Rational group delusions

How is it possible that so many big banks failed catastrophically? A new paper (pdf) by Roland Benabou tells a new part of the story, showing how organizations can systematically delude themselves even if most individuals within it are rational.
What happens, he says, is a form of groupthink. Of course there’s nothing new about this. But it’s generally thought that groupthink arises from either a faith in asymmetric information (“these guys must know something I don‘t“) or from irrationality such as the halo effect (“he‘s a nice guy so he must be right“) or over-confidence. 
However, Benabou shows how groupthink can spread even if individuals are rational. Let’s say your boss and a few of his associates get a damn fool idea - say to buy ABN Amro, or to hold mortgage derivatives, or lend to dodgy companies, whatever. You think these are bad ideas. What do you do?
You could speak up. But the costs of this might be high; even if  don’t get sacked, you might be ostracised in various subtle ways, and even if you don’t you risk feeling foolish during the time - which could be many months - in which your warnings seem not to be vindicated. And the benefits of speaking up are small. You’ll not change corporate strategy or win friends in high places.
Rational cost-benefit calculation then says you should keep quiet. Of course, you could change jobs, but this is costly if you’ve built up job-specific human capital - and it‘s pointless if other firms are also deluded.
So, you might rationally choose to stay for the ride and keep quiet. Indeed, rather than change the organization, it’s easier to change your beliefs, to not think about the impending disaster.
And as many people do this, so an organization can become mad even if most people in it are rational and well-informed.
Here, though, comes the rub. This sort of thing is more likely to happen in  hierarchies. If workers cannot influence managers’ beliefs, they are more likely to just go along with them and rationally delude themselves that things are OK. “People will contagiously invest excessive faith in a leader’s “vision”” says Mr Benabou.
This, of course, corroborates my prior, that the banking crisis is due in part to failures of a particular form of ownership,  the hierarchical dispersed shareholder mode.

Comments

[Nigel Sedgwick]

I wonder if the auction in 2000 of radio spectrum for UK 3G mobile licences was a good earlier example of group-think delusion?

Some details here:
http://www.ofcom.org.uk/static/archive/spectrumauctions/auction/auction_index.htm

Interestingly, that one involved the government too.

Best regards

[Luis Enrique]

oof, I don't fancy reading the paper to find out where the hierarchical result comes from, but I am surprised by it. In a commune that takes it decision by vote, if the individual takes the beliefs of the group as given, I'd have thought the same sort of arguments go through. I wouldn't have said that communes are any less prone to group think. But perhaps that's just because I'm thinking of hippie communes.

[Dan]

Nigel Sedgwick - Are you suggesting the government is part to blame for a series of private companies overpaying for the 3G licences, which used an auction technology specifically designed to reveal the maximum value given to the licences by the companies in question?

I don't really see how it is "[interesting]" that that one "involved" the government. I don't even see how "also" is appropriate, unless you're spreading the increasingly contorted and not increasingly true "FM/FM caused the crisis!!!!!" meme.

[Rob Knight]

There is an horrific irony here, given that one of the main purposes of having markets in derivatives or bank shares or whatever is to enable a wide variety of people with differing opinions to trade based on their beliefs. Perhaps if the banks had operated internal prediction markets, in which underlings could simply carry out anonymous trades in order to send the message to their superiors rather than enter an argument about it, they might have ended up with a much more insightful strategy.

[dearieme]

Such things were explained decades ago by the great Cyril Northcote Parkinson. You should have read him in your youth, Dillowbert, rather than wasting your time with the superficialities of Marx.

[Nigel Sedgwick]

Dan asks me: "Are you suggesting the government is part to blame for a series of private companies overpaying for the 3G licences, which used an auction technology specifically designed to reveal the maximum value given to the licences by the companies in question?"

Well, I'm certainly putting that idea into play.

There is a possible case, every time government licences what is in effect a partial monopoly. Both mobile telephone companies and banks are specially licenced cases. Therefore there is a case, even a strong cases, that government action has influenced what the companies have done.

In the case of banks, the government sets the licence terms and, in particular, the level of equity investment required and the level of support for fractional reserve banking. Both of these look (to me at least) to have been wrongly set over the last few half decades. There is also the issue of such separation as there was/is on combining retail banking and investment banking. Though not all of these issues are unique to the UK, each government makes its own decision as to the details; on that, I note that a lot of banking activity moved from the USA to the UK, because of the easier regulatory regime (or so I understand).

In the case of mobile phone companies, I understand that only 5 licences were let (which is less than the number of interested parties). Image what would have happened if say 10 or 12 licences had been let, or even allowing each company to bid for as many MHz as it thought appropriate. Thus the government has effectively (and I am concerned this is purposeful) inspired something (perhaps fear of missing market opportunity) by running the chosen sort of restricted monopoly auction. If this is what did happen, my concern is that monopoly legislation has been used to increase government revenues (a hidden tax) rather than to protect the people from commercial cartel/monopoly.

I hope the above explains my thoughts on how government is involved.

Concerning "also" (a word I did not use) and FM/FM (presumably free markets), I'm not sure that I have understood your point. My "too" is mobile phone companies in addition to banks, as both are NOT free markets but are specially licenced by government.

Accordingly, it is NOT my view that free market capitalism should be blamed for the particularly severe mess we are in. [Note aside: however, I do believe that free market capitalism 'suffers' from bubbles and recessions; also that it contains self correction mechanisms that work well enough most of the time. And this is where governments keep largely out of it; that is except for modest protection against the sort of monopoly/cartel action that occurs mostly (if not entirely) in government-controlled markets.]

Finally on my points, perfection is not obtainable in free markets any more than it is anywhere else in society and economics. Governments that strive for perfection (as has the Blair/Brown government, and particularly the Brown government) just end up with a worse situation than if they did much less, or even nothing.

Returning ever so briefly to Chris Dillow's original posting, I too found the 51-page article too much. Perhaps rational people, if they are humanly rational, just find it too much to simultaneously optimise two different things: maximum profit and keeping on the sweet side of (socialist) government.

Best regards

[Dan]

Fair enough, I misrepresented "too" as "also".

Anyway, about 5 years ago I did some (undergrad) work on the 3G licences, but I am working a little from amnesia. What I am 99% sure about is that the maximum number of licences given the available bandwidth *were* auctioned off, and what I am 100% sure about is that rules were put in place to ensure that as much competition as possible took place given this.

[Concerned Citizen]

Is this what happened at Corpus Christi as well? they knew individually they were shot, but kept going till prize day just in case?

[ost]

raivo pommer
raimo1@hot.ee

Ostgeld krisis

Länder vor der Pleite: Der ungarische Forint, der polnische Zloty, die tschechische Krone und der rumänische Lei stehen massiv unter Druck. EU-Währungskommissar Almunia warnt bereits vor dem Schlimmsten.

Die Europäische Union wappnet sich gegen mögliche Staatsbankrotte in einzelnen Mitgliedsländern. "Wir sind politisch und wirtschaftlich darauf eingerichtet, uns diesem Krisenszenario zu stellen", sagte EU-Währungskommissar Joaquin Almunia am Dienstag in Brüssel. Die Kommission plant kein generelles Hilfspaket, sondern will von Fall zu Fall entscheiden.

[Adrian P]

MAybe it was deliberate ploy by the Global elites ( and their Sock Puppet frontmen in Parliament and Congress to destroy western society and create a New ( FEUDAL ) World Order.

Tru www prisonplanet (dot) com

[Bob B]

For another and crucial part of the story of how we got where we are, try Martin Wolf on: The Long Road to Ruin:
http://www.ft.com/cms/8787ae00-2a26-11dc-9208-000b5df10621.html?_i_referralObject=1035752223&_i_referrer=rss

IMO right now we need, above all, robust analysis of how we got into the mess we are in and what to do about abating the consequences before we start moralising and political squabbling about who is to blame.

Of course, the problem is that analysis is so much more challenging than hurling brickbats.

Btw Berle and Means, in their book: The Modern Corporation and Private Property (1932), were warning of the downstream consequences of the separation of ownership and control in modern corporations:
http://en.wikipedia.org/wiki/The_Modern_Corporation_and_Private_Property

Which is one of the reasons we are where we are.

Executive directors and managers will pursue their own interests unless shareholders - especially institutional shareholders - take on more active roles to check and balance the powers of those who control large corporations, particularly large financial institutions. If shareholders are incapable of doing the job, the task will fall to governments and the appointed regulatory institutions.

As Greenspan admitted: "that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending." [NYT, 23 October 2008]

[Bob B]

Try this news report from 2002:

"Lord Wakeham is to admit to the inquiries into the collapse of Enron that he had raised questions about [Enron's] accounting procedures.

"The Tory peer, a non-executive director of Enron, will explain to US congressmen investigating the corporate collapse that his queries were blocked by company bosses. Lord Wakeham, a member of Enron's audit committee, has told friends: 'We asked lots of questions but we didn't get any answers. We couldn't find out what was going on.'"
http://www.independent.co.uk/news/uk/politics/wakeham-will-say-he-queried-enron-accounts-659758.html

Enron - the smartest guys in the room:
http://www.youtube.com/watch?v=0zMakN-EMLg

[dirigible]

"How is it possible that so many big banks failed catastrophically?"

Bankers.

Next!

[diogenes1960]

have any of you ever worked in industry? The idea that you have to keep up with the bench-mark is so inherent these days that it is tantamount to an invitation to fraudulent behaviour, Plus the fact that HR culture doesn't award pay rises, but prefers to grant non-pensionable discretionary bonuses based on performance targets.... apply these factors to a finance function and wait for the fall-out.

[Matt Grist]

Chris, see my post on irrationality and emotions in cognition. You argue many acts are rational that appear irrational - I argue for rejecting the category of irrationality altogether.

http://socialbrain.rsablogs.org.uk/?p=206

[Jonathan]

Why is no one reading the work of Mises, Hayek, Rothbard? We can come up with complex explanations, most of which have some wisdom but without an understanding of the consequences of institutional set up of a fiat money, fractional reserve banking, top down regulation, central bank rate fixing etc... we will be doomed to repeat the mistakes of the past. Austrians have much to teach yet it is a bottom up process of learning as we cannot expect the state to endorse their views. I have an open request for logical problems with Austrian theory...so far, and I look, nothing. Takers?

[reason]

Jonathon,
why do you think the work of Mises, Hayek and Rothbard(????) contain the truth that otherwise can't be found? I'm very suspicious of any world view that avoids empirical testing. Plenty of people have pointed out that while the Austrian model superficially explains much, it doesn't explain many of the specific correlations we actually see:

To quote from a comment on another blog:
Have look at this:

http://oregonstate.edu/cla/polisci/faculty-research/sahr/sumprice.pdf

The, in my view quite wrong, Austrian/libertarian view of inflation only looks at the inflation graph and they immediately loose their grip on reality.

Yes, the inflation graph at first glance looks pretty scary. But go look at the real GDP graph. It's exponential too, and really takes off post depression. Also notice how flat GDP growth is pre-1915?

Now look at the graph for y/y changes in inflation pre-1915. Notice all the churn? Ok. Now look the 1915-present graph. See how the chop disappears? That corresponds to a period of massive increase in GDP and standard of living. It also happens to corresponds to the era of modern economics, which some would argue was ushered in by Keynes.

In human terms, the period of history that Austrian/libertarians would view as an inflationary holocaust corresponds to the largest gains in standard of living in the history of the human race. It also corresponds to a period of economic stability - all that inflation/deflation chop and churn in the pre-1915 period was not fun. Imagine prices swinging around that violently today? How could you run a business or a government in that environment?

I think there are serious issues raised by exponential growth/inflation; not the least of which is the simple fact that it isn't sustainable, but in my view it would be terribly foolish to revert to the dismal income inequality and price chop and churn of the pre-modern era. It'd be like throwing out antibiotics at the first appearance of MRSA.

Or Paul Krugman:
http://www.slate.com/id/9593

A good general criticism of the Austrian school can be found here:
http://www.huppi.com/kangaroo/L-ausmain.htm

Now I agree that there are institutional problems with the banking system. And criticisms of fractional reserve banking are not limited to the Austrian school (Soddy for instance). But fractional reserve banking is not an invention of government, so the only way to stop is to ban it and actively suppress it (since it is profitable for banks in normal times). So it seems governments are not only the problem, they must be the solution as well. (This sort of paradox often seems to me to come up with Austrian economics, I can't work out whether they think entrepeneurs are geniuses - who can see the future - or totally naive - and cannot understand monetary policy or hedging.)

[reason]

But Jonathon,
maybe I'm doing your comment a disservice. In a post caused "rational group delusions" it seems oddly appropriate.

[Aaron S.]

Interesting article. What you mentioned in the first portion, "A new paper (pdf) by Roland Benabou tells a new part of the story, showing how organizations can systematically delude themselves even if most individuals within it are rational.," is extremely true! I've seen it happen a million times before. Sad, but true.

[rolex day date]

And a lot of it reflects a switch from bank deposits to securities; foreigners “other investments” in the UK, http://www.watchgy.com/ mostly bank deposits, fell by £143.2bn in Q1. And of course there’s no guarantee such buying will continue.
http://www.watchgy.com/tag-heuer-c-24.html
http://www.watchgy.com/rolex-submariner-c-8.html