Tuesday, October 25, 2011

Trust and mistrust

Many economists agree that today the U.S. economy is caught in what Keynes called a “liquidity trap.” While the Federal Reserve Bank is engaged in what is called “quantitative easing,” essentially increasing the money in circulation, banks and companies are awash in cash. One result is that the Fed is trying to “push on a string.” No amount of easing can convince financial and non-financial institutions to lend or invest the money they already have.

The preference for liquidity means that decision makers are unwilling to take the risk of investing dollars in their own projects or the projects of borrowers. One question is why there is so little tolerance for risk, or conversely so much desire for safety. There are two kinds of risks to consider, market risk and counter-party risk. The former is familiar. We can never be certain that a project will pay off. The future is unknown. But the latter risk is less common. It is based on a suspicion that appearances are deceiving. Just because a company or banks says that its earnings, cash flow, book value, are “X,” does not mean that this is so. At the height of the financial crisis, counterparty risk was pronounced, because decision-makers did not how to value the mortgage backed securities that formed such a large part of commercial and investment banks’ portfolios. The “books” could not be trusted. As a result, financial institutions stopped lending to each other in the “repo” or repurchase market. They could not trust that the collateral for such loans was properly valued. One argument suggests that counterparty risk is one reason the Federal Reserve Bank has failed to stimulate economic growth. All the money in the world cannot reduce mistrust.

Perhaps this is a reminder of how much our markets depend on trust. We trust that the U.S. government will never default on its bonds, and that it can, if it wishes, lend “its full faith and credit” to other entities who want to borrow our money.  It is also why inflation is an emotional as well as a economic issue. Should inflation devalue the dollar we would interpret this as the government’s violation of our trust in its currency. One-reason investors trusted the faulty assessment of the bond-rating agencies, such as Fitch and Moody’s, is that they are a part of a quasi-monopoly sanctioned by the government.

But there is another kind of trust that is not trust in others, but trust in oneself. From a psychodynamic point of view, a person can trust himself because he has an internalized image of his parents and siblings as loving and beneficent. The psychological equation goes something like this, “If the most important people in my life loved me, then surely I can trust my own impulses.” People fortunate enough to have had such an experience can make decisions with emotional conviction.

Such people naturally gain the confidence and trust of others, as they should. The dilemma is that sometimes people can project what we might call a “pseudo-conviction.” This is based on an internal experience of feeling defective, of being unlovable, but the resulting despair can lend an urgency to the wish that one’s needs be met. Here the psychological equation goes like this, “Only by being admired and loved will I be able paper over my defects.” We call such people narcissistic, and if they have a modicum of talent, they too can win the trust of others by virtue of their drive and sense of urgency.

The problem is that such people are more likely to play fast and loose with data that purport to measure economic value. The desire for admiration undermines their integrity.  Beginning in 2001, several years before the financial crisis, Lehman Brothers recorded a temporary loan of securities, as the sale of securities, so that at the end of each quarter it looked like they had more cash than was the case. News reports also suggest that during the financial crisis itself, Richard Fuld, the CEO of Lehman Brothers, could not tolerate the idea that the firm was worth far less than he imagined, and that this stubbornness contributed to the firm’s demise. His refusal may have reflected his own narcissistic investment in the glory of the firm, the same emotional investment that enabled misleading accounting practices. One compelling issue worthy of exploration is what role narcissism played in the run up to, and the unfolding of, the financial crisis.

Tuesday, October 18, 2011

Rational expectations and impulse control

The awarding of the Nobel prize in economics to Thomas Sargent raises interesting questions how about how individuals and groups think about the future. The prize, for the theory of “rational expectations,” proposes that in the aggregate large groups of people, come to a shared and reasonable understanding of the future of some economic variable, for example inflation or exchange rates.

This theory is a version of the “wisdom of crowds.” The price of a company’s publicly traded stock, it suggests, reflects all the available information about the company’s prospects. This is why for example, day to day movement in share prices are close to random. The only new information that can change the price of a stock is by definition unconnected to current knowledge, and therefore will have no systematic effect on the stock’s price. If the effect were systematic, so the argument goes, it would have been anticipated.

This feels like a heady conception, connected more to data than to experience, though it is rooted in the not unreasonable idea that “common sense” will prevail. The term “prevail” is key however. There are periods when common sense is not sensible, for example in market bubbles, when even the “smart -money” has to follow the crowd if it wants to participate in the rewards. Intelligent investors, who identified early, the high tech stock bubble at the turn of this century, and sold their high tech stocks, underperformed the market for several years. It takes time for common sense to assert itself, and in the interregnum the objective facts matter less than other peoples’ opinions. The wisdom of crowds takes a back seat to crowd psychology.

The question then becomes when is a crowd rational and when is it irrational. The common conception of crowds as irrational is based on the idea that people feel less inhibited in a crowd because they are anonymous. We have impulses which if expressed would be gratifying, but we know that expressing them would get us into trouble by inducing guilt or provoking retaliation.  The anonymity protects us.

Freud suggested a twist on this conception. We identify with a leader of the crowd who promises to release us from our inhibitions, as long as we agree to put our impulses in the service of his goals. We remain subordinates, but this time to our leader rather than to our conscience. So the dividing line between the wisdom of crowds and the crowd as mob depends on when and whether impulse control is weakened. This is why we associate market bubbles and their collapse with fear and greed, two very strong impulses.

Researchers like Thomas Sargent who believe that the market is efficient, rightly suspect that the literature on “cognitive bias” is only of secondary importance. Common sense will prevail -- except of course when fear and greed do.

Saturday, October 15, 2011

The IBM report; "Capitalizing on Complexity"

IBM recently released a report, “Capitalizing on Complexity” describing the results of interviews it conducted with CEO’s around the world. Executives, they report, believe that business is going global, that customers are harder to secure and retain, and that leaders need to be creative. The IBM researchers frame these responses as part of the growing complexity of the world of business with its new and intense interdependencies among regions, industries, and markets. One result is that executives need to be more creative.

Reading the report raises the question of why the rhetoric about change has itself changed so little over the last 30 years. When Donald Schon wrote, “Beyond the Stable State” some 30 years ago, or Alvin Toffler, the book “Future Shock, these ideas of about pace, complexity and unpredictability were front and center. The continued repetition of these themes feels ritualistic, akin to a mantra.

Mantras can be invoked to stop thoughts. So the natural question becomes what is that thought that has not been admitted into this rhetoric. Perhaps the terms “interdependency” and “complexity” mask a more difficult question; what is the appropriate integration of society and economy, when is one subordinate to the other? Olympus, the Japanese camera company, fired its British CEO after only 6 months because he ran roughshod over its consensus culture.  However, urgent were its problems-- net profits had fallen 85% -- the social context imposed constraints on how decisions were to be made and at what pace. Japan is in fact the test case of the stalemate between society and economy. Its last two decades were “lost” economically, because the state could not abide the destruction of the country’s banking system and all the economic and social relationships this system supported.

Of course, each CEO when looking at his or her own situation has to be more nimble and creative. And there is little doubt that deregulation over the last two decades has unleashed creativity. But if the IBM researchers are serious and want us to confront the new interdependencies, they should be asking; “what are the collective challenges we face.” What systems should we use to regulate our many sided relationships, economic, social and psychological, with each other?

Wilfred Bion, the psychoanalyst who studied group dynamics said, “man is at war with his own groupishness.” We need the group to acknowledge our worth, but we hate the group for being able to do so.  This conflict results in unconscious dynamics. Perhaps the repeated mantra of “interdependence and complexity” is a psychological defense against really looking at our fundamental dependence on one another for the fulfillment of our individual lives.

Wednesday, October 12, 2011

The Market’s Ineffability

John Paulson, the famous hedge fund owner who successfully shorted the housing market in the run up to the financial crisis, made some wrong bets recently. The economic recovery and inflation he anticipated have not happened. As the New York Times notes, his bet on gold was right for the wrong reasons. Gold rose, not because of inflation but because of chronic uncertainty. It is now falling. His Advantage fund is down $6 billion and many of his investors may decide to withdraw their money.  

One source of the market’s emotional appeal is its “ineffability,” the experience that we as traders and investors are subordinate to its judgment and its surprises.  Leo Melamed, the entrepreneurial engine behind the Chicago Mercantile exchange, the exchange that first introduced currency-futures trading, writes about the “beauty of markets.”  “But the important effect of trading is that it keeps me linked to reality and truth. The beauty of markets, and for me their quintessential characteristic, is that they are the final determinant of veracity. Washington policy makers, Tokyo or Berlin ministers, officials of governments the world over can try to tell the world whatever they want, but the markets tell the world the truth…their opinion doesn’t count a tinker’s dam unless or until it is endorsed by the market.” (Melamed, Escape to the Futures, 1996, p. 436).

It is easy to dismiss this as an exaggeration or a cover-up, but Paulson’s recent failure does suggest that the market’s truth can elude the most talented investor. One sees in this quote as well the pleasure associated with feelings of “awe.” The feeling of awe I suggest is derived from the self-organizing property of the markets, the fact that its logic is formed behind our backs and yet is built by our own hands. The pleasure we take in discovering self-organization is found in many places. People interested in group dynamics speak of the “music of groups," biologists are fascinated by the self-organizing dynamics of a bee colony, scientists by the logic and integrity of a natural ecology, legal philosophers by the evolution of common law, and even Marxists by the hidden hand of history. Awe emerges when we realize that despite our most purposeful efforts the logic of a self-organizing system takes us to destinations we never anticipated. No wonder critics of markets describe the love of markets as a kind of religious fundamentalism.

Perhaps this provides some insight into the rage people feel upon discovering that markets are fixed and manipulated. It represents an attack on our common and shared subordination to the truth and thus to our common fate. It is no longer the great equalizer. The resulting feelings of betrayal—the game has been rigged- may be more important than the anger at oversized compensation and unfairly distributed rewards.

Friday, October 7, 2011

Stepping in the same river only once: The legacy of Steve Jobs

The reflections on Steve Jobs’ life highlight his emergence out of the counter culture of the 1960’s. Though he was born at the very tail end of the baby boom, the Beatles, Buddhism and the Whole Earth Catalog inspired him. It is interesting that in the 1960’s a radical Marxist philosopher, Herbert Marcuse, published an essay on “the new sensibility” of the period, arguing that through its expression; “Technique would then tend to become art, and art would tend to form reality; the opposition between imagination and reason, higher and lower faculties, poetic and scientific thought, would be invalidated.”

The prose feels utopian, but surely one of Jobs’ great achievements was to bring aesthetics and design to the new technologies, to link beauty and utility.  The connections between Apple’s products and the counter-culture run deeper. Jobs showed how technology could be an extension of human abilities, echoing Norbert Wiener's wish thirty years earlier, that with the new technologies, which he called “cybernetic,” we might witness “the human use of human beings.” By developing the graphical user interface he brought “power to the people” in the sense that the desktop computer was easy to use and extended a person’s reach into the World Wide Web. Jobs, of course, was acutely conscious of these linkages, reflected in his famous -- shown only once—commercial, in which he equated IBM with Big Brother, the leader portrayed in Orwell’s dystopian novel of a totalitarian world. Interestingly, the 1960s was also the time when organizational development, a technology for corporate change, with its own utopian strivings for the end of hierarchy, also emerged.

These connections should lead us to be cautious about thinking that Jobs’ achievements might be duplicated, or that they could become the basis of a new business model. It is the dream of every marketer that his product or service speak to the consumer’s soul, that it express the customer’s way of life. But in truth, brands rarely achieve this unity of product and user. Think of how the tag line of the early sixties, the “Pepsi generation” was rendered. It too referenced the culture’s consciousness of a “new generation” but it referred to a substance, flavored sugar water, and a use, drinking, which were utterly conventional. This kind of advertising succeeds more by stimulating anxiety – “am I a member of the new generation or am I out of it,” than by extending or amplifying a sense of identity.

Steve Jobs strode on the stage just when the question of how the new technologies would reshape experience was percolating through the arts, theater, and politics. It was the prelude to the postindustrial revolution. He had the genius to position himself smack in the middle of this burgeoning cultural debate and expressed the issue pragmatically in product design. The counterculture was the wind behind his back. I think this is the case where you can only step in the same river once.

Thursday, October 6, 2011

Steve Jobs is dead

Naturally, many of us are thinking of Steve Jobs’ death.  It came before his time. He had a genius for creating pleasing consumer products that stimulated only engagement, never resistance.  But apparently his own temperament and relationships to those with whom he worked was quite different.  There he thrived on conflict and contest and could be experienced as a bully.  The ethos of humanistic management suggests that he could not have possibly motivated followers, but the people who worked for him must have stretched themselves far more, and reached goals far greater than they could ever have imagined. Perhaps this puzzle reveals how much people want to belong to and identify with a success story.  They are willing to tolerate considerable abuse to be on the winning team. 

Why should this be?  Perhaps as we mature, and are no longer at the center of our parents’ loving world, we come into touch with our anonymity, so we yearn for one bite at the apple, our “one minute of fame.”  Steve Jobs is dead, yet the world will go on without him and Apple continues to exist as a company with a valued franchise.

If the marketplace is a network of transactions, and each of us are nodes, we do have to live with its indifference toward us. This has always been a hard pill to swallow and is one reason why the reactions against the market, whether from the left or the right have been so powerful.   Maybe there are times, as some economists claim, when the market is “perfect.” But it is certainly not natural. It is an artifice, a cultural achievement which may go against our nature. We really need to understand the implications of this.

Monday, October 3, 2011

For the love of money

At the conclusion of the wonderful film, The Social Network, the fictionalized Mark Zuckerberg is seen trying to unsuccessfully “friend” a woman who had rejected him at the beginning of the film because, in her eyes, he was a jerk. The simple moral message is clear; “Money can’t buy you love.” As successful as he is, the woman will always consider him a jerk.  So is there a desire for money?

Freud says somewhere that there is no desire for money, because desire is built upon our earlier experiences as infant and children, and when we are young, we have no conception of money. This suggests that the pursuit of money is indeed the indirect pursuit of love. One can see the problem here. The love attendant upon getting a lot of money is always suspect. Aren’t people pretending to love you to profit from their connection to you? This gives an account of why the pursuit of money might become compulsive, and why those who pursue money seem greedy. As you get more money, your grow more suspicious of others who wish to connect to you. So you need even more money to extract the signals of love from others. So greed is not really a hunger for money it is the unsatisfied need for love.

It does not have to always turn out this way of course. For example, the wealthy hang out with the wealthy, they gain some modicum of appreciation through philanthropy, or if they are “self-made,” they take pride in their achievement, that is they love themselves. One suspect that Steve Jobs, who is not by most accounts at all philanthropic, fits the last category and rightfully so. He is a genius!

But one has to ask how this dynamic works when it becomes general. What happens in a bubble when becoming wealthy seems within easy reach?  People become wealthy on paper without experiencing the crucible of hard work that should accompany real money-making. They are, in this sense, immature money seekers.  The power they feel to spend their wealth becomes its own aphrodisiac. They are in love with themselves, another word for narcissism. The psychodynamics of the bubble is therefore the psychodynamics of narcissism. Perhaps this gives some insight into why bubbles will always be with us. Who can resist the siren song of being at the center of a loving world?

Sunday, October 2, 2011

Markets and memory

Kahneman and Tversky, two founders of the behavioral economics school of thought, conducted a simple experiment to indicate what they called the “anchoring bias.” People were asked, “How many African nations belong to the UN?” Before they answered, the experimenters spun a “wheel of fortune” with numbers on it. Those who saw a high number on the wheel tended to guess high on the number of nations, those who saw a low number, guessed low. The wheel had nothing to do with African nations and the UN, hence their term “an anchoring bias.” The wheel had established an irrelevant but compelling anchor.

This bias is among the many “cognitive biases” researchers have used to critique the conception of economic man as rational. But I think the term “bias” is itself biased. It suggests something that is misdirected and off-center. Anchoring is in fact one example of a much larger phenomenon; human beings have memories, these memories are linked to a sense of identity, and identities are never readily relinquished.

There is an even older saw in economics; “disregard sunk costs,” which means begin everyday as if you were born anew and optimize your allocation of capital accordingly. In other words, “what’s bygone is bygone.” Were this rule followed, all markets would clear immediately, housing would drop to its market clearing price however low, banks would write down debt to sell it on a secondary market at a few cents on the dollar. Kodak, a company that has struggled for over a decade to find its way into the digital age, and is about to run out of cash, would shut down tomorrow and simply auction off its over 1000 valuable patents, returning the money to shareholders.

But markets don’t clear like this. People have memories and desires. The ultimate anchor is, “who I was, and whom do I hope to continue to be,” e.g., a Kodak scientist, a responsible leader in Rochester, New York, where Kodak is headquartered, a home-owner in my community. Perhaps the only market that may not have a memory is the stock market itself, which according to many analysts moves randomly from day to day. But if the market for capital assets clears, while other markets, such as the labor market and the housing market, don’t, we are set up for gridlock.  If Kodak’s share price continues to fall, some other company may acquire it to get its patents, thereby avoiding an auction, and promptly lay-off most everyone, many of whom will not be able to sell their houses or be willing to accept minimum wage jobs. 

Karl Marx once famously characterized capitalism as a system in which “all that is solid melts into air.” But this is correctly understood as a fantasy about a society whose members have neither memories nor desires.