A fellow by the name Eric Falkenstein absolutely nails it :
In an expansion investors are constantly looking for better places to invest their capital, while entrepreneurs are always overconfident, hoping to get capital to fund their restless ambition. Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic entrepreneurs seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign, such as naïve hope that they will learn what works once they get their funding, or sincere delusion that the characteristics are the essence of the seemingly promising activity. The mimicking entrepreneurs are a consequence of investing based on insufficient information that is thought sufficient, but they make things worse because they misallocate resources that eventually, painfully, must be reallocated.
Once the number of mimics is sufficiently high, their valueless enterprises become too conspicuous and they no longer pass off as legitimate investments. Failures caused by insufficient cash create a tipping point, notifying investors that some of their material assumptions were vastly incorrect. Areas that for decades were very productive, are found to contain exceptional levels of fraud, or operate with no conceivable expectation of a profit. Everyone outside the industry with excessive mimics marvels at how such people—investors, entrepreneurs, and their middlemen--could be so short-sighted, but the key is that the mimics and duped investors chose those business models that seemed most solid based on objective, identifiable characteristics that were, historically, correlated with success. An econometric analysis would have found these ventures a good bet, which is why investors did not thoroughly vet their business models. For example, banks stocks through 2007 were one of the best performing industries since industry data has been available in the US, and performed well in the 2001 recession). Another notable example: when I was head of economic risk capital allocations for KeyCorp in the 1990s, residential mortgages had the lowest risk allocation because of their decades of minuscule loss rates; speaking with an economic risk capital allocator recently, they currently have the highest.
Efforts to prevent the next recession face a large difficulty, in that the impetus by necessity will be in the area that invites the least concern, because that is where mimics fester. Any risk analysis that can identify risky ventures necessarily identifies safe ones, and when these safe investment characteristics become known to the mimics, they will be exploited. Top down risk management, the focus of so much policy talk in Basel, Washington, and wonky journals is futile, because risk grows dangerously only where one does not suspect it (G-7 sovereign debt, anyone?).
This suggests focusing on robustness, as opposed to prediction, because the system works against rational expectations, especially those consensus ideas that come out of large bureaucracies. After all, what better sufficient statistic for a mimic to exploit than some well-known regulatory bullet point that supposedly ensures trivial risk? Recessions are not going away; they are endogenous because zero mimicry is not an equilibrium among insects, reptiles, or humans. Expect more unexpected recessions, just not real soon, and not in subprime housing.
This beautiful and certainly correct model explains a number of disparate things, such as :
- Why Ycombinator is such shit today, in spite of Paul Graham being so smart a decade or two ago.
- Why "upstanding" (in their own view) members of the "community" hate me so in every "community" ever, be it BTC derpage or Romanian online publishing or whatever else have you. The discussion usually centers around "politeness", because the mimics don't really have the intellectual ability to identify, nor the ethical fiber to enunciate the real problem : I am disruptive. I am disruptive, and they require a particular sort of formal stability to spin their silks.
- Why my punishment modeli works so well : it's exactly the bane of mimicry, the only way to survive in such an environment is to do it for real, rather than pretend like you're doing it.
- Why, as little as we might like this idea, copyrights, trademarks and patents aren't going anywhere anytime soon. While the superficial seductiveness of "information wants to be free" and other similar bullshit is very compelling, the most important antagonist in business is mimicry, and tools are needed to fight it. These may not be very good tools, but they still can't be removed, only replaced, with better ones. So don't tell me how information "wants" things, it doesn't. Tell me instead how are you going to design a better copyright model. That's what's worth money.
I am thankful for this, I feel smarter for having read it. Thank you Mr. Falkenstein.———
- As described in the earlier Romanian "Arta pedepsirii", the art of punishment : "punishment must be impredictable, disproportionate and visible". Impredictable so the guilty is caught operationally unprepared, disproportionate so the guilty is caught financially unprepared, and visible so his unpleasant experience may serve others well, through showing them that their turn will come, it will be at an inconvenient moment and it will not have been worth it. [↩]