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Basically, It’s Over: A Parable About How One Nation Came To Financial Ruin

An excellent parable by Charlie Munger on how one nation came to financial ruin.

In the early 1700s, Europeans discovered in the Pacific Ocean a large, unpopulated island with a temperate climate, rich in all nature’s bounty except coal, oil, and natural gas. Reflecting its lack of civilization, they named this island “Basicland.”

The Europeans rapidly repopulated Basicland, creating a new nation. They installed a system of government like that of the early United States. There was much encouragement of trade, and no internal tariff or other impediment to such trade. Property rights were greatly respected and strongly enforced. The banking system was simple. It adapted to a national ethos that sought to provide a sound currency, efficient trade, and ample loans for credit-worthy businesses while strongly discouraging loans to the incompetent or for ordinary daily purchases.

Moreover, almost no debt was used to purchase or carry securities or other investments, including real estate and tangible personal property. The one exception was the widespread presence of secured, high-down-payment, fully amortizing, fixed-rate loans on sound houses, other real estate, vehicles, and appliances, to be used by industrious persons who lived within their means. Speculation in Basicland’s security and commodity markets was always rigorously discouraged and remained small. There was no trading in options on securities or in derivatives other than “plain vanilla” commodity contracts cleared through responsible exchanges under laws that greatly limited use of financial leverage.

In its first 150 years, the government of Basicland spent no more than 7 percent of its gross domestic product in providing its citizens with essential services such as fire protection, water, sewage and garbage removal, some education, defense forces, courts, and immigration control. A strong family-oriented culture emphasizing duty to relatives, plus considerable private charity, provided the only social safety net.

The tax system was also simple. In the early years, governmental revenues came almost entirely from import duties, and taxes received matched government expenditures. There was never much debt outstanding in the form of government bonds.

As Adam Smith would have expected, GDP per person grew steadily. Indeed, in the modern area it grew in real terms at 3 percent per year, decade after decade, until Basicland led the world in GDP per person. As this happened, taxes on sales, income, property, and payrolls were introduced. Eventually total taxes, matched by total government expenditures, amounted to 35 percent of GDP. The revenue from increased taxes was spent on more government-run education and a substantial government-run social safety net, including medical care and pensions.

A regular increase in such tax-financed government spending, under systems hard to “game” by the unworthy, was considered a moral imperative—a sort of egality-promoting national dividend—so long as growth of such spending was kept well below the growth rate of the country’s GDP per person.
Basicland also sought to avoid trouble through a policy that kept imports and exports in near balance, with each amounting to about 25 percent of GDP. Some citizens were initially nervous because 60 percent of imports consisted of absolutely essential coal and oil. But, as the years rolled by with no terrible consequences from this dependency, such worry melted away.

Basicland was exceptionally creditworthy, with no significant deficit ever allowed. And the present value of large “off-book” promises to provide future medical care and pensions appeared unlikely to cause problems, given Basicland’s steady 3 percent growth in GDP per person and restraint in making unfunded promises. Basicland seemed to have a system that would long assure its felicity and long induce other nations to follow its example—thus improving the welfare of all humanity.

But even a country as cautious, sound, and generous as Basicland could come to ruin if it failed to address the dangers that can be caused by the ordinary accidents of life. These dangers were significant by 2012, when the extreme prosperity of Basicland had created a peculiar outcome: As their affluence and leisure time grew, Basicland’s citizens more and more whiled away their time in the excitement of casino gambling. Most casino revenue now came from bets on security prices under a system used in the 1920s in the United States and called “the bucket shop system.”

The winnings of the casinos eventually amounted to 25 percent of Basicland’s GDP, while 22 percent of all employee earnings in Basicland were paid to persons employed by the casinos (many of whom were engineers needed elsewhere). So much time was spent at casinos that it amounted to an average of five hours per day for every citizen of Basicland, including newborn babies and the comatose elderly. Many of the gamblers were highly talented engineers attracted partly by casino poker but mostly by bets available in the bucket shop systems, with the bets now called “financial derivatives.”

Many people, particularly foreigners with savings to invest, regarded this situation as disgraceful. After all, they reasoned, it was just common sense for lenders to avoid gambling addicts. As a result, almost all foreigners avoided holding Basicland’s currency or owning its bonds. They feared big trouble if the gambling-addicted citizens of Basicland were suddenly faced with hardship.

And then came the twin shocks. Hydrocarbon prices rose to new highs. And in Basicland’s export markets there was a dramatic increase in low-cost competition from developing countries. It was soon obvious that the same exports that had formerly amounted to 25 percent of Basicland’s GDP would now only amount to 10 percent. Meanwhile, hydrocarbon imports would amount to 30 percent of GDP, instead of 15 percent. Suddenly Basicland had to come up with 30 percent of its GDP every year, in foreign currency, to pay its creditors.

How was Basicland to adjust to this brutal new reality? This problem so stumped Basicland’s politicians that they asked for advice from Benfranklin Leekwanyou Vokker, an old man who was considered so virtuous and wise that he was often called the “Good Father.” Such consultations were rare. Politicians usually ignored the Good Father because he made no campaign contributions.

Among the suggestions of the Good Father were the following. First, he suggested that Basicland change its laws. It should strongly discourage casino gambling, partly through a complete ban on the trading in financial derivatives, and it should encourage former casino employees—and former casino patrons—to produce and sell items that foreigners were willing to buy. Second, as this change was sure to be painful, he suggested that Basicland’s citizens cheerfully embrace their fate. After all, he observed, a man diagnosed with lung cancer is willing to quit smoking and undergo surgery because it is likely to prolong his life.

The views of the Good Father drew some approval, mostly from people who admired the fiscal virtue of the Romans during the Punic Wars. But others, including many of Basicland’s prominent economists, had strong objections. These economists had intense faith that any outcome at all in a free market—even wild growth in casino gambling—is constructive. Indeed, these economists were so committed to their basic faith that they looked forward to the day when Basicland would expand real securities trading, as a percentage of securities outstanding, by a factor of 100, so that it could match the speculation level present in the United States just before onslaught of the Great Recession that began in 2008.

The strong faith of these Basicland economists in the beneficence of hypergambling in both securities and financial derivatives stemmed from their utter rejection of the ideas of the great and long-dead economist who had known the most about hyperspeculation, John Maynard Keynes. Keynes had famously said, “When the capital development of a country is the byproduct of the operations of a casino, the job is likely to be ill done.” It was easy for these economists to dismiss such a sentence because securities had been so long associated with respectable wealth, and financial derivatives seemed so similar to securities.

Basicland’s investment and commercial bankers were hostile to change. Like the objecting economists, the bankers wanted change exactly opposite to change wanted by the Good Father. Such bankers provided constructive services to Basicland. But they had only moderate earnings, which they deeply resented because Basicland’s casinos—which provided no such constructive services—reported immoderate earnings from their bucket-shop systems. Moreover, foreign investment bankers had also reported immoderate earnings after building their own bucket-shop systems—and carefully obscuring this fact with ingenious twaddle, including claims that rational risk-management systems were in place, supervised by perfect regulators. Naturally, the ambitious Basicland bankers desired to prosper like the foreign bankers. And so they came to believe that the Good Father lacked any understanding of important and eternal causes of human progress that the bankers were trying to serve by creating more bucket shops in Basicland.

Of course, the most effective political opposition to change came from the gambling casinos themselves. This was not surprising, as at least one casino was located in each legislative district. The casinos resented being compared with cancer when they saw themselves as part of a long-established industry that provided harmless pleasure while improving the thinking skills of its customers.

As it worked out, the politicians ignored the Good Father one more time, and the Basicland banks were allowed to open bucket shops and to finance the purchase and carry of real securities with extreme financial leverage. A couple of economic messes followed, during which every constituency tried to avoid hardship by deflecting it to others. Much counterproductive governmental action was taken, and the country’s credit was reduced to tatters. Basicland is now under new management, using a new governmental system. It also has a new nickname: Sorrowland.

How Underdogs Can Win: A Lesson From The Swiss

Last night something amazing happened. While the Swiss hockey team ultimately lost in a shootout to the powerhouse Canadians, they earned a point for tying the game. How did this happen?

On paper, the two teams don’t even compare. The Canadian roster is full of superstars while the Swiss have largely a ho-hum roster. In terms of payroll, this would be the same as the Yankees facing the local high-school baseball team. The game should have been a blowout. No one expected the Swiss to win or, for that matter, even compete.

The Swiss knew if they played the conventional way — that is, if they let the Canadians move and pass without opposition — they would certainly lose.

So they employed an unconventional strategy which didn’t rely on skill: The Swiss found a way to greatly reduce the skill advantage held by the Canadians. Much like the basketball teams highlighted in Malcolm Gladwell’s How underdogs can win, the Swiss conceded nothing and applied constant pressure.

Applying pressure over the entire ice surface requires a lot of work but very little actual skill. In hockey, much like basketball, teams often concede a large percentage of the playing surface before trying to stop the other team. This favors the skilled teams over the unskilled teams. Applying relentless pressure over the entire playing surface, like the Swiss, neutralized the skill advantage of their superior opponent.

Only when the game went into a shootout, when the Swiss could not apply their skill neutralizing strategy of constant pressure, did the Canadian skill win the game.

Malcolm Gladwell is a staff writer at the New Yorker and the author of The Tipping Point: How Little Things Make a Big Difference, Blink, Outliers and most recently, What the Dog Saw.

Lessons of the Past

The tendency to relate contemporary events to earlier events as a guide to understanding is a powerful one. The difficulty, of course, is in being certain that two situations are truly comparable. Because they are similar in some respects does not assure us that they are similar in all respects.

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When we try to understand contemporary events, we often relate them to ones from the past. We do this within the context of our own lives and within the context of human history as a whole. We try to learn from our own mistakes and those of our ancestors.

The issue is that it can be hard to be sure if what is happening now and what happened before are truly comparable. They may be similar in some respects, but we cannot know if they are similar in every meaningful way.

The way we set policy is often flawed. The underrated historian Ernest May argues that we attempt to avoid the mistakes of previous generations by pursuing policies that would have made sense in the past but do not today. May wrote that lawmakers make analogies with history. However, they tend to seize upon the first which comes to mind, without considering differences. They reject disconfirming evidence. In his book, Lessons From the Past, he traces the impact of historical analogy on US foreign policy.

He found that because of reasoning by analogy, US policymakers tend to be one generation behind, determined to avoid the mistakes of the previous generation. They pursue the policies that would have been most appropriate in the historical situation but are not necessarily well adapted to the current one.

Policymakers in the 1930s, for instance, viewed the international situation as analogous to that before World War I. Consequently, they followed a policy of isolation that would have been appropriate for preventing American involvement in the first World War but failed to prevent the second. Communist aggression after World War II was seen as analogous to Nazi aggression, leading to a policy of containment that could have prevented World War II.

The Vietnam analogy had been used repeatedly over many years to argue against an activist US foreign policy. For example, some used the Vietnam analogy to argue against US participation in the Gulf War–a flawed analogy because the operating terrain over which battles were fought was completely different in Kuwait/Iraq and much more in our favor there as compared with Vietnam.

May argues that policymakers often perceive problems in terms of analogies with the past, but that they ordinarily use history badly: When resorting to an analogy, they tend to seize upon the first that comes to mind. They do not research more widely. Nor do they pause to analyze the case, test its fitness, or even ask in what ways it might be misleading.

Machiavelli’s Mistake: Why Good Laws Are No Substitute For Good Citizens

A summary of Samuel Bowles’ lecture series entitled “Machiavelli’s Mistake” at the Santa Fe Institute.

1. Moral Sentiments and Material Interests

The classical thinkers from Aristotle to Aquinas, Rousseau, and Burke recognized the cultivation of civic virtue not only as the test of good governance, but also as its essential foundation. Machiavelli and Hobbes broke with this Aristotelian tradition.

Readers of Machiavelli’s Discourses learned that “all men are wicked … hunger makes them industrious, laws make them good.” Adam Smith’s invisible hand provided a decentralized model for how this constitutional alchemy might be accomplished. Good institutions thus came to displace good citizens as the sine qua non of good government. Prices would do the work of morals.

This classical economists approach – now the canonical model of policy-making in economics– now does not ignore moral behavior, but instead assumes it to be unaffected by incentive-based policies designed to harness self-interest. Along with civic virtue, explicit incentives and constraints could thus contribute additively to good government. The classical writers did not worry that laws designed to induce “wicked” citizens to act as if they were good might induce even the good to act as if they were wicked.

They should have worried. Experimental and other evidence show that while most individuals are far from wicked, treating people as if they were often crowds out the common generous, ethical, and reciprocal behaviors upon which the functioning of modern liberal democratic societies depend.

2. Is liberalism a parasite on tradition?

The parasitic liberalism thesis holds that markets and other institutions endorsed by liberals depend on family-based, religious and other traditional social norms that are endangered by these very institutions. Liberal society thus fails Rawls’ test of “stability:” it does not “generate its own supportive moral attitudes.” Experimental evidence presented in Lecture I, provides support for the idea. I represent the thesis in a model of the dynamics of institutional and cultural change, indicating the conditions under which the cultural dynamic of liberal society leads to economic dysfunction, instability and eventually collapse. I then provide surprising cross-cultural evidence that is inconsistent with the implications of the model.

Liberal societies are distinctive in their civic cultures, exhibiting levels of generosity, fairmindedness, and civic involvement that distinguish them from non-liberal societies. The parasitic liberalism thesis fails not because it misunderstands the cultural consequences of markets, but rather because it overrates the benign contribution of tradition to the moral underpinnings of liberal institutions, and underrates the contribution of the liberal state and other non-market aspects of the liberal social order to the flourishing of these civic virtues.

3. Machiavelli ‘s Mistake: Do good fences make good (enough) neighbours?

Two empirical puzzles show that some incentives work almost exactly as conventional economic theory predicts while others backfire. Under what conditions, then, can prices do the work of morals. Unraveling these puzzles and answering this question requires an understanding of the causal mechanisms by which material incentives crowd out moral motives. Experimental and other evidence suggests that explicit incentives and social motivations may be less than additive due to individual desires for autonomy, self esteem and fairness, which may be compromised by incentives. The material incentives favored by economists can also crowd out institutions that provide at least second best governance of social dilemmas.

How should a sophisticated hypothetical social engineer – that is, one who is aware of the motivational and institutional crowding out problem – design policies and institutions? Three results are demonstrated. First the optimal use of incentives may be either greater or less in the presence of motivational crowding out compared to a case where it is absent. Second, cultural market failures are pervasive, and result in overuse of markets even under ideal conditions for (Coasean) bargaining in the design of property rights and other institutions. Finally, a new second best theorem is proposed: the better definition of property rights and other policies considered by economists to improve incentives may degrade economic performance when they crowd out ethical motivations and alternative governance institutions.

Jamie Dimon — What Caused The Financial Crisis

Jamie Dimon’s testimony at the Financial Crisis Inquiry Commission (on what caused the financial crisis):

I believe the key underlying causes of the crisis include: the creation and ultimately the bursting of the housing bubble; excessive leverage that pervaded the system; the dramatic growth of structural risks and the unanticipated damage they could cause; regulatory lapses and mistakes; the pro-cyclical nature of policies, actions and events; and the impact of huge trade and financing imbalances on interest rates, consumption and speculation. Each of these causes had multiple contributing factors, many of which were known and discussed before the crisis.

As the housing bubble grew, new and poorly underwritten mortgage products helped fuel asset appreciation, excessive speculation and far higher credit losses. Mortgage securitization had two major flaws that added risk: nobody along the chain had ultimate responsibility for the results of the underwriting for many securitizations, and the poorly constructed tranches converted a large portion of poorly underwritten loans into Triple A-rated securities. In hindsight, it’s apparent that excess speculation and dishonesty on the part of both brokers and consumers further contributed to the problem.

Excessive leverage by consumers, some commercial banks, most U.S. investment banks and many foreign banks, pervaded the system. This included hedge funds, private equity firms, banks using off-balance sheet arbitrage vehicles, nonbank entities, and even pension plans and universities.

Several structural risks or imbalances grew in the lead-up to the crisis. Many structures increasingly relied on short-term financing to support illiquid, long-term assets. A small structural risk in money market funds that allowed investment in up to 180-day commercial paper or longer term asset-backed securities became a critical point of failure when losses on such securities encouraged investors to withdraw their funds and liquidity was not available to meet redemptions. Over time, repo financing terms became too loose, with some highly leveraged financial institutions rolling over this arrangement every night.

Financial institutions were forced to liquidate securities at distressed prices to repay short-term borrowing. Investors caused enormous flows out of the banking and credit system as they collectively acted in their own self- interest.

In many instances, stronger regulation may have been able to prevent some of the problems. I want to be clear that I do not blame the regulators. The responsibility for a company’s actions rests with the company’s management. However, it is important to examine how the system could have functioned better. The current regulatory system is poorly organized with overlapping responsibilities, and many regulators did not have the statutory resolution authority needed to address the failure of large, global financial companies.

While banks in the mortgage business were regulated, most of the mortgage industry was not or lacked uniform treatment – mortgage brokers were not regulated and insurance regulators were essentially unaware of large and growing one-sided credit insurance and credit derivative bets by some companies. Basel II capital standards, which were adopted by global banks and U.S. investment banks, allowed too much leverage. Extraordinary growth and high leverage of Fannie Mae and Freddie Mac were allowed where the fundamental premise of their credit was implicit support by the U.S. government.

The abundance of pro-cyclical policies has proven harmful in times of economic distress. Loan loss reserving causes reserves to be at their lowest levels at times when high provisioning is needed the most. Although we are a proponent of fair value accounting in trading books, we also recognize that market levels resulting from large levels of forced liquidations may not reflect underlying values. Continuous credit downgrades by credit agencies in the midst of a crisis also required many financial institutions to raise more capital.

Many macroeconomic factors also contributed to the crisis, including the impact of huge trade and financing imbalances on interest rates, consumption and speculation. The U.S. trade deficit likely kept U.S. interest rates low, and excess demand kept risk premiums depressed for an extended period of time.

“I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much.”

Source: http://www.fcic.gov/hearings/pdfs/2010-0113-Dimon.pdf

Atul Gawande: Error in Medicine: What Have We Learned?

Over the past decade, it has become increasingly apparent that error in medicine is neither rare nor intractable. Traditionally, medicine has down- played error as a negligible factor in complications from medical intervention. But, as data on the magnitude of error aceumulate—and as the public learns more about them—medical leaders are taking the issue seriously. In particular, the recent publication of the Institute of Medicine report has resulted in an enormous increase in attention from the public, the government, and medical leadership.

Several books have been defining markers in this journey and highlight the issues that have emerged. Of particular note is Human Error in Medicine, edited by Marilyn Sue Bogner (2), published in 1994 (unfortunately, currently out of print) and written for those interested in error in medicine. Many of the thought leaders in the medical error field contributed chapters, and the contributions regarding human factors are especially strong. The book is a concise and clear introduction to the new paradigm of systems thinking in medical error.

Source

Dr. Atul Gawande, is the New York Times bestselling author of Better: A Surgeon’s Notes on Performance , Complications: A Surgeon’s Notes on an Imperfect Science, and The Checklist Manifesto: How to Get Things Right .