Friday, June 17, 2011

Wildfire (again)

I wrote this article years ago, after the fall of the Northern Rock bank in England, which was the first run on an English bank in a hundred years. A while later, when it looked as though Greece was going to default on its debts, I put it back to the top since it had started to look like a prophecy.

It's now 17th June 2011. Last year Greece was bailed out on promise of economic reforms, but those reforms were exceedingly unpopular and have just brought down its government and it is again on the verge of default. The IMF has refused to supply money, effectively blackmailing Germany into paying Greece's debts.

This isn't a long term solution. The problem will recur. Similar problems have occurred in Ireland and Portugal, and been 'solved' by similar methods. The longer this sort of solution is attempted, the more catastrophic the eventual reckoning will be.

Note of 10th May 2010

I've put this back to the top because of the financial crisis in Greece. It was originally written after the UK banking crisis that turned into the (first half of the most recent) depression. Sovereign debt default is the next stage of an inevitable process. We have to ask ourselves whether it is better to take the hit now, or put the crisis off again. Next time there may not be an entity large enough to organise a bailout.

I'm going to stick my neck out and make a prediction. Today is 10th May 2010. I predict that either Greece will default on its debts, or the EU will bail it out, and then within the next five years other EU nations will default. The resulting financial effects will domino, and there will be widespread bank defaults. No government will be able or willing to guarantee the banks this time. The turmoil will cause Japan to default on its debt, and the result of that will be a terrifying financial apocalypse the like of which has never been seen. There will be revolutions and wars. 

Original Article:

There are few good arguments from analogy. Anyway, here's mine:

Once upon a time, the forestry service put out wild fires.
Nowadays they start them.

Once upon a time, banks built solid marble buildings with Doric columns.
Nowadays they rent cheap offices with plastic chairs and nasty carpets.

And I think these facts are related.

Let's look at the war going on in the woods.

The natural enemies of plants are trees. If you have an expanse of open earth, the first things that grow there will be grasses and nettles. Grasses grow fastest of all, finding new earth with their wind-blown seeds and rapidly colonizing everywhere they can fix roots.

Nettles are next. Nettles have the trick of making poisons. Grazing animals don't eat them. Because animals eat the grass, the nettles are taller than the grass. So they can see the sun. Whilst the grasses, being short, die in the shade of the nettles.

A patch of open earth will soon be covered in grass. Soon after that it will be covered in nettles. The thick covering of nettles means that the grazing animals will not go there.

This opens up a place where trees can grow. Trees have the knack of making wood. Wood allows them to grow taller than the nettles. The trees get so tall that they can rise out of the nettle patch entirely, and then begin to spread their branches wide, spreading a vast carpet of leaves. Blotting out the sun. The nettles, which protected the trees from the grazing animals, die. But by this time the trees have grown so tall, and with such thick bark, that the grazing animals can't reach any edible bits of the tree. So the patch is covered in trees. And this is the final state of the world.

So we might wonder why grasses and nettles still exist, if they always lose.

The answer is fire.

A forest fire is an awful thing. Dry trees burn very well, and there is sufficient wood to create an inferno which is hot enough to set light to a tree.

Every so often, even in the oldest and most permanent forest, there will be a period of drought. The trees will become so dry that a lightning strike can set one burning. And the flames will set light to a nearby tree. And the fire will begin to rage through the dry woods, incinerating everything in its path. And nothing will stop it. Not even the arrival of the rains. Until the whole of the forest is a smouldering wreck, and everything is dead except the fire-tolerant seeds hidden in the ground.

Which will begin to grow. Grasses grow fastest, because they don't need to make wood or poison. But grazing animals eat them........

A forest fire is a dreadful thing. It moves faster than you can run. It destroys everything and everyone. You never want to be anywhere near one. Nothing escapes but birds.

So the forestry service used to put out forest fires. And this was a very good thing.

But the trees grew and kept growing until the density of wood in the forests was so high that one day there was a forest fire and it had so much fuel to feed on that the foresters could not put it out. And because there had not been a fire for so many years, a lot of people had got a little careless, and built their homes in the woods.

And the fire that burned was bigger and fiercer than a normal forest fire, because there was so much wood. And you do not ever want to be near even a normal forest fire.

So these days the forestry service starts forest fires. They keep the density of the trees low, and if you are skilled in the ways of the woods you can predict where the fires will go, and to an extent control them and protect people.

You never get the embarrassing situation that happens when there hasn't been a dry patch for a while, and lightning hasn't felt like striking much, and the woods are overgrown and dry and waiting like a tinder box for the spark that will unleash hell.

And who knows if this latest innovation of the foresters will have an unintended side-effect? So far it seems to work well.

What about banks?

Banking is a very risky business. You borrow money from people. And you lend money to people. But there is no symmetry.

People lend you money so that it will be safe. Once upon a time, you would build a nice strong building and charge people to keep their money in it, where it would be safe. This model has fallen out of fashion. But at any rate, people's primary motivation is that their money should not fall into the hands of the sort of person who is forever talking about giving it to the poor but whose favourite Maid is suspiciously well dressed for a girl who lives in the woods.

So you are sitting in a nice strong building full of money. And you can practically hear the outlaws plotting in the woods about tunnels and bulldozers and other ways of making what is inside the building cease to be inside it.

So you need to find some way to get rid of the stuff. And it turns out that there are plenty of people who are willing to take it off your hands and keep it safe for a while themselves. They do this by buying houses and setting up businesses and other wholesome things, and they have promised to pay the money back slowly, with some interest, and most importantly both you and the Sheriff know where they live.

And everything is going so swimmingly that you can barely believe your luck, until Crazy Jake walks into a bar and tells everyone that Mr Shylock put all of the town's money into a scheme to mine gold in the hills and it turns out that there ain't no more gold in them thar hills and all the money is gone.

Now Crazy Jake is a big fat liar. At the most you only put a very small amount of spare money of your own into that scheme and yes, it is gone, but no one need care particularly because there is plenty of money in the bank to go round.

But people are a suspicious lot, and a few people pop round, not at all concerned, really, to ask for their money back so that they can keep it under the bed instead.
And a few people come round as normal to ask if they can have their money back because they have bills to pay.

And towards the end of the day you realise that the bank is out of cash. But everything will be alright tomorrow, you promise, because there are lots of interest payments on loans due in.

Tomorrow there is a line round the bank half a mile long. Because a couple of non-crazy people have been talking about how they asked the bank for some of their money back and the bank didn't have any money.

And you are a dead man. If you don't actually get hung from a lamp-post on the spot, you will be carted off to a dungeon somewhere and kept there forever. Crazy Jake has killed you as randomly and with as little malice as a lightning bolt hits a tree.

And the only people who are happy are the people that you lent all the money to, because their creditor is dead. And maybe the mess will all get sorted out eventually and they will be paying their interest to the people who've lost all their money by trusting it to you. And maybe it won't.

This is called a bank run, and it is why banking is a risky business.

Bank runs used to happen all the time. You can see black and white footage of huge queues round banks. Bank runs feature frequently in Westerns.

Banking is a very risky business, entered into by gamblers of the bravest and most reckless kind.

There is no way round it. The problem is that you are making money by lending long term and borrowing short term. That is what a bank does. If you aren't doing that, you aren't a bank.

Imagine that you are a gambler of the most reckless kind, who has a way to make large amounts of money at the price of occasionally and unpredictably being hung from a lamp-post.

To make it work, you need to get people to trust you with their money. These people may or may not be fools, but they certainly know about bank runs. They know that if a bank is behaving recklessly, it may suddenly cease to exist.

What should you build your building out of?

You should build it out of stone. And you should face the stone with marble. It should look as though it has been built out of pure money, by people who have lots of money, and intend to be around for a very long time.

Sober, serious, professional people. People who wear suits.

The minute you start to express the slightest bit of creativity, imagination or flair, the minute you're caught renting an office, as though you hadn't got the slightest intention of lasting for ten thousand years, then people will begin to take their money out and put it with more serious people. And we know what happens then.

Now once upon a time, this was what banks looked like. English towns are full of great big solid old banks built along classical lines, with lovely solid sounding names like 'The Trustees Savings Bank", or "The National Westminster Bank". Boring as hell, but lovely safe places to trust with money. Of course, they weren't actually. That's why they had to try so hard to look as though they were.

When I was a little boy, there was a new bank startup in England called "William's and Glyn's". I thought that that was a really nice name, and sounded very human and decent. They offered high interest rates and good service and they advertised heavily. And my father wouldn't put his money anywhere near them, because they sounded like they were just a couple of guys who'd started a bank.

But nowadays, banks don't look all solid like they used to. All the lovely solid marble buildings that look as though they will last for ten thousand years have been converted into public houses.

The last time I went into a physical bank, I found myself sneering at the crappy quality of the furniture. And anyone who knows me will tell you that I am not one to care too much about the quality of furniture. But this stuff was made out of formica, and it wobbled.
They don't even have sensible names any more. They're called "Natwest" or "Floyd's TSB" or "Egg". They're behaving like people who've been christened Thucydides by unworldly parents, and who have decided that they prefer to be called Diddy.

What has changed? Nothing recently. There hasn't been a serious bank run for years and years.

What has happened is that recently, the folk memory of bank runs has vanished. No one can remember what they were any more. So trusting money to a bank has stopped being scary. It will be safe. They will look after it carefully.

In fact trusting money to a bunch of gamblers to gamble with has started to seem like the boring option. Real men stick their life's savings in stocks and shares, or in exotic derivative instruments like property prices in areas where no more property can be built. Safe as houses.

What changed?

Government got involved in banking. A government can prevent a bank run. All it has to do is say: "Don't worry about your money. We guarantee that we will pay it all back if the bank fails."

The government can make this guarantee, because it has guns and tanks. So if it needs money it can steal it.

So if the government makes the guarantee, it is believed. Panic over. No-one needs to worry about whether their bank is solvent. No bank runs.

That's why we haven't seen a bank run in a while.

I believe that bank runs work the same as wildfires:

Lightning struck a while back. Through heroic efforts by all the governments in the world, a vast amount of money was stolen, and the fire was put out by pouring all this money over it. No one got hurt.

But the woods are still full of dry tinder. Be very afraid.

Thursday, June 9, 2011

Overconfidence Bias

The other day, a friend and I are out throwing cricket balls to one another.

I believe that when practising a skill, you should set the difficulty of the thing you're practising to the point where you fail one time in ten. Then you're getting positive emotional reinforcement from your successes, while constantly practising things that are still challenging, and pushing yourself periodically. If you're practising a skill that is in fact dangerous, then this also gives you a reasonable chance of avoiding injury, if the usual failure case is to not get injured.

I felt that the throws Joe was giving me were getting below the one in ten level, i.e. I seemed to be catching most of them routinely without having to try too hard, and I was about to ask him to make them harder.

Instead, we started counting successes and failures.

Over the next twenty or so throws, the total number of catches was 14, and I dropped the ball seven times. i.e. the true rate was about one in three.

Both Joe and I thought that this was due to getting freaked out by suddenly making success/failure a thing that was noticed, or possibly getting distracted by the effort of counting. So we carried on. Neither of us thought that the throws had got more difficult because of the counting.

Over the next twenty throws, the proportion of catches rose, until after about seventy-five, the proportion was 60 to 15. I'd completely stopped worrying about counting, and I'm pretty sure that the effort of remembering the two numbers wasn't interfering.

I think we were observing learning actually happening, as the rate changed from one in three to one in four.

We ended the session there, since we were both bored, but I really can't now believe that I'm capable of catching nine out of ten similar throws.

And so I wondered for a bit what it is that makes a person (I'm assuming I'm typical!) who can do something one time in three, and has done it lots recently, and presumably failed one third of the time, believe sincerely that they are likely to succeed nine times out of ten.

A little research brings up the term Overconfidence Bias, which seems somewhat related, where people back their own judgements to be right 'with 90% confidence', and then get it right about 40% of the time.

Afterwards the thought occurred to me that I must have been miscalibrating my 9/10 rule all my life.

I used it to learn to ski and to learn to row, and at the moment I'm trying to use it to learn to catch cricket balls, and I imagine in various other contexts where I was learning to do some physical skill.

And then it occurred to me that I had no idea why I believed that that was the right ratio anyway.
I just seem to have come up with it once, tried it, found that it worked, and then adopted it as an article of belief without ever trying any other way of learning physical skills.

That also sounds like overconfidence, but actually it's called the Congruence Bias.
If you have a theory, you test it by doing what it says to do and seeing if it works.

And in fact if that's all you do, that's a terrible way of testing a theory. You should be looking into the dark and asking if, when you try something else, do you still get good results.

But it's hard to do this.

I'm now thinking 'I should try catching really hard throws'.
But I don't want to. I know what will happen. I'll get my fingers broken and my hands hurt and I'll teach myself to fear the ball even more than I already do.

I'm thinking 'I should try to catch really easy throws'.
But I don't want to. It will be very boring and I'll learn nothing from it.

It is difficult, this 'rationality'. Once you start looking at what you believe and why, and what you do and why, you find all sorts of odd things going on.