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It’s Easier to Be Brilliant than Right

Saturday, September 25, 2010

There is a danger with intellectual brightness. It is to overemphasize and develop a bias for cleverness, quickness, facility with data, and the ability to persuade.

In 1936, John Maynard Keynes wrote this profound and justly celebrated paragraph: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval … Soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

Note that Keynes speaks of the power of both right and wrong ideas, and of their power for good or evil.

In 1938, the American Enterprise Institute was founded to work on the powerful ideas of the enterprising or free market economy. At AEI, it is enjoyable to be surrounded by smart people. But there is a danger with intellectual brightness. It is to overemphasize and develop a bias for cleverness, quickness, facility with data, and the ability to persuade.

More than 30 years ago an excellent old boss of mine, Ed Bottum, called me into his office. As I sat down, I saw some proposal or other of mine lying on his desk. He leaned forward, looked me earnestly in the eye, and unforgettably said, “Alex, it’s easier to be brilliant than right.”

I have thought of that wonderful lesson hundreds of times over the decades since.

Isaac Newton was possibly the most brilliant mind ever. But when it came to the financial bubble of his day, the South Sea Company bubble of 1720, he displayed Ed Bottum’s rule. He was an early investor in South Sea stock, doubled his money, and sold out. The stock went on up, and Newton bought back in, only to suffer large losses when the bubble collapsed. He wrote disgustedly, “I can calculate the motions of the heavenly bodies, but not the madness of people.”

That is the problem with modeling financial markets: how do you calculate the madness of people?

Using the mathematics all built on Newton’s laws, scientists can with amazing precision send rockets to other planets and indeed out of the solar system. This is impressive, so it is often said about economics and finance, “It’s not rocket science,” meaning it is not that hard.

Well, the math may be easier, but, in a deeper sense, economics and finance are harder. The math of rocket science is determinative: you are certain of how forces will affect the flight of the rocket, and all the rocket scientists will agree, because these are objective matters—complex, but determinative.

This is not true of economies and financial markets. What the math is trying to refer to there is riddled with the uncertainty arising from the interaction of human psychology, expectations and behavior. So we find that economists and others who predict financial markets never agree with each other and are very often embarrassingly wrong. It is not rocket science, indeed—it is more difficult than that.

One insight of economists that is clearly right, however, is the amazing power of the market economy—one characterized by enterprise, freedom, the rule of law, and the advance of knowledge—to make life better for ordinary people over time. This is quite apparent from the path of real per capita Gross Domestic Product of the United States over more than 100 years. The trend is strongly north-east on the graph: we are about six times better off than our predecessors in 1900. We have come to take economic improvement so much for granted that we may not recognize how truly amazing this is.

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This economic progress is accompanied by the buildup of the aggregate equity value of firms. The Dow Jones Industrial Average has gone from 66 in 1900 to about 10,500 currently. This represents an average compound gain in nominal dollars of about 4.7 percent per year (plus you would have gotten dividends). That is the average annual gain in price, but we can immediately see from the chart how the financial markets introduce cycles of booms and busts.

Pollock2

The great economist Joseph Schumpeter rightly told us: “The capitalist process progressively raises the standard of life of the masses.” “Masses” is an old-fashioned term—let us say, “The capitalist process progressively raises the standard of life of ordinary people.” Schumpeter goes on: “It does this through a series of vicissitudes.”

Why the vicissitudes—the booms and busts? Because the effects of innovation are uncertain.

For example, here’s a description from the Lords of Finance of the 1920s, which of course ended in financial crisis: “The bubble began … rooted in economic reality and led by the growth of profits. From 1922 to 1927, profits went up 75 percent.” That was the “Coolidge prosperity.” There was innovation and change: “the ‘old economy’ of textiles, coal and railroads [were] struggling, as coal lost out to oil and electricity … trucking bypassing the railways, while the ‘new economy’ of automobiles and radio and consumer appliances grew exponentially.” All these were true technical and economic advances, but were still followed by the infamous crash.

Max Planck, the great physicist, made this provocative observation: “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

But in finance, in contrast, this allows new generations to repeat the errors of previous ones.

“History, which has a painful way of repeating itself, has taught us that speculative overexpansion invariably ends in over-contraction and distress,” wrote financier Paul Warburg in 1929.

How can such painful lessons be forgotten? But they do get forgotten, cyclically. For example, consider this description, by Michael M. Thomas in “The Overclass”: “Things were really popping. People were caught up in an easy-credit financial boom—based mainly on real estate speculation.” Is this about 2005? Nope: America in 1831.

Our latest round of forgetfulness resulted in the great 21st-century housing bubble, which was heavily promoted by government policies and reflected mistaken ideas about credit from brilliant people.  

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Near the top of this bubble, in 2005, Federal Reserve Chairman Alan Greenspan addressed the American Bankers Association: He noted that there had been “local excesses” in real estate prices, but assured listeners that “the vast majority of homeowners have a sizeable equity cushion with which to absorb a potential decline in house prices.” But neither he nor anybody else thought that national average house prices would, or could, fall by 30 percent, as they did.

In the early 2000s, it was Greenspan’s strategy to promote a housing boom to offset the recessionary effects of the by-then burst technology stock bubble of the 1990s. “Greenspan cut interest rates when housing prices were still on an upward trend. Nothing responds more to a cut in interest rates than the housing market,” wrote Richard Koo wrote in Balance Sheet Recession, “thus creating an important offset to the wealth lost in the share markets. Greenspan spoke before Congress in July, 2002, saying that the negative wealth effect from the collapse of the share market was largely offset by the positive wealth effect coming from the housing market.”

Koo judged in 2003: “It was a brilliant strategy.” But it is easier to be brilliant than right.

The inflation of the bubble was promoted by the government in the form of the Fed, but also of course by the GSEs, Fannie Mae and Freddie Mac, both of which are now broke.

Here’s what some brilliant fellows, Nobel Prize winner Joseph Stiglitz, former White House budget director Peter Orszag, and economist Jonathan Orszag said about the risk of Fannie and Freddie in 2002: “The risk to the government from a potential default on GSE debt is effectively zero.” The cost to the government of the failure of the GSEs is now variously estimated at sums from about $200 billion to $400 billion.

The Chairman of the Senate Banking Committee, Senator Chris Dodd, had this to say in July 2008: “What’s important are facts—and the facts are that Fannie and Freddie are in sound situation … They have more than adequate capital. They’re in good shape.” This was less than two months before Fannie and Freddie failed. Of course, Dodd was a principal sponsor of the Dodd-Frank Act or as I call it, the “Faith in Bureaucracy Act,” which depends upon the idea that the government can know the future.

The housing bubble was only one part of a real estate double bubble, as shown in Graph 4.

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The commercial real estate bubble was just as extreme as the housing bubble, and is also resulting in huge losses. This second bubble is heavily financed by loans on the books of banks, the most heavily regulated of businesses. But being so heavily regulated did not keep them out of trouble.

We are now in a period of transition, living in the wake of the double bubble. We should remember this excellent definition by the economist Jacob Viner: “A period of transition,” it runs, “is a period between two periods of transition.” There will be many periods of transition ahead.

These days we also hear much about uncertainty. So there is the Pollock corollary to Viner’s definition: “A period of uncertainty is a period between two periods of uncertainty.” You will also experience many periods of uncertainty.

This is nicely summed up by a quote from Winston Churchill: “I think we differ principally in that you assume the future is a mere extension of the past, whereas I find history full of unexpected turns and retrogressions.”

Thinking of unexpected turns, here is a photo of two distinguished gentlemen.

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They are Senator Smoot and Congressman Hawley—successful, well-intentioned, respectable, serious men, the chairmen of their respective committees in the U.S. Senate and House of Representatives, implementing an idea of their time—namely the Smoot-Hawley tariffs. The result was the unintended disaster of making the world depression much worse.

So: “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.”

Yes. And it’s easier to be brilliant than right.

This article is adapted from a lecture at an American Enterprise Institute intern dinner in July 2010.

Alex J. Pollock is a resident fellow at the American Enterprise Institute, Washington, DC. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.

FURTHER READING: Pollock also wrote“It Wasn’t a Bubble—It was a Double Bubble” and "Error vs. Fraud" on how groups of intelligent, sophisticated people find themselves caught together in the recurring bubbles and busts. He also argues, "Countercyclical Loan-to-Value Limits Can Help Prevent the Next Bubble."

 

Image by Darren Wamboldt/Bergman Group.

 

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