Dummkoepfe

by Henry on August 15, 2011

Michael Lewis’s recent article brings up again the question of why Germans bought so much toxic financial waste in the run-up to the financial crisis. It seems clear that his ‘because they’re all obsessed with shit’ theory isn’t any better an explanation than his Provo gangsters and fairy rings take on Irish economic disaster. But that still leaves an open question.Peter Frase takes one go at it here, first using Lewis’ earlier work to ding the ‘idiots’ theory of why the meltdown happened:

bq. One popular interpretation of the crisis, and of Lewis’s book, is that the explosion of sub-prime lending and securitization was the result of mass stupidity, and that huge numbers of people simply failed to understand or account for the incredible financial risks they were taking. This is basically the approach Ezra Klein takes when he quotes Larry Summers’ famous remark that “there are idiots” and concludes that the crisis was a consequence of human weakness and error in the context of a system with few regulatory restraints. … Yet idiocy does not stand up as a the central causal factor behind the crisis. For one thing, it seems odd that there would be such a concentration of idiocy in the most lucrative field of the American economy, one which has been leeching the brightest minds out of the rest of the society for decades. Moreover, it is necessary to explain not only the preponderance of idiots, but the tendency for their idiocy to work systematically _in the same direction._ … In academic finance, the technical term for idiots is “noise traders”, and they are thought to provide erratic and irrational actions that may destabilize markets but do not systematically move them in one particular direction. …

bq. Though the financial crisis produced a great deal of institutional calamity … the individual people responsible for the worst decisions of the last decade managed to greatly enrich themselves even as they nearly annihilated the global economy. … it’s undeniable that some of them, particularly toward the end, were getting high on their own supply, taking the the bogus triple-A ratings on toxic subprime garbage at face value even though they had an inside understanding of the con game they represented. …ultimately, these people–who in a just world would be penniless and serving extended prison terms–walked away with millions of dollars. There are plenty of apt descriptions for people like that, but “idiots” isn’t the one I would choose.

and then pointing out that even if everyone wasn’t an idiot, there did appear to be a heavy concentration of them in the investment arms of German banks.

bq. German institutional investors, or as they are called at one point, simply “Dusseldorf”. Lewis never really tries to explain their outsized appetite for murky subprime instruments. … In the language of the “varieties of capitalism” school of comparative political economy, Germany is what is known as a “coordinated market economy” or CME, whereas the U.S. is a “liberal market economy” or LME. The structure of the market in a CME is fundamentally different in that it relies heavily on coordination between firms, based on tight long-term inter-linkages and above all, trust. This contrasts with the more ruthlessly competitive ethic of the LME, in which formal contracts take the place of reciprocal trust relations. So German bankers and investors were a) relative novices at modern securities wizardry; b) steeped in a capitalist culture quite different from the dog-eat-dog rapacity of the American version.

The stylized story that is doing the rounds among comparative political economy of Europe people is a little different than this. It points to how the EU forced Germany to get rid of rules that favored its regional and local banks, obliging these banks to seek new investment opportunities outside the local and _Land_ businesses that had previously provided their bread and butter. And when they went international, they found many people who were willing to sell them unimpeachable investment opportunities, and little internal or external capacity to figure out when someone was trying to sell them a pup …

Here, the suggested problem is an organizational one as much as (or more than) a cultural one – banks which are geared to a certain kind of business, and which suddenly find themselves being pushed out of that market, are likely not to have built up the expertise that will allow them to prosper in new ones. What this explains (and the cultural explanation does not) is why it is that Deutsche Bank (which was far bigger) appears to have done conspicuously well out of the crisis, while its smaller compatriots have done very badly indeed. Of course, this isn’t to say that this theory is _right_ : political scientists often have a poorish enough understanding of what is happening in markets – but if there are better ones, or contradictory evidence for this one, I’d be interested to hear it.

{ 62 comments }

1

Memory 08.15.11 at 8:59 pm

As of the late 1990’s (I haven’t worked in this area since then), German banks were divided between the Land-level banks that were small and reliant on embedded (Soskice would probably call them institutionally complementary) relationships with clients on the one hand and the large, well capitalized, international banks headquartered primarily in Frankfurt. The former group generally conform to the CME stereotypes, but in my experience they were watched over carefully by the Land-level regulators, of whom the ones that I have encountered were quite sophisticated and represented some of the more impressive minds I know of from the Bundesbank. In 1998, these people were determined to protect their charges against an expected flood of foreign competition offering financial services that small businesses and depositors were not sophisticated enough to evaluate fairly. They were planning their battle carefully and knew the EU rules proposals very well. It is my understanding that they largely won and that penetration of foreign banks into the deposit and small business credit markets were not very great, though this is only an uninformed impression. More significantly for this discussion, however, is the fact that these small players were not directly involved in the international SIV markets. Inasmuch as they participated, they went through the big banks in Frankfurt. I suspect without evidence that they played a role similar to pension funds in the U.S. relative to the big banks: credulous and unsophisticated investors to be fleeced.

The Frankfurt banks in 1998 were looking forward to going to to toe with London and New York – ac competition in which they were convinced they had a huge advantage because of their exceedingly strong capitalization and the high quality/stability of their assets (ownership in and loans to German manufacturers are pretty damn safe). These banks were hiring American and British analysts and sending their own people abroad to be prepared for the deregulation. In my opinion, it would be insane to claim that these banks were clueless victims of LME hucksters who were offloading toxic securitized investment vehicles. I suspect that they were just playing the same game that their colleagues in the U.S. and London were playing at the time, but they had large piles of safe but low or long-term earning assets that they could use as a basis for leverage AND access to the savings of depositors locked in the ‘low performing’ Land-level banks (with which these banks had longstanding relationships).

I would give a great deal to go back and talk to the NRW bank regulators again now and hear about what happened in the decade between 1998 and 2008.

Just uninformed speculation by a comparative political economist who doesn’t think that the VoC framework is all that useful when talking about the last decade of large scale international finance.

2

shah8 08.15.11 at 9:47 pm

I think this is an interesting question, and to the best of my knowledge and thinking ability, I think the German involvement with Ireland reflects the general political calculus of export-industry dominated states. In other words, it’s a feature of modern day mercantilist political economy as the home economy’s currency grows stronger and stronger. There is a relatively firm elite consensus at home, with the pie split up in various ways, and anyone who wants more has to expand overseas (not a business who’s trade is originally overseas anyways). However, much or most of the system has an investment in the success of the newcomer such that entrant has state backing for all intents and purposes. That actor probably has had political help all the way through, and expects things to be resolved between high level bureaucrats, so bad terms that more wary entities would have shied off of becomes part of contracts, with every expectation that if the worst happen, my guy will talk to your guy…without much thought about what circumstances would prevent using the quiet leverage which prevents heavy losses.

I think such things after thinking about China’s long adventure in Australia/New Guinea, the more recent misadventures by the major construction company in KSA and Poland, and Japan’s banking/commodities spectacle in the late eighties and nineties.

3

Myles 08.15.11 at 11:42 pm

What this explains (and the cultural explanation does not) is why it is that Deutsche Bank (which was far bigger) appears to have done conspicuously well out of the crisis, while its smaller compatriots have done very badly indeed.

Given that Landesbank managers are well-known to be morons, I would have thought this to be the most obvious explanation: they are morons.

LME or CME have got nothing to do with it; failure to do and ineptitude at doing due diligence, lots.

4

Doctor Slack 08.16.11 at 12:08 am

For one thing, it seems odd that there would be such a concentration of idiocy in the most lucrative field of the American economy, one which has been leeching the brightest minds out of the rest of the society for decades.

Ummm, no it doesn’t. What? Concentrations of idiocy in lucrative fields of the economy are a basic part of the history of capitalism since the days of John Law if not before. Put a bright group of people together, indoctrinate them with an idiotic (but superficially clever-sounding) party line, and let it be known that they can have nice houses, gobs of money and hookers by the score if they hew to the party line. Voila. A concentration of idiots.

5

Tom West 08.16.11 at 12:56 am

it seems odd that there would be such a concentration of idiocy

Considering that throughout history, groups of the most powerful, informed, and educated people have moved together in a fashion that often ensured their physical as well as economic destruction, I have no trouble whatsoever believing that the well-known human tendency towards pack behaviour and wishful thinking far outweighs the combined reasoning of any number of the elite (or anyone else).

We are crooked timber.

6

john c. halasz 08.16.11 at 1:08 am

Also add in the factor that the Landesbanken boards were sinecures for superannuated apparatchiks from the political parties.

7

Mary C 08.16.11 at 1:10 am

Thanks for posting this …. I always wondered why the Germans got sucked into this. I had faith in their orderliness and intelligence and was surprised they would believe Americans who were obviously lying and getting away with it.

8

joel hanes 08.16.11 at 2:10 am

The most lucrative field of the American economy doesn’t pick the smartest available graduates as its new-hires — it picks those who are most aristocratic, admitting only recent grads from a very small number of the most elite (and expensive) schools. It’s a method that’s nearly guaranteed to produce intellectual monoculture.

9

TheSophist 08.16.11 at 2:20 am

Which Zizek book is it in which he spends several paragraphs pontificating on different European countries’ approach to shit (as manifested through their approach to toilet bowl design)?

Interestingly (at least to my mind) the discussion is repeated, almost verbatim, in one of the short stories in DFW’s Oblivion. The characters having the discussion are rather air-headed secretaries, and I’ve wondered if giving them this particular dicussion is Wallace’s way of stating on his evaluation of Zizek’s profundity.

10

ezra abrams 08.16.11 at 2:30 am

jeez, is it really that hard ?
people were making good money – real good money.
In, I think, 2005 , there was a story in the times, lady answers her cell phone, honey, I just got my bonus, we not buying a 2million $ apartment , we are in the 5-10 range…

I just don’t understand why it is that hard to understand; as G Morgenson has shown , the originators were just flat out liars, and GS and MS and BoA etc either knew or were willfully blind; and for that much money, you can be awfully blind.

As for the people hired by wall street – economists don’t seem to undertand the difference between smart and intelligent; if you read zombie econ, the potted history from say onward, most of those guys are smart: they come up with some brilliant theory, and it last for a few years, untill undone by the next theory; no one eve stops and says, is this any way to run an academic discipline (the answer is no, see BEWLEY, Truman F.: Why Wages Don’t Fall During a Recession., which is what any half competent scientist would do)

11

NMissC 08.16.11 at 2:37 am

First, what is hard about understanding why people did things that made giant fortunes from doing something that in the middle or long run was insane? Or that wrecked the economy generally while they stepped away intact?

Second, there was this: “banks which are geared to a certain kind of business, and which suddenly find themselves being pushed out of that market, are likely not to have built up the expertise that will allow them to prosper in new ones. ”

That is exactly what happened with dereg of the s&ls in the early 80s, and caused the s&l crisis. Sleepy small town s&ls were told they had to step up to more sophisticated business to deal with the impact the spike in interest rates was having on their business. And they did stuff that was crazy and stupid.

12

SB 08.16.11 at 3:18 am

I find this thread alarming. Is a stylized story the standard of comparative political economy theory in academic circles? Shouldn’t the authors of the hypothesis provided data? Aren’t there other academics looking to see if the hypothesis is falsifiable? Why would Henry be asking here for what a literature search in science would readily yield?

Sigh, or am I being obtuse and is the point to just discuss how interesting it all may be?

13

Sebastian 08.16.11 at 3:40 am

SB – yes, you are obtuse, in several ways:
1. Henry is blogging here, not writing an academic paper – the reason academics like to blog is, among other things, that it allows them to test out ideas and conjectures, without going through the labor and time intensive process of assembling all the necessary evidence. Having such an idea is often the first step in the process – before you engage in the actual deep research, you want to make sure you’re not overlooking anything obvious.

2. There is not much research about the crisis yet, and even less on the specifics of the German case. For the reasons stated in 1., research takes time. For research to get published and gain sufficient amount of attention to be worthwhile to try to falsify takes a lot of time. Somehow people find that harder to deal with in the social sciences than in physics, but the issue exists in both fields.

3. This is a stylized version – it’s useful for a big picture, but it has a lot of moving parts that require a lot of research to nail down. Various researchers are working on in depth accounts of various parts of that explanation – the Höppner group at the Cologne Max Planck, for example, has done a lot of work on the effect of the EU in pushing Germany to dismantle parts of its model. Most of that work is on corporate governance, but they’ve branched out to other issue areas.

4. Yes, people disagree on aspects of this – but the fact that there is some agreement on the basic contours of what’s going on isn’t a bad thing.

14

SB 08.16.11 at 5:18 am

Well, thank you Sebastian, after 20+ years in academia it is nice to discover what everyone else is doing. And to find out that people writing a blog are indeed …. blogging.

What I found alarming was the very clear difference between how social science seemed to be represented here and the methodologies of mathematics and physical science with which I am far more familiar. I felt that this was interesting. Perhaps you disagree.

15

Zamfir 08.16.11 at 6:18 am

SB, I think you’re more looking at the difference between a field where people would like to use the results for decisions, and fields where the main short term interest is from other researchers. Ask cosmologists about dark matter, and you’ll get many just-so stories that don’t have as hard evidence as people would like to have. But they’ll still tell it’s probably mostly WIMPs, because that’s where things are vaguely pointing towards.

But the only interested people, outside of the field, are people with a purely intellectual interest in the question. It’s much safer to toss around unsubstantiated working hypotheses in such an environment. You can continue saying “not proven yet” as long as you want.

But in some fields, and much more in social sciences, people completely outside the field would like results now, if possible. If a likely but unsubstantiated working hypothesis is the best result available, they might run with that.

16

Ginger Yellow 08.16.11 at 6:45 am

More significantly for this discussion, however, is the fact that these small players were not directly involved in the international SIV markets.

Huh? Rhinebridge, the SIV whose collapse kicked off the entire financial crisis, was IKB’s. WestLB had a SIV, SachsenLB had a SIV, LBBW had a SIV, BayernLB had a SIV, HSH Nordbank had a SIV. Almost every SIV in Europe was run by a Landesbank.

17

Ginger Yellow 08.16.11 at 6:47 am

And FWIW, I’d certainly agree that you can draw a direct line from the removal of the AAA guarantee from the Landesbanks to their piling in to US subprime via SIVs and ABCP conduits.

18

SB 08.16.11 at 7:06 am

Yes, I see that you may have a very different working style. One of the things to be avoided in the physical sciences is starting with a story and then seeking data to fit that story. It is also questionable to seek early consensus – in doing so it provides an element of coerciveness to thinking and potentially undermines the ultimate credibility of the research. The physical sciences are oddly competitive in the need to claim first credit and independence of that initial thought. That seems to be the nature of that beast.

Once an idea passes through the stylized version stage, what happens next? Will a hypothesis emerge before all the facts so that it can be tested against an emerging narrative? Or will the research be more forensic in nature?

19

Henri Vieuxtemps 08.16.11 at 7:13 am

Don’t know anything about German banking, but ‘idiocy’ is (or used to be anyway) a technical term. Surely none of those bankers had an IQ below 30; likely above 120, for most of them. So, call it what you want, but it’s certainly not idiocy or even stupidity. Institutions operate on their own logic.

20

Walt 08.16.11 at 7:41 am

SB, you’re wildly extrapolating in order to indulge in some random anti-social-science prejudice. Are you seriously arguing that in the hard sciences that people never start with a theory, and then proceed to test that theory?

21

Sebastian 08.16.11 at 7:47 am

SB is probably ScentofViolets.

The idiocy thing is interesting. Do we have to tell ourselves that they were stupid? Is it too scary for us to admit that really really smart people can do lots of damage when they are wrong/deceive themselves?

22

Alex 08.16.11 at 8:10 am

The assumption that stupidity can be modelled as randomness is surely one of the stupidest things in the whole field. What is stupidity, if it isn’t making the same mistakes over and over again? Fundamentally, isn’t it the inability to learn, or the refusal to change one’s mind in the face of discrepant information, or the inability or refusal to be aware of one’s mistakes* – all of which are much the same thing?

In this case, the specific stupidity is the tendency of economists to deal with any new problem by finding an intellectual construct that lets them ignore it.

So some of the actors are irrational or misinformed. Right, well, let’s assume they are random, so therefore there are the same numbers of unreasoning longs and shorts, they cancel out, and the rational minority (i.e. folks like us) determines the trend. This is functionally equivalent to saying “Nyaa nyaa nyaa I can’t hear you” – we’ve found a way to relax the core assumption of the entire project of economics without changing even one prediction or policy recommendation one bit. Quite the trick.

What would economics look like with a better model of wrongness?

*see the Dunning-Kruger effect.

23

SB 08.16.11 at 9:01 am

Walt, Sebastian

I don’t know who Scent of Violets is. I don’t have any particular prejudices regarding social sciences. I merely expressed my surprise and interest in a process which is quite different from that of physical sciences research.

But you do remind me of one of the funnier comments made to me at a small but very good conference in Europe. I left a talk to find the ladies room and immediately ran into a junior faculty from a state school in the Midwest. He introduced himself and then looked at my name tag. Without pausing to allow me to introduce myself, he said “Oh, you MIT people think you’re so smart!”

Just because I come from a different discipline doesn’t mean I have a preconceived notion about yours. Now, I am not interested in having some silly on-line argument. I was interested in knowing more about the process of social sciences research. Thank you Zamfir for your thoughtful response. My apologies to Henry for the distraction.

I’ll let everyone get back to the main thread.

24

Henri Vieuxtemps 08.16.11 at 9:02 am

I bet they are all perfectly rational, inside the institutional framework. Had they been irrational, they would’ve never risen through the ranks in the first place. The quote “…ultimately, these people–who in a just world would be penniless and serving extended prison terms–walked away with millions of dollars. There are plenty of apt descriptions for people like that, but “idiots” isn’t the one I would choose” describes it very well.

25

Walt 08.16.11 at 9:09 am

SB, I’m a mathematician. I think you may want to reflect on the lesson of that “Oh, you MIT people think you’re so smart!” story some more.

26

William Timberman 08.16.11 at 9:13 am

Small or large, anyone in the business of managing someone else’s money is probably vulnerable to the My guy can get me 20%, can your guy get me 21%? tease that you used to hear in fashionable circles in the 80s. Despite their smarts, their professional expertise, and their German-ness, I doubt that the guys in the Landesbanks were that much different from the yellow-tied financial advisers of the 80s, or Bernie Madoff, or the herds at Goldmann Sachs or AIG.

The fragility of civilization is always FAR too abstract a concept for such less-than-good burghers, no matter how adept they may be as financial engineers, and needless to say, the theories of goodness then being applied to them would only be considered falsifiable by collectivist loonies like Marx, or Oxbridgean skeptics like Keynes. Woe (as always) is us….

27

SB 08.16.11 at 9:19 am

You missed the point of it entirely.

28

ajay 08.16.11 at 9:41 am

The assumption that stupidity can be modelled as randomness is surely one of the stupidest things in the whole field. What is stupidity, if it isn’t making the same mistakes over and over again?

Yes, this is just stuck in there with no justification at all, and it’s (at least) highly contentious. If you have a financial deal which looks superficially attractive but has in fact got very serious and non-obvious drawbacks, then the idiots will all go for the deal and the non-idiots won’t. The idiots will, in fact, “work systematically in the same direction” in exactly the way that Frase says they won’t.

There is a similar jump of logic in this sentence: “it seems odd that there would be such a concentration of idiocy in the most lucrative field of the American economy, one which has been leeching the brightest minds out of the rest of the society for decades. ”

“Most smart people work in banking” is, even if it’s true (which it isn’t), not the same as “most people who work in banking are smart people”. I live in London. Thanks to the presence of the Royal Ballet and its supporting schools, it’s probably true that most British ballerinas live in London. London has in fact been leeching the best ballerinas out of the rest of the country for decades. But you try stopping an average Londoner on the street and asking her to do a quick grande jetée.
And, that aside, it’s certainly not the same as “the people making the decisions about structured product investment strategy are smart people”.

29

Walt 08.16.11 at 9:52 am

The point wasn’t that you shouldn’t jump to conclusions based on little bits of information?

30

Metatone 08.16.11 at 10:01 am

We know that after the EU changes we ended up with Landesbanken who all went out and created SIVs.

I think there is definitely some sense in which they were inexpert customers of Deutsche Bank and others who advised them on the SIV route. It seems more likely to me that rather than foolishly trusting US/UK bankers, they foolishly trusted “good men of Frankfurt.” Although maybe they also trusted the ratings agencies too much?

There was a blindspot in many regional banks trying to grow, you can see it at Northern Rock, about the fundamental risks. Throw in Timberman’s point about competitiveness and greed too. (@25)

Finally it’s worth noting however that we still have very little idea of how well Deutsche Bank did in the long run. We know they made out like bandits selling dubious tranches left, right and centre in the boom times. However, the opacity of the bailouts and of the refunding of DB – aided by their close links with the Bundesbank – mean we have no idea how much pain they actually deserved when the crisis came.

31

SB 08.16.11 at 10:27 am

Alex,

The point is that people often bring their preconceived notions into a situation. Just as the junior faculty from xxxx made an unwarranted assumption about me, I found that instead of responding to my query, Sebastian and you appeared to respond to an impression of what kind of person must be asking those questions. I was hoping for enlightenment – Crooked Timber is wonderful that way – I get to learn about something I don’t do – and instead I got on-line aggression. I understand that it is displaced, but it is annoying nonetheless. And I lost an opportunity to learn something that really interested me.

Can we stop arguing now?

Best,
SB

32

Andrew F. 08.16.11 at 11:07 am

Hmmm… stripped of jargon, the hypothesis seems to be “German banks were too trusting, because in the world to which they had grown accustomed such trust was justified.”

Perhaps there is some special culture of these banks of which I’m not aware, but “too trusting” isn’t how I’d describe international German business in general. We’re talking about an economy heavily tilted towards exports, i.e. where many companies do business across borders and cultures all the time. We’re talking about a country in which some of the biggest companies have entered into large settlements in the US for alleged violations of the Foreign Corrupt Practices Act, the substance of which involves bribery of foreign officials.

Nor do I think the bad investments in question were particularly murky, such that German banks had to simply trust an issuer or underwriter. When someone describes the investments as murky, there are three main possibilities:
1. The available descriptions of the investments, or the actual terms of the investments, are vague, ambiguous, and otherwise imprecise;
2. The person is simply unfamiliar with the investments, and so the investments are murky to him;
3. The person has become familiar with the investments, the terms are clear, but he’s attempting to relate to his audience.

In the case of popular treatments of securitized investments, I think (2) occurs frequently. It’s not that the investments were murky; it’s that the assumptions – the very clear assumptions – about default rates were wrong. No investor had to rely on trust to understand the instruments and put money in.

Lots and lots of banks were stuck with junk when default rates made it clear that newer vintages of mortgages would not follow the path of older vintages, and that the models used to describe the risk of investment would need reworking.

I can’t decide whether the proposed narrative – the trusting good social democratic Europeans fleeced by the avaricious and anti-social American banks – is too condescending towards German banks, too hostile towards American banks, or just plain naive.

33

kidneystones 08.16.11 at 12:32 pm

I’m going with the mass stupidity theory. I took one half-credit economics course a million years ago and dropped it. I expect I might have passed, but I wouldn’t bet more than a nickel on it, so I feel well-qualified to chime in.

Long and short of it is this: only a nation of idiots could have believed Wolfowitz and Cheney when the cost of the Iraq war was being discussed. Free or 5 million dollars?. America’s spectacularly low casualty rate helped support the illusion that America was so awesome that the US could ship a hundred thousand troops half-way around the world with equipment, stick them in the desert and the entire exercise would pay for itself.

Saw a good interview with Dr. Doom who put the cost of the Afghan and Iraqi adventures at 2 trillion and counting.

The real question for me is what would have happened had their been a comprehensive discussion on the real financial costs to America of the invasion. From what I recall of the time, the urge for catharsis/revenge was shared across the political divide. Folks forget that for all Bush’s follies, he actually did a fairly good job of channeling this sentiment away from American Muslims. My great fear during the Bush years was that Bush would launch a major attack on Iran. I’m not convinced, therefore, that a frank discussion of the real financial costs of the war would have averted invasion.

Indeed, my guess is that given the choice between a two trillion dollar price tag for a marginally successful prosecution of two war that would tie up US troops for ten years and the cost of nuking Baghdad, Tehran, and several cities in Pakistan or Afghanistan, a large number of Americans would have argued for the latter. That would have been bad. Doing nothing certainly was not an option. Was lying about the real cost of the war the right thing to do at the outset? I don’t frankly see Americans being talked out of doing something wild. Recall Friedman and his “suck on this” observations. Twas an ugly time. And we’re all still paying for it. You know we’re all in deep doo-doo, btw, when the strongest and most consistent anti-war political figure in America is Ron Paul.

34

Henry 08.16.11 at 12:39 pm

On the ‘do the decisions of noise traders correlate’ question, this paper is interesting. On the ‘story’ bit – SB, the reason I described it this way is because I’ve heard it from several people but never seen it written down, and hence view it as an interesting hypothesis to be tested rather than an argument that has been applied to the evidence. This is not to say that someone hasn’t investigated it properly somewhere; rather, that if they have, I haven’t read it.

35

mark blyth 08.16.11 at 1:25 pm

I read the Lewis piece and thought that the ‘scheisse’ angle was a bit overdone but I had no real problem with the cultural story. Henry ‘pits’ this against an alternative institutionalist story but I don’t see them as rival. The following strikes me as running in the same direction:

a) Lewis is right, German like rules. I am married into a family of them. (This is not a scientific finding, but I know). The Eu’s solution to the massive agency problem at the heart of the Euro that we are now dealing with was to try and write a complete contract that got around the problem of ex ante specification of all possible states of the world by writing rules that would limit behavior to a set of delimited parameters that the institutions of the Euro could cope with. Rules. Problem was the minute that they were announced everyone violated them, even the Germans themselves. Contrast that to the incomplete contract that is the EU’s political project and that worked rather well.

b) The Landesbanks were shoved out into the market and they were suckers. It is also true that in 2006 New York short-hand for ‘garbage pail’ was Dusseldorf. But its not inexperience alone. I heard that first in an interview I did with a CDS designer back in 2007. If it has an official wrapper from S and P (a government authorized NRSRO remember) then they would buy it. The game was turning crap into something rated and then you sold it to the Germans (or Norwegians apparently).

c) The ‘idiocy’ all goes in one direction story is true. The notion that idiocy moves in different directions and cancels itself out is exactly the type of fallacy Nassim Taleb has been railing against. It presumes some kind of large numbers, normal distribution, and a real world that is apparent to non-idiots that we are all informationally aware of and converge upon in our trading decisions.

If that were in any way true we wouldn’t be sitting in a world were markets squeal for budget cuts, and then when they get them they squeal louder about a lack of growth. It wouldn’t also be the same world where the German government is simply unable to accept any responsibility for flooding the periphery with cheap money for a decade so that everyone could buy BMWs and now wants the same folks they gave the cash to to pay it all back via budget cuts that undermine their own economy (as seen in today’s figures).

Idiocy going the one way is the norm. It is not an error.

In sum, its a complex world. Why look for one ‘right’ story?

36

AcademicLurker 08.16.11 at 1:42 pm

Do we have to tell ourselves that they were stupid? Is it too scary for us to admit that really really smart people can do lots of damage when they are wrong/deceive themselves?

I believe “too clever by half” is the phrase you’re looking for.

37

Alex 08.16.11 at 2:24 pm

It’s also possible that Germany’s role was purely structural. As a nation with a huge trade surplus, it can’t but be a huge net saver. As a nation with a trade surplus and an ageing population and strong financial regulation, it was very likely to account for a lot of demand for AAA securities. Given that the financial sector invented a machine to print AAAs without limit, it’s not surprising that a lot of AAAs ended up in Germany.

“Germany” here is really a synecdoche for export-intensive developed economies – the only big exception was China. But “German” banks were competing – they couldn’t just offer T-bill rates. Chinese banks had to hand over their dollars to PBOC because, well, otherwise they’d all be shot. Hence the “Germans” ended up with the famous Deutsche Bank CDO whose only means of support was a Las Vegas cocktail waitress’s tips (ISTR D^2 can actually quote the reference number), or rather, several hundred of them who lived in the subdivision the underlying mortgages came from. And the Chinese got the full faith’n’credit of those there United States.

Regarding economic stupidity, the sad thing about rat-ex is that there’s surely so much intellectual potential in trying to understand economic stupidity and come up with a formalism that gives you useful results in an economic model. Obviously, it’s going to be hard, but that’s another way of saying “interesting and important”. There’s probably more than one Nobel in it, plus any number of top-tier publications and quite a few careers. But they chose to dodge the question.

For example, even if you accept the notion that irrationality is random, just questioning how long it takes to regress to the mean has interesting results. If the crazies rush in one direction and take a while to drift back, that implies a source of business cycle fluctuations and an opportunity to make out like a bandit. If they sober up quickly, well, then the standard assumption wouldn’t be far off the truth.

Another one: is irrationality endogenous?

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Billikin 08.16.11 at 2:48 pm

Peter Frase: “For one thing, it seems odd that there would be such a concentration of idiocy in the most lucrative field of the American economy, one which has been leeching the brightest minds out of the rest of the society for decades. Moreover, it is necessary to explain not only the preponderance of idiots, but the tendency for their idiocy to work systematically in the same direction.”

Greed doth make fools of us all.

Even Isaac Newton lost his shirt in the South Sea Bubble.

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Sev 08.16.11 at 3:09 pm

#10 Beat me to it.
#32 The relevance of the Iraq comparison may be the prestige of the US; its military capacity, its economic strength. Who could believe what a wreck it would turn out to be? I hardly mean to imply that we are finished, just easily over-estimated at times.

The credit cycle has always amused/puzzled me. Wouldn’t banks do better by avoiding the extremes of easing/tightening? Probably; their employees, not so much.

Are we functionally more intelligent than lab rats, or just better rationalizers?

I find the ‘global glut of savings’ a persuasive theory of the GFC in general. Yes, people will engage in the usual misdeeds, torpor, credulousness, but even more so when there is an external locomotive force. A rising tide floats all schemes.

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mark blyth 08.16.11 at 3:26 pm

Agreed, because the arrows go the same way. When we say something is structural and impute demand to that structure, we are short-circuiting the agency process that still makes that happen. Many things are structurally demanded but never happen – Adam Smith saw this with his notion of ‘effectual demand’ so this is hardly new. So at the end of the day German brokers and dealers saw a lot of saving and old folks and thought anything AAA a good bet. Its the same story with a different inflection.

I hadn’t heard about the cocktail waitress CDO stream. I knew about the Ebay earnings one from Peter Goodman’s book.

Agreed on the rational theory of irrationality. Some work on rational arbitrageurs following Brunnemeier tries this. I think that the Ur-Problem may be that stupidity as a category assumes a parallel ‘correct’ real world view that we deviate from and then come back to. But in a bubble there is no reality apart from the market moving perceptions of the participants. There is no mean to regress to in the moment, and that’s when the money is made. The mean could be the long run trend, but that assumes no secular shift off trend is likely, and if you believe that I have a Black Swan for sale…

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Sebastian(1) 08.16.11 at 3:32 pm

SB – unfortunately there were two Sebastians involved here – I only wrote the first answer, I don’t really know who Scent of Violet is, either (s/he’s a frequent poster that gets into lots of fights). Next time you’re interested in other people’s work and disciplinary differences, maybe use the words “interested,” and “curious” rather than “alarmed”… (also, you might want to read some philosophy and/or sociology of science if you think any science actually works according to Karl Popper).

Mark – I find this “Germans like rules” meme incredibly irritating. I am German. Coming to the US I was bombarded with a plethora of rules and social norms that it took me years to – more or less – figure out. Some Germans may be more direct in pointing out to you when you’re breaking such rules than most US-Americans, but that doesn’t mean those rules don’t exist and aren’t followed here. And in terms of economics, Germans break rules all the time. Germans are corrupt – probably about as corrupt as Americans on average. They cheat on their taxes – about as much as Americans. As you say yourself, they broke the EU stability pack without much qualms. I just don’t see how this alleged rule obsession tells us anything about political economy.

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Zamfir 08.16.11 at 3:40 pm

@Andrew F., you point about German international businesses does not necessarily extend to the Landesbanken (if D^2 complains about that plural form again, I am Dutch and therefore allowed). The point is that they were regional banks, whose usual business was rather conservative and based on much more interwoven connections between economic actors.

It’s all handwavy story-telling, but the points made about the nature of Germany’s internal ways of financing are not complete bollocks. You’ll find lots of German bankers on boards of companies, and the same bankers on the board of their suppliers, and of their competitors. Trust here doesn’t mean “We loan you money based on your blue Aryan eyes”, it means “we loan you money because we know your business at least as well as you do”.

And German-ness doesn’t have to be a strictly necessary component of the crisis. It’s just that bubbles need suckers somewhere by their very nature, especially as some of the participants seem to have come out just fine, thank you. And the biggest suckers will be turn out to be those with largest combination of greed and Dunning-Krueger. The crisis left plenty of those in the US too, and many other places. This is just a hypothesis why this particular German group of actors became one of the noticable suckers.

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mark blyth 08.16.11 at 3:56 pm

Sebastian (1). You came to the US and stayed. maybe that tells us something?

You may find the rules-meme irritating but try teaching a semester at a major German university and then compare that to the UK, Denmark, France and the US (where I have also taught) and tell me rules are not more important in one context than the other. Perhaps the general point is this. If Germans don’t think the rules would work why bother designing a whole continental political economy around them? Or, why continue to hold other countries to them after the fact when its self-apparent that they are harmful (from maastricht to austerity)?

44

roger 08.16.11 at 4:22 pm

It seems that the Lewis story and the structural story are both variants of the dumb story.
“Here, the suggested problem is an organizational one as much as (or more than) a cultural one – banks which are geared to a certain kind of business, and which suddenly find themselves being pushed out of that market, are likely not to have built up the expertise that will allow them to prosper in new ones.’
The polite phrase about not having built up the expertise is, impolitely, they were idiots.
But who wasn’t an idiot in the 00s?
I think the question, however, is: what is idiocy, here.
Rebecca West, in Black Lamb and Grey Falcon, tells an excellent story about a conversation she has with a nurse in the 1930s, when West was convalescing and heard on the radio about the assassination of the King of Yugoslavia. The news upsets her, and when the nurse comes in she is alarmed that West is upset until she hears that it is just that the King of Yugoslavia was assassinated. The nurse says, oh dear, did you know him? Evidently considering the assasination otherwise unimportant: “Her question made me remember that the word “idiot” comes from a Greek root meaning private person. Idiocy is the female defect: intent on their private lives, women follow their fate through a darkness deep as that cast by malformed cells in the brain. It is no worse than the male defect, which is lunacy: they are so obsessed by public affairs that they see the world as by moonlight, which shows the outlines of every object but not the details indicative of their nature.”

Although these associations with gender are evidently a little dubious, West’s definition of idiot seems to be what is really in play. Expertise was skewed by a certain holistic blindness: the construction of the de-regulated financial world was undertaken with a naive, even idiotic belief that the bits of it could be absolutely separated from each other. Then, in their separate compartments, one could make bets on other bits. Greenspan, famously, opposed regulating derivatives because they were only bought by the wealthy, who could “afford’ the losses, which meant basically that they wouldn’t leak out of their compartment. And in fact the current Treasury Department is busy trying to push back certain rules from Dodd Frank because they regulate areas that are supposedly ‘insulated’ from the rest of the financial world, and can be left to the good will or greed of the players. This is the endemic idiocy that might well be institutional. The cultural aspect would come in with the particular way incentives were skewed, and the political trajectories in which they operated. West’s nurse, who couldn’t see the connection between the assassination of a minor potentate and the balance of power, and the German bankers both suffer from thinking that they live in worlds that are insulated from contingent and distant outside forces. The difference is that the German bankers also suffered from lunacy -they felt that they could still make money on those forces.

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Alex 08.16.11 at 4:54 pm

If Germans don’t think the rules would work why bother designing a whole continental political economy around them?

To be fair, the other nations and institutions involved spent a lot of their time second-guessing what the Germans would want from the eurozone. Trying to work out what Hans Eichel would accept, what he would actually prefer, and to what extent the first could be influenced on some topic by starting with the second on another, was the top priority of several world class diplomatic services for most of the 1990s.

And to some extent, this was a reflection of the stereotypes of Germans the French and Italians and Eurocrats painted on their walls.

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William Timberman 08.16.11 at 5:14 pm

roger @ 44

Even when our smartfellas understand what to do about the tragedy of the commons, or the paradox of thrift, they can’t make us do what their analysis says we ought to do unless and until not only they, but we in all the glory of our numbers understand as well.

The proper education can eventually convince the blind pilot to trust his instruments, and the voter to accept what his intuition trembles at, but what a slog it’s turned out to be getting from there to here in the politcal sense. The ideological death struggles being waged staged between Boehner and Geithner in the U.S., or Barroso and Trichet in Europe are already ample evidence of the difficulty. If we dither long enough, fatal evidence of it might well arrive in the Presidency of a Michele Bachmann or Rick Perry. I suppose a cynic might consider such poetic justice the only justice that will ever be administered in the libertarian, Confederate and fundamentalist know-nothing zoo we have over here on this side of the Atlantic, but does anyone really believe that that the inhabitants of that zoo will be its only sacrifices?

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Barry 08.16.11 at 5:34 pm

Ajay: ““Most smart people work in banking” is, even if it’s true (which it isn’t), not the same as “most people who work in banking are smart people”. I live in London. Thanks to the presence of the Royal Ballet and its supporting schools, it’s probably true that most British ballerinas live in London. London has in fact been leeching the best ballerinas out of the rest of the country for decades. But you try stopping an average Londoner on the street and asking her to do a quick grande jetée.
And, that aside, it’s certainly not the same as “the people making the decisions about structured product investment strategy are smart people”.”

Your logic is flawed; the correct analogy would be how skilled London *ballerinas* are at ballet. The original comment pointed out that Wall St has been hiring smart people for quite some time, and is highly competitive, externally and internally. Those who can’t/won’t hack it are kicked out. That suggests that the survivors, which all decision-makers there would be, aren’t dumb, and don’t get fooled too often.

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Barry 08.16.11 at 5:39 pm

mark blyth: “Or, why continue to hold other countries to them after the fact when its self-apparent that they are harmful (from maastricht to austerity)?”

Because the financial elites profit from this. To me, the current story of the EU/ECB financial crisis is to a large part the efforts of the big money guys in the UK, France and Germany to make sure that they pull their profits, no matter how bad the other countries suffer.

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Zamfir 08.16.11 at 6:32 pm

If Germans don’t think the rules would work why bother designing a whole continental political economy around them? Or, why continue to hold other countries to them after the fact when its self-apparent that they are harmful (from maastricht to austerity)?
You can’t put that on the Germans. The importance of rules on the European level is that they can agreed upon in advance by by negotiation between national government, who are in the end the only institutions that truly have the democratic mandate to make political decisions.

The alternative to rule-based actions (implemented by relatively constrained technocratic processes) is to give more ability to European institutes to make political decisions on a case by case basis. But the current EU is not set up to give much mandate to such institutions, nor is there very much popular support for changes in that direction.

Sure, the current setup is far from perfect. But nearly every alternative (like the Eurobonds) comes down to a transfer of decision making power to a federal European level without an accompanying construction of a democratic frame that can control and give mandate to such power.

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SB 08.16.11 at 8:12 pm

@ Henry

Thanks for the response.

@ Sebastian (1)

“also, you might want to read some philosophy and/or sociology of science if you think any science actually works according to Karl Popper”

Thank you, I’ll have a look at it.

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Sebastian(1) 08.16.11 at 8:53 pm

mark – the reason I’m here is a combination of the fact that the US has a comparative and absolute advantage in graduate education for social scientists (which was much larger when I came 7 years ago when neither MPI nor Bremen had graduate schools) and path dependency. I like it here, but I certainly wouldn’t mind going back to Germany/Europe either if opportunity (now for two people…) arises.

I’m with Zamfir on the rule-based institutions. People were aware of the economic risks posed by a single currency area with relatively heterogeneous members and tried to write rules to address those risks.
Given the uniqueness of the situation (and thus inherent uncertainty), I can see how one could tell a Mark Blyth ;-) type of story about the role of ideas in determining which rules exactly they wrote and which potential problems they focused on.

But “Germans like rules” – that just doesn’t make sense as an explanation. Why did they (or rather their politicians) break the rules right away then? I thought Germans all obey the rules like when they drive cars in a traffic jam? Also, in the current crisis, they seem to make things up as the come more than follow any rules. It’s not like Merkel is super insistent on Maastricht Criteria atm – and austerity isn’t a specific set of rules – it’s the same type of stuff the IMF used to impose – and I don’t think the IMF has ever been accused of undue German influence.

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bcgister 08.16.11 at 9:44 pm

“Long and short of it is this: only a nation of idiots could have believed Wolfowitz and Cheney when the cost of the Iraq war was being discussed. Free or 5 million dollars?.”

I’ve got to suppose that the run up to the Iraq war probably provides a good parallel to the sale of dubious MBS to German bankers, but I wouldn’t look at it firstly as a parallel in stupidity. The Iraq war was entered into after a clear effort to deceive, from firing General Shinseki for saying significantly more than Rumsfeld’s advertised number of men would be needed to secure the country to having Colin Powell present half baked theories and dubious “evidence” at the UN. Once the sale had been made, support for the war had remarkable staying power, regardless of the intelligence of any of the individuals who might have been brought to buy into that rational.

I’d guess a similar process could be found for local German bankers and MBS, from the history of mortgage investment through the bogus AAA ratings assigned by such stalwarts of securities analysis as Standard and Poor’s.

So, I don’t think there’s much aside from normal human “stupidity” here. How the sale was made would be a historical question while how the belief in that investment was maintained within the community of German bankers would be an investigation into the cultural maintenance of beliefs that are increasingly contradicted by evidence. It’s kind of reminescent of E. E. Evans-Pritchard’s unsuccessful attempts to expose witch doctors in ‘Witchcraft, Oracles and Magic Among the Azande.’

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Shay Begorrah 08.17.11 at 12:31 am

Zamfir@49

Sure, the current setup is far from perfect. But nearly every alternative (like the Eurobonds) comes down to a transfer of decision making power to a federal European level without an accompanying construction of a democratic frame that can control and give mandate to such power.

I think the current setup is “close to perfect” if you are President Sarkozy or Chancellor Merkel.

The failure to build a European “democratic frame” does prevent effective pan European government but it should be remembered that this suits major national political parties in the larger states and the surplus countries just fine. If you are in the winning political party in Germany or France you effectively choose the broad fiscal policy options that will be on offer for the rest of Europe, and particularly the Eurozone, to choose from. Any kind of more federal solution with the EP playing a more significant role would lessen the size of the prize for elections in France and Germany, so expect their collective enthusiasm for more pan EU popular democratic input to be at a low level until the EU has already acceded to all of their demands.

This has little to do with Michael Lewis’ article but it might explain why the proposed solutions to the European portion of the GFC do not seem to involve losses coming home to roost in either France or Germany, and why sneering discussion of German and French banking or character failures are less common than might otherwise be expected.

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Frank in midtown 08.17.11 at 4:44 am

They obviously aren’t idiots/morons. They have degrees, certificates, and charters testifying to their intellect. They have not consistently made bad decisions, just a couple, now and then, as does everyone. This is the problem with having to make decisions, make one bad enough, you’re an idiot. Such is the burden of people who have to make big decisions. There is never enough time and faced with the challenge of fact based decision making, I’m sure they found it expedient to develop a gut-feel for those kinds of things.

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zamfir 08.17.11 at 6:42 am

@shay, no matter what you think would be good about a federalized Europe, the current system has to work with a European population that is for a large part not asking for a federal Europe, and that definitely does not agree on how such a federal Europe should look like.

Thing is, I don’t really like the ‘shock doctrine’ kind of logic you lately hear about Europe, that the current crisis should be used to implement a more centralized Europe without asking the people who would only say no.

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Shay Begorrah 08.17.11 at 10:03 am

zamfir@55

I am not particularly keen about a federal Europe either, and the barely disguised enthusiasm of the supporters of a euro-federalism with Gaulist characteristics for forcing through changes while they have the upper hand is deeply distasteful.

However the current “Europe of the majority of ruling political parties in surplus countries” seems to be the worst of all possible worlds, it has opaque and democratically unaccountable decision making processes that do affect the whole of Europe.

Pre Lisbon and pre Eurozone arrangements would seems to be have been the place to have stuck until the EU had taken steps to build some kind of pan European polis. That is another topic though.

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ajay 08.17.11 at 10:09 am

The original comment pointed out that Wall St has been hiring smart people for quite some time, and is highly competitive, externally and internally. Those who can’t/won’t hack it are kicked out. That suggests that the survivors, which all decision-makers there would be, aren’t dumb, and don’t get fooled too often.

No, I’m afraid there are a lot of unaddressed assumptions in that one as well. Wall Street indeed hires some very smart people. It doesn’t necessarily follow that it hires only very smart people, or that being able to hack it is a result of being very smart, or even that the sort of jobs that the very smart people get hired for are also the sort of jobs that allow you to progress to being a senior decision maker.

That suggests that the survivors, which all decision-makers there would be, aren’t dumb, and don’t get fooled too often.

Right. On the other hand, actual recent history suggests that the survivors do in fact get fooled fairly regularly.

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Barry 08.17.11 at 11:39 am

“Right. On the other hand, actual recent history suggests that the survivors do in fact get fooled fairly regularly.”

As has been repeatedly pointed out, these fools in general made mucho money on being fooled.

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Zamfir 08.17.11 at 12:46 pm

ajay, there’s a difference between losing a good gamble, and being fooled (by taking an a priori bad gamble). Both cases leave you without a chair when the music stops, but they are IMO not quite the same thing.

A lot of post-crash analysis seems to come down to asking whether we are looking more at the first or more at the second in specific cases. The Landesbanken (as organizations) look like a good fit for “got fooled”, either by themselves or by smarter operators. Because there don’t seem to be much examples of them that played the high finance game and won.

But many individuals in the financial sector don’t seem to have lost, compared to any likely other career they could have had. Some people did really lose out, but a lot of those seem more cases of losing a good gamble, than of being a fool.

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Jaheira from Germany 08.18.11 at 1:14 am

It’s the lack of liability
Apart from the Land Banks, it’s also the private Commerzbank and Dresdner Bank which failed. I think German managers can dare more immoral behavior because they have a very low risk for painful legal liability. Usually there is no court hearing at all, because the states attourny can’t prove that a deliberate crime has taken place and not stupidity. And if there is, managers go free, make a deal or just get mild scentences for being members of the elite.
The former boss of the German Post, Klaus Zumwinkel had commited tax fraud worth 1.2 million Euros. He had to pay back the money, pay fine of 1 million Euros and he got 2 years of jail on probation. So he had to do no jail time.
The theory of expactancy-value says that German managers can dare to damage their companys for a meantime better income.

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P O'Neill 08.18.11 at 3:11 am

It’s astounding that Lewis was able to amass that word count in VF on that topic and never mention the Depfa/Hypo affair, in which a German bank spins off to Ireland to take advantage of light-touch regulation and low taxes but gets bought by the clowns at Hypo right before a multi-billion dollar hole appears in its balance sheet.

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Andrew F. 08.20.11 at 6:30 pm

W/r/t the more organizational as opposed to cultural explanation, I suppose we would look for evidence that the firms in question had sought expertise in the relevant products. We might look for this in new hires during the relevant period, news or disclosure of the use of expert outside firms, or reorganization of analytical resources within the firms towards understanding the products.

I also think that this may simply be a question of timing. The firms find themselves in need of new investments quickly at the height of the structured finance fever, and they move into it. Other firms may have done the same but for the fact that they had more resources devoted to established lines of business and less need to find new ones. In other words, it may not be so much a lack of expertise as the unfortunate confluence of having the same wrong knowledge as everyone else and greater opportunity/will to lose money on that same wrong knowledge.

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