Privileging analytical functions over intuitive ones played out with real consequences in the 2007 financial crisis. My second book, A Decade of Delusions, dealt directly with whether the crisis was a thoroughly random occurrence, or an unpredictable but foreseeable one—a Grey Swan rather than a Black. Chapter 9, “Contagious Speculation,” published in early 2006 and 2007 and Chapter 10, “The Tipping Point,” written in February 2008 make clear that the coming of a crisis should have been expected.
In testimony before the National Commission on the causes of the financial and economic crisis in the United States, Warren Buffett candidly observed: “very, very few people could appreciate the bubble,” which he called a “mass delusion” shared by “300 million Americans.” Regulators echoed similar refrains. Ben Bernanke, Federal Reserve Chairman since 2006, told the Commission a “perfect storm” had occurred that regulators could not have anticipated.
To be sure, if you labor through the commission’s report you will be struck by the sheer volume, scope and complexity of the financial, economic, and behavioral forces that coalesced in crisis.
The report is indicative of the aforementioned paralysis our analytic cognition experiences in the face of relevant but as of yet unconnected mountains of information. A report can only outline a plot in retrospect. The complexity of the episode presented is staggering even after the fact. The likelihood of inductive analysis unraveling that complexity in the midst of the blind momentum leading up to the crisis is low. That is what makes it a gray swan. In missing the forest for the trees, most analysis is, in reality, ignorant of its subject.
Intuition serves two functions. First, it feels change, calling for response on an instinctual level. This is a deductive way of knowing. Further, it filters and focuses analytic faculties to concentrate on the particulars related to that initial sensation. Attention to intuitive feelings is required before that capacity can serve to clarify inductive efforts. One or both are needed to seek safety during the advent of calamity.
These principles apply more broadly than in avoiding disaster, however. Steve Jobs’ conflicted tenures at Apple are a poignant example of an intuitive genius in an analytical world. Jobs’ feelings generated uncompromising conviction. Once a course was set, inexhaustible attention to detail pressed the analytic into the service of intuition. There was nothing smooth about the process, though. Perennial tensions with the board over direction resulted in an on-again off-again relationship that was due in no small part to Jobs’ prioritizing intuitive conviction over data. Still, we see in him the success of which intuition is capable in a world dominated by linear sequential thinking.
In terms of markets, if we privilege the linear over the intuitive, we will excel at explaining change, but not preparing for it. Jobs’ leadership was proactive, outlining the proper path forward with uncompromising conviction. It represents a wholly different system of governance than that of our financial system. The Federal Reserve is, and always has been, as reactive as Jobs was its opposite. Analysis at the Fed is perennially behind the curve.
Moving to Today
When released in 2010, the report on the financial crisis was of no practical value. The damage had been done. The justification for its expense and effort was “to prevent whatever happened from ever happening again.” The Dissenting Statement to the majority opinion—which I found uniquely uncompromising—argued that it was U.S. government housing policies that were a major contributor to “whatever happened.” That was, in their view, a financial crisis in 2008, resulting from a massive housing bubble between 1997 and 2007, supported by the creation of 27 million subprime and Alt-A loans, many of which were poised to default as soon as the bubble began to deflate. The central player in that drama was the Fed, which has sole authority for setting the standards of responsible lending among nationally chartered banks.
As shocking as it may seem given the Fed’s colossal malfeasance culminating in the financial crisis, since 2010 it is once again in the driver’s seat, showing every indication of enabling the next crisis. This time, however, the easy money-induced malinvestments are much more broadly dispersed, although, at least in terms of the equity markets, far less leveraged than was residential real estate heading up to the last crisis. Tragically, many of the victims will be the same. The prospective homeowner—already on thin ice when claiming the “Sergeant Schultz defense” (innocent by virtue of having been ignorant of the facts)—who didn’t comprehend the downside of the subprime loan to which he committed, is little different than today’s unwitting buyer of any number of different assets. Denied by the Fed of any traditional safe harbor for their savings, investors have sought return in the capital markets. They are in dangerous territory and their chances of being victimized are high. It is now ETFs and other exotic financial instruments that are the wolves in sheep’s clothing lying in wait for unsuspecting investors.
The real value in reading the report is not as a historical account of water already passed under the bridge, but as…preamble. In its analytic search for potentially repeatable patterns—which, ironically are most often found in the soft behavioral sciences—the report conveys a wealth of unintended insights. Most importantly, history is inconveniently non-ergodic, refusing to satisfy our needs for order and stability by predictably repeating itself. Therefore, efforts at prevention are not likely to be attempted.
Benjamin Graham once noted, “You don’t need to know a man’s exact weight to know he’s obese.” In an early 1929 exchange between Graham and Bernard Baruch, both agreed that the market had advanced to such “inordinate heights, that the speculators had gone crazy, respected investment bankers were indulging in inexcusable hijinks, and that the whole thing would have to end up one day in a major crash.” Several years later Graham lamented, “What seems really strange now is that I could make a prediction of that kind in all seriousness, yet not have the sense to realize the dangers to which I continued to subject the account’s capital.” Baruch, in writing the foreword to the 1932 edition of Extraordinary Popular Delusions and the Madness of Crowds, expressed sentiments others will feel again should this current episode in financial folly end badly.
Some years ago a friend gave me a copy of Extraordinary Popular Delusions. In a vague way I had been familiar with the stark facts of these events, as who is not? But I did not know . . . the astonishing circumstances of each of the greater delusions of earlier eras. I have always thought that if in 1929 we had all continuously repeated “two and two still make four,” much of the evil would have been averted.
Had the financial crisis, which Warren Buffett dubbed a “mass delusion” above, been allowed to run its cathartic course, ultimately resulting in a mass aversion to equities – I would not be writing this post. By truncating the downside, no matter how compelling the reasons, the Fed bought us time at the expense of resolution. By my reading, the report rekindles memories of a classic rhyme:
Humpty Dumpty sat on a wall,
Humpty Dumpty teetered about to fall.
But all the Fed and Treasury’s men,
Stabilized Humpty Dumpty to a chorus of Amens,
And set Humpty Dumpty atop the wall again.