The real reason that capitalism is so crash-prone.

http://www.newyorker.com/reporting/2009/10/05/091005fa_fact_cassidy

by prat • 17 years ago

42 57 17 years ago

hy3lxs• 17 years ago

Great read. My two favorite quotes:

The Prisoner’s Dilemma is the obverse of Adam Smith’s theory of the invisible hand, in which the free market coördinates the behavior of self-seeking individuals to the benefit of all. Each businessman “intends only his own gain,” Smith wrote in “The Wealth of Nations,” “and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” But in a market environment the individual pursuit of self-interest, however rational, can give way to collective disaster. The invisible hand becomes a fist.

and

Limiting the development of [complex] securities would stifle innovation, the financial industry contends. But that’s precisely the point. “The goal is not to have the most advanced financial system, but a financial system that is reasonably advanced but robust,” Viral V. Acharya and Matthew Richardson, two economists at N.Y.U.’s Stern School of Business, wrote in a recent paper. “That’s no different from what we seek in other areas of human activity. We don’t use the most advanced aircraft to move millions of people around the world. We use reasonably advanced aircrafts whose designs have proved to be reliable.”

The second seems quite applicable to software engineering as well.

Perceval5• 17 years ago

It's unfortunate that the article uses the Prisoner's Dilemma as its example, because the Prisoner's Dilemma is actually not the best game model to set up as the opposite of the Invisible Hand. A more appropriate model would be the Tragedy of the Commons, which was proposed by a fellow named Garrett Hardin in an article in a 1968 edition of Science magazine.

If you are interested in formal modeling of coordination problems, an interesting overview can be found in Elinor Ostrom's book Governing the Commons. In chapter one she gives an overview of the Prisoner's Dilemma, the Tragedy of the Commons, and the Logic of Collective Action (Mancur Olson's theory). After reviewing these abstract formal models, she looks at other possible institutional solutions for coordination problems.

Here are some links:

http://en.wikipedia.org/wiki/Prisoners_dilemma

http://en.wikipedia.org/wiki/Tragedy_of_the_Commons

http://en.wikipedia.org/wiki/Logic_of_Collective_Action

http://en.wikipedia.org/wiki/Coordination_game

http://en.wikipedia.org/wiki/List_of_games_in_game_theory

DanielBMarkham• 17 years ago

Any quick one-liners or easy-to-understand wisdom that you've gained from the material? The entire subject area looks immensely fascinating, yet very dense at times.

jamesbritt3• 17 years ago

Interesting view on the Tragedy of the Commons and whether it is an accurate assumption:

http://www.britac.ac.uk/pubs/src/keynes95/06sec5.cfm

anamax2• 17 years ago

One difference between designing airplanes and govt regulation is that designing airplanes isn't prone to folks making design decisions to benefit to friends and family.

Political corruption is pretty much a fact of life whenever govt gets involved in money.

I don't see why folks who complain about corruption involving govt contracting believe that financial regulation will be any better.

chimariko6• 17 years ago

Although capitalism is crash-prone to some extent it is the most reliable system mankind has ever come up with. It is arguably because it's idea of individual success reflects the nature of the animal the system is supposed to work on.

rauljara• 17 years ago

"its idea of individual success reflects the nature of the animal the system is supposed to work on."

I don't quite follow you. Please explain.

chimariko6• 17 years ago

Sure, what I mean is that the pursue for individual success is a key feature of Homo sapiens species. Traditional capitalism declares it as its main trait. The fact that participants of a capitalist system are encouraged to act according to their natural behavioral patterns makes capitalism the most stable system ever known.

chimariko6• 17 years ago

You should point out what you disagree with instead of (in addition to) downvoting. What is your opinion?

nazgulnarsil• 17 years ago

pat explanations were getting old a year ago. please don't upvote this crap.

CodeMage• 17 years ago

Okay, we won't. Oh, wait, were you referring to the article?

johnnybgoode• 17 years ago

I have been seeing a lot of these "Look at this forgotten/unknown economist who predicted/explained everything!" type of articles. Yes, they are probably almost always wrong, but how is everyone on HN supposed to know?

3pt14159• 17 years ago

The real reason it is so crash-prone => fiat currency and a fractional reserve banking system.

Locke1689• 17 years ago

The vast majority of economists do not believe this to be true.

pyre4• 17 years ago

The vast majority of economists thought that such a crash couldn't happen. They thought that it was impossible because we are so much smarter now than we were back in the 1920's.

Perceval5• 17 years ago

The author of the article almost alludes to this when they write:

>Consider the freeze that started in August of 2007. Each bank was adopting a prudent course by turning away questionable borrowers and holding on to its capital. But the results were mutually ruinous: once credit stopped flowing, many financial firms—the banks included—were forced to sell off assets in order to raise cash. This round of selling caused stocks, bonds, and other assets to decline in value, which generated a new round of losses.

We might be less crash-prone if we had system that didn't crash when the growth of the money supply was interrupted. It seems like it's not just maintaining the current level of credit is necessary for stability, but the indefinite exponential expansion of credit is necessary to stave off problems.

Kayem• 17 years ago

Anything run by greed is crash-prone.

pchristensen• 17 years ago

Because much of the perceived value in capitalism is based on assumptions, and assumptions can change in value much faster than physical assets?

For instance, Detroit has not been a valuable place to have a business or home for decades but it has faded slowly, but the assumption that housing prices would go up forever was worth trillions, but as soon as it was disproved, those trillions disappeared fast.

chimariko6• 17 years ago

Financial market affects today's economy a lot. There's a great demand for assumptions and forecast involved in financial services. However the reliability of today's forecast and analysis methods leaves a lot to be desired. This situation is the cause of the current crisis.

arihelgason• 17 years ago

"What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization."

The problem is misaligned incentives. Cash bonuses paid out long before the consequences of decisions become clear create problems.

Financial institutions can partly remedy this by replacing annual bonuses with long-term reward schemes like that adopted by Credit Suisse in 2005. If a decision proves to have been reckless/short-sighted a few years on, bonuses can be retracted.

anamax2• 17 years ago

> The problem is misaligned incentives.

That's an appealing theory, but the only evidence produced to date that compares the performance of folks who got long-term compensation with those who got short-term shows that the firms that used short-term compensation did better than the ones that used long-term compensation.

http://causesofthecrisis.blogspot.com/2009/09/three-myths-ab...

timwiseman2• 17 years ago

If a decision proves to have been reckless/short-sighted a few years on, bonuses can be retracted.

Retracting something already given can be difficult, especially if the employee has moved on to another place. There are ways, of course, with "clawback clauses" and similar things, but that seems unnecessarily clunky if I understand them correctly.

Basing bonuses on long term performance after it has had long enough to play out and (at least most of) the consequences known may very well be a good idea though.

kiba3• 17 years ago

Failure is a feature of capitalism. It is to be expected.

However, what shouldn't really happen is a cluster of failures. That's caused by misinformation in the pricing system. Real saving rate doesn't matched up with interest rate, so people are being fooled by non-existent capitals.

At least that's how I understand it.

kburn• 17 years ago

Absolutely. Clusters of failures are just popping bubbles built on incorrect information.

Everyone knows that everyone is after more money, it's a prime motivation. This makes it easy to manipulate if you can make a credible looking "investment".

Confusion3• 17 years ago

As Marx correctly understood, capitalism is best likened to a force of nature: it doesn't have any moral basis and can have both morally positive and negative consequences. This is why we need governments to keep capitalism in check: unchecked capitalism also leads to activities we find morally unacceptable. Like evolution favors only those traits that add reproductive value, capitalism favors only those activities that increase capital. This may mean obtaining a monopoly, deceiving customers and competitors, employing slaves and generally any other activity we disapprove. In a fully rational market, the customers would not accepts those practices, but as Keynes said: the market can stay irrational longer than you can stay solvent. Moreover, capitalist principles cause an important part of the customers not to care about the immoral consequences: they don't see them because the market isn't transparent or because they do not want to see them. We therefore cannot trust the market to merely expose the positive sides of capitalism. Failures, even clusters of failures, are to be expected and can only be avoided by government intervention. As long as a government lauds the free market and has the irrational expectation that the market will straighten itself, we will continue to suffer the consequences of unchecked capitalism.

Perceval5• 17 years ago

Wow, it's hard to know where to begin with this post. It seems strange to me that you're trying to use Marx to justify a liberal position. After all, Marx would be the first to disagree with you about the feasibility of using the state to check the market. Marx saw the state as little more than the 'executive committee' of the bourgeoisie, so using the state to check the market is just not going to happen until revolution leads us out of the capitalist stage of history.

Your equation of evolution and capitalism has a nasty heritage of Social Darwinist thinking. I think it's a misunderstanding of both evolution and of capitalism. Better not to make such an analogy.

Monopolies, deception, fraud, slaves, and so on are not at all unique to capitalism and have been with humanity throughout history. There's no compelling reason to believe that capitalism favors these practices for rational or irrational reasons.

It's not clear why the government is the only institution in society that can avoid failure. It's moreover not clear that the government doesn't play a role in setting up failures as a consequence of its intervention. Marx (or Lenin at the least) would certainly hold that it's the state that creates the very phenomena like monopolies that you decry as "irrational."

kiba3• 17 years ago

If the government is trying to head off failures, then it become a quasi-political game. Politics also happens to be a far more violent affair than the play-wars of businesses.

To be threatened with a gun for the purpose of forceful extraction of your wealth is FAR DIFFERENT than peaceful voluntary exchanges championed by capitalists.

Also you misunderstood failures(as in loss). Failures is a feature of capitalism. Failure play an improtant part of resource allocation by telling companies what not to allocate to.

Likewise, success(as in profit) tell companies that this is what consumers want. It could be that consumers want lot of trashy poor quality mass produced goods or high quality expensive goods. The market help companies decide what to produce.

chasingsparks• 17 years ago

http://www.newyorker.com/reporting/2009/10/05/091005fa_fact_...

I couldn't find the view on one page / print button for a minute. The above is the proper URL if you, like me, do not enjoy pressing next.

jerf2• 17 years ago

I think this is a better way of thinking about it than "greed". The next natural conclusion that follows is that nobody actually knows how to fix this. It may even be an intrinsic attribute of a growing economy; it may literally be impossible to avoid, short of not having a growing economy.

Centralized management makes the lockstep-motion problem radically worse, solving the positive feedback problem by nearly eliminating feedback and cutting straight to the failure case. ("But the central planners can use feedback!" - not on even remotely the same level of granularity, by definition of "central".) Cutting down the positive feedback loop powering the bubble pretty much inevitable involves cutting out the positive feedback loop driving the economy in general. What's left, really?

Rather than preventing crashes, we probably ought to focus on having the wisdom to be prepared for them when they come.

scythe• 17 years ago

Hyman Minsky argued exactly that for a long time, and he's only recently been taken seriously:

http://www.boston.com/bostonglobe/ideas/articles/2009/09/13/...

abefortas4• 17 years ago

Some people are against having a growing economy. Obviously the economy cannot grow indefinitely.

Confusion3• 17 years ago

As long as the population grows or technology keeps improving, an economy can continue to grow.

Perceval5• 17 years ago

The traditional citations here are The Club of Rome and various environmentalist that reject the possibility of sustainable industrial civilization.

The Club of Rome published a famous book in 1968 called The Limits to Growth. They are seen as making a kind of modern day Malthusian argument.

http://en.wikipedia.org/wiki/Club_of_Rome

http://en.wikipedia.org/wiki/The_Limits_to_Growth

http://en.wikipedia.org/wiki/Thomas_Robert_Malthus

jerf2• 17 years ago

Growth does not imply the use of more resources. Economic wealth comes from knowledge and command of atoms. Software is wealth, books are wealth, and so on. Such wealth clearly requires a baseline of control over resources and energy, but we get more efficient with it over time so it's not the linear relationship that so many seem to think.

There's a lot of growth left to do, and all precluding our growth now will do is make damn sure we never actually build a sustainable society, because it's not possible with our current technology.

We'll worry about how to manage a non-growing economy when we get there. That situation is so unlike the current situation that even speculation has rather limited value.

(See also: http://www.jerf.org/iri/post/2417 , which is too long to put here and not entirely on topic, but is fleshed out a bit more.)

timwiseman2• 17 years ago

At least in principle, I do not see why it cannot. Growth implies that the GDP is going up, considering that IP/software/etc can all contribute to the GDP then as long as people continue to work creatively then it can in principle grow indefinitely.

launic• 17 years ago

The title of the article is "Rational Irrationality" and not letting the system to crash now, seems to me (and to many others) very irrational.

"too big to fail" syntagm does not look good either to the author of the article, in the end he says:

"As memories of September, 2008, fade, many will say that the Great Crunch wasn’t so bad, after all, and skip over the vast government intervention that prevented a much, much worse outcome. Incentives for excessive risk-taking will revive, and so will the lobbying power of banks and other financial firms." ... "The next time the structure starts to lurch and sway, it could all fall down."

Bailing out big companies is not capitalism as we learned about it. And the bottom line is it hasn't crashed now, the governments did not let it crash. Whether this is good or bad, I guess we will see in the future.

The real reason that capitalism is so crash-prone.

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