Incentives Align To Create Bubbles

from the blame-game-not-necessary dept

In the latest financial crisis, we've seen even more focus on casting blame than following most financial crises. It may be because of the sheer size of the mess this time, and it may be because the events that led up to this mess are a lot more difficult to understand than in the past -- and may even feel more nefarious. However, the deeper you look into the crisis, the harder it is to directly assign blame for the majority of the mess. Yes, there were scammers and fraud on the margins, but for the most part, everyone was doing things in a way that makes sense. This, among other things, is a key point brought out by Henry Blodget's article in The Atlantic about why these types of collapses happen so often. Basically, there is some amount of irrationality in the system, but over time, as more and more people seem to be making money against the irrationality, more and more explanations are made for why that irrationality is actually rational. And since the irrational activity goes on for so long, it becomes nearly impossible for most people to really believe that things are so irrational. So, it's not that there's anyone who did anything wrong that needs to be blamed, so much as we need to blame ourselves, for not taking enough time to recognize that what seems irrational in the beginning actually is irrational.

Of course, along those lines, it's important to realize that, as painful as market corrections like this are going to be, the end result is often beneficial. During the bubble period, lots of money gets thrown at certain things (infrastructure or products) that post-bubble are available for quite a discount. Bubbles help build up new institutions, and even if the original investments get washed away, something good often comes out of them in the end. It may not be clear yet how this financial crisis will eventually work out, but now is a decent time to be looking for opportunity in the carnage rather than worrying about who to blame.
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Filed Under: blame, bubbles, incentives


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  1. identicon
    Josh, 24 Dec 2008 @ 7:44am

    Rational/Irrational

    There is simply no way to make something that is fundamentally irrational into a rational proposition. Any explanations trying to do so are wrong. The only irrationality built into the system is the people in that system.

    Whether they are willfully irrational (refuse to accept despite knowing better), unsophisticated irrational (normally rational person that just doesn't understand the market, yet is in it anyway), or ignorantly irrational (can't think rationally to save their life) - it doesn't matter, and there's no point arguing which they are - it is the people that are irrational, and thus we get this mess.

    Beliefs like 'housing values will continue to increase indefinitely' and 'a good idea is selling credit default swaps as insurance to someone who doesn't own a stake in a company and may have motive and ability to force a company to the point of failing (otherwise known as buying insurance on your neighbors house and then setting it on fire)' are irrational no matter how you try to explain it.

    There were (rational) people giving warnings that this was going to happen as much as a year before everything collapsed and they were mostly ignored. The real question is why banks and financial institutions didn't start deleveraging in an orderly way, or reducing their own exposure to the CDOs and mortgage-backed securities.

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