(image by Bill Black)
Reprinted from neweconomicperspectives.org
John Coates, a former derivatives trader at Goldman Sachs is now a researcher. He wrote a column in the New York Times entitled "The Biology of Risk" that I hope will be widely read.
In this column I explain why his most important conclusions cannot follow logically from his own description of his research finding. While he relies on blood tests, his account of trading when it goes horribly wrong is curiously bloodless and disingenuous. As a Goldman and Deutsche Bank refugee he knows better, but he presents a sanitized version of the crisis portraying the controlling officers and traders at the largest banks as helpless victims of raging hormones rather than fraud perpetrators and facilitators.
Coates' description of the crisis as triggered by a biologically-induced excessive risk-aversion on the part of traders rests on a failure to understand why varieties of financial risk are vastly different. More fundamentally, he fails to even consider the facts (and relevant literature) demonstrating that the key financial participants were engaged in a series of "sure things" accomplished through accounting control fraud and cartels.
"Risk," particularly Coates' false implicit assumption that "risk" is a single concept in the financial sphere, has almost nothing to do with the current crisis, any more than it had to do with the Enron-era crisis or the second (and vastly more destructive) phase of the savings and loan debacle. Further, but for the recognition of S&L regulators that we were dealing with an epidemic of accounting control fraud and the resultant "sure things" the S&L debacle would have grown to resemble closely our most recent crisis in terms of its magnitude and damage.
Coates work is not flattering to finance in the conventional form of flattery. He essentially says Michael Lewis' description of the "culture" in Liar's Poker is correct -- traders are males who act crazy because they are selected by crazy male bosses. Coates reports that traders have raging hormones and that these hormones vary and tend to be convergent. It is a measure of finance's desperate search for praise that Coates' work is warmly received by big finance. The attraction is that it serves as an apologia for their culpability. We're not crooks -- we're perpetually pubescent prisoners of our pituitaries. White-collar defense attorneys are already seeking to present behavioral finance and neuroscience defenses to prosecution.
Coates Relies on Implicit (False) Assumptions
Coates was subjected to the disastrous training about finance provided by failed finance theory, Goldman Sachs, and Deutsche Bank, and has gone on to specialize in studying biology, so it is not surprising that his key errors are in finance, criminology, and logic. He was taught, for years, to think about finance in a manner that was not simply incorrect, but dangerously false. Because so much of his work relies on implicit assumptions he is blind to when those assumptions are false. When we make implicit assumptions we cannot test those assumptions and challenge ourselves to support them with facts and logic. Reliance on (false) implicit assumptions is the hallmark of why theoclassical economics fails to learn from its catastrophic errors that shape the criminogenic environments that drive our recurrent, intensifying financial crises.
Financial Risks Vary Widely in Ways that are Critical to Crises
Throughout his article, Coates implicitly conflates "risk" with "volatility" and treats "risk" as a single, uniform concept. Financial risks, however, vary enormously in ways that are critical to understanding crises. They can all produce volatility, but that is an effect of a complex interaction of a vast number of factors. A measure such as purchasing credit default swaps (CDS) that might protect an investor against some types of risks will fail entirely against other types of risks even if they produce the same (initial) volatility. When the protective measures fail, that failure will produce much greater volatility.
Risks with Negative Expected Values: Gambling against the House
There are many risks that have a negative expected value. Gambling against the House is a common example. Gambling against the State (lotteries) has an enormously negative expected value. Most forms of control fraud produce an extremely positive expected value from the perspective of the firm or NGO. From the perspective of society, of course, such frauds produce a negative expected value. Accounting control fraud produces an exceptionally negative expected value for the firm or NGO as George Akerlof and Paul Romer explained in their 1993 article ("Looting: The Economic Underworld of Bankruptcy for Profit") and as I have explained many times. The accounting control fraud "recipe" for a lender, or purchaser of loans, explains why this is true and why it produces the three "sure things." The fraud recipe guarantees (1) record (albeit fictional) reported profits in the near term, (2) the controlling officers will promptly be made wealthy by modern executive compensation, and (3) and the lender (purchaser) will suffer severe losses, though it will only recognize those losses years later.
The fraud recipe produces severe "adverse selection" because its second "ingredient," grow like crazy by making (purchasing) really crappy loans with a premium yield, requires the lender (purchaser) to gut its underwriting system and controls. When one guts underwriting and controls one makes adverse selection severe. (This is most true in long-term real estate lending.) We have known for centuries that adverse selection in lending produces a negative expected value.
Conflicts of interest also produce loans and investments that have a negative expected value.
Risks that Have a Zero Expected Value
Some financial risks have a zero expected value. Taking interest rate risk is a good example of this kind of risk. There are, and will be, many claims that there is a sure thing strategy that investors can follow to make money by taking interest rate risks, but these are scams. If there were really a "sure thing" strategy for making money by taking interest rate risk the creator of the strategy would have most of the world's wealth within a year.