It’s the Stupidity, Stupid.

We, humans, only appear rational. Rationality is a funny illusion that the objective parts of our minds play on the subjective parts. Think of playing a piano. We can watch a concert by the world’s best pianist and remember every detail of their behavior, but we cannot go from that observation, untrained or experienced in piano playing, and play the same, magnificent concert ourselves.

The subjective execution of the objective observation does not connect. You might argue that this is due to the “muscle memory” of the pianist which the observer would lack, and it is really a physiological limitation than a neurological one. Let’s take trained behavior out of this and meet in the parking lot.

When you go shopping for groceries, pay attention to how the cars stack up relative to the entrance door. You will find the aisle in front of the door is stacked up much higher than any other aisle, and that the number of cars in those other aisles steeply decline the further away you get from the entrance aisle. In effect, the cars distribute in a bell curve.

If we were rational, we would distribute in the shape of a semi-circle. A semi-circle is the best way for everyone to get a close as possible to the door. A bell curve is the shape of randomly behaving individuals settling about a single objective, the entrance. In the lot, we are thinking more of our objective, the entryway, not as much our geometric distance from it. Our perception is that the best place to park is the location which gives us the best view of that entrance, the aisle directly in front of it.

One way we deal with our tendency to act irrationally is to limit our behaviors so that the randomness is safely bound. The parking lot, again, is a great example of this. While we allow individuals to park in any aisle they want, no matter how irrational, we don’t seem to mind obeying the lines with in which we must park (for the most part). What happens when those lines disappear?

A friend of mine had a great example of this, pictured. This picture was taken in his work parking lot after they had experienced some rain, enough to make the already fading lines disappear. His vehicle, unfortunately for him, is the jeep stuck in the middle. Let’s remember that this is a work parking lot, which means that the individuals who are parking here do so habitually (it should also be noted that some of these parkers are engineers, who should be highly rational). Erase the lines, and the illusion of rationality disappears.

The lines in the parking lot are the physical embodiment of regulation. They are an objective, observable indicator of the legal frame within which one can park. These lines are used to make the parking lot not only an effective place to park but to enter and exit. We accept these rules because they do, in fact, make our lives easier and safer by making them less random. They are in effect the admission that our subjective minds must be bound to work in an objectively rational way.

Effective laws work by properly bounding the randomness of our behaviors so that are free to act however we want. This way we can effectively be confident that these behaviors will do no worse than only affect ourselves. However, this is not the case with out current financial system.

Unlike parking lots and street signs, the world of finance exists in a conceptual form. The boundary of objective and subjective behavior is easily muddled since the only place they are effectively measured is in the mind of those operating within those financial institutions and the regulators which observe them. We cannot easily identify when someone double-parks a derivative or accelerates their bank into a high risk situation.

We need boundaries within which randomness can safely occur; where risk can exist, but not jeopardize the safety of the whole system. Right now we are heading the wrong direction. The TARP money and the directives regarding its use are not objective boundaries, but subjective directions, telling banks how to behave. Like valets parking cars, this method may work to some extent, but it is costly, time consuming and prone to failure based on the competence of the valets.

The reason the market lacks confidence to trade is because they have just experience a multicar pile-up in their parking lot far worse than the one pictured. Piles and piles of cars (probably a semi and a few campers) are jammed in end over end and no one knows how to get their vehicles in or out. There are no lanes so no one knows who to trust for direction.

Directing bank behavior, regarding lending, is if anything a short term solution. We want a financial environment in which banks are self-motivated to make their random, subjective decisions in a safe environment. To do this, we need to establish an objective, measurable parameter all the banks can agree to, lines in the lot. Start with either eliminating high risk loan types or limiting the percentage of high risk loans any single bank can hold. Second, we need to stop the ability to mix and mask loans into things such as derivatives or other secondary types of financial tools. We must know for certain that the parking lot is for parking cars and nothing else.

The function of loans is fundamentally to give a short term resource to help individuals get towards a long term gain. Any activity with that loan, derivatives or other kinds of repackaging, is fundamentally betting on those loans’ successes or failures and should be treated as gambling. Gambling on the success or failure of one’s fiscal solvency is also part of the challenge with the stock market as well. Tools like short selling also do this same thing with the stock values. Together these bets make a very dynamic and unstable economic system.

Imagine if we started taking bets on the ability of individuals to get in or out of the parking lot unscathed. By being able to bet on the success or failure of cars to get out undamaged would mean that some individuals will be putting money on the ability of some cars to destroy others. Those gamblers’ end objective is not to get cars in and out, but to make money by damaging cars in the lot. This is effectively what our banking system and stock market have done by allowing any type of bet beyond the initial stock buy or loan to be played. What we should learn throughout our recorded history, and from the recent wars in Iraq and Afghanistan, is that destruction is far easier, cheaper and a surer bet than construction and success. The risk of the initial act of loans or stock purchase is risk enough for the system. The rules of these are clear like lines in the lot.

Our economic system needs to be sorted out with a guarantee that the lot is indeed a parking lot and not a demolition derby. Until those laws are properly set, any confidence in the market will be short term and shallow, an illusion of rationality.