the dunning–kruger effect

In 1999, two academics from Cornell University in the United States, Justin Kruger and David Dunning, published a paper in the Journal of Personality and Social Psychology with the title ‘Unskilled and Unaware of It: How Difficulties in Recognizing One's Own Incompetence Lead to Inflated Self-Assessments’. The so-called Dunning–Kruger effect has since become an established trope in the field of psychology, although most people outside that field have probably never heard of it. However, the conclusions reached by this pair have never been more relevant.

The authors begin by relating the story of McArthur Wheeler, who robbed two banks in Pittsburgh on a single day in 1995 in broad daylight. He was arrested that evening, less than an hour after footage from surveillance cameras was broadcast on the local evening news. When police showed him that footage, Wheeler was incredulous.

“But I wore the juice!” he muttered.

Apparently, he was under the impression that smearing his face with lemon juice would render him invisible to video cameras. I think that I can guess what gave him this idea—lemon juice can be used as a primitive form of invisible ink—but to believe that it would render him invisible to video cameras betrays a level of ignorance that beggars belief.

The authors then make three points. The first two are probably uncontroversial: (1) in many areas of life, success depends on knowing which rules to follow and which strategies to pursue; and (2) people differ in the knowledge and strategies that they apply in these situations. The third point, which is more likely to evoke skepticism, is that when people are incompetent in the strategies that they adopt to achieve success, they suffer a double blow: not only do they reach erroneous conclusions and therefore make unfortunate choices, but their incompetence deprives them of the ability to realize their mistakes. Or, as Charles Darwin wrote in The Descent of Man in 1871, “ignorance more frequently begets confidence than does knowledge.”

One example used by Dunning and Kruger is the ability to determine whether a given sentence is grammatically correct. If a person’s knowledge of grammar is incomplete or incorrect, then such an assessment would be impossible. Another example is the widely reported ‘above average’ phenomenon: when people are asked to assess their ability in a given task, more than half of those polled rate themselves as ‘above average’, which is of course mathematically impossible. Both are perfect examples of what psychologists call ‘cognitive bias’.

The current relevance of this concept should now be obvious: the present occupant of the White House clearly thinks that he’s a genius when he is probably of below average intelligence. The fact he has stated that he is more likely to trust his ‘gut instinct’ than the opinion of an expert merely confirms that diagnosis. And the possible consequences of such arrogance are likely to be beyond his ability to comprehend.

For example, it is doubtful that he is aware of what happened the last time tariffs were imposed on goods imported into the USA on the draconian scale he has implemented. The Smoot–Hawley tariffs, named after the Utah senator and Oregon congressman who sponsored them, were signed into law by President Herbert Hoover in 1930. And while they may not have actually caused the Depression of the 1930s, they certainly made it much worse than it otherwise would have been.

There is also an echo of that period in the pre-Christmas turmoil on global stock markets; the Wall Street crash of 1929 didn’t cause the Depression either, but it was predicated on irresponsible speculation, and it did lead to a drying up of credit, thereby aggravating the economic situation at the time. So trade wars are a good thing, are they Mr Trump?

And because fools don’t understand nuance, this buffoon has decided to pull the 2,000 US troops currently in Syria out of the country on the grounds that Islamic State has been defeated (and he can take the credit). No it hasn’t! The kind of poisonous ideology espoused by these perverts may have suffered a military setback, but its attractiveness to a small minority of Muslims will take much longer to eradicate. And he is too stupid to realize that President Erdogan of Turkey is rubbing his hands at the chance to go after the Kurds in northeast Syria without interference from the USA. There is a moral aspect to this situation too: as President Macron of France has commented, albeit less crudely, you don’t shit on your allies.

There is another aspect of the Dunning–Kruger effect that I haven’t mentioned thus far: if a person is functionally incompetent, not only are they unable to recognize that failing in themselves; they fail to see it in other people too. Trump supporters: take note.

profit of doom

One of the recurring themes in the history of money is that every system for its creation and management contains within itself the seeds of some unforeseen future abuse.

The Colour of Money.

There is a widely held belief that the financial crisis of 2008 was caused by the creation of securities backed by American sub-prime mortgages. This is not true, although selling mortgages to people with almost no ability to repay their loans certainly didn’t help. The real cause of the crisis was an arcane activity known as ‘re-hypothecation’.

This piece of financial jargon needs to be explained. Most people, when they buy a house, have to take out a mortgage. Legally, they own that house, but the bank or other lender has the hypothetical right to repossess the house if the borrower falls behind with their repayments. This is hypothecation. If the lender uses the house as collateral for their own financial transactions, this is a simple form of re-hypothecation.

Of course, investment banks, brokers and other financial players don’t pull this stunt with mortgaged houses, but they do something very similar when buying bonds, commodities, futures and other financial products. In fact, according to the International Monetary Fund (IMF), the average number of times that the collateral for an initial trade is pledged to secure further transactions is four, a degree of leverage that would have made Archimedes break out in a cold sweat.

I should underline what this means: if four is the average number of times that the collateral for a trade is re-hypothecated, then the amount of collateral backing the global financial market is 25 percent. This should make everyone nervous, because with this level of under-capitalization, the global financial system is what might politely be termed ‘another accident waiting to happen’. The old practices have not been abandoned, and it is only a matter of time before the crisis of 2008 is repeated, probably with more serious repercussions than last time.

Although re-hypothecation lay at the heart of the 2008 crisis, this activity became possible only after the Glass–Steagall Act was repealed in 1999, thus destroying the wall between investment and commercial banking that had been put in place by President Franklin Roosevelt in response to the Great Depression to protect the savings of ordinary Americans.

Another effect of the Commodity Futures Modernization Act (CFMA), the official title of the legislation that repealed the Glass–Steagall Act, was to deregulate the trade in credit default swaps, collateralized debt obligations and other financial legerdemain. However, despite the obvious connection between CFMA and the financial meltdown that occurred almost a decade later, then Treasury secretary Laurence Summers continues to deny any responsibility for the resulting mess, although the president under whom he served, Bill Clinton, has since conceded that his signing of CFMA was based on bad advice, advice that one must assume came from Summers.

Despite the liberalization of financial markets that occurred in 1999, US Treasury rules continued to restrict re-hypothecation to a maximum of 140 percent of the original collateral. Unfortunately, such a rule did not exist in London, which is why AIG, Lehman Brothers and other American financial institutions carried out most of their transactions there, using UK-based subsidiary companies. Did you ever wonder why Lehman Brothers and Bear Stearns were allowed to fail, while other US financial institutions were given what were effectively cash handouts on the grounds that they were ‘too big to fail’? And did you ever wonder why it took $85 billion to bail out AIG? Surely a firm that was this much in debt deserved to go under, especially given that its losses were a direct result of re-hypothecation in London and not merely a temporary blip.

Allowing an ailing company to fail is the archetypal response in a genuinely free market, so President George W. Bush got it right with Lehman Brothers. He went wrong subsequently because the collapse of Lehman Brothers revealed a complex web of re-hypothecated financial transactions, and the realization that this kind of behaviour was widespread in financial circles induced panic among senior US administrators. The reasoning appears to have been that if Lehman Brothers, a relatively small investment bank with no retail business, was in such a mess, then the collapse of a larger financial institution in a similar pickle would trigger a catastrophe of unimaginable proportions, especially if that institution had a retail banking arm. This was the origin of the ‘too big to fail’ scenario, which merely encouraged more reckless speculation by banks, whose operators could continue with business as usual, safe in the knowledge that they had an implicit promise of rescue if they made catastrophic errors of judgement.

Although he hasn’t said so publicly, President Bush, like his predecessor, must have been given bad advice, and also like his predecessor, that advice is likely to have come from his Treasury secretary, who in this case was Henry Paulson. It should not be forgotten that Paulson, as a former CEO of Goldman Sachs, was one of the people behind the move to convert sub-prime mortgages into products that could be sold to unsuspecting investors, although this doesn’t excuse the Royal Bank of Scotland and other European banks that bought these intrinsically worthless securities and subsequently lost huge amounts when these ‘structured investment vehicles’ went sour. It doesn’t take a financial wizard to work out that an investment offering a rate of return that is above par must entail an increased risk.

Of course, other banks got into difficulties for other reasons. Northern Rock, for example, borrowed on short-term money markets to fund its mortgage business. I would have thought that a child in a kindergarten would instinctively grasp that borrowing short to lend long is not a sustainable business model.

It is a mistake to imagine that the surviving institutions have learned the lessons of 2008. In 2011, Goldman Sachs re-hypothecated assets worth $28.17 billion, but even this staggering total pales into insignificance when compared with JP Morgan Chase, which re-hypothecated assets worth $546.2 billion, and Morgan Stanley, which added $410 billion to the total. Although I cannot find more up-to-date figures, it must be reasonable to assume that this financial skullduggery not only continues to be practised but is also on a similar scale.

It must have seemed like a good idea when financial systems were globalized in the 1980s, and so it was. Globalized finance meant that international trade was made easier, but in the intervening years, partly as a result of the deregulation of financial services in major markets, the global financial system has become an end in itself, hence the massive proliferation of what are euphemistically called ‘derivatives’. It has become a system for channelling more and more money into fewer and fewer hands. There was a time when a country’s stock market index reflected the overall state of its economy, but the Dow Jones Industrial Average has been at or near record levels in recent months, yet the US economy remains in the doldrums. The only beneficiaries appear to be the country’s big financial players. I have heard Goldman Sachs described as ‘a money-making machine’. It is nothing of the kind; it is a money-grabbing machine. It does not create wealth.

What of the future? The labyrinth of re-hypothecated trading positions, collateral for which is a mere 25 percent of what should be the case, means that the failure of one link in the chain will have a domino effect on financial markets. And any chain, whether actual or metaphorical, is only as strong as its weakest link. The only unknown is the location of that weakest link, but when the crash does come, some financial institutions will not be ‘too big to fail’. They will be too big to save. It may be time to check whether there’s room under your mattress for your hard-earned savings. After all, they won’t be much less safe than if you put them in a bank. And they will earn only marginally less interest.

three-card monte

In the decades prior to their defeat by the British on the Plains of Abraham in 1759, the French ran a thriving colony in Quebec (‘New France’). However, administration from the centre was extremely casual: money arrived irregularly from the home country, and the colonial authorities were forced to improvise.

The model that they chose to emulate was that of Massachusetts, which in 1690 had issued the first paper money in North America. However, the only durable stock of paper available was playing cards, which had the dubious advantage of bearing the official government signature. These then became promises to pay that could be redeemed for gold or silver when ships from France finally arrived in the colony. Different suits were worth different amounts.

Unfortunately, as with regular paper money, if too many cards are dealt inflation results. In the final years of New France this occurred: need was immense, while the means for redemption were tiny. The purchasing power of the playing cards became vanishingly small, and this particular fiscal experiment ended in 1759 with the French defeat.

It is with some sadness that I report this story. Had it become standard practice throughout the world to use playing cards as money, then the recent activities of investment banks might have been more widely recognized as gambling earlier than turned out to be the case. It would also have been glaringly obvious that they were playing with a rigged deck.

In this respect, investment banking has a lot in common with the confidence trick known in America as ‘three-card monte’ and in the UK as ‘find the lady’, because the object of the ‘game’ is to identify which of three cards is the queen of hearts. If you see such a game in progress, by all means stay and watch, but on no account should you bet any money, because you are certain to lose. Despite appearances, it isn’t a fair game: the widespread encouragement to invest in mortgage-backed securities a few years ago merits a broadly similar description.

Three-card monte is usually played in a side street close to a busy area with a lot of people passing by on foot. The first thing you will see is a man standing behind an upturned packing case or cardboard box manipulating three cards and inviting spectators to put money on their ability to identify the queen. You should bear in mind that the ‘dealer’ is not alone. Some spectators will be ‘shills’, or accomplices, each with a different role to play in the perpetration of the scam.

At least one shill will be playing; he may be winning easily, or he may be losing outrageously. There is a reason behind these different strategies. In the first case, the appeal is to simple human greed; the second is a set-up for a second shill to make his ‘pitch’ to a potential ‘mark’, or victim. I always enjoy playing the latter, because part of the fun of watching a three-card monte operation is in identifying all the shills and listening to what they have to say. The most common angle is that they will point out that the game is crooked, but that they know how to beat it. I can see the appeal to vanity here: this offers a chance to scam the scammers. Of course, I always dip out when the question of putting down money arises. It is a pity that this strategy wasn’t followed by many employees of the big investment banks, who rushed to buy securities that offered exceptionally high returns with apparently little risk. With hindsight, it would be fair to say that they fell for both the appeal to greed and the appeal to vanity.

So how is it done? It is actually quite easy to follow the queen. However, when the dealer picks up the three cards, note that he must have two in one hand. A skilled card sharp can choose which of these cards to ‘throw’ onto the playing surface. The usual assumption is that he has thrown the bottom card, but if the two cards are being held correctly, it is just as easy to throw the top card. In other words, it is impossible, if the switch is done properly, to spot which of the two cards has been thrown first. So effective is this technique that even the shills may not be able to follow the queen, so a system of secret hand signals is needed to let them know its location.

What happens if the mark places his money on the correct card? Given that the golden rule in this type of con is that the mark is never allowed to win, how can this difficulty be circumvented? The usual tactic is for one of the shills, who will be aware that the mark has picked the correct card, to place a higher bet on the same card. The dealer then declares that he accepts only the highest bet in any given round of the game.

There are other tricks that can be employed, including the mystifyingly named ‘Mexican turnover’, which is an alternative method of dealing with the awkward circumstance where a mark selects the correct card. It, too, requires a degree of legerdemain. However, there is an interesting variant that I’ve seen being used in London that doesn’t require any such manipulation of the cards, although it is likely that the dealer can do so if required, because the three cards are always slightly curved around their long axes, which is a prerequisite for the standard throw described above.

In this variant, one shill will be playing, and he will choose the correct card to bet on each time. He can do this because he looks at the card first. Then he reaches ostentatiously for his wallet to take out some money, turning away from the cards as he does so. As this is taking place, the dealer brazenly swaps the queen for one of the other cards. Cue a second shill, who can point out to a potential mark how stupid the man must be for not keeping a finger on his chosen card while getting his money out. The mark is then asked to place his finger on the card while the second shill gets out his money.

And now comes the pitch: if the mark is prepared to match the stake wagered by the second shill, they can share the winnings. I cannot describe how the mark is relieved of his cash by this method, because whenever I’ve been in the position of the mark in this scenario, this is the point where I’ve always ‘made my excuses and left’. Older readers will recall that this was the standard form of words used by News of the World journalists in less prurient times as part of their exposés of illicit sex, drug dealing and other activities of which the newspaper disapproved, before it decided that it was more profitable in the long run to stay and watch. After all, whatever form money takes, there will always be some people who want more of it and who will not be deterred by the annoying detail that what they choose to do to get more of it might be illegal.

the colour of money

How much reliance do you place on promises? Do you, for example, expect them to be kept? Before you answer, you might want to consider the following:

The Hongkong and Shanghai Banking Corporation Limited promises to pay the bearer on demand at its office here ONE HUNDRED HONG KONG DOLLARS.

Inscription on HK$100 banknote.

This statement is meaningless. Assuming that the bank isn’t going to exchange your $100 note for another, I can’t help but wonder what it thinks the promise means. It’s obviously not going to exchange your $100 banknote for one $70 and two $15 notes, although it might as well given that this so-called promise is no more than a form of words. A piece of paper bearing such a promise is essentially worthless. Money is only as good as the confidence that people have in it, and paper money, it turns out, is no more than a gigantic fraud perpetrated against willing victims.

Until the First World War, it was possible to go into the head office of a note-issuing bank in most industrial countries and exchange such a promissory note for its equivalent value in gold. The war put paid to that practice. In even earlier times, silver (or gold), neatly fashioned into convenient units, was the only kind of money. Its value was real and instantly recognizable. Now all the ‘silver’ coins are cupronickel, which, if not intrinsically worthless, has a value that is a mere fraction of the amount engraved on the coin. Gold coins still exist, but they are not for everyday commercial transactions: they are simply bullion, a convenient way to amass and store wealth.

When humans first began to coalesce into settled agricultural communities, there was no money, and any inter-community trade would have been via the medium of barter. This would have worked well enough between small communities with broadly similar products to offer and similar needs, but as villages became towns and towns became cities, the need for a more efficient system would have become increasingly apparent. Hence the invention of coins, which resolved the obvious difficulty of finding someone who was willing to exchange their cattle directly for a wagon, or a sack of grain for a bolt of cloth.

Unfortunately, anyone receiving a gold or silver coin could not be sure what they were getting: coins might be of their proclaimed weight and therefore value, or they might be less. They might also contain an unknown amount of a base metal. Over time, a coin’s intrinsic value would be related to the perceived reliability of the issuing authority. In other words, money would either be reliable but scarce or unreliable but relatively plentiful. In both cases, uncertainty would be built in: uncertainty over opportunities for earning money, or uncertainty over what that money, once earned, would buy.

However, ingenuity didn’t stop with the invention of coins. The next innovation was the establishment of banks, which were used principally as repositories for accumulated wealth. They flourished first in the Roman Empire and reached a high level of development in the Italian city-states of the Renaissance. However, the first major innovation in banking practice took place in Amsterdam in the early seventeenth century. The majority of coins in circulation at that time were appallingly deficient in weight and/or purity, so the city’s merchants created a bank that was owned by the city—an embryonic central bank. The Bank of Amsterdam solved the problem of quality by going back to a system that had preceded the invention of coins: weighing. A merchant could bring all the coins that he had received in the course of business to the bank, and after they had been weighed their total value would be credited to his account.

This turned out to be a reliable form of money, because the merchant could then transfer some of that credit to a fellow merchant, and the recipient could be sure that he was getting honest weight. It wasn’t long before payments through the bank commanded a premium over conventional transactions. But then came an interesting discovery: the money deposited with the bank didn’t have to sit idly; the bank could lend that money. The borrower then had an amount that could be spent, but the original deposit could also be spent. There is an obvious difficulty here: the borrower and the depositor must not come for their money at the same time. They must trust the bank, trust it as far as believing that it isn’t doing what it does as a matter of routine.

One of the recurring themes in the history of money is that every system for its creation and management contains within itself the seeds of some unforeseen future abuse. It was thus with coins, clipped, ‘sweated’ with acid and otherwise debased until faith in their value had been eroded almost beyond repair. And so it was with the Bank of Amsterdam, which lent huge sums to the Dutch East India Company. The men who ran the bank were often the same men who ran the company, and over time the scrutiny given to loans grew increasingly lax. Times became harder for the company: there was war with Britain, and ships didn’t come back. One by one, loans went into default. As noted above, a bank can operate only if its depositors do not come for their money all at once. However, if they even suspect that they won’t be able to withdraw their money, they are sure to come. And they did. The Bank of Amsterdam was wound up in 1819.

However, long before the Bank of Amsterdam finally closed its doors, a far more spectacular example of banking malfeasance had occurred in France. Louis XIV had died in 1715, leaving the country bankrupt after a long and extravagant reign marked by a succession of largely pointless wars with much of the rest of Europe, and an heir only five years old. The country was therefore left in the hands of the regent, the Duc d’Orléans, a dissolute character with an expensive lifestyle and a big problem. The treasury was empty.

Apparently hopeless situations such as these offer opportunities for a scoundrel, and it wasn’t long before one appeared. John Law was the son of an Edinburgh goldsmith who, in 1716, obtained permission from the regent to open the Banque Générale. As part of the deal, Law’s bank took over the debts of the regent, and therefore of the country. In 1718, the bank became the Banque Royale, meaning that notes issued by the bank were guaranteed by the king; these notes were, in essence, promises to pay their holders their face value in silver or gold. It is not difficult to see why the regent was so easily persuaded.

In 1717, Law had acquired the Mississippi Company to support the French colony of Louisiana and to mine the ‘unlimited’ supplies of precious metals to be found there. However, as would soon become apparent to holders of the bank’s notes, the gold and silver backing the notes was in mines as yet undiscovered in the unexplored parts of the colony, which extended well beyond the boundaries of the modern American state, north to Minnesota, west to the Rockies and east to the Alleghenies.

By 1719, Law’s notes were being issued in the hundreds of millions. Government creditors who were paid off in the notes rushed to buy stock in the Mississippi Company and the Banque Royale. From the proceeds of these sales, more money could be lent to the government, more notes could be issued, and yet more stock could be sold. It was in effect a closed system for recycling worthless paper in which everyone involved was getting rich, on paper. The word ‘millionaire’ first appears during this episode.

Inevitably, doubts began to surface about the reality of the gold and silver, and people started to bring in their banknotes for redemption. By no stretch of the imagination was there enough gold and silver to pay off the notes, so payment was suspended. Law was lucky to get out of Paris alive.

However, there is another side to this story. In his role as comptroller general of France, Law had directed large sums into building canals and other useful public works. His mistake was not in issuing paper money but in issuing too much of it. Could the system be made to work if used in moderation?

The Bank of England had been set up in similar circumstances in 1694. The king, William of Orange, was also in debt, not as a result of succeeding Louis XIV but as a result of fighting him. He was persuaded that such a bank would solve his problems. Rich private subscribers put up the cash he needed, in return for which they were allowed to issue notes backed by the king’s promise to pay. This evolved into a system whereby these original subscribers, goldsmiths and the like, issued banknotes secured against the bullion in their vaults. When the Bank of England received such notes, it returned them for redemption, thus ensuring that these early bankers weren’t reckless in their issuing of banknotes.

As noted above, this remained the paradigm for the management of money until after the First World War, by which time the issuing of banknotes had become the prerogative of central banks. However, around this time the private banks discovered that they could make more money and therefore more profit not by lending money but by investing it. And therein lay the seeds of further abuse. Where investment had once been in stocks and shares, it metamorphosed into another system for recycling worthless paper: ‘structured investment vehicle’ sounds very impressive, until you realize that this was the label attached to an investment backed by American sub-prime mortgages. Which swindler thought that one up?