Gambling, economic growth and imagination
America's homeowners feel like busted gamblers after a bender in Vegas. They
wagered not only the nest egg, but the nest, with the abandon of tulip-bulb
traders in 17th century Holland. Americans are hard put to explain how the
American dream turned into a chip on the craps table. The focal point of
speculation was the asset one usually associates with secure domesticity. What
happened to the risk-averse Economic Man of textbooks?
The textbook was misleading to begin with: we are all gamblers and always have
been, argues Reuven Brenner, the Repap Professor of Business at McGill
University. In a series of books beginning in 1983 with History: The Human
Gamble and culminating with his latest volume, A World of Chance:
Betting on Religion, Games, Wall Street , Brenner yanks economics
inside-out by placing risky behavior at the center of the economic model.
Conventional economics describes an artificial world of slight deviations from
equilibrium; Brenner presents the real world, in all its danger and
uncertainty. Man lives not only by the sweat of his brow, but by the fortitude
of his intestines, for survival demands that we take mortal leaps of a kind
that are unknown to the conventional model. Men who would prefer to be timid
risk everything to leapfrog their peers before they themselves are left behind.
Rather than award yet another Nobel Prize to an economist who put bells and
whistles on the conventional model (Princeton University Professor Paul Krugman
was honored this past weekend ''for his analysis of trade patterns and location
of economic activity",) the Swedish Academy should have honored Brenner, who
gives us a model that makes sense in the real world of tumult and uncertainty -
2008 should have been Brenner's year, given the cataclysmic breakdown of the
conventional model. Only a few months ago, the governments of the world went
about their business as if nothing unusual was at work; now they are lurching
from one emergency plan to another and warning of a new Great Depression.
This sort of thing isn't supposed to happen in the imaginary world of the
consensus economic model. Radical changes, though, are the underlying premises
of Brenner's approach, which "deals with jumps - relatively large changes. The
traditional economic models can deal with small changes, where people adapt
passively but do not bet on any new idea," he writes. People take risks because
they know that gambling may be the only survival strategy under given
Why, for example, would Americans bet their homes? Within Brenner's framework,
we need to look to the circumstances that prompt apparent risk-friendliness,
rather than click our tongues over an outbreak of collective madness. As
Brenner and his wife, economist Gabrielle Brenner, explain:
reach the age of fifty or fifty-five and have not "made it", what are their
financial options to still live the good life? Except for allocating a few
bucks to buy lottery tickets, it is hard to think of any other option. If
people find themselves down on their luck and see no immediate opportunities to
get rich, what can they do to sustain their hopes and dreams? Allocating a
fraction of their portfolios on games with a chance to win a large prize is
among the options. And when people are leapfrogged - that is, when some
"Joneses" who were "below" them jump ahead - how can they catch up? They will
tend to challenge their luck too for a while, taking risks that they might have
contemplated before in business, financial markets, and other areas but did not
follow up with action.
As it happens, a huge
number of Americans began to turn 50 or 55 during
the past 10 years, as the baby boomers approached
retirement. Between 2005 and 2025, the number of
or over will jump from around 15% of the population to 25%.
Between 1990 and 2000, that is, the baby boomers reached the age at which
workers are supposed to earn their highest lifetime compensation and salt away
most of their retirement savings. Americans who saved money during the 1990s
put a great deal of it into the stock market and were bitterly disappointed. An
American saver who invested in 1996, just as the boom was getting underway,
would have given up all his gains by October 2002, at the stock market's
following the technology stock collapse. If the same investor held on to a
broad market portfolio all the way to the present, he would only break even
American asset markets did not offer returns high enough for the baby boomers
to earn enough to retire. There are a number of reasons for this. One is that
not only Americans, but Europeans, Japanese, and above all Middle Easterners
are aging rapidly and seeking retirement assets, such that the price of all
capital assets rose and their prospective rate of return fell. Capital markets,
as I have argued in the past, come down to old people lending money to young
people, and the declining numbers of young people in the industrial world
during the past generation are reflected in shrinking investment opportunities.
The prospective retirees of the world had no choice but to take more risk in
order to earn the returns they required. Riskier assets were brought to the
marketplace, such as subprime mortgages and high-yield loans. Professional
gamblers - the hedge funds - raised US$4 trillion to bet on the riskiest
portion of pools of mortgages and corporate credit. Americans found that the
global demand for mortgage bonds created an inexhaustible supply of cheap
credit even for the riskiest borrowers.
With home prices rising 10% a year between 1998 and 2006, Americans found that
they could use leverage to achieve triple-digit returns on their equity (if you
buy a $200,000 house with $10,000 down and its price rises by 10%, or $20,000,
your return on equity is 200%).
In retrospect, it may seem silly for the baby boomers to have assumed that they
could double the price of their homes and then all sell their homes to each
other and retire on the proceeds. Demographics ultimately destroyed the home
As a group, the baby boomers did not have sufficient funds on which to retire,
and, given the condition of American asset markets, could not earn sufficient
returns on conventional assets. Instead, they chose to "leap into uncertainty",
in Brenner's phrase. This sounds fairly general, but Brenner has elaborated his
view in a number of startling ways. How, for example, do entrepreneurs set
prices for new products, where demand is unknown? Brenner demonstrates (in
"Rivalry") that the mechanism by which they do so depends on the creation of
new markets. In effect, Brenner has replaced the view of human behavior at the
center of economics, and from this elaborated a set of theories, each of which
has enormous analytic power.
In Brenner's model, survival means maintaining one's social status, one's place
in the pecking order or the corporate food chain, because falling behind
decreases the likelihood of survival. Rivalry is the driving force, not an
abstract measure of utility. There is something profoundly Biblical in this
view: "I considered all labor and all excelling in work, that it is a man's
rivalry with his neighbor. This also is vanity and a striving after wind." -
The Jewish sages of late antiquity spoke of an "evil impulse", variously
identified with competitive or sexual drives, without which no one would build
a house, start a family or open a business. The entrepreneur, in Brenner's
view, resembles Goethe's Mephistopheles, who introduces himself as "the spirit
that always wishes evil, but always does good".
Brenner strongly believes that the greatest contribution to welfare comes from
letting individuals bet on ideas, pursue innovations, and overturn the existing
order of things. A profound faith in a beneficent providence is required to
draw this conclusion, for it is easy to argue that betting on ideas may produce
apocalyptically harmful outcomes.
Rivalry between nations never was so clear cut as in the preparations for World
War l. Each European nation feared being leapfrogged by the others. France
feared Germany's high population growth rate, Russia feared Germany's intrusion
into the restive western wing of its empire, Germany feared Russian
industrialization, England feared the losses of its ability to control the
continental balance of power, Italy felt left out, and so forth. All had
excellent reasons to fight rather than be left behind, but the result was the
collective ruin of all the European nations.
At the outbreak of the war in 1914, some of Europe's best minds exulted in the
"leap into uncertainty". Thomas Mann, arguably the greatest writer of the past
century, wrote a famous essay entitled "Thoughts in War" comparing the
risk-taking attitude of the artist and that of the soldier. A great sense of
liberation from the ordinary swept over Europe as its nations prepared to risk
everything for their place at the head of the queue. The trouble is that they
risked everything, and they all lost everything.
The stench of brimstone precedes the entrepreneur. As God told Mephistopheles
in the Prologue in Heaven of Goethe's Faust, human beings tend toward
unconditional rest, and to keep them on their toes God assigns them a companion
who must act as and be perceived as a devil. The great theorist of
entrepreneurship, Frank Knight, of the University of Chicago, is one of Reuven
Brenner's spiritual ancestors. His 1921 book Risk, Uncertainty and Profit
showed that entrepreneurs' compensation derives from the leap into uncertainty,
that is, the assumption of unhedgable risk.
Knight, unlike Brenner, thought that entrepreneurship did not add enough wealth
to justify the disruption that it occasioned. Joseph Schumpeter, who took from
Mephisto the notion of creative destruction and applied it to economics, was
pessimistic about the future of capitalism. He thought communism would triumph.
The apogee of gambling on ideas well might have been the Internet stock bubble
of the late 1990s, when any undergraduate with a few computer science credits
could launch a company on the equity market. It is hard to find the fault in
the system from a pure economic standpoint, for America's markets were the
world's most efficient. The trouble is that when we speak of a leap into
uncertainty, we leave the realm of probability distributions and enter the
realm of the imagination. The entrepreneur's vision of society five or 10 or 20
years ahead is what counts - how lives, mores and tastes will change.
Thomas Alva Edison had one sort of vision of the future when he invented the
electric light bulb and the phonograph. The Internet entrepreneurs of 1999 had
quite a different one, in which the delights of youth culture would somehow
substitute for cash flow. Once investors concluded that music downloads,
multi-player games, chat rooms and pornography did not justify a market
capitalization larger than America's manufacturing plant, the illusion was gone
and so were the valuations.
For that matter, the ill-fated markets for structured credit and mortgages of
the past 10 years had the undivided attention of some of the world's best
applied mathematicians. Never before were risks so parsed, measured, cut, dried
and marketed to different investor groups with different risk preferences.
Professional gamblers, or "hedge funds", were enlisted to manage the riskiest
part of the capital structure, while legions of mathematicians arranged other
securities to be as safe as possible - for example, AAA-rated securities backed
by subprime mortgages that are now trading at 50 cents on the dollar.
We have no choice but to leap into uncertainty, where imagination takes the
place of probability distributions. Standing still and doing nothing is the
most dangerous strategy of all. The one thing we know about all places and all
times is that if you stay in the same place doing the same thing long enough,
someone is going to come along and rape the crops, burn the women and take you
out of the picture.
But what if our imagination goes wrong? If Ecclesiastes (4:4) recognized that
business stems from rivalry, as Reuven Brenner maintains, this must be balanced
against Jeremiah (7:24), which warns that the people "walked in the counsels
and in the imagination of their evil heart, and went backward, and not
forward". Brenner has given us as much as economics possibly can: he walks us
to the moment of the mortal leap, describes the conditions that motivate it,
and reminds us that we have no choice.
But it is important to keep in mind that economics does not explain everything.
If we decline to raise a next generation, and abandon ourselves to so-called
youth culture, ultimately we will encounter imbalances that economic policy
cannot cure. Our imagination is the basis on which we make leaps into
uncertainty, and how we cultivate this imagination ultimately may be of greater
import than economics as such.
Note: 1. A World of Chance: Betting on Religion, Games, Wall Street, by Reuven and
Gabrielle A Brenner with Aaron Brown. Cambridge
University Press (August, 2008). ISBN-10:
0521711576. Price US$29.99, 352 pages.