Overconfidence and the financial crisis

By Felix Salmon
May 5, 2009

Malcom Gladwell kicked off this morning’s New Yorker summit with a talk about the causes of the financial crisis in general, and of the collapse of Bear Stearns in particular, and started provocatively, by saying that if his diagnosis of the problem is correct, then really “there aren’t any solutions”.

Gladwell’s diagnosis is simple: massive amounts of overconfidence, as revealed by its two most common symptoms, miscalibration and the illusion of control. Both of which can be seen in spades in the person of Jimmy Cayne, whose interviews with William Cohan for House of Cards show a man who’s really very deluded about what Cohan, and Cohan’s readers, are going to think of him.

More generally, said Gladwell,

What’s going on on Wall Street isn’t the result of experts failing to act as experts: it’s the result of experts acting exactly like experts act. It’s not a result of incompetence, it’s a result of overconfidence.

When we look for evidence of miscalibration in people, he said, we find it overwhelmingly in experts. We find it when people are in conditions of great stress and complexity and competitiveness. And we find it overwhelmingly with older, more experienced people, doing difficult things which they feel very strongly about.

Jimmy Cayne, said Gladwell, is the picture of overconfidence — and he’s quite typical when it comes to heads of Wall Street banks. And so, Gladwell concluded:

Our goal is not to enhance the expertise on Wall Street. Expertise they have in spades. Our goal is to rein in the expertise on Wall Street. Wall Street needs to be slower, less competitive, and a lot more boring.

This is undoubtedly true — the difficult thing, of course, is how to legislate it, in a world where banks are falling over themselves to repay TARP funds and start taking on lots of risk again. Here’s Matthew Richardson and Nouriel Roubini write in the WSJ this morning:

Consider also recent bank risk-taking. The media has recently reported that Citigroup and Bank of America were buying up some of the AAA-tranches of nonprime mortgage-backed securities. Didn’t the government provide insurance on portfolios of $300 billion and $118 billion on the very same stuff for Citi and BofA this past year? These securities are at the heart of the financial crisis and the core of the PPIP. If true, this is egregious behavior — and it’s incredible that there are no restrictions against it.

But if there were restrictions against this behavior in particular, the same banks, or other banks, would find other ways to chase risk, just because they’re so confident that they can make billions of dollars — and get themselves out of their present hole — by doing so. They might even be right: 95% of the time, they probably are right. But that’s the Rubin trade: it works until it doesn’t. And although it’s the easy solution to the problem, it’s also a very worrying solution to the problem, because it just sets up yet another inevitable meltdown at some unknown point in the future.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

If you’re an expert, and your overconfidence results in disaster, then you acted incompetently. Experts get the big bucks becuase they’re supposed to know what they are doing, and they didn’t.

You can call it overconfidence, or delusion, but it doesn’t matter. They still f***ed up.

As for citi and BofA continuing to make risky bets, I mean, investments, it’s like when some loser borrows money and gambles it away in Las Vegas, and finds somebody else to lend him some more, which he bets with the hopes of winning big so he can pay off the first loan. He has little to lose on the second loan, because if he doesn’t pay off the first loan, the second one won’t matter.

U.S. Treasury, meet your two-time losers.

Posted by KenG | Report as abusive

What about the overconfidence of the experts who do the regulation? Why is it always the case that when observers spot an undesirable consequence of free human behavior, they assume that some all-knowing, disinterested solon can intervene to prevent it? Hayek called it “the Fatal Conceit”. I also disagree that there aren’t any solutions — one great solution who be to stop socializing the risk of failure.

Posted by Paul McMahon | Report as abusive

There is a realted piece by Steve Keen (hat tip Yves Smith)

http://www.debtdeflation.com/blogs/2009/ 05/04/debtwatch-no-34-the-confidence-tri ck/

In his recent speech “The Road To Recovery“, Australia’s Reserve Bank Governor Glenn Stevens used “the C word” 17 times–versus, for example, 15 uses of the “R” word (”recession”). The message was clearly that, if only we can all be confident, then the other “R” word (”recovery”–which received ten mentions) will surely occur.

Posted by tyaresun | Report as abusive

It is not overconfidence that causes zombies to love toxic waste. They crave volatility because they have limited liability. See “The Put Problem with Buying Toxic Assets” at http://ssrn.com/abstract=1343625

First, a quote from my teacher, Paul Feyerabend:

“Modern science, on the other hand, is not at all as difficult and as perfect as scientific propaganda wants us to believe. A subject such as medicine, or physics, or biology appears difficult only because it is taught badly, because the standard instructions are full of redundant material, and because they start too late in life. During the war, when the American Army needed physicians within a very short time, it was suddenly possible to reduce medical instruction to half a year (the corresponding instruction manuals have disappeared long ago, however. Science may be simplified during the war. In peacetime the prestige of science demands greater complication.) And how often does it not happen that the proud and conceited judgement of an expert is put in its proper place by a layman! Numerous inventors built ‘impossible’ machines. Lawyers show again and again that an expert does not know what he is talking about. Scientists, especially physicians, frequently come to different results so that it is up to the relatives of the sick person (or the inhabitants of a certain area) to decide by vote about the procedure to be adopted. How often is science improved, and turned into new directions by non-scientific influences! it is up to us, it is up to the citizens of a free society to either accept the chauvinism of science without contradiction or to overcome it by the counterforce of public action. Public action was used against science by the Communists in China in the fifties, and it was again used,, under very different circumstances, by some opponents of evolution in California in the seventies. Let us follow their example and let us free society from the strangling hold of an ideologically petrified science just as our ancestors freed us from the strangling hold of the One True Religion!”

Possibly because of him, I always ask questions like: Why did you need to use math? What are the assumptions of any theory or thinker? Are they exaggerating, lying, fudging,etc.? Is the expertise a skill, a position in a group, etc.?

One thing is very clear, which is that expertise is no guarantee of the ability to reason, write, explain, intuit, etc. If someone were to take the time to document basic fallacies of logic or misstatements of what certain theories say or what certain thinkers believed in the major press sources, it would be a full time job. Just look at the wonderful blog called Adam Smith’s Lost Legacy. I thought of doing a blog like this on Burke, but almost everything written about him is wrong or misleading.

As to our topic, I find these claims of complexity laughable. The expert should be able to explain to you the risks in very simple language. If he can’t, then say goodbye. When you read some of the explanations given for this risky behavior, they often violate common sense or basic reasoning. If you take a risky product, then divide it up into less risky and more risky within the risky product, it doesn’t magically make the risky product less risky.

I’m for Narrow/Limited Banking precisely because we need a foundation to the free market that everybody can understand.

KenG wrote: “If you’re an expert, and your overconfidence results in disaster, then you acted incompetently. Experts get the big bucks becuase they’re supposed to know what they are doing, and they didn’t.”

Put another way, one of the areas in which experts should exhibit competency is the area of knowing the limitations of their own expert knowledge. Particularly because no one else is qualified to locate those limits, since they’re not experts themselves. Thus, an expert who has failed to take into account the fact that their own expertise is likely to lead them astray is an incompetent expert. It would be good if we could build this into our understanding of who gets to be called an ‘expert’.

Posted by LP | Report as abusive

Overconfidence, in my experience, is more of a problem with smart people than experienced people.

I largely agree with this diagnosis, but I don’t agree that it doesn’t imply a solution. The solution is simple, regulate banks so that nobody is “too big to fail”. If overconfident experts of moderate sized banks blow themselves up I don’t really care.

Posted by Dan K | Report as abusive

I don’t think it is legislatable. The only way I see this happening is if we can find a way for these big banks to fail.
Felix – I think you addressed this in the (distant) past, but what is your take on allowing the likes of Citi and/or BofA to go bust? Too risky? Too complicated? I’m pretty compelled by the Simon Johnson line of thinking.

I don’t think overconfidence is limited to Wall Street. Fed Chairman Bernanke looks pretty confident to me.

I’d change dwj’s remark to : overconfidence is a problem for both smart and experienced people, since it’s a problem for people with some kind of authority, who think that by the mere fact that they have authority, they must be exceptionally capable.

Posted by a | Report as abusive

On Citi/BofA, there’s a huge difference between having to take out insurance on a subprime related assets originated or purchased at par, and buying up those assets from liquidations at 10 to 20 cents on the dollar. Still, having taken the government’s dollar, I do think they should have refrained from prop trading.

Posted by Ginger Yellow | Report as abusive

I agree strongly with Paul McMahon above. I’ll also add that it is nonsense to make people slow down in capitalism. The expression is, “fail faster,” and it’s a good one. If you want to make any changes at all, then just add, “fail faster and smaller.” I don’t have a problem reducing the impact of financial manipulations, or lessening their scope, but to slow things down will only produce loopholes and black markets.

Posted by J.V. | Report as abusive

I, too heard MG speak on the psychology of overconfidence and, while I think his books are masterfully supported and I subscribe to his philosophies and tenets on a daily basis, I find his view of ‘overconfidence’ somewhat flawed.
I think it would be difficult for MG to argue against the idea that what he calls overconfidence is actually just sheer hubris and arrogance. These are qualities hardly worth analysis, so MG calls it overconfidence and it becomes a relevant topic.
If you look at the examples he cites – most notably the guys on Wall Street and General Hooker in the Battle of Chancelorsville – these are clearly examples of hubris getting the better of an individual.
The difference is really a matter of timing. What would be called confidence is only dubbed ‘overconfidence’ when it yields a negative result. For instance, everyone know Mohammed Ali for his confidence before his fight with Frasier. Had Ali lost, we would be talking about his overconfidence… Overconfidence can only be identified in the light of the result. Patton, Montgomery, Ali and Ruth all displayed the sort of confidence that we hope our children will aspire to. Had they lost, they’d be the subject of MG lectures.

Also, in his lecture, MG touches on the inability or unwillingness to listen to those around you as one of the hallmarks of overconfidence as he sees it. Again, this is arrogance, not overconfidence. I’m quite sure that more than one person told Edison that the quest for artificial light was something better left behind. Also, there were enough people telling Chamberlain to negotiate with Hitler that he took their advice.

Bottom line is that while Malcolm Gladwell has given us some really great social analysis in his books, his current lecture is revealed as deeply flawed with a short objective glance. If I subscribed to the tenets of his argument, i might suggest that MG has become so successful at the contextual analysis of social phenomenon that he’s come to believe that any passing connections he makes between cause and effect are, in fact, brilliant by simple virtue of him having thought of them. Overconfidence? I’ll let you decide.