Thursday, October 16, 2008

The Long and the Short of It

Most of us are starting to get crisis fatigue (on top of which election fatigue is starting to set in, too). Everyday there seems to be a new story about a financial institution going under or some knee-jerk government reaction. Coming as this does just before important elections for little ol’ Aotearoa New Zealand, there is a real temptation to unhook the modem and go hide in some secluded backwater (you know, like Christchurch).

That said (being an economist, I always have a “but”), something I find fascinating about much of what is going on around us is the temporal aspect of it all. We seem to have a disconnect between what is “in our face” and the longer term outlook. The value of the mortgage backed securities is a case in point. No one wants to buy them but chances are they will have some (if not a lot) of value several years down the track, even after taking into account a proportion of constituent mortgages that default.

Similarly, the way we (well, financial institutions directly but the general populace have acquiesced in this) compensate the sellers of financial products is skewed toward the short-term. You sell the product and get the commissions. Big bonus. Several years down the track, after you have taken your golden handshake or jumped ship, the underlying turns toxic.

Of course, without having crystal balls it is a little petty to expect that we will be able to foresee all the bad stuff that will happen. But the thing is we don’t need to see it exactly. All we need to know is that something bad is going to happen. Things happen in cycles. Sometimes the cycles are elongated and sometimes they are shallow but they cycle. And if the cycle happens to be accentuated, well the drop is going to be case of “I get to see my lunch for a second time”. Why are we surprised that we are getting the payback for a) dodgy lending practises/housing policies, b) incentives for banks to put stuff off balance sheet, c) over-reliance on ratings agencies, d) a belief that the work of some executives is actually worth many millions of dollars? [How many so-called “hundred year events” have you experienced? Ok – they are not necessarily related but I’ve lived through six economic/financial crises of varying magnitudes and several “hundred year” weather patterns.]

Too many people believe they fully understand what is going on around them. They don’t. They have heuristics that are seemingly confirmed but they don’t actually understand. For some things that is ok. I get into a lift with only a rudimentary understanding of how the counterweight helps stop the thing plummeting 20 storeys down. But if I am signing up for a mortgage that has the potential to leave me homeless or even just take a massive chunk out of my disposable income in a couple of years, by closing my eyes and just signing I am abrogating my responsibilities. Worse still the grinning salesman who says “keep the pen” after I sign.

It seems that the vast majority of humanity does not want to look ahead. To paraphrase Douglas Adams, if we had foresight we may well have never come down from the trees. But all we need to know is that things will turn sour at some point in the future and then ask ourselves “How confident am I that my decisions today are going to stand me in good stead when the shit hits the fan?”

There is a wonderful comment in a Freakonomics post comparing the behaviour of mortgage lenders and pregnant teenagers – both profess to not knowing how it happened.

2 comments:

Ruth said...

We are all economists now it seems! Should we wear suits?

My view is that NZ is ok - and doesn't it annoy you that Mark Weldon is always moaning and wanting everyone to do his job for him?

Everyone has an opinion - and very few are objective.

Noah "Nog" M. said...

It certainly doesn't help that governments everywhere are reducing the costs of complete failure. And by bailing out failing banks, they basically burn the good banks that don't need to be bailed out. They especially don't need to be rewarding dumbness.


-Nog