This American Life: Inside Job

April 12, 2010

After defending This American Life‘s economics reporting yesterday, I feel betrayed by this week’s episode. Listening to the episode before bed was a mistake, because it really annoyed me. To try and draw a general lesson from this, I’d say that I’m annoyed by people who act as if making money in asset markets (or any markets) is easy. The evidence used by people who argue this position generally takes two forms:

1. “Asset x used to be worth five dollars. Now it’s worth one hundred dollars! Clearly, people who bought when it was worth five dollars made a lot of money, and they didn’t do anything to earn that money.”

2. “Business y is making a lot of money. It’s not obvious to me that they are doing anything to deserve that money. Therefore, they are making a ton of profit without having to do any work for it.”

Such arguments would be more laughable if they weren’t so common. Here’s my suggestion to you: next time you see someone making what you think is easy money, ask yourself this question: “What would I have to do to make money in that way?” If your answer is, “I’m not sure,” then you’ve already shown that making money is harder than you thought it was 10 seconds ago. If your answer is, “Well, if I knew then what everyone knows now…” then just stop right there. You didn’t know then what everyone knows now. That’s why you’re not rich.

That first part is about as close as I can get to summarizing my position without being terribly disorganized and long-winded. But I’m also going to write about the episode that so annoyed me. Start by imagining this scenario:

You and a group of eight other people declare that you’re all confident that the population of Iceland exceeds 20 million people. I tell you and your friends that I’m willing to bet anyone $10,000, but no less than $10,000, that the population of Iceland doesn’t exceed 20 million. Well, you are all very confident, but because you’re low on cash, you can only manage to raise $9,000 to bet against me. But you really want to make this bet. Fortunately, we live in a sophisticated financial world, so I make you guys an offer: I’ll join in as an investor in your bet against me. I’ll offer $1,000 to add to your $9,000 so you can complete your $10,000 bet.

How would you describe my position in this market? Clearly, I’m massively short on the position that Iceland’s population exceeds 20 million. But I also have a small long position here, because of a strange quirk of the market in which we made this bet (the $10,000 minimum).

It gives me no pleasure to say that Alex Blumberg and the NPR Planet Money team do not understand why short selling is good. In the program this week, Blumberg says that in general, short selling is good because it helps keep prices from getting too inflated, it helps tamp down the irrational exuberance of the market. In the example case I made up above, though, Blumberg would say that because without me, the bet would never have happened in the first place, short selling actually makes prices higher and more irrational.

All of which goes to show, it’s dangerous to have a model that is basically wrong but not entirely wrong if you use it in normal contexts, and then try to extend that model into new and unfamiliar contexts. The right model for why short selling is good is that you want to get as much information into the price as possible, and you want people to have incentives to gather and use information they have about asset prices.

In order to say that short selling doesn’t work in the Magnetar case, you would have to argue that somehow, Magnetar’s trading wasn’t giving any information to the market. But it clearly was, as TAL‘s reporters so skilfully describe in the program. Magnetar was saying, through its bets, “We are extremely confident that everyone else is underestimating the risk of CDOs. We’re so confident in this that we’re willing to sponsor and invest in what everyone else thinks are the ‘risky’ parts of the CDOs, because we believe that the entire thing is so risky that we will make money when its value collapses.” As it turns out, everyone should have paid more attention, because Magnetar was right.

Since I’m just complaining here, I’m going to talk about another thing that annoys me: people who use the knowledge they have in 2010 to retrospectively make money on Wall St. in 2005-06. That’s not how it works, NPR’s Planet Money team! Again, recall that every transaction has a buyer and a seller. If Magnetar was buying bets against its own CDOs, that means that someone else had to be selling it bets that the CDOs would not collapse. Since Magnetar didn’t have access to the information that is so obvious now, in 2010, Magnetar was, at the time, taking a risk. And there were people who would have made money if Magnetar had been wrong.

Summary and lessons:

1. Making money is harder than it seems to people who don’t think about it carefully. If it weren’t, people who don’t think about it carefully would be rich. But they’re not.

2. If you have a model that isn’t quite right, you may be able to say fairly accurate things about some situations while still being horribly wrong about other situations.

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