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Abstractions and morality in modern finance

Posted by Lisa Pollack on Dec 23 16:00.

Over the last three years, modern finance has been bailed out by policymakers and, by extension, taxpayers. But policymakers and financiers are taxpayers too, and hence themselves bear at least some of the costs of the crisis.

Why are we so good at creating complexity in finance? How do we reconcile the bad decisions that we make when we do things like structure single-tranche CDOs, trade the ABX index, or give mortgages to people who can’t afford them?

Creating complexity

First, though, a bit on why we’re are good at complexity in finance, and how we’re likely to keep getting even better at it. We’re becoming smarter, and in a particular way. From Wired’s science blog, Frontal Cortex (emphasis ours):

The Flynn effect has always been tinged with mystery. First popularized by the political scientist James Flynn, the effect refers to thewidespread increase in IQ scores over time. … What’s most peculiar is how scores have increased:

1) Scores have increased the most on the problem-solving portion of intelligence tests.

2) Verbal intelligence has remained relatively flat, while non-verbal scores continue to rise.

3) Performance gains have occurred across all age groups.

4) The rise in scores exists primarily on those tests with content that does not appear to be easily learned.

What’s puzzling about this increase in general intelligence is that it appears where we’d least expect it. While one might assume that IQ scores could increase over time in terms of crystallized intelligence — the part of the test that measures particular kinds of knowledge, such as being able to count or vocabulary words — it’s actually increased on measures of fluid intelligence, which is the ability to solve abstract problems.

Which is to say that as generations pass, we have become smarter, but a particular type of smarter. The kind of smart where your 5-year-old can fix your Blackberry while you are busy drawing parallels between the EFSF and a CDO.

We’ve become better at abstract thinking. We don’t have any trouble analysing a financial market that has no physical location, or considering credit exposures to sovereign nations through derivatives contracts. It’s just what we do.

Furthermore, as the ability to think abstractly correlates with intelligence, it becomes a self-reinforcing cycle where the people who are best at such reasoning stay longer in education, and get even better at abstract thinking, becoming even more intelligent… until one day, after many years of study, a good portion of them land in investment banks. So what do you think happens next? To what task is the abstract thinking capability employed?

Is it any wonder, then, that modern finance has become progressively more complex?

But at the same time, wouldn’t these exceptionally intelligent people be able to see the potential instability they are creating, and the increasingly large potential loss to society as a whole through bailouts, and the bypassing of the real economy?

Making bad decisions at arm’s length

It raises a moral question. One that we will discuss by introducing the trolley problem. This is the FT Alphaville version of the thought experiment created by Philippa Foot in 1967.

Out for a walk one Christmas eve, you climb a footbridge to get over some railway lines. Just as you get to the top of the bridge, you notice that an out-of-control trolley is hurtling towards five men working on the tracks farther down from where you are. Too far away to shout to warn them, you look on in horror, certain it’s going to kill them all. Then you realise that there’s a lever next to you. If you pull it, the trolley will divert to a separate set of tracks where there is only one man working. If you pull the lever, the Trolley will kill the one man, but the five will be saved. Do you pull the lever?

Got the answer in your mind? What about in this situation:

Again, you are on the footbridge, same runaway trolley. But no lever. However, there is a very large gentleman standing next to you. You realise (with certainty) that if you push the man onto the tracks as the trolley is passing, it will stop the trolley and the five men will be saved, but the man you have pushed will die. Do you push the man onto the tracks?

Most people pull the lever, but most will not push the man. The situations, of course, are actuarially identical.

Why the difference?

Well, for one, we are hard-wired not to kill our fellow human beings. At least not those who are posing no threat to us whatsoever.

However, introduce some mechanics in between us and murder, and all of a sudden our frame of mind changes. People who would never be able to kill with their bare hands are willing to drop bombs on civilians and pull levers leading to the death of a bystander. As soon as there is some distance between ourselves and the person we are harming (even when that person is ourselves), our evolutionary tendencies to not kill take a backseat.

In case you are still thinking in survivalist terms, i.e. that in war we defend ourselves even if it means attacking civilians to do so, consider this next example.

Nearly everyone would rush to the aid of a drowning child, but not all of us send money to countries where children are starving to death.

Distance from the consequence of our inaction, or insertion of a tool into the action that we take, allows us to make decisions in ways that are logically, and morally, inconsistent.

A mind for finance

And so it is that we get more intelligent and even better at the abstract thinking that allows us to introduce more complexity into the financial game that many of us play. Those who don’t work in finance look on and wonder why we get up to the things that we do, but for the most part they don’t mind as long as it doesn’t affect them.

But lately, it has affected many of them. Too many. In many quarters, from the Occupy movements to new regulations, finance is being held to account. But those in markets will no doubt out-smart such efforts yet again…

… after all, it’s not like they have to push the fat man off the bridge.

This post was inspired by a few WNYC’s Radio Lab podcasts, which have discussed the above concepts, albeit without the finance angle.

Related links:Chimp Fights and Trolley Rides – WNYC’s Radio Lab (Podcast)
Killing Babies, Saving the World - WNYC’s Radio Lab (Podcast)
Are Smart People Getting Smarter – Wired’s Science Blog, Frontal Cortex
Phillipa Foot and the Trolley Problem - Brainiac on the Boston Globe

This entry was posted by Lisa Pollack on Friday, December 23rd, 2011 at 16:00 and is filed under Capital markets, People. Tagged with CDO, EFSF, global financial crisis.