Book Club – Panic (Review #2)

(This is written by another Finance PhD Student.)

I didn’t intend to write a review of Michael Lewis’s anthology of financial journalism, Panic!, but at the insistence of a couple friends, I was compelled at least to offer up some comments.
Given the constraint that it’s a collection of mainstream press articles, the book does a reasonably good job of exposing how investors often repeat past mistakes and subsequently attempt to discern how they went wrong by distinguishing causes among a vast number of moving parts.  These articles do a pretty good job of explaining some technical transactions without boring the reader too much.
Ultimately, most of the articles are business magazine pieces, written for a more-informed-than-average reader, who would nonetheless struggle to explain what a put option is.  I’m willing to give that kind of article a bit of slack in explaining the technical details of the Black-Scholes model.  The average Fortune reader doesn’t really need to know that the most-widely used options pricing model depends on assuming that stock price variance is normally distributed.  It should be good enough for that target audience (and probably the same target audience for Panic!) to know that Black-Scholes is a theoretical model based on complex math, which occasionally diverges disastrously from a messy reality.   It’s pretty hard to write a good piece on derivatives for the lay person without being terribly dull, given that the phrase “historical standard deviation” probably blows over most people’s heads.  There are some really technical transactions described in this book, and some are definitely better explained than others, but on average, the coverage is pretty solid.
Ultimately, we’re talking about a major problem of human psychology.  People continue to make similar mistakes repeatedly—it’s part of the human condition to believe sincerely that we’ve learned something dramatic about our last biggest mistake and vow never to participate again.  But these mistakes are repeated because we forget the pain of the past, and there’s always a new generation that didn’t participate in the last implosion that needs to learn for themselves.  (We always think we’re smarter than the people that have gone before us and won’t get caught like the earlier stooges.)  While I recognize that the articles suggest that there are lots of greedy investors and institutions gambling for short-term gains, it’s terribly misguided to think that they are “idiotic, brainless, and lacking in critical thinking skills.”  It’s easy to make that criticism while sitting on the sidelines or in hindsight, but a lot tougher when you consider the constraints and pressures that come with being a player in the market.   There are plenty of smart people who face a tough balancing act correctly evaluating short- vs. long-term values.
If I had a major complaint about the book, it’s that I’d have liked a little bit more coverage of systemic nature of the financial marketplace.   It is important to understand, at a base level, how the freedom of capital movement creates and exacerbates financial bubbles and crashes.  I love being able to walk into one bank and move my savings to another bank with a higher paying interest rate.  I love the freedom to sell one shitty stock to buy into a better company.  But that freedom, spread through all investors, has the systemic characteristic that pushes societal investments towards short-term gains.
Ultimately, one of the understated issues in all of this is improved financial liquidity and freer capital movement.  Because it’s easier for capital to seek out the best marginal gains, an entire industry has developed to attract and deploy that capital.  The institutional investor, looking to attract capital because their personal compensation packages are correlated with the size of their fund, is under enormous pressure to deliver immediate returns.  Underperform and the capital flight renders the fund manager without pay.   (I’m not going to argue that the compensation structure for fund managers is “right” (in all senses), but I’ll accept it for what it is, while appreciating that it makes some sense to correlate pay with performance.)  But it’s ultimately the freedom of capital to seek out the best returns that creates the competition for them.  It’s a basic characteristic of our economy.  I’m not here to apologize for or condone everything that has gone on.  There was plenty of greed, fraud, and innocent victims.  But much of that is made possible by this freedom of capital.
It’s possible that some capital movement restrictions help reduce the frequency and depth of bubbles and panics.  Trading curbs, for example, restrict capital from fleeing equity markets during dramatic declines in value.  They offer investors a moment’s pause to consider the larger picture, a moment to evaluate whether the market is reacting to a true change in the world, or simply anomalous herding behavior.  Through the curbs, we’re slowing down capital movement, giving investors room to process changes in a complex, fast-moving world and hopefully alleviating the pain involved in a stock market crash.
Alternatively, consider the impact if people weren’t allowed to make investments because they don’t have sufficient capital reserves.  What if we had laws that prevented us from engaging in risky financial bets?  While I don’t explicitly suggest that we need more regulation, there are federal laws that prevent most of us from directly investing in hedge funds.  Only accredited investors, high net worth people, may directly participate in risky investment vehicles like hedge funds.  At a base level, that’s a capital movement restriction.  If we removed these kinds of restrictions, how significant would the market implosion have been if there was even more competition for capital?  If we tightened the restrictions, perhaps by requiring a 20% down-payment on a house, how minimal might the housing bubble have been?  I’m definitely not advocating substantial capital restrictions, directly.  But I tend to think that a Consumer Protection Agency would probably have an indirectly limiting impact on capital and that might not be such a bad thing.  And it would have been worth discussing that more in the book.
I might have gotten off on a tangent there.  I really enjoyed the collection of high-level articles covering some of the financial issues we’ve gotten depressingly familiar with in the last couple years.  I might have liked to see more treatment of some basic and systemic ideas, but I think that Lewis’s compilation provides a valuable coverage of how the symptomatic issues can create an bubble environment and how our system might be poorly set up to evaluate the big picture.

Other reviews can be found here and here and discussion here.

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