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A question for Andrew Lo

Posted By Russ Roberts On December 3, 2009 @ 12:14 pm In Financial Markets | Comments Disabled

He says in an interview [1]:

Q: In one article, you compare a disaster that befell a mountain climbing expedition on Mt. Hood to what has happened in the financial system. Could you explain that?
That was a situation where some very experienced climbers made what many considered a rookie mistake. And the reason was because their perception of risk was actually quite a bit lower than the reality. We all have mental models of the world — all of us, except perhaps a few fortunate Zen masters. In many cases, those mental models are misleading. Some of us think of ourselves as better athletes than we are, or as more attractive than we may be. It’s important to bring these models into agreement with reality when discrepancies can actually hurt us. Ultimately we do that through the forces of natural selection. We learn by trial and error. In the case of the mountain climbers, unfortunately, the error was extraordinarily costly in terms of taking their lives.

Q: And you see a similar dynamic in the build-up to the financial crisis.
Absolutely. The example of the mountain climbers is so instructive. Many people are now asking, “How could it be that some of the most sophisticated financial institutions in the world ended up making what now, in retrospect, seem like rookie mistakes, such as taking on too much leverage?” But the fact is, when you’re building a business and the perceived risks have declined because of years of success and prosperity, well, you become complacent about some of those risks in the same way that these very experienced mountain climbers figured this was not a very challenging mountain. It was that false sense of security and perceived lack of risk that led to their demise.

I think this is the common view of the crisis. A mixture of hubris, overconfidence, ignorance, and myopia.

There is one problem with it. The people who allegedly made those rookie mistakes made enormous amounts of money. My questions: is it a mistake if the result is making an enormous amount of money?

My view is that they weren’t making a mistake. They did precisely what the incentives told them to do–take lots of risks with borrowed money. In the worse case scenario, you’ll get fabulously rich–the execs at Lehman and Bear [2]. In the best case scenario, you get even more money than that–the execs at Goldman and JP Morgan. So how what do mistakes have to do with the crisis?

The taxpayers ended up paying the price, not the risk-takers. Our mistake was not paying attention. But we usually don’t. We don’t have time or much of an incentive. But now that we see how it worked, we can tell the politicians to stop creating the bad incentives. They may not listen. But if people recognize the problem (rather than blaming it on human nature), we have a chance.

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[1] in an interview: http://qn.som.yale.edu/article.php?issue_id=12&article_id=246

[2] the execs at Lehman and Bear: http://cafehayek.comwww.law.harvard.edu/faculty/bebchuk/.../BCS-Wages-of-Failure-Nov09.pdf

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