The Doom Loop in the Financial Sector: And Other Black Holes of Risk

Preface

ix The custodians of the Grand Library of Baghdad, one of the glories of the civilized world in the 13th century, might be forgiven for not having anticipated the day in 1258 when a band of horsemen from Mongolia consigned the entire collection to the waters of the Tigris, which, it is said, ran black with the ink leached out from thousands of precious manuscripts. Even very much later, in the 1920s, it is understandable that most German Jews, proud citizens of a cultured land, had no inkling of the catastrophe awaiting them with the impending resurgence of barbarism. We are wiser and better informed now, although there is still much in our behaviour for commentators to chew on, especially when it comes to our inability to do simple comparisons among risks (see Gardner 2008). A favourite example among risk experts is the temporary shunning of air travel after the events of September 11, 2001, disregarding the excess fatalities per passenger-mile faced by those who chose to drive their cars rather than to fly. Admittedly, many small tragedies are scattered across populations when individuals stubbornly prefer some obscure fad to good evidence and expert opinion. Parents who are determined to believe that vaccinations cause autism, for example, endanger and sometimes unwittingly kill their children, and can also contribute to the deaths of other children, out of a perverse excess of concern for their well-being (see McNeil 2009). There are still too many episodes of such idiocy, but one should also keep in mind that, on the whole, modern societies have come a long way, in a relatively short Preface x | The Doom Loop in the Financial Sector time, from a past during which seeking medical attention for any ailment greatly increased one’s risk of additional misery and death. Those who take delight in cataloguing the public’s egregious inability to handle risks sensibly almost always overlook the equally obvious, and far more consequential, mistakes made by industry and government, which arguably have fewer excuses for their persistent mismanagement of risk. There is a real danger that, in focusing too much attention on the small personal and family tragedies that result from the difficulties that ordinary people have in making sensible decisions under conditions of uncertainty, we neglect a far more damaging tendency in contemporary societies: the urge, among those who should know better, to make huge and extremely risky bets. This is a curse that afflicts the most powerful economic and political elites on the planet, who, among other things, have recently packaged their national economies into a set of exotic black boxes and used them as collateral at casinos. The collapse of the hedge fund Long-Term Capital Management (LTCM) in September 1998 threatened the liquidity of global financial markets and prompted an urgent rescue mission by the U.S. Federal Reserve. It thus prefigured, in miniature, the financial crisis that exploded ten years later. One might have expected that the LTCM episode would serve as a warning against the madness of infinite leverage and of excessive faith in the mathematical modelling of risk for derivatives, and reinforce the need for close regulation of the banking sector to prevent excessive risk-taking. On the contrary, however, under President George W. Bush the deregulatory mania was given free rein, and the captains of capital used LTCM and Enron as models for refashioning the entire financial sector into a colossal Ponzi scheme, the unravelling of which may be still be only in its early stages. It is as if decisionmakers have been deceived by their own presumed sophistication with the tools of risk management (see Nocera 2009). More precisely , the financial elite abused a limited facility with statistical manipulation in order to disguise a level of imprudent risk-taking so monumental in scope that no one knows where the ultimate Preface | xi limit of the downside risk may be. Like the hapless librarians of medieval Baghdad, the citizens of contemporary nations, ranging in size from Iceland to China, had no inkling of the calamities that were about to strike (see Parker 2009). Equally clueless, apparently, were the “masters of the universe,” the chieftains of the great investment and commercial banks who ran the casinos. This became apparent in a long and detailed article published in the New Yorker in September 2009 on the anniversary of the failure of Lehman Brothers (see Stewart 2009). Over a period...