flip two or three projects, they would be good for the next five years.

And if the leap for a big score fails, there is always a bail-out of some sorts. The question is who gets the bail-out and who pays for it....

Robert Reich argues that moral hazard for large players has been expanding and accelerating with a string of large scale bail-outs that have occurred because XYZ was too systemically important to be allowed to fail. And to avoid these failures, the risk was nationalized and the rewards privatized. One way sure thing bets are a great way for the house to lose money.

When it comes to risky behavior in the market, America has a double standard. We're told that economic risk-taking as the key to entrepreneurial success, but when big entrepreneurs take big risks that fail it's amazing how often they get bailed out. Indeed, the history of modern American business is littered with federal bailouts, loan guarantees, and no-questions-asked reorganizations. Some are well known, such as the Chrylser bailout of 1979, the savings and loan bailout of 1989, and the airline bailout of 2001. Most occur in the relative dark, such as the 1998 bailout of giant hedge fund Long-Term Capital Management (courtesy of former Fed chair Alan Greenspan), the not infrequent bailouts of under-funded corporate pension plans by the government's Pension Benefit Guarantee Corporation, price supports for big agribusinesses facing market downturns, or the current bailout of Wall Street being engineered by Ben Bernanke's Fed. Behind every one of these bailouts are CEOs or financial executives who were rescued from their bad bets.

Nouriel Roubini argues that the Federal Reserve's recent actions to backstop JP Morgan's buy-out/bail out of Bear Stearns is a continuation in this trend of encouraging moral hazard and thus excerbating bad decision making:

In the Bear Stearns case it has been argued that there was no bailout as the shareholders of Bear have been effectively wiped out. This argument is incorrect in many dimensions. First, since Bear was insolvent shareholders should have been wiped out 100%; the residual value of their equity – however little at $200m - means that they still fully own the firm and that they would benefit from increases in the market value of the firm that may derive from the liquidity support that the Fed provided if the JPMorgan deal does not go through.

since Bear was insolvent closing it down without the Fed loan would have implied that not only shareholders would have been wiped out 100% but also that other creditors of Bear – who lent without properly considering the significant risks that they were undertaking – would have suffered significant losses. Instead the Fed bailout made such creditors of Bear whole, a most disturbing and moral hazard laden outcome.....

Third, not only Bear shareholders were not fully wiped out as they would have been if Bear had been allowed to go bankrupt; but all the senior management of Bear has been kept in place – starting with that reckless golf and bridge-AWOL Jimmy Cayne – when a proper solutions would have been to fire them all without any golden parachute or rich severance package.

So we have a jackpot society where being massively wrong is not neccessarily a bad thing as the costs of being wrong have systemically been passed along to others. And this leads to the second area of delusion, as the incentives are not properly lined up to encourage people to be good decision makers. I'll work with the run-up to the Iraq war and the housing bubble as my example.

Being right has not been a good career move. The social conventions and the political calculation argue against good judgment if that judgment results in emotionally unsatisfying actions. In 2002, Bill Clinton argued that the Democrats lost the mid-term elections because too much of the party was concerned about being right instead of appearing strong:

When people are feeling insecure, they'd rather have someone who is strong and wrong rather than somebody who is weak and right.

Jim Henley got the basic take on the invasion and occupation right, it was going to be a cluster f*ck and a fiasco for multiple reasons and the incompetence dodge is an invalid dodge. However, he is writing his retrospective on his decision process at his personal blog of a few thousand hits per day while the people who have systemically been wrong on one of the major foreign policy questions of the day are still being held up as serious thinkers in major, elite opinion validating forums. Dave at the Glittering Eye has the taxonomy of judgement analysis, and it is a brutal in the dodges people have used to explain their reasoning. As Thersites at Eschaton notes, quite a bit of support for the war among elite decision makers was on the basis of opposition to the people opposing the war --- the DFHs had to be proven wrong.

Furthermore, the entrenched bureaucracies and mindsets know that admitting that they are wrong will have severe personal impacts within their social networks. For instance,  John Robb of Global Guerrillas is passing along a tidbit that one of the Army's premiere think tanks rejects the entire concept of 4th Generation Warfare and other unconventional, alternative paradigm thinking despite the fact that the 4GWers have been much closer to reality in their verifiable predictions than traditional defense thinkers.

So being right is a good way to be marginalized for being right. And this does not apply only to Iraq and defense analysis. Paul Krugman was dismissed as being 'shrill' when he correctly noted that the numbers in the Bush campaigns did not add up, and that there was a pattern of deceitful behavior. Nouriel Roubini and Brad Setser have been noted as 'perma-bears' and gloomsters for noting that what can not go on forever will not go on forever. And now some of their earlier pessimistic estimates are now looking to be a bit too rosy. Being right is not a good career move.

But why are these incentives that encourage bad decision making and discourages good decision making so common --- that is the question Barry raised, and one I have skirted around as I have discussed some of the mechanisms instead of the root causes of tolerating or encouraging a corrupted OODA loop.

I don't have too many good answers beyond the fact that we as a society have been rich enough for long enough to be able to afford to be flattered by fantasy instead of working towards reality. Furthermore, I imagine that the greater concentrations of wealth allows for a greater concentration of messaging in support of a version of fantasy that is profitable to the funders of fantasy than a counterfactual of lower societal influence and wealth Gini coeffciecients. But at this point I am speculating instead of analyzing.

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