Wednesday, March 18, 2009

Hubris v. Greed

cat imageIn the wake of systemic failure, it is important to study the error and figure out why it occurred.

Our knee jerk reaction to the failure of a major company like AIG or Enron is that the companies were driven by greed. They took unacceptable risks, and the risks led to failure.

A better explanation is that these companies fell to hubris … with hubris defined as an arrogant overconfidence in one's investing knowledge.

Both AIG and Enron were filled with the best and brightest from top business schools. The students put into practice all of the equations that they learned from the professors at our leading progressive universities.

They hedged their investments feeling certain that their derivatives, short positions, government backed re-insurance and mathematical equations would allow them to invest massive amounts of public capital without risk.

The hubris is that one can hedge risk by taking a leveraged position. In all of the complex equations, the financial world lost track of the real value that backed their securities.

The problem was not with risk taking. Nor is it a problem with people receiving rewards for the risks they take. The problem was that a legion of smug technocrats felt that they could march from the University and take their entitled position in the upper rungs of society simply by plugging numbers into the hedging equations taught in school.

Our financial collapse occurred because our financial institutions had taken leveraged positions to hedge risk while arrogantly ignoring the fact that their leveraged position had created systemic risk.

People who face risk with humility rarely create the systemic risks as those who march onto the battlefield blinded by hubris.

Hubris is not unique to the wealthy. One form of widespread hubris is the belief that we are all entitled to high paying jobs with guaranteed health care and lucrative retirement benefits ... without anyone really laying forth a solid plan to create such a utopia.

Hubris is not unique to the private sector. Politicians, clergy and tenured professors can all fall victim to the vice. Mao's Cultural Revolution is a great example of bureaucratic hubris run amok. There was so much faith in the five year plan that people failed to notice (or even acknowledge) the lack of food in the countryside until millions were falling of starvation.

Properly identifying the cause of the systemic fault is important.

Unfortunately, people have an instinctual desire to place blame on others.

Politicians or regulators, for example, would not want to accept the blame as hubris as such an admission would make the political share blame with the private sector.

The press would never report on the hubris of the press. Academicians see themselves as transcendent and could never accept that they led people students down a blind alley.

I understand the desire to place the entire blame on the nameless faces on Wall Street. However, if the problem is widepread hubris within our culture at large, then laying blame on a single segment of the economy might lead to even further calamity.

One element of our cultural hubris is a belief that we are all entitled to a well paying job with full health and retirement benefits. If we proceed with a misdirected anger at all risk takers, we might end up driving the people with the ability to create well paying jobs from our midst.

Look at the large number of innovations created by people who faced risk with humility and made great discoveries in the process.

If the drum beat of hatred and wealth envy aimed at Wall Street destroys those who face risk with humility, then we might see a dramatic decline in our standard of living. The people who feel entitled to well paying jobs will be led to naught.

The self interest of politicians, the media, and academicians is to blame the greed of risk takers in the private sector for all wrongs. When listening to their words, we must understand that it is against their self-interest to acknowledge any role played by their own hubris in our financial woes.

The financial collapse shows that our financial institutions were wrong in their belief that highly leveraged positions hedged risks. The hubris of the technocrats that built this house of cards is extraordinary.

In acknowledging this problem, we must recognize that hubris is not unique to Wall Street. It can exist in the minds of smug bureaucrats, public servants, lawyers or even in the population at large. America bred a population who feel entitled to prosperity but who seems to have become clueless on how one goes about creating the wealth that they inherited.

We should not simply accept the diagnosis of politicians who lay blame of greed in the free market. Misdiagnosing the malady might lead to a cure which is worse than the disease.


Anonymous said...

The banks are insolvent because they chased a profit too far.

Now we have to bail them out.

Cut it up and redefine it with euphemisms all you want, it's still irresponsible behavior of a few in an unregulated market now milking the many who did nothing more than pay their taxes.

In short... who cares if it's hubris or greed, the market didn't self regulate in time, which is a fine enough argument for even my limited government frame of mind to justify a heavy dose of regulation to make sure it doesn't happen again.

y-intercept said...

People can chase profits too far in a regulated economy. For that matter, the Fed had been actively trying to regulate the economy through the monetary supply. GSEs like FreddieMac regulated the mortgage market via its re-insurance policies.

These regulations appear to have actually magnified the scope of the problem.

BTW, my post was not a euphemism as the diagnosis that the problem was the result of greed of a few (as you suggest) or widespread hubris (as I believe) leads to dramatically different remedies.

If it is the problem of a few bad apples, then we need to find ways to prosecute these few bad apples.

If the problem was the hubris of technocrats; then we won't solve the problem by creating an army of technocratic regulators. The technocratic regulators will simply amplify the systemic fault.

Maurice J. DupreƩ has an interesting article on the hubris of the idea that we can create a financial system free of risk though mathematical models. The article is a PDF