by Share the post "Three Things I Think I Think – Financial Crisis Edition" Here are some things I think I am thinking about: Warren Buffett on the financial crisis, investing with a sound premise & silly Congressional ideas. 1 – What Caused the Financial Crisis according to Warren Buffett? The National Archives released documents related to the Financial Crisis late last week. Among them were some interviews with Warren Buffett on the crisis. I noticed that, aside from being nerdy white guys, the only thing I might have in common with Buffett is that we both believe the cause of the financial crisis was, well, just about everybody: “I think the primary cause was an almost universal belief, among everybody ‑‑ and I don’t ascribe particular blame to any part of it – whether it’s Congress, media, regulators, homeowners, mortgage bankers, Wall Street ‑‑ everybody ‑‑ that houses prices would go up.” I’ve described this several times over the last 7 years and every time I do it I seem to catch a bunch of flak from people with a political bone to pick. And every time I see someone trying to place sole blame on “the government” or “wall street” or “house flippers” or whoever, I am reminded of how common fallacies of composition are in the financial world. We don’t see things in totality.
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Here are some things I think I am thinking about: Warren Buffett on the financial crisis, investing with a sound premise & silly Congressional ideas.
1 – What Caused the Financial Crisis according to Warren Buffett? The National Archives released documents related to the Financial Crisis late last week. Among them were some interviews with Warren Buffett on the crisis. I noticed that, aside from being nerdy white guys, the only thing I might have in common with Buffett is that we both believe the cause of the financial crisis was, well, just about everybody:
“I think the primary cause was an almost universal belief, among everybody ‑‑ and I don’t ascribe particular blame to any part of it – whether it’s Congress, media, regulators, homeowners, mortgage bankers, Wall Street ‑‑ everybody ‑‑ that houses prices would go up.”
I’ve described this several times over the last 7 years and every time I do it I seem to catch a bunch of flak from people with a political bone to pick. And every time I see someone trying to place sole blame on “the government” or “wall street” or “house flippers” or whoever, I am reminded of how common fallacies of composition are in the financial world. We don’t see things in totality. We see what we want to see inside of the big picture so we can confirm what we already believe. This just leads to a lot of narrow minded thinking that causes more arguments than objective analysis.
2 – Investing with a False Premise. One comment I disagreed with (at least partly) was Buffett quoting Ben Graham on investing with a false premise:
“You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”
I don’t know about that. If you’ve read my paper on the monetary system or portfolio construction you’ve probably noticed that this is the primary thing I am trying to avoid when analyzing the economy – false premises. There are so many myths and misconceptions about money that you can get into a lot of trouble buying into these ideas. Whether it’s flawed concepts like the money multiplier, crowding out, being a permabull/bear, dividend investing for safe income, “beat the market” or whatever. Starting with a sound premise is an intelligent way to improve the odds that you’ll succeed going forward.
Of course, you have to maintain some rationality within this context. Extremists get killed in the financial markets because they tend to go all in on what they believe. Believing that house prices never go down was obviously irrational (and I had that argument with a lot of people back in 2005/6), but the fact that asset prices usually go up is not an unsound premise from which to start because the economy usually expands and people tend to become more productive over time. So, in this example, being a rational optimist always beats being a perma pessimist AND a perma optimist.
3 – Let’s talk about that silly balanced budget idea. One myth that just never dies is this idea that the US government is going bankrupt and needs to tighten its belt so we avoid impending crisis. I’ve spent an inordinate amount of time debunking this myth over the last decade, but I wanted to congratulate a group of economists for fighting back against a truly stupid idea – a federal balanced budget amendment. Mark Thoma linked to this letter yesterday highlighting the dangers of a balanced budget amendment. I’ll just point out two facts:
First, one of the most powerful economic policies we have in place are what’s called automatic stabilizers. This is the tendency for the budget deficit/surplus to expand and contract naturally to offset economic conditions. So, during a recession government deficits rise because spending naturally increases due to things like unemployment benefits while tax receipts decline. This leads to more income to the private sector and a flow of net financial assets that helps offset the decline. And the exact opposite happens during booms thereby cushioning against the risk of booms. If we had a balanced budget amendment in place the economy would likely be a lot more volatile because these stabilizers would be gone.
Second, the federal government plays an important role in ensuring that our states don’t turn into Greece. As I’ve explained before, since the states have balanced budget amendments they are constrained by a true solvency constraint. The states, like Greece, have real limits on how much debt they can issue. But since the US states run trade surpluses/deficits against one another with no foreign exchange rebalancing then the poor states are always exporting more dollars than they’re importing. They can borrow to offset this, but there’s a Congressionally mandated limit to this borrowing. So, where does the income come from that helps avoid inevitable insolvency and occasional financial crisis? You guessed it – it comes from the federal government who takes more from the rich states and redistributes it to the poor states. It sounds like socialism, but it’s actually saving capitalism from itself. And it works beautifully in the case of a single currency system by helping us avoid the debacle of a situation that is Europe….
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