Tuesday, November 11, 2008

Why the experts missed the leading indicators

In the movie Midway, the intelligence analyst played by Hal Holbrook was trying to determine the Japanese plans and found a reference in a single message to “AF”. By analyzing the location of the airplane sending the message they suspected that “AF” was the Japanese code for the island of Midway. By falsely reporting a problem with the fresh water distillation system on Midway, they tricked the Japanese into referring to Midway, using the code “AF”, in a subsequent message. Knowing that “AF” was Midway allowed the analysts to predict the Japanese attack on Midway in time for the US forces to be in place to defeat it.

The point is that in most cases the leading indicators are very small and easy to over look. By the time those small indicators grow to a size that can be analyzed with statistical tools it’s tool late to do much to fix things.

Without the almost insignificant reference to “AF” the US forces would not have known that Midway was the true Japanese target until it was too late to get the US forces into position to block that attack.

In the same way the “experts” missed the small leading indicators for the current economic woes. The sub-prime mortgage losses and the derivatives that fueled the collapse were not created by the people who bought the mortgages or derivatives, those were conceived of by the smartest people the banking and securities companies could hire. While the experts patted each other on the back and collected huge bonuses for the sale of those mortgages and securities, the leading indicators of factory closings, lay offs, and people who were now working below their experience, skill, and former salary levels got missed.

The problem is that the “experts” waited until the conditions were obvious, which would be like the US waiting for the enemy forces to attack rather than looking for those tiny leading indicators that would allow you predict events.

Are the experts stupid? Not at all, but I believe they fell into two traps, first they fell victim to their own expertise and only looked at the leading indicators within their specialties and only at the indicators that their theories told them were important. Second, like an expert witness in court, they got paid to justify decisions that their employers had already decided were correct.

In the case of the loss of manufacturing jobs and the switch to the “knowledge economy” they failed to recognize that there will never be enough knowledge jobs to support the shear number of potential US workers losing the old jobs. In the case of the financial markets, the got paid to come up with new financial methods to allow previously ineligible borrowers to get loans and credit.

In both cases the experts didn’t see that as jobs were lost those borrowers ability to repay loans was more and more at risk. Again, the experts watched as the leading indicators showed that the limits had been reached and the theory got pushed to a ridiculous extreme. As with most things when pushed to the extreme, the lending practices failed. But, since the decision makers income was tied to making more loans, they continued long after prudence dictated they should stop.

Upton Sniclair, may have said it best “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

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