Dollars funnel.

In my post on why the future doesn’t get funded I examined the question of unimaginative funding that locks up the better part of the world’s wealth in “safe” investments. In that post I argued that the kind of person who achieves financial success is likely to do so as a result of putting on blinders and following a few simple rules, whereas more imaginative individuals who want adventure, excitement, and experimentation in their lives are not likely to be financially successful, but they are more likely to have a comprehensive vision of the future — precisely what is lacking among the more stable souls who largely control the world’s financial resources.

Of course, the actual context of investment is much more complex than this, and individuals are always more interesting and more complicated than the contrasting caricatures that I have presented. But while the context of investment is more complicated than I have presented it in my previous sketch of venture capital investment, that complexity does not exonerate the unimaginative investors who have a more complex inner life than I have implied. Part of the complexity of the situation is a complexity that stems from self-deception, and I will now try to say something about the role of self-deception on the part of venture capitalists.

One of the problem with venture capital investments, and one the reasons that I have chosen to write on this topic, is that the financial press routinely glorifies venture capitalists as financial visionaries who are midwives to the future as they finance ventures that other more traditional investors and institutional investors would not consider. While it is true that venture capitalists do finance ventures that others will not finance, as I pointed on in the above-linked article, no one takes on risk for risk’s sake, so that it is the most predictable and bankable of the ventures that haven’t been funded that get funding from the lenders of last resort.

Venture capitalists, I think, have come to rather enjoy their status in the business community as visionaries, and are often seen playing the role in their portentous pronouncements made in interviews with the Wall Street Journal and other organs of the financial community. By and large, however, venture capitalists are not visionaries. But many of them have gotten lucky, and herein lies the problem. If someone thinks that they understand the market and where it is going, and they make an investment that turns out to be successful, they will take this as proof of their understanding of the mechanisms of the market.

This is actually an old philosophical paradox that was in the twentieth century given the name of the Gettier paradox. Here’s where the idea comes from: many philosophers have defined knowledge as justified true belief (something that I previously discussed in A Note on Plantinga). I myself object to this definition, and hold, in the Scholastic tradition, that something known is not a belief, and something believed cannot be said to be known. So, as I see it, knowledge is no kind of belief at all. Nevertheless, many philosophers persist in defining knowledge as justified true belief, even though there is a problem with this definition. The problem with the definition of knowledge as justified true belief is the Gettier paradox. The Gettier paradox is the existence of counter-examples that are obviously not knowledge, but which are both true and justified.

Before this idea was called the Gettier paradox, Betrand Russell wrote about it in his book Human Knowledge. When stated in terms of “non-defeasibility conditions” and similar technical ideas, the Gettier paradox sounds rather daunting, but it is actually quite a simple idea, and one that Russell identified with simple examples:

“It is clear that knowledge is a sub-class of beliefs: every case of knowledge is a case of true belief, but not vice versa. It is very easy to give examples of true beliefs that are not knowledge. There is the man who looks at a clock which is not going, though he thinks it is, and who happens to look at it at the moment when it is right; this man acquires a true belief as to the time of day, but cannot be said to have knowledge. There is the man who believes, truly, that the last name of the Prime Minister in 1906 began with a B, but who beleives this because he thinks that Balfour was Prime Minister then, whereas in fact it was Campbell Bannerman. There is the lucky optimist who, having bought a lottery ticket, has an unshakeable conviction that he will will, and, being lucky, does win. Such instances can be multiplied indefinitely, and show that you cannot claim to have known merely because you turned out to be right.”

Bertrand Russell, Human Knowledge: Its Scope and Limits, New York: Simon and Schuster, 1964, pp. 154-155

Of Russell’s three examples, I like the first best because it so clearly delineates the idea of justified true belief that fails to qualify as knowledge. You look at a stopped clock that indicates noon, and it happens to be noon. You infer from the hands on the dial that it is noon. That inference if your justification. It is, in fact, noon, so your belief is true. But this justified true belief is based upon accident and circumstance, and we would not wish to reduce all knowledge to accident and circumstance. Russell’s last example involves an “unshakeable conviction,” that is to say, a particular state of belief (what analytical philosophers today might call a doxastic context), so it isn’t quite the pure example of justified true belief as the others.

An individual’s understanding of history is often replete with justified true beliefs that aren’t knowledge. We look at the record of the past and we think we understand, and things do seem to turn out as we expected, and yet we still do not have knowledge of the past (or of the present, much less of the future). When we read the tea leaves wrongly, we are right for the wrong reasons, and when we are right for the wrong reasons, our luck will run out, sooner rather than later.

Contemporary history — the present — is no less filled with misunderstandings when we believe that we understand what it is happening, we anticipate certain events on the basis of these beliefs, and the events that we anticipate do come to pass. This problem compounds itself, because each prediction borne out raises the confidence of the investor, who is them more likely to trust his judgments in the future. To be right for the wrong reasons is to be deceived into believing that one understands that which one does not understand, while to be wrong for the right reason is to truly understand, and to understand better than before because one’s views have been corrected and one understands both that they have been corrected and how they have been corrected. Growth of knowledge, in true Popperian fashion, comes from criticism and falsification.

This problem is particularly acute with venture capitalists. A venture capital firm early in its history makes a few good guesses and becomes magnificently wealthy. (We don’t hear about the individuals and firms that fail right off the bat, because they disappear; this is called survivorship bias.) This is the nature of venture capital; you invest in a number of enterprises expecting most to fail, but the one that succeeds succeeds so spectacularly that it more than makes up for the other failures. But the venture capital firm comes to believe that it understands the direction that the economy is headed. They no longer think of themselves as investors, but as sages. These individuals and firms come to exercise an influence over what gets funded and what does not get funded that is closely parallel to the influence that, say, Anna Wintour, has over fashion markets.

Few venture capital firms can successfully follow up on the successes that initially made them fabulously wealthy. Some begin to shift to more conservative investments, and their portfolios can look more like the sage of Omaha than a collection of risky start ups. Others continue to try to stake out risky positions, and fail almost as spectacularly as their earlier successes. The obvious example here is the firm of Kleiner Perkins.

Kleiner Perkins focused on a narrow band of technology companies at a time when tech stocks were rapidly increasing, also known as the “tech bubble.” Anyone who invested in tech stocks at this time, prior to the bubble bursting, made a lot of money. Since VC focuses on short-term start-up funding, they were especially positioned to profit from a boom that quickly spiraled upward before it crashed back down to the earth. In short — and this is something everyone should understand without difficulty — they were in the right place at the right time. After massive losses they threw a sop to their injured investors by cutting fees and tried to make it look like they were doing something constructive by restructuring their organization — also known as “rearranging the deck chairs on the Titanic.” But they still haven’t learned their lesson, because instead of taking classic VC risks with truly new ideas, they are relying on people who “proved” themselves at the tech start-ups that they glaringly failed to fund, Facebook and Twitter. This speaks more to mortification than confidence. Closing the barn door after the horse has escaped isn’t going to help matters.

Again, this is a very simplified version of events. Actual events are much more complex. Powerful and influential individuals who anticipate events can transform that anticipation into a self-fulfilling prophecy. There are economists who have speculated that it was George Soros’ shorting of the Thai Baht that triggered the Asian financial crisis of 1997. So many people thought that Soros was right that they started selling off Thai Baht, which may have triggered the crisis. Many smaller economies now take notice when powerful investors short their currency, taking preemptive action to head off speculation turning into a stampede. Similarly, if a group of powerful and influential investors together back a new business venture, the mere fact that they are backing it may turn an enterprise that might have failed into a success. This is part of what Keynes meant when he talked about the influence of “animal spirits” on the market.

What Keynes called “animal spirits” might also be thought of as cognitive bias. I don’t think that it one can put too much emphasis on the role of cognitive bias in investment decisions, and especially in the role of the substitution heuristic when it comes to pricing risk. In Global Debt Market Roundup I noted this:

It seems that China’s transition from an export-led growth model to a consumer-led growth model based on internal markets is re-configuring the global commodities markets, as producers of raw materials and feedstocks are hit by decreased demand while manufacturers of consumer goods stand to gain. I think that this influence on global markets is greatly overstated, as China’s hunger for materials for its industry will likely decrease gradually over time (a relatively predictable risk), while the kind of financial trainwreck that comes from disregarding political and economic instability can happen very suddenly, and this is a risk that is difficult to factor in because it is almost impossible to predict. So are economists assessing the risk they know, according to what Daniel Kahneman calls a “substitution heuristic” — answering a question that they know, because the question at issue is either too difficult or intractable to calculation? I believe this to be the case.

Most stock pickers simply don’t have what it takes in order to understand the political dynamics of a large (and especially an unstable) nation-state, so instead of trying to engage in the difficult task of puzzling out the actual risk, an easier question is substituted for the difficult question that cannot be answered. And thus it is that even under political conditions in which wars, revolution, and disruptive social instability could result in an historically unprecedented loss or expropriation of wealth, investors find a way to convince themselves that it is okay to return their money to region (or to an enterprise) likely to mismanage any funds that are invested. The simpler way to put this is to observe that greed gets ahead of good sense and due diligence.

Keynes thought that the animal spirits (i.e., cognitive biases) were necessary to the market functioning. Perhaps he was right. Perhaps venture capital also can’t function without investors believing themselves to be right, and believing that they understand what is going on, when in fact they are wrong and they do not understand what is going on. But unless good sense and due diligence are allowed to supplement animal spirits, a day of reckoning will come when apparent gains unravel and some unlucky investor or investors are left holding the bag.

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Grand Strategy Annex

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Second Thoughts from a Financier

George Soros, who made himself rich by shorting the currency of economically marginal nation-states (and therefore making them even poorer, if only for a time), has found a little project. Like Enlightenment-era benevolent tyrants with their claque of hired intellectuals, Soros has assembled some economic claqueurs to applaud the performance art he has made of his career as a financier. Since today the preferred form of intellectual society is the think tank rather than the salon, Soros’ claqueurs have been dutifully assembled as a think tank, and the new think tank has celebrated its introduction to contemporary intellectual society with a conference at King’s College Cambridge.

An aging merchant of the Middle Ages, sumptuous in his gold and furs but having second thoughts about his soul, would endow a monastery, or perhaps even take the habit himself in his dotage and confer all his properties to the institution that takes him in as a simple friar by way of atonement for his sins of covetousness. Well, Soros isn’t quite ready to go that far, but since religious houses were essentially medieval think tanks, by a quirky logic we might convince ourselves that economic think tanks are the religious houses of our day.

It is difficult to say which is more laughable: Soros’ think tank or the ability of these established, reputable economists of entertaining new ideas. I am reminded of a scene near the end of My Fair Lady (I’m thinking of the musical version with Rex Harrison and Audrey Hepburn). Eliza Doolittle’s father, previously a self-justifying slacker, is headed to a church to marry his common-law wife. He says to Eliza, “Now I’m respectable, she wants to be respectable.” Who doesn’t want to be respectable? Soros wants to be respectable, and to that end, by way of intellectual atonement, he has endowed a think tank. But respectability is a sworn enemy of creative, innovative thinking. True novelty in thinking comes with a willingness to not be respectable. Since think tanks are all involved in an elaborate dance with other entities that both crave and confer respectability, the entry of a think tank in the ranks of the reputable means a systematic cultivation of respectability in all opinions. This is one of the reasons that think tank publications usually read with all the gripping intensity of an editorial written by a committee.

In the Financial Times story, Economists clash on cause of crisis, Chris Giles wrote that, “Many of the world’s top academic economists agreed yesterday that the financial and economic crisis had exposed fatal flaws in their subject and ideas were urgently needed to keep economics relevant. While this represented an unusual consensus, the eminent economic brains lived up to their stereotype by disagreeing on what policies, if any, should be adopted to prevent a repetition.”

In any case, and despite any disagreements, they’ve got their ducks all lined up: a think tank, several Nobel laureates, a conference at King’s College Cambridge, and a website. I guess that makes it official. The website has a nice little introductory video with the director, Robert Johnson, George Soros himself, and several others offering soundbites. I was particularly intrigued by the soundbite from Soros. The patron of the new Institute for New Economic Thinking has delivered himself of this nostrum:

“Keynes has really had an insight, but after a while the economics profession rejected it and returned to classical economics, so this became the neoclassical school. And that neoclassical view of markets has become dominant, and this view has proven to be false in the recent financial crisis. So it’s appropriate in looking for new ways in interpreting financial markets the conference should be held where Keynes was teaching.”

This quote is in a short video that you can view by clicking on “Kickoff Conference” and then clicking on “Kicking off INET”

This particular statement resonates with me as I have in this forum several times addressed the idea of historical falsification both left and right. It has become a commonplace on the right that the collapse of the Soviet Union was a decisive historical refutation of Marx, while it has equally become a commonplace on the left that the recent financial crisis was a decisive historical refutation of free markets. While I do not deny the possibility of history falsifying theory, I do not believe that either of these instances are good cases, and neither of them prove the point their advocates wish to prove. I take the collapse of the Soviet Union as proof at tyranny cannot long endure, and the recent financial crisis as proof that irresponsible lending practices cannot long endure.

With apparently sanguine ease, if not sang-froid, the leftists of today overlook Marx’s “falsification” by history, just as the contemporary right will soon overlook the “falsification” of capitalism by history. Recently I was reading the Infinite Thought blog and saw a piece about an upcoming conference on historical materialism. The call for papers reads (in part):

“Notwithstanding repeated invocations of the ‘green shoots of recovery’, the effects of the economic crisis that began in 2008 continue to be felt around the world. While some central tenets of the neoliberal project have been called into question, bank bailouts, cuts to public services and attacks on working people’s lives demonstrate that the ruling order remains capable of imposing its agenda… Whether their focus is the study of the capitalist mode of production’s theoretical and practical foundations, the unmasking of its ideological forms of legitimation or its political negation, we are convinced that a renewed and politically effective Marxism will need to rely on all the resources of critique in the years ahead.”

It has long been a joke that the only Marxists left in the world are teaching in universities, and here we see that the old buggers still dream of a “renewed and politically effective Marxism.” Hope springs eternal in the human breast.

I continue to believe (as I argued previously, though I don’t recall exactly where) that the soul-searching within the economics profession as a result of the recent financial crisis is not function of the depth or totality of that crisis, but rather a function of the fact that elite professionals in banking and economics who had seemingly secure positions paying six figures in the financial industry suddenly and rather rudely found themselves without work, or knew someone who lost their job under traumatic circumstances. Previously this was unthinkable. In all the recessions since the Second World War, it was mostly, almost exclusively, the lowest tier of workers who lost their jobs. Thus the “unthinkable” proportions of the immediately past crisis was largely a result of over-representation of these elite classes in the professions, in the media, and in academia.

I‘m not terribly concerned about the future of capitalism, because, as I have stated many times, capitalism isn’t a theory as much as it is a weed: it crops up anywhere that it isn’t eradicated. Capitalism is simply what people do when they are given freedom to trade. Marx called free trade “that single, unconscionable freedom.” I’m not exactly sure why free trade is unconscionable, but I am sure that if you give people every freedom except the freedom to trade, you create a black market. There is still capitalism, but it is hidden, concealed. If you regulate trade, the ingenuity of the individual will do everything within the power of its imagination to circumvent, by hook or by crook, the regulations to the degree possible. As interdiction creates a black market, so regulation creates a gray market.

So bring on the regulators and the Keynesians and the disgruntled and the thwarted: if they have their hour in the spotlight, they will also most assuredly have their hour of reckoning. If they enjoy the approbation of the public at the present moment, they will also eventually experience the backlash of the public. And, whatever people happen to be saying, they will all the while be involved in the ordinary business of life, and they will seek to conduct the ordinary business of life as freely as they can.

In the meantime, I won’t be expecting any shocking revelations from INET.

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I previously discussed Soros in Humbug at Davos.

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Grand Strategy Annex

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