"swings in confidence are not always logical. The business cycle is in good part driven by animal spirits. "

From the WSJ:

"Animal Spirits Depend on Trust

The proposed stimulus isn't big enough to restore confidence.

By ROBERT J. SHILLER

President Obama is urging Congress to pass an $825 billion stimulus package as soon as possible. But even that may not be enough to stabilize the economy, since it fails to take into account the downward spiral of animal spirits that is underway and may continue to worsen. ( I TEND TO AGREE )

David Gothard

The term "animal spirits," popularized by John Maynard Keynes in his 1936 book "The General Theory of Employment, Interest and Money," is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings( INCLUDING HOW WE SEE THE GOVERNMENT ), and our sense of the extent of corruption and bad faith( RAMPANT ). When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people.( THE FEAR AND AVERSION TO RISK )

Fiscal policy adjustments are what almost all the pundits and the economic policy advisers have in mind when they say now is the time to pursue Keynesian policies. Especially now, when conventional monetary policy is ineffective( I DON'T AGREE. WE COULD PRINT MONEY. ), since short-term interest rates on safe assets are close to zero( ZIRP ), Keynesian theory would argue that the government should have a fiscal target. If spending would otherwise be less than full employment GDP, the government should put more money into people's pockets.( THAT'S THE PLAN )

But lost in the economics textbooks, and all but lost in the thousands of pages of the technical economics literature, is this other message of Keynes regarding why the economy fluctuates as much as it does. Animal spirits offer an explanation for why we get into recessions in the first place -- for why the economy fluctuates as it does. It also gives some hints regarding what we need to do now to get out of the current crisis.

A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others. In talking about animal spirits, Keynes sought to convey the message that swings in confidence are not always logical( RATIONAL ). The business cycle is in good part driven by animal spirits( YES ). There are good times when people have substantial trust and associated feelings that contribute to an environment of confidence. They make decisions spontaneously. They believe instinctively that they will be successful, and they suspend their suspicions. As long as large groups of people remain trusting, people's somewhat rash, impulsive decision-making is not discovered. ( TRUE )

Unfortunately, we have just passed through a period in which confidence was blind. It was not based on rational evidence( PRUDENCE ). The trust( I CALL IT WISHFUL THINKING ) in our mortgage and housing markets that drove real-estate prices to unsustainable heights is one of the most dramatic examples of unbridled animal spirits we have ever seen.

Furthermore, while animal spirits have been high over a very long period of time, a whole new system for the granting of credit had been generated. Some 30 or 40 years ago there was much less intermediation in financial markets. But then along came financial innovation and a new financial system, not just in mortgages and housing but throughout the credit system, with complicated strategies of securitization and use of derivatives. The more complex the transaction the more trust is needed to sustain the transaction. ( THE MORE PRUDENCE )

Then too, over the past several decades a vast "shadow" banking sector developed that engaged in the purchase and sale of such securities. To a great extent these traders borrowed short term at low interest rates against collateral of asset-backed securities, of which residential mortgage-backed securities would be just one example. What enabled them to do that? It was the animal spirits( WISHFUL THINKING BASED UPON GOVERNMENT GUARANTEES ). Those who loaned short to the shadow banking sector were confident. They thought they would be repaid. (They also thought they could insure against loss by the purchase of derivatives). They were trusting. But as soon as these lenders lost their confidence they were no longer trusting. It was like a classic bank run( YES. A CALLING RUN. ), but this time not on the formal banking sector but on those who borrowed short, and loaned long -- on the shadow banking sector. Lenders to the shadow banking sector wanted to be the first not to renew their loans.( TRUE )

The trust in the innovative lending practices was excessive; now that trust is replaced by deep mistrust. The wreckage of formerly towering financial institutions is all around us. Evidence of our overconfidence repeatedly appears in media stories, and thus we are constantly reminded that we were foolish to have been so trusting( IMPRUDENT ).

The danger at this point is that if the actions we take are not aggressive enough to have a substantial, visible impact on the economy, then confidence will continue to plummet( TRUE ). The Obama administration estimated its initial $775 billion stimulus package would shave about 1.8% off the unemployment rate from what it would otherwise be. Even so, by the time any package takes full effect the unemployment rate may be substantially higher than it is today.

So what must we do to revive our animal spirits and economic growth? We must be certain that programs to solve the current financial and economic crisis are large enough, and targeted broadly enough, to impact public confidence. Not only do we need a fiscal stimulus significantly greater than the proposal that is currently on the table, government action is also needed to take the place of the credit markets that seemingly worked so well when animal spirits were high. The Treasury and the Federal Reserve not only need a fiscal target, they also need a credit target. This should not be a dollar number( GOOD ), but rather a target for how the credit markets should behave. The goal should be that those who would normally receive credit in times of full employment can once again find it easy to do so, at rates with realistic risk premiums. ( OK )

There are three ways to restore these credit markets. The Treasury and the Federal Reserve have been inventive in applying all three methods. The first is the extension of rediscounting. The Fed has invented many different special loan facilities. They have even invented ingenious ways to combine Treasury money to make very large-scale loans while still within the legal requirement that the Fed can only lend against safe collateral when using TARP funds for the Term Asset-Backed Securities Loan Facility, which will support consumer, student and small-business loans. But so far the total amount of such rediscounting has been small relative to the size of the credit markets. They need to be much larger.( YIKES )

Second, so far more than $250 billion of government money has been used to recapitalize banks. But just making the banks solvent is not enough. The banks, whose managers are suffering from the same flagging animal spirits( I'VE CALLED THEM SHELL-SHOCKED ) as the rest of the economy, will not expand their credit much just because they are more solvent. The banks will only expand if they see profitable opportunities to grant loans and if their fear of failure is diminished. It will take much more than keeping the banks solvent to make them take on the disappeared credit flows. ( WE DON'T HAVE TIME )

And, finally, especially in considerably expanding the powers to support the lending of Fannie Mae and Freddie Mac, government-sponsored enterprises have replaced a significant portion of the mortgage markets. But the government should do much more here as well. For example, failed banks might be kept alive longer as bridge banks under government supervision with the purpose of making credit freely available.( A HYBRID. BAD IDEA. )

The interventions so far have been in the right direction. Federal Reserve Chairman Ben Bernanke has been especially inventive and aggressive. But the theory of animal spirits and the loss of confidence tell us that a great deal more still needs to be done. Now is not a time for the timid. To meet our needed fiscal-policy target, the Obama administration's fiscal stimulus should be much greater. And to meet our credit target, the expansion of special loan facilities, recapitalization of banks, and use of government institutions to grant credit where it has dried up must be on a scale great enough to overwhelm further doubts about the economy.( TOO MUCH )

In due course our animal spirits will once again turn positive, but we would rather that happen this year or the next rather than five or 10 years from now. There is only one way to speed this process: greatly expand governmental support of credit markets and pass a much larger fiscal stimulus plan than is now proposed.( I DON'T SEE IT THIS WAY. ALTHOUGH I AGREE ON THE APPROACH, I DISAGREE ON THE PARTICULARS. WE CANNOT AFFORD A HUGE STIMULUS OF GOVERNMENT SPENDING. WE NEED TO NATIONALIZE THE BANKS, AND HAVE A SMALL STIMULUS THAT WILL DO SOME GOOD, BUT NOT A LOT. WE COULD ALSO USE MONETARY POLICY. STILL, IT'S PLEASANT TO READ AN ECONOMIST THAT I FEEL SIMPATICO WITH. )

Mr. Shiller is professor of economics at Yale University and chief economist at MacroMarkets LLC. His new book, with George Akerlof, "Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism," will be published by Princeton next month."

our fear circuitry kicks in and panic ensues, a flight-to-safety leading to a market crash. This is where we are today.

From Freakonomics:

"This Is Your Brain on Prosperity: Andrew Lo on Fear, Greed, and Crisis Management

By Stephen J. Dubner

Andrew Lo

Andrew W. Lo is the Harris & Harris Group Professor at M.I.T. and director of its Laboratory for Financial Engineering. (Here are some of his papers.)

To my mind, he’s one of the most fluent guides to the state of modern finance in that he combines the rigors of a quant with a behavioralist’s appreciation for human intricacy( HUMAN AGENCY EXPLANATION ). He has agreed to write a guest post here (hopefully not his last — please encourage him!), an insightful look at how “extended periods of prosperity act as an anesthetic in the human brain,” lulling everyone involved into “a drug-induced stupor that causes us to take risks that we know we should avoid( WISHFUL THINKING ).”

Fear, Greed, and Crisis Management: A Neuroscientific Perspective
By Andrew W. Lo
A Guest Post

The alleged fraud perpetrated by Bernard Madoff is a timely and powerful microcosm of the current economic crisis, and it underscores the origin of all financial bubbles and busts: fear and greed( TRUE ).

Using techniques such as magnetic resonance imaging, neuroscientists have documented the fact that monetary gain stimulates the same reward circuitry as cocaine — in both cases, dopamine is released into the nucleus accumbens. Similarly, the threat of financial loss activates the same fight-or-flight circuitry as physical attacks, releasing adrenaline and cortisol into the bloodstream, which results in elevated heart rate, blood pressure, and alertness.( OK )

These reactions are hardwired into human physiology, and while some of us are able to overcome our biology through education, experience, or genetic good luck, the vast majority of the human population is driven( INFLUENCED ) by these “animal spirits” that John Maynard Keynes identified over 70 years ago.

From this neuroscientific perspective, it is not surprising that there have been 17 banking-related national crises around the globe since 1974, the majority of which were preceded by periods of rising real-estate and stock prices, large capital inflows, and financial liberalization. Extended periods of prosperity act as an anesthetic in the human brain, lulling investors, business leaders, and policymakers into a state of complacency, a drug-induced stupor that causes us to take risks that we know we should avoid( I AGREE THAT WISHFUL THINKING IS VERY IMPORTANT. HOWEVER, THOSE RISKS TAKEN INCLUDE CRIME, AND THE COMPLACENCY INCLUDES GOVERNMENT GUARANTEES AND EFFECTIVENESS. ).

In the case of Madoff, seasoned investors were apparently sucked into the alleged fraud despite their better judgment because they found his returns too tempting to pass up. In the case of subprime mortgages, homeowners who knew they could not afford certain homes proceeded nonetheless, because the prospects of living large and benefiting from home-price appreciation were too tempting to pass up. And investors in mortgage-backed securities, who knew that the AAA ratings were too optimistic given the riskiness of the underlying collateral, purchased these securities anyway because they found the promised yields and past returns too tempting to pass up.( SOME OF THIS IS CRIMINAL OR NEGLIGENT BEHAVIOR. )

If we add to these temptations a period of financial gain that anesthetizes the general population — including C.E.O.’s, chief risk officers, investors, and regulators — it is easy to see how tulip bulbs, internet stocks, gold, real estate, and fraudulent hedge funds could develop into bubbles. Such gains are unsustainable, and once the losses start mounting, our fear circuitry kicks in and panic ensues( I AGREE ), a flight-to-safety leading to a market crash. This is where we are today.( I AGREE COMPLETELY )

Like hurricanes, financial crises are a force of nature that cannot be legislated away, but we can greatly reduce the damage they do with proper preparation.( I DISAGREE. GOVERNMENT GUARANTEES AND BAGEHOT'S PRINCIPLES CAN RID US OF THIS PESTILENCE. )

Because the most potent form of fear is fear of the unknown, the most effective way to combat the current crisis is with transparency and education. In the short run, one way to achieve transparency is for our president-elect to convene a “crisis summit” once in office, in which all the major stakeholders involved in this crisis, and their most knowledgeable subordinates, are invited to an undisclosed location for an intensive week-long conference( NO ).

During this meeting, detailed information about exposures to “toxic assets,” concentrations of risky counterparty relationships, and other systemic weaknesses will be provided on a confidential basis to regulators and policymakers, and various courses of action can be proposed and debated in real time( NO. COLLUSION CENTRAL. ). Afterward, a redacted( YES. OF MEANING. ) summary of this meeting should be provided to the public by the president, along with a specific plan for addressing the major issues identified during the conference. This process would go a long way toward calming the public’s fears and restoring the trust and confidence that are essential to normal economic activity.( NO. GOVERNMENT GUARANTEES WILL. JAWBONING IS OF LIMITED, ALTHOUGH SOME, USE. )

In the long run, more transparency into the “shadow banking” system; more education for investors, policymakers, and business leaders; and more behaviorally oriented regulation( FINALLY. YES. ) will allow us to weather any type of financial crisis( I AGREE ). Regulation enables us to restrain our behavior during periods when we know we will misbehave; it is most useful during periods of collective fear or greed and should be designed accordingly( YES ). Corporate governance should also be revisited from this perspective; if we truly value naysayers during periods of corporate excess, then we should institute management changes to protect and reward their independence.( HOW ABOUT THEIR EFFECTIVENESS.)

If “crisis is a terrible thing to waste,” as some have argued, then we have a short window of opportunity — before economic recovery begins to weaken our resolve — to reform our regulatory infrastructure for the better. The fact that time heals all wounds may be good for our mental health, but it may not help maintain our economic wealth."

I disagree. Poor regulation and legislation result in a crisis. However hard and counterintuitive it is, we must address these issues in calmer times. This is no harder for a human to do than value investing.

"Moral of the story: If you want to design such a scheme and get away with it, make it legal"

As I said, I believe this. From Economix: "Do Bailouts Encourage Ponzi Schemes? By Utpal Bhattacharya":

"Say I convince my friend Elvis to invest $100 with me, promising to double his money in a month. Next I convince my friends Simon and Garfunkel. They each give me $100, and I use the $200 to pay off Elvis. Elvis is impressed and tells all his friends. I take $100 each from four of them — John, Paul, George and Ringo — and use the $400 to give back $200 each to Simon and Garfunkel. Suddenly everyone wants to invest with me. I take money from eight of them, then 16, then 32, and so on. When a lot of people are involved, I disappear with the money that I raised in the last round.

The scheme that I have just illustrated is called a Ponzi scheme. It is named after Charles Ponzi, who raked in $15 million in nine months in 1919 and 1920. At the height of his success, Mr. Ponzi was hailed by those he was cheating as the greatest Italian who ever lived. “You’re wrong,” he said modestly, “there’s Columbus, who discovered America, and Marconi, who discovered radio.” “But, Charlie, you discovered money,” they told him.

What is being called the biggest Ponzi scheme of all time was uncovered just a few days ago. The Wall Street legend Bernard Madoff is reported to have told influential investors that he could guarantee them a 1 percent monthly return. That promise probably sounded too good to be true — and it was.

Ponzi schemes — to the extent that people realize, even subconsciously, that something is not right — should work only if investors are irrational ( WISHFUL THINKING ). Investors in the last round know that they will lose their money when the organizer disappears with their funds. No one wants to play the last round, making the second-to-last round actually the last. Those people will refuse to take part as well. Using this logic again and again, no one should take part.

But sometimes our greed or our naivete trumps our rationality ( WISHFUL THINKING ). Almost a century after Charles Ponzi, people continue to fall victim to Ponzi schemes like the one attributed to Mr. Madoff. A recent Google search revealed more than 100 such schemes being investigated all over the world.

Not all Ponzi-like economic activity is bad or illegal.

Social Security, which involves the younger generation paying some of the retirement benefits of the older generation, is a perfectly legal Ponzi scheme.

Asset pricing bubbles, where the intermediary takes in a cut every round, is a Ponzi scheme grafted to a bubble, and they are legal. For example, when people take out mortgages they can’t afford, based on the expectation that their homes will continue to increase in value, they are engaging in legal Ponzi and bubble activity.( BECAUSE AT SOME POINT SOMEONE WILL BE WRONG? )

But what happens when the music stops and people find themselves playing the last round of the Ponzi game?( OOPS )

The federal government may chose to spend billions to bail out the last-round players to protect overall financial stability ( I BELIEVE SO, AND I BELIEVE MOST PEOPLE DO ). The Ponzi participants will get a piece of the bailout but will still have a net loss. The problem is that taxpayers have to foot the bailout bill, and they may have even greater net losses than the people who initially signed up for the Ponzi game ( AND? YOUR POINT BEING? ).

If taxpayers stand to lose more money than Ponzi players, it is suddenly rational to play the game. That’s because only by getting a piece of the bailout will Ponzi participants protect themselves from the larger losses faced by taxpayers( THAT'S A LOT OF PLANNING ). This is what happened in the early 1990s in nearly all the countries transitioning from communism: promises of state bailouts encouraged gigantic Ponzi schemes ( I SAY THAT IT WAS THE MAIN CAUSE OF THIS CURRENT CRISIS ). In Albania, it even led to a civil war ( IT MIGHT LEAD TO UNPLEASANT SOCIAL REACTIONS HERE ).

Therefore, while some Ponzi-like behavior is legal and even beneficial for our economy, bailouts only serve to reinforce behavior that can lead to even riskier Ponzi schemes( CORRECT ). So, though many of us recognize deals that are too good to be true, bailouts will encourage us to take part in such deals( THEY ENCOURAGE RISKY BEHAVIOR, WHICH IS THE CAUSE OF OUR CURRENT CRISIS. NAMELY, TOO MUCH RISK ). The $700 billion federal bailout may eventually lead to Ponzi schemes large enough to make Mr. Madoff’s reported $50 billion swindle pale in comparison ( WHICH IS WHY WE NEED TO CHANGE THE SYSTEM. I BELIEVE THAT WE CANNOT GUARANTEE BAILOUTS LIKE THIS ANY LONGER ).

Moral of the story: If you want to design such a scheme and get away with it, make it legal — like investments in subprime mortgages, or investments in energy from water. Then involve as many people as possible, so that it becomes “too big to fail.”( THAT'S WHAT I BELIEVE HAPPENDED ) Some of the $700 billion bailout money may actually be used to rescue some of your investors ( THAT'S HAPPENING NOW ).

I believe that the Implicit and Explicit Government Guarantees to intervene in a financial crisis are what explain the enormous risk by individual human agents that led to this crisis. This post lends credence to that belief, in my opinion.

"What does an auto industry default cascade look like? "

Tracy Alloway on Alphaville with a post about why the Automakers would be bailed out through TARP:

"What does an auto industry default cascade look like? Like this, from Bank of America:

And that’s the reason why the US government may well be considering bailing out the country’s flailing auto industry using Tarp funds, according to the Wall Street Journal. It may even go so far as to request the second tranche of the Tarp to do so, according to the article.

Why the desperation determination to bail out what seems like a dying industry? BoA’s Jeffrey Rosenberg explains:
A GM default with no [government] support could lead to payment defaults by GM to its suppliers. The most concentrated of these, Axle, provides little of its sales outside of GM so a default by GM likely cascades into a default at Axle, but becomes limited there. However, consider the exposure of Lear. Here, a default of GM could significantly restrict the ability of Lear to supply Ford. If a payment default from GM lead to a default of Lear and an inability to supply Ford, that could impair Ford’s ability to provide payments to other suppliers. Next, with Ford as its major supplier, Visteon could face payment difficulties.

…

The systemic risk argument of a set of cascading payment defaults is borne out in the close linkages between suppliers and manufacturers. However, as we have argued before, Debtor-In-Possession (DIP) financing helps to forestall such a systemic risk outcome by allowing companies to continue to operate, and in this case, to continue to make payments to their suppliers, and avoid such an event.

By BoA’s reckoning, it would take about £30bn in DIP financing to save General Motors alone (about 2 times working capital plus a £10bn cushion).

Does that seem like a lot? Yes, but when you see graphs like the above you start to understand why the government is concerned about systemic risk.

Of note however, is how potential DIP financing would work. The Fed Reserve has, under “unusual and exigent conditions,” the ability to lend to corporations on a securitised basis — though the funding requires a bankruptcy so the Fed and Treasury can obtain senior claim on all assets. Back to BoA:
Repayment of the loan would contemplate a restructured GM achieving long term viability such that loan proceeds could be paid off over time, say 5-10 years, refinanced or sold to the private market under demonstrated viability several years out.

A 10-year bet that the US auto industry will recover? A rather big gamble for the government (and taxpayers) then."

The gamble that the Treasury Dept. doesn't want to take is with employment and production falling off a cliff. The actual economic sense of the bailout, without Political Economy thrown in, is minimal, and rests on a great deal of Wishful Thinking. I've given pretty stringent requirements for the bailout, which I doubt will be met, but I understand the fear underlying this bailout.

If you believe as I do, that the government not bailing out Lehman caused a crisis of faith in the government's willingness and ability to get us all out of this mess, then you can understand why this bailout is necessary. If you don't think that this is what the underlying assumption and context really is, then I can easily understand your being against this bailout.

"demand for people who can actually judge credits on their own, rather than relying on ratings agencies and buy-side quants to do it for them. "

Felix Salmon on the Justin Fox post on low-information assets and high-information assets:

"Justin Fox has a great post on Bengt Holmström's distinction between low-information and high-information assets:

There are low-information assets--cash, bank deposits, money-market securities--where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets--stocks are the best example--where the value is highly uncertain, and every investor assesses it differently.

Securitization is the process of transforming low-information assets, like corporate debt, into high-information assets, like opaque CDO-squareds. And I think this insight is the best way of answering Richard Wagner's exam question about securitization:

The burden of non-performing loans is thus dispersed throughout the economy rather than residing with the original lender. Does this development weaken the incentive offenders of lenders to monitor borrowers and thereby weaken overall economic performance?

Classically, the answer to this question -- the one which all of Wagner's students gave -- was no. Investors in CDO-squareds, under the kind of assumptions commonly made by economists, have perfect information about all the underlying loans."

There comes a point when these assumptions become depressing rather than comical.

"In reality, of course, they don't. But more to the point, it's orders of magnitude harder to understand a CDO-squared than it is to understand a single loan -- and single loans are hard enough to understand themselves. You can start making correlation assumptions and the like in an attempt to simply matters, but that only pushes off the moment of reckoning: you still need to crunch a lot of data to come up with empirically-based correlation assumptions, and no one ever had either the ability or the inclination to do that."

They had a theory and a model, but not the data. Instead, apparently, they inserted data from other investments into their models.

"Financial innovation nearly always involves a move towards higher-information assets from lower-information assets. This is not a good thing. It's easy to say things like "don't invest in something you don't understand", but how on earth is anybody meant to understand something as high-information as the stock market, let alone things like CPDOs?"

I'm not sure of the point. Also, I'm beginning to lose the thread about High-Information. I'd need to know more about what else this phrase applies to. I'm also a bit confused about "understand".

"A lot of the boom in debt markets during the Great Moderation, I think, was a result of buy-siders being seduced by instruments which they believed required little if any sleeves-rolled-up credit analysis. Maybe one surprising consequence of the credit crunch will be an increase in demand for people who can actually judge credits on their own, rather than relying on ratings agencies and buy-side quants to do it for them."

I still believe that it was Wishful Thinking. However, I completely accept his conclusion.

"how do we explain an increase in optimism? "

Here's another take by Lawrence H. White on Casey Mulligan's notion of Optimism causing the Housing Bubble:

"If I understand him rightly, I don’t much disagree with Professor Mulligan. We agree that Federal Reserve policy acted to promote the housing price boom by lowering real interest rates. The difficult question is: what share of the boom can we attribute to monetary policy, and what share to other independent sources? Applying Professor Mulligan’s way of computing the impact of lower real interest rates alone on the present discounted values of houses, correct anticipation in 2002 of real T-bill rates — which were about to go 200 basis points lower for the next three years — can account for only around a six percent rise in house prices. Thus the milder-discounting effect by itself accounts for only a fraction of the actual run-up in prices observed, assuming correct anticipations. The present-value calculation is straightforward.

We can get a bit more impact out of lower interest rates by noting that the lowering of mortgage lending standards implied an even larger drop in risk-adjusted mortgage rates than in risk-free Treasury rates. Market participants did not have any clear basis in historical time series for anticipating that this drop would reverse itself soon.

Still, I agree that the joint hypothesis “real interest rate anticipations were correct and they alone fully explain the rise in house prices” is untenable. Of course, we already knew that anticipations of house prices could not have been correct, given that nobody would pay $300,000 for a house in 2006 that he knew would be worth only $200,000 two years later. "

I agree with this. No Spigot Theory.

"Professor Mulligan reasonably proposes to attribute the bulk of the rise in house prices to some kind of ex-post-mistaken (but not necessarily irrationally exuberant) anticipations, offering the hypothesis that “it was optimism that raised housing prices, not much of anything tangible during the boom. Whether it was optimism about future interest rates, future tastes, or future technology is more of a quibble.” Optimism about “tastes” here includes optimism about the future growth of demand in particular local housing markets. Something like that would seem to be required to explain why the house price boom was so highly concentrated in a few states. We can’t explain such concentration by appealing only to optimism about technology or national economic policy variables.

An appeal to optimism, of course, doesn’t really explain events but simply gives us a reframed question: how do we explain an increase in optimism? I suggest that optimism (regarding whatever) during this period was not independent of the rising rate of aggregate nominal income growth that was being fueled by Fed policy. Expansionary monetary policy may have (at least cyclically) effects on relative prices and real variables, like the real demand for houses, through income channels, not only through its effect on the real interest rate. I anticipate, and agree, with Professor Mulligan’s likely response that more needs to be done to quantify these other effects."

There seems good reason to believe that their was such an overabundance and overly magnified aspect of Wishful Thinking in this current situation. However, for the explanation, we need to understand the presuppositions, assumptions, and context of this explosion of Wishful Thinking. I believe that a lot of it comes down to an overestimation of what government can do, and simply thinking of the actors in this drama as free market adherents misses the true nature and assumptions of their belief system, which includes plenty of government intervention when it's in their interest.

"it will be because scores of people made outsize bets on his prowess without taking the time to fully understand what they were investing in."

Here's a post in the NY Times by Ron Lieber and Tara Siegel Bernard that counsels against Wishful Thinking:

"When wealthy investors are willing to hand over a sizable sum to a single money manager they heard about at the country club, certain first principles of investing bear repeating."

I worry about first principles when I invest five dollars.

"That manager, Bernard L. Madoff, is accused by the Securities and Exchange Commission of running a fraud scheme that may be the biggest in Wall Street history. But if it ends up in the record books, it will be because scores of people made outsize bets on his prowess without taking the time to fully understand what they were investing in."

Just please don't tell me that they didn't know that these investments were risky. That's not on.

"All investors, but especially those with a high net worth, need to maintain a healthy sense of humility about their level of ignorance. Alternative investments, whether they are hedge funds or venture capital or private equity, can be complicated. They contain unpredictable levels of risk. But all too often, people are willing to overlook those risks because, well, everyone else is doing it. Or they simply place too much trust in too few hands."

All of this falls into Wishful Thinking: These investors ignored reality. They knew that the investments were risky, but were willing to look the other way for higher returns. These investments can be complicated to understand, but their being inherently risky is not.

"Thankfully, outright fraud is pretty rare. It is not every day that a Wall Street legend like Mr. Madoff is arrested and accused of running a multibillion-dollar Ponzi scheme. And by the time something like that happens, it is too late for investors with their life savings caught in the mess to escape the impact."

Here's more Wishful Thinking, that will lead to some criminals avoiding detection. There's no way to know the exact level of Fraud a priori.

"But there are plenty of strategies you can employ to lessen that impact or, better yet, avoid getting ensnared in this kind of situation in the first place. Here are a few:"

Don't have more than a few, unless you plan to organize your whole life around them like religious practice.

"5 PERCENT Any investment has at least a remote possibility of going to zero or close to it. But when you are dealing with hedge funds and other exotic fare, the risks can be bigger, for reasons like leverage and strategy or lying and stealing.

That means that you should never put more money in than you can afford to lose. Say, 5 percent of your net worth, or better yet, 5 percent of your liquid net worth. Losing that will hurt, but it will not maim.

“We have always gone with 5 percent or less because if it is a total wipeout, someone can still sustain themselves with 95 percent of their capital intact,” said Ian Weinberg, president of Family Wealth and Pension Management in Woodbury, N.Y. "

Fine.

"HUMILITY Investing, in general, requires humility. Few people have enough of it. It is the reason so few people put most of their money in index funds, which track various asset classes rather than trying to pick the winners in each.

One problem with hedge funds is that they appeal to all the wrong instincts. They are for the privileged. Investors need to have a minimum net worth to qualify. In the case of the money managed by Mr. Madoff, many people seemed to have gotten in on it by belonging to the right country club.

“He was dealing with extremely wealthy individuals,” said Harold Evensky, president of Evensky & Katz, a financial planning firm in Coral Gables, Fla. “All too often, they make relatively easy marks because the pitch is, ‘You’re special, you can get something that other people can’t get.’ ”

But you are probably not special. Bill Gates is special, and he is the beneficiary of the best investment opportunities from the smartest people in the business. The Ford Foundation is special. The people who run Harvard and Stanford and Yale’s endowments are special.

You, however, are probably hearing about the second- or third- or fourth-tier ideas in the world of alternative investments. That does not mean the managers pitching them cannot make them work. But be honest with yourself: if you are in on them, how special could they really be, given the enormous demand for truly unique investment opportunities?"

This one is decidedly hard to get across. If you're rich, then you must know what you're doing. To me, it's largely luck.

"SMARTS You may be rich and you may be smart. But smart about this sort of investing? Not so much.

“I think a lot of millionaires, maybe they inherited a couple of million or they didn’t earn their money through any investment savvy,” said Milo M. Benningfield, a San Francisco financial planner. “A lot of those people have money and are extremely vulnerable, in part because they’re supposed to be smart because they have money. It’s a paradox.”

There is no shame in not understanding Mr. Madoff’s split strike conversion strategy. Admit your ignorance, question your investment adviser’s certainty and seek a plain English explanation of the opportunity that is in front of you. "

Lovely. It is a Paradox. You should definitely have a plain English and clear and truthful explanation of the investments and risk before investing in anything. It defies credulity that you have to tell people this.

"RESEARCH Doing your homework on a sophisticated investment opportunity is not always easy. Your financial planner or wealth manager may not have the time or the skills to do a thorough investigation, either.

On Thursday, a hedge fund research and advisory firm called Aksia L.L.C., sent a letter to clients reminding them of all of the red flags it had uncovered about Mr. Madoff’s operation long before his arrest. Aksia was not the only entity to sound the alarm, and its note has a bit of a chest-beating, self-congratulatory vibe to it.

Still, it is a great read. (It is linked to the version of this article at nytimes.com/yourmoney.) And it is a reminder that having some sort of expert on your team, or your investment firm’s team, is a pretty good idea.

If you are game, you may even accompany your designated experts as they visit the entity that is promoting the opportunity. “We encourage them to join us,” said Simon Fludgate, the head of operational due diligence at Aksia. “We were told explicitly that you cannot go to see Madoff.” The barring of such field trips was one of many bad signs."

He was like the Wizard of Oz.

"SECRETS One hard part about investing in hedge funds is that some of the most successful ones will not say much about how they work. If they disclose too much about their tactics, others will copy them and their investors will be hurt. (So will the managers’ take-home pay.)

Not all of them behave this way, though. “Most of them are willing to be very open with us,” said Thomas Ruggie, a certified financial planner in Tavares, Fla. “If they are not willing to be fairly open, that typically causes us to shy away from moving forward with that company. We have two hedge funds that send us quarterly audited reports on everything they’ve done.”

While Mr. Madoff’s supposed returns were fully available to all, investment advisers were less successful in understanding how he did what he did. “I knew that their returns were always good, but I knew that nobody could explain how they made their money,” said Mr. Weinberg. “In our attempts to look under the hood, it was impossible to ascertain what they were doing.”

That kind of secrecy may soon prove to be less of an issue, though. Given the billions of dollars that may have disappeared under Mr. Madoff’s watch, regulators are likely to take an interest in what went on behind the scenes — and make it easier for investors to find out for themselves in the future. "

This one's easy mate. They didn't make money. Game over.

Again, Wishful Thinking is necessary for Fraud. There will generally be many warning signs that are ignored and avoided, as if investigating them would lead to jinxing the investments.

"To take it at face value is a bit naïve."

As I thought, there's endless reporting on Madoff, so I'm just going to pick out tidbits that interest me. Here's Paul Kedrosky:

"More Madoff Near-Misses: Barron's, MAR/Hedge, etc.

A Barron's story from 2001 is being forwarded everywhere today. In it, the publication came close to nailing the Madoff story almost eight years ago. Here is a key paragraph:

Still, some on Wall Street remain skeptical about how Madoff achieves such stunning double-digit returns using options alone. The recent MAR Hedge report, for example, cited more than a dozen hedge fund professionals, including current and former Madoff traders, who questioned why no one had been able to duplicate Madoff's returns using this strategy. Likewise, three option strategists at major investment banks told Barron's they couldn't understand how Madoff churns out such numbers. Adds a former Madoff investor: "Anybody who's a seasoned hedge- fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve."

More here, and the original MAR/Hedge story that seemingly sparked the Barron's piece is here.

And while I'm on the subject of Bernie Madoff near misses, an insider view from someone who did due diligence and walked years ago."

This is an example of Wishful Thinking. You see what's going, but choose to ignore it, on the hope that you'll be wrong. It's very common, which is why people who commit fraud can use it so effectively. It's a bit like the magician using expectations to fool people.

"that it was optimism that raised housing prices, not much of anything tangible during the boom."

I often find myself agreeing with Casey Mulligan, although I'm not sure why. But once again, I agree with his basic point:

"Professor White showed that one-year real interest rates were low during the housing boom. That’s a good starting point because, if the Fed can affect anything real, it is the short-term interest rate. Now let’s use that information to demonstrate that the impact on housing prices is minimal.

Since I will demonstrate that the housing-price impact is small, I will assume that the supply of housing is fixed; an elastic supply of housing would only reduce the price impact below what I calculate here.

Each house in place today produces services for a number of years. To a good approximation, we can assume that each house lasts forever, except that it depreciates exponentially (but slowly). The market value of the house is the present value of those services. Low interest rates can raise housing prices (although not much), because future services are discounted less.

Suppose that annual real interest rates were going to be one percentage point (100 basis points) lower for a year. Then the cost of buying a house, holding it for a year, and then selling it would be essentially one percent less. The low one-year interest rate would not affect the selling price at the end of the year because, by assumption, the reduction lasted only for a year and the next buyer will be back to normal interest rates. So the source of benefit from the low rate is that the initial buyer reduces the carrying cost for a year.

A 100-basis-point-lower interest rate for one year would justify paying about $202,000 for a house that would ultimately be worth $200,000. A 100-basis-point-lower interest rate for two years would raise purchase prices by about two percent. (Actually, it would be less, because of the discounting of the second year, not to mention the supply response.) A 200-basis-point reduction for two years would raise purchase prices by less than four percent, etc.

Thus, interest-rate reductions for a short horizon do raise housing prices, but not much by the standards of this recent housing boom when housing prices were tens of percentage points higher (according to Case-Shiller, practically 100 percent higher). A house that would ultimately be worth $200,000 was actually selling for something in the neighborhood of $300,000.

Perhaps Professor White would argue that market participants expected short term interest rates to remain low for much longer than a couple of years. If so, he is on shaky ground. First, such a claim is at odds with long-term interest-rate data. As I indicated in my article, long-term mortgage rates were not low during the housing boom. It’s not hard to find commentary from those years recognizing the low short-term rates were not expected to last."

I agree with this. The low interest rates do not explain this crisis. At best, they are a necessary condition.

"Second, such a claim gets closer to my hypothesis: that it was optimism that raised housing prices, not much of anything tangible during the boom. Whether it was optimism about future interest rates, future tastes, or future technology is more of a quibble."

What does optimism mean?

1.	a disposition or tendency to look on the more favorable side of events or conditions and to expect the most favorable outcome.

2.	the belief that good ultimately predominates over evil in the world.

3.	the belief that goodness pervades reality.

4.	the doctrine that the existing world is the best of all possible worlds.

It would seem that it is 1 that he means. The most favorable outcome in:
1) Interest Rates
2) Future Tastes
3) Future Technology

I prefer "wishful thinking":

interpretation of facts, actions, words, etc., as one would like them to be rather than as they really are; imagining as actual what is not.

I prefer this phrase because I believe that people knew that they were taking risks, but chose to ignore them. There was a real disposition to ignore reality and history and even common sense.I'm not quite sure that they were optimistic. There was too much uncertainty in the world and too little faith in the Bush Administration for optimism. I hope that I'm making the difference clear.

I believe that much of this malady has to do with a general belief in the incompetence of the Bush Administration. So, my views, they don't qualify as a theory, predict that there will be a major change in the perception of our situation after we have left President Bush behind. The swearing in of President Obama should lead to more optimism, if you will, than we see now. I don't like how many predictions I've given on this blog. Perhaps it's time to sign off.