Monday, October 6, 2008

Hedging on Stupidity

Tyler Cowen's top two (related) reasons why we have a credit crunch:

"1. Collective stupidity: A lot of Greeks believed in Zeus and a lot of people in 1938 thought Hitler would be good for Germany. They were just plain, flat out wrong. I'll also put "model error" under this heading. The relevant stupidity concerned both the fate of home prices and the degree of acceptable leverage.

"2. Writing the naked put: This is Bob Frank's main explanation, noting that he uses different terminology and adds a relative status dash to the argument. If you don't know options theory, just imagine betting against the Washington Wizards to win the NBA title every year. For a lot of years you'll earn super-normal returns, but one year (not anytime soon, I can assure you) you'll be wiped out. That is essentially the strategy the banks were playing. They were going "short on volatility," so to speak. In the meantime they reaped high returns and some amazing perks for private life. It's hard to just call the party to an end, even if you have a relatively long time horizon."

...Adds Matthew Yglesias:

"And of course if you can actually make the bet with other people’s money, leverage the hell out of that money, and then make your take-home pay in the form of fees taken from the annual gains rather than having too much of your money tied up the principle, you do even better. There’s probably not much of a regulatory solution to people making bad bets in this way. But between now and whenever the next bailout-requiring crash, I’d like to see much higher taxes on the super-wealthy. I’m not that concerned about preserving incentives for multi-millionaire financiers to keep doing their work."

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