Panic

DeLong reviews Lewis.

What is Lewis' take on the current crisis? His first arresting point is that this is something that we have done to ourselves rather than something that shadowy villains have done to us. "The striking thing ..." he writes, "is how egalitarian it has been. ... Stan O'Neal, the former CEO of Merrill Lynch, was fired for the same reason the lower-middle-class family in the suburban wasteland between Los Angeles and San Diego may have lost its surprisingly nice home. Both underestimated the likelihood of an unlikely event: a financial panic. ... The small army of Wall Street traders ... look as naive and foolish as the man on the street. ... The man on the street ... acted on the same foolish principles that have guided ... Wall Street traders."

His second arresting point is that all of the attempts to manage risk have done so by applying a mathematical theory of finance that is guaranteed to break down when a panic actually comes and when real risk is there to be managed. Lewis quotes John Seo of Fremont Capital saying: "It's hard to believe that anyone - yes, even me - ever believed it [the theory]. It's like trying to [replace] a fire-insurance policy by dynamically increasing or decreasing your coverage [bet that there will be a fire] as fire conditions wax and wane. One day, bam, your house is on fire, and you call for [someone to sell you] more coverage?"

His third arresting point is that it was the confidence that the models could manage risk that has in fact created the kinds and sizes of risk that the models certainly cannot manage.

Egalitarian, indeed. I've thought about this a lot: Even if you did everything you were supposed to do with your 401k or IRA or whatever -- rebalancing, diversifying, etc., etc., you're still looking at losses of 40% or higher. I won't even venture to guess what this will do to people's psychology and the market. Personally, I hate my 401k and the money taken out of my payroll only to be lost each month.