In Alex J. Pollock’s new book, Finance and Philosophy: Why We’re Always Surprised, not only do these two disparate topics co-exist, they help answer the question of why smart people – investors, traders, bankers, regulators, politicians – continue to make the same money mistakes, and are continually surprised at the unfortunate results.
Pollock, a former bank executive, Federal Home Loan Bank of Chicago CEO, and scholar at the American Enterprise Institute for a decade, and now distinguished senior fellow at the R Street Institute in Washington, D.C. brings a broad historical perspective and a sardonic style to his evaluation of our tendencies to repeat the worst of financial history.
It’s well known that even more than 25 years after the Berlin Wall came down, the red deer on the formerly Czechoslovakian side of the border will never wander across the grassy median that was once guarded by an electric fence and sharpshooters. Somewhere, ingrained in their DNA, is a learned warning against this risky behavior – a lesson that persists in generations of deer born well after that border fence came down.
Why can’t human beings take the same lessons of boom and bust, bubbles and crashes that are clearly described in history books – and learn from experience? That’s where Pollock’s wry humor and philosophic bent help understand the hubris that makes every generation believe that not only can it predict the markets, but control them. Or as he puts it bluntly, why do we have a financial crisis roughly every ten years?
Start by accepting the author’s well-argued thesis that: “The financial future is not only unknown, but unknowable.” It’s a truism that exists despite the efforts of generations of economists, analysts, investors and bankers, using insight, computer models – and soon artificial intelligence – to predict the financial future. The inherent problem, says Pollock is that all of us – from the Federal Reserve on down – are in a constant feedback loop, where our expectations of others’ behavior changes our own.
Pollock cautions against confusing risk with uncertainty. Risk is quantifiable by mathematical means. But uncertainty cannot be measured or predicted accurately because: “The systems in financial markets are made up of interacting human minds, theories, strategies, predictions, actions, and expectations – all taking account of each other and often changing their expectations about each other’s future behavior. Add in group psychology and crowd behavior, the tempting emotions of optimism and hope, then the driving emotions of panic and despair” – and Pollock says that unintended, surprising consequences should be expected – even though those events always surprise the smartest among us.
That is the setup for a series of wry perspectives on financial crises throughout the ages – with special emphasis on the widespread panic engendered by the 2008-2009 mortgage bubble that bedeviled our top financial sages. Whether it was Fed Chairman Ben Bernanke consistently denying the possibility of a recession even as we entered one, or the Treasury Secretary (and former Goldman Sachs CEO) admitting amazement at the depth and breadth of the collapse, or the politicians proclaiming that Fannie and Freddie would be solvent forever (they went on to swallow $187 billion of taxpayer dollars), Pollock demonstrates how human nature triumphs over intelligence, to produce these financial disasters.
Even worse, notes Pollock, we can’t even seem to agree on the causes in hindsight. But our natural response – more government regulation – merely sets us up for the next crisis. He points out that in the wake of the most recent financial mess, regulators decided to designate large financial firms as SIFIs—“systemically important financial institutions”. The only problem, says Pollock, is that “the biggest SIFI of all is the Fed – and it has not volunteered to be honored by the designation.”
And that is where the metaphysics of philosophy and finance intertwine in a series of well-considered observations designed to explain how we fail, time and again. Fannie Mae and Freddie Mac become Adam and Eve eating the “apple of risk” in the housing finance Garden of Eden, corrupted and expelled, after being tempted by leverage in the form of the serpent. Isaac Newton’s speculative losses in the South Sea Bubble come not because he failed to understand the laws of physics, but because he could not calculate “the madness of people.” And the mortgage bubble is reduced to a massive game of musical chairs.
Pollock, the banker, insightfully reminds us that the collateral for a mortgage loan is not “the house” – but the <<price of the house.>> “The only way a housing lender can recover funds from the property is by selling at some price. A house and land have physical, objective existence, but as we have already seen, a price has no objective existence.”
And after a fascinating dissection of the Savings & Loan crisis of the 1980s, Pollock can’t resist noting: ”With striking irony, the Federal Reserve in the aftermath of the 21st century housing bubble has become the biggest investor in long term, fixed rate mortgages. It is, in effect, the biggest savings and loan in the world!”
Has Pollock peered into the future at the next financial crisis? One of his witty aphorisms, duly listed at the end of the book, is <<Pollock’s Law of Finance: Loans which cannot be repaid, will not be repaid.>> The $1.5 trillion student loan snowball comes to mind.
In the long tradition of insightful financial commentary that includes Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds and Frederick Lewis Allen’s Only Yesterday, now comes Alex Pollock’s fascinating Finance and Philosophy: Why We’re Always Surprised. It should be required reading in economics classes, or before opening an investment account – and by every member of Congress. Alas, we’ve already had our financial crisis of the decade. And if history and Pollock are our guides, these lessons must be learned again and again.
Terry Savage is a nationally syndicated personal finance columnist, and the author of several books, including The Savage Truth on Money.