Friday 30 November 2012

The Credit Crunch and the normal distribution of intelligence

15 points of separation

Three months ago the press decided that we had reached the 5th anniversary of the credit crunch, thought to have started in August 2007. Most of their explanations concentrated on bankers and their creation of derivatives based on mortgage debt. Absent from this account was any clear admission that citizens differ in their ability to understand numbers.

Looking at the credit crunch through the lens of general intelligence provides another perspective. This brief note, written to another intelligence researcher two years ago, looks at the issue in terms of standard deviations of intelligence, so each sigma is 15 IQ points. A 2 sigma is IQ 130, a 3 sigma IQ 145.

How did the international bankers screw up?

The managers were 2 sigmas, and they hired too many 3 sigma mathematicians whom they couldn’t really understand. The 3 sigmas were so happy with their bonuses that they kept cranking out complicated derivatives.

The managers liked the answers they got from the mathematicians, which seemed to make risk disappear by distributing it very widely.

They cranked up a sales campaign run by 1 sigmas, who cruelly exploited the –1 sigmas and –2 sigmas, all encouraged by vote buying politicians (2 sigmas?) who wanted to give everyone a house even if they couldn’t pay for it. 

A few 2 sigma bank managers could have stopped the rot, but most of them had been fired because they were too old, and couldn’t adapt to selling complicated derivatives.

People can only easily communicate within 1 sigma bands, so the situation was ripe for confusion.

Hence John Paulson and a few other 3 sigmas made immense fortunes by understanding all this and then working out a way of shorting mortgage protection insurance securities. Paulson made a personal gain of 2.5 billion dollars.

I hope that explains it all.

Epilogue: Damn the bankers

Looking at the recent press coverage, the “damn the bankers” narrative downplayed the part played by governments who were only too glad to encourage any borrowing that made their voters happy. Far from just being lax in their regulation of banks, Governments often encouraged the relaxation of lending criteria which brought in new grateful homeowners. Citizens lapped up the credit, correctly gambling that if enough people got into debt they would never have to pay it back. So, the irony is that citizens who got into debt probably played their cards better than those who built up their savings.

In fact, the general intelligence perspective on the credit crunch places it in the general context of how citizens of different ability levels deal with each other. This goes far wider that just the management of credit. More of that later.

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