So, what caused the current financial crisis? No, not the specific events but rather the underlying cause, the cultural fault. David Brooks believes there are two competing schools of thought. It’s the greed theory vs. the stupidity theory.

Brooks begins with the greed theory:

[T]he U.S. financial crisis is a bigger version of the crises that have afflicted emerging-market nations for decades. An oligarchy takes control of the nation. The oligarchs get carried away and build an empire on mountains of debt. The whole thing comes crashing down. [The] remedy is clear. Smash the oligarchy. Nationalize the banks. Sell them off in medium-size pieces. Revise antitrust laws so they can’t get back together. Find ways to limit executive compensation. Permanently reduce the size and power of Wall Street.

Next, the stupidity theory:

[O]verconfident bankers didn’t know what they were doing. They thought they had these sophisticated tools to reduce risk. But when big events — like the rise of China — fundamentally altered the world economy, their tools were worse than useless.
The stupidity narrative suggests we should preserve the essential market structures, but make them more transparent, straightforward and comprehensible. Instead of rushing off to nationalize the banks, we should nurture and recapitalize what’s left of functioning markets.

One of my guiding principles is never blame on malice what can be blamed on stupidity. Obviously, greed played a significant role in the crisis, but I’ve never thought it was a form of coordinated greed so much as it was a lot of individual greed that blinded most of those in the financial industry to the massive flaws in the system. Simply put, greed led to stupidity which led to the crisis.

I know it’s satisfying to blame everything on the greedy elites — populist anger is the in thing. But here’s the problem: you can’t eradicate greed. Lots of people will always act out of self interest, no matter the system and no matter if they’re in the public or private spheres. We can’t say “the system caused greed, let’s jettison the system and create a new one” because every system is susceptible to greed. What we can say is that the system, as it exists now, propagates stupidity, so let’s reform the system.

Both the greed theory and the stupidity theory lead to the conclusion that change is necessary. But how we change is predicated on where we see the faults. In the long run, I think we’re better off trying to increase smart decision making than we are trying to create a system impervious to greed.

  • J. Harden

    It was the GCF: “Gaussian copula function” — obviously what we need is more transparency when using the bivariate normal risk distrubition via Sklar’s theorem. Freak’in retards! — my dog could have figured out that to remove consideration of many different marginal risk distributions by transforming the marginal variates to uniforms, and then specifying dependence as a multivariate distribution on the uniforms — is about the DUMBEST thing you can do.

    Or it could have just been greedy mortgage brokers, I’m not sure.

  • Aaron

    Thanks for taking the time to look at the root causes of this whole mess, instead of just the symptoms. This was very useful for understanding things.

  • ExiledIndependent

    Greedy and stupid. Dangerous combination.

  • Mike A

    “But when big events — like the rise of China — fundamentally altered the world economy, their tools were worse than useless.”

    To J. Harden’s point, mathematical models are only as good as the assumptions used to develop them. Complex probability formulas incorrectly applied will yield incorrect results. I don’t think the point of the article was to state these people were “duh” stupid. I think the point is that smart people who apply models without taking into account changes in the underlying assumptions are behaving in a stupid manner.

  • kranky kritter

    Hmm, part of your hypothesis seems to be that we will be more successful trying to make people less stupid than trying to make them less greedy. I’ll have to think about that one for awhile. But I can’t help but worry that smarter people will be more greedy on average, blunting whatever net positive effect we mgith have hoped for. :-)

    I am also a firm believer in positing ignorance before malice. At the same time, I feel pretty strongly that in this instance there must have been many actors aware of both the various unsustainable trends underlying things and the likely fact that the risk they were offloading on others was potentially far greater than advertised. Whether such folks were smart folks who decided not to care or dumb folks who decided not to worry does not seem especially material. But it does seem apparent that there was plenty of not caring, because there are lots of folks out there who made a ton of money and who are as of today still way ahead even counting fractional losses in the last year.

    It’s not realistic to me to think that any reasonably intelligent person involved in these escapades could have failed to notice that the entire market (from high prices to bad mortgages to risky packages to fraudulent ratings) was ultimately built on the impossible premise that RE prices could continue to indefinitely grow 2 or 3 times as quickly as average American income.

    So the most parsimonious explanation to me is that such folks were simply making too much money to consider seriously worrying about it. That sounds like greed to me.

    I recall one moment in the CNBC doc House of Cards vividly. The narrator asked one of the insiders how much blame he felt. And it seemed pretty clear to me that the notion was a pretty novel one to him. What I am seeing on the part of powerful finance insiders appears to be the economic equivalent of the Nuremburg defense.

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  • ClintJCL

    I didn’t finish read this, but I do want to post a disagreement with one part of this:

    “One of my guiding principles is never blame on malice what can be blamed on stupidity.”

    That’s a dangerous guiding principle.

    More on that:

  • Wilbert

    Greed and stupidity both contributed in the financial crisis. The greedy people didnt really care if things didnt work out in the end. The stupid people let the greedy people feast. Oh well, I guess live and learn.