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America’s homeowners feel like busted gamblers after a bender in Vegas. They wagered not only the nest egg, but the nest, with the abandon of tulip-bulb traders in 17th century Holland. Americans are hard put to explain how the American dream turned into a chip on the craps table. The focal point of speculation was the asset one usually associates with secure domesticity. What happened to the risk-averse Economic Man of textbooks?
The textbook was misleading to begin with: we are all gamblers and always have been, argues Reuven Brenner, the Repap Professor of Business at McGill University. In a series of books beginning in 1983 with History: The Human Gamble and culminating with his latest volume, A World of Chance: Betting on Religion, Games, Wall Street , Brenner yanks economics inside-out by placing risky behavior at the center of the economic model.
Conventional economics describes an artificial world of slight deviations from equilibrium; Brenner presents the real world, in all its danger and uncertainty. Man lives not only by the sweat of his brow, but by the fortitude of his intestines, for survival demands that we take mortal leaps of a kind that are unknown to the conventional model. Men who would prefer to be timid risk everything to leapfrog their peers before they themselves are left behind.
Rather than award yet another Nobel Prize to an economist who put bells and whistles on the conventional model (Princeton University Professor Paul Krugman was honored this past weekend ”for his analysis of trade patterns and location of economic activity,”) the Swedish Academy should have honored Brenner, who gives us a model that makes sense in the real world of tumult and uncertainty – 2008 should have been Brenner’s year, given the cataclysmic breakdown of the conventional model. Only a few months ago, the governments of the world went about their business as if nothing unusual was at work; now they are lurching from one emergency plan to another and warning of a new Great Depression.
This sort of thing isn’t supposed to happen in the imaginary world of the consensus economic model. Radical changes, though, are the underlying premises of Brenner’s approach, which “deals with jumps – relatively large changes. The traditional economic models can deal with small changes, where people adapt passively but do not bet on any new idea,” he writes. People take risks because they know that gambling may be the only survival strategy under given circumstances.
Why, for example, would Americans bet their homes? Within Brenner’s framework, we need to look to the circumstances that prompt apparent risk-friendliness, rather than click our tongues over an outbreak of collective madness. As Brenner and his wife, economist Gabrielle Brenner, explain:
If people reach the age of fifty or fifty-five and have not “made it,” what are their financial options to still live the good life? Except for allocating a few bucks to buy lottery tickets, it is hard to think of any other option. If people find themselves down on their luck and see no immediate opportunities to get rich, what can they do to sustain their hopes and dreams? Allocating a fraction of their portfolios on games with a chance to win a large prize is among the options. And when people are leapfrogged – that is, when some “Joneses” who were “below” them jump ahead – how can they catch up? They will tend to challenge their luck too for a while, taking risks that they might have contemplated before in business, financial markets, and other areas but did not follow up with action.
As it happens, a huge number of Americans began to turn 50 or 55 during the past 10 years, as the baby boomers approached retirement. Between 2005 and 2025, the number of Americans aged 60 or over will jump from around 15% of the population to 25%.
Between 1990 and 2000, that is, the baby boomers reached the age at which workers are supposed to earn their highest lifetime compensation and salt away most of their retirement savings. Americans who saved money during the 1990s put a great deal of it into the stock market and were bitterly disappointed. An American saver who invested in 1996, just as the boom was getting underway, would have given up all his gains by October 2002, at the stock market’s following the technology stock collapse. If the same investor held on to a broad market portfolio all the way to the present, he would only break even after inflation.
American asset markets did not offer returns high enough for the baby boomers to earn enough to retire. There are a number of reasons for this. One is that not only Americans, but Europeans, Japanese, and above all Middle Easterners are aging rapidly and seeking retirement assets, such that the price of all capital assets rose and their prospective rate of return fell. Capital markets, as I have argued in the past, come down to old people lending money to young people, and the declining numbers of young people in the industrial world during the past generation are reflected in shrinking investment opportunities.
The prospective retirees of the world had no choice but to take more risk in order to earn the returns they required. Riskier assets were brought to the marketplace, such as subprime mortgages and high-yield loans. Professional gamblers – the hedge funds – raised US$4 trillion to bet on the riskiest portion of pools of mortgages and corporate credit. Americans found that the global demand for mortgage bonds created an inexhaustible supply of cheap credit even for the riskiest borrowers.
With home prices rising 10% a year between 1998 and 2006, Americans found that they could use leverage to achieve triple-digit returns on their equity (if you buy a $200,000 house with $10,000 down and its price rises by 10%, or $20,000, your return on equity is 200%).
In retrospect, it may seem silly for the baby boomers to have assumed that they could double the price of their homes and then all sell their homes to each other and retire on the proceeds. Demographics ultimately destroyed the home price bubble.
As a group, the baby boomers did not have sufficient funds on which to retire, and, given the condition of American asset markets, could not earn sufficient returns on conventional assets. Instead, they chose to “leap into uncertainty,” in Brenner’s phrase. This sounds fairly general, but Brenner has elaborated his view in a number of startling ways. How, for example, do entrepreneurs set prices for new products, where demand is unknown? Brenner demonstrates (in “Rivalry”) that the mechanism by which they do so depends on the creation of new markets. In effect, Brenner has replaced the view of human behavior at the center of economics, and from this elaborated a set of theories, each of which has enormous analytic power.
In Brenner’s model, survival means maintaining one’s social status, one’s place in the pecking order or the corporate food chain, because falling behind decreases the likelihood of survival. Rivalry is the driving force, not an abstract measure of utility. There is something profoundly Biblical in this view: “I considered all labor and all excelling in work, that it is a man’s rivalry with his neighbor. This also is vanity and a striving after wind.” – Ecclesiastes 4:4.
The Jewish sages of late antiquity spoke of an “evil impulse,” variously identified with competitive or sexual drives, without which no one would build a house, start a family or open a business. The entrepreneur, in Brenner’s view, resembles Goethe’s Mephistopheles, who introduces himself as “the spirit that always wishes evil, but always does good.”
Brenner strongly believes that the greatest contribution to welfare comes from letting individuals bet on ideas, pursue innovations, and overturn the existing order of things. A profound faith in a beneficent providence is required to draw this conclusion, for it is easy to argue that betting on ideas may produce apocalyptically harmful outcomes.
Rivalry between nations never was so clear cut as in the preparations for World War l. Each European nation feared being leapfrogged by the others. France feared Germany’s high population growth rate, Russia feared Germany’s intrusion into the restive western wing of its empire, Germany feared Russian industrialization, England feared the losses of its ability to control the continental balance of power, Italy felt left out, and so forth. All had excellent reasons to fight rather than be left behind, but the result was the collective ruin of all the European nations.
At the outbreak of the war in 1914, some of Europe’s best minds exulted in the “leap into uncertainty.” Thomas Mann, arguably the greatest writer of the past century, wrote a famous essay entitled “Thoughts in War” comparing the risk-taking attitude of the artist and that of the soldier. A great sense of liberation from the ordinary swept over Europe as its nations prepared to risk everything for their place at the head of the queue. The trouble is that they risked everything, and they all lost everything.
The stench of brimstone precedes the entrepreneur. As God told Mephistopheles in the Prologue in Heaven of Goethe’s Faust, human beings tend toward unconditional rest, and to keep them on their toes God assigns them a companion who must act as and be perceived as a devil. The great theorist of entrepreneurship, Frank Knight, of the University of Chicago, is one of Reuven Brenner’s spiritual ancestors. His 1921 book Risk, Uncertainty and Profit showed that entrepreneurs’ compensation derives from the leap into uncertainty, that is, the assumption of unhedgable risk.
Knight, unlike Brenner, thought that entrepreneurship did not add enough wealth to justify the disruption that it occasioned. Joseph Schumpeter, who took from Mephisto the notion of creative destruction and applied it to economics, was pessimistic about the future of capitalism. He thought communism would triumph.
The apogee of gambling on ideas well might have been the Internet stock bubble of the late 1990s, when any undergraduate with a few computer science credits could launch a company on the equity market. It is hard to find the fault in the system from a pure economic standpoint, for America’s markets were the world’s most efficient. The trouble is that when we speak of a leap into uncertainty, we leave the realm of probability distributions and enter the realm of the imagination. The entrepreneur’s vision of society five or 10 or 20 years ahead is what counts – how lives, mores and tastes will change.
Thomas Alva Edison had one sort of vision of the future when he invented the electric light bulb and the phonograph. The Internet entrepreneurs of 1999 had quite a different one, in which the delights of youth culture would somehow substitute for cash flow. Once investors concluded that music downloads, multi-player games, chat rooms and pornography did not justify a market capitalization larger than America’s manufacturing plant, the illusion was gone and so were the valuations.
For that matter, the ill-fated markets for structured credit and mortgages of the past 10 years had the undivided attention of some of the world’s best applied mathematicians. Never before were risks so parsed, measured, cut, dried and marketed to different investor groups with different risk preferences. Professional gamblers, or “hedge funds,” were enlisted to manage the riskiest part of the capital structure, while legions of mathematicians arranged other securities to be as safe as possible – for example, AAA-rated securities backed by subprime mortgages that are now trading at 50 cents on the dollar.
We have no choice but to leap into uncertainty, where imagination takes the place of probability distributions. Standing still and doing nothing is the most dangerous strategy of all. The one thing we know about all places and all times is that if you stay in the same place doing the same thing long enough, someone is going to come along and rape the crops, burn the women and take you out of the picture.
But what if our imagination goes wrong? If Ecclesiastes (4:4) recognized that business stems from rivalry, as Reuven Brenner maintains, this must be balanced against Jeremiah (7:24), which warns that the people “walked in the counsels and in the imagination of their evil heart, and went backward, and not forward.” Brenner has given us as much as economics possibly can: he walks us to the moment of the mortal leap, describes the conditions that motivate it, and reminds us that we have no choice.
But it is important to keep in mind that economics does not explain everything. If we decline to raise a next generation, and abandon ourselves to so-called youth culture, ultimately we will encounter imbalances that economic policy cannot cure. Our imagination is the basis on which we make leaps into uncertainty, and how we cultivate this imagination ultimately may be of greater import than economics as such.
Note: 1. A World of Chance: Betting on Religion, Games, Wall Street, by Reuven and Gabrielle A Brenner with Aaron Brown. Cambridge University Press (August, 2008). ISBN-10: 0521711576. Price US$29.99, 352 pages.