Monday, November 17, 2008

The Hidden Context of the Financial Crisis

The failure of the financial system to respond as desired to Washington’s initial bailout of AIG this summer, the autumn failure of the broader $800 billion bailout package, and the subsequent change of course by Paulson--who is now using his $800 billion in ways not intended when Congress gave it to him--suggest that we do not really know what is going on. The precise focus of these initial efforts on individual companies, as though Washington felt that American economic fundamentals were fine and only a few minor glitches (e.g., AIG, WaMu, Lehman, GM) needed attention, suggests the problem: the typical tendency of people to focus on superficial events rather than underlying causal dynamics.

As far as the financial crisis is concerned, we do not really know what is going on.

An easily overlooked part of understanding is to consider things that did not, but might have, taken place. The “dark side of the moon”—i.e., the unseen event or the alternative that did not occur--can only be seen by shining light on it; this is hard to do and expensive. (Taleb, Black Swan, 132.) Therefore, we focus on the known and presume to explain why it had to occur. The resulting narrative is understandable and satisfying…but probably a fairytale.

We need to force ourselves to consider the “dark side of the moon.” This mental exploration is necessary for understanding; possibly, it will also warn us about surprises yet to come. My assumptions here are:

  1. when something happens, it is in truth a near thing; but for the precise correlation of precursor events that actually occurred, any one of a multitude of other things might have happened;
  2. while some of those potential outcomes are now no longer possible, others may remain lurking in the shadows of potentiality, waiting for a chance to emerge as the new reality; the fact that A occurred may not preclude B from subsequently happening anyway.

Is Assumption #2 correct? Can we evaluate it for a specific set of circumstances so as to inform our understanding of the future?

Which other outcomes might have occurred this fall instead of the financial crisis that in fact did occur? Of those, which remain possible?

I know an intelligent, sober person who withdrew all her savings from an unstable bank the day of the initial market crash because she could not afford to take the chance of not being able to access her funds without delay. How close did we come to having the whole U.S. public lose faith in the banking system to that degree, generating an Argentina-style run on the banks? Surely, it is at least plausible that such an eventuality could still occur. Suppose Washington spends every billion it can get its hands on bailing out the rich, and then something provokes such a loss of faith in the system. What would be the result? General chaos followed by emergence of a dictatorship, to the relief of the masses? Rejection of capitalism in favor of socialism? Revolution? Decline of the U.S. into third world status?

This thought experiment sensitizes us to the possibility that we have, so far, been very lucky, despite the hardship already caused by the financial crisis...and that our luck may not hold much longer. The experiment suggests that thinking along these lines may help us to figure out ways to minimize the likelihood of feared outcomes, rather than blundering into them. Do we blunder into bad outcomes that could have been avoided? Given the fact that Washington chose to reduce oversight over the financial system while simultaneously choosing to conduct a highly expensive, expansionist foreign policy, one could be forgiven for thinking so.

If the financial crisis on Wall Street was unleashed by Washington’s decision to weaken regulatory controls, it seems to follow that we could have avoided the crisis simply by following standard procedures already in place. However, that conclusion overlooks several long-term negative “features” of the broader environment:

  • Continuation of the expensive foreign policy, including wars in Iraq and Afghanistan;
  • Collapse of the housing bubble and rise in foreclosures;
  • Worsening strains on the health care system;
  • Degradation of America's infrastructure;
  • Continuing rise in the U.S. national debt;
  • Continuing degradation of the economic position of the average American.

The broad economic environment seems to have been getting more and more unbalanced and bimodal (most getting poorer while the lucky and corrupt got richer), suggesting that even maintenance of normal regulatory procedures might not have sufficed to prevent the financial crisis.

That, in turn, suggests that, while a return to responsible regulation may well be a necessary first step and while bailouts may possibly be a useful short-term “finger in the dike,” we are not even close to putting the economic fundamentals back in order: the housing crisis, the economic well-being of the average citizen, and the cost of a militant foreign policy must all be taken into consideration. It follows that we should anticipate further shocks until steps have been taken to address those systemic weaknesses.

This analysis may be sufficiently sobering already, but it is even more sobering to reflect that the above remarks are all truly rather obvious, which raises the question:

What else is there that we do not know?


Famed Nobel Prize-winning economist Freidrich Hayek provided some background insights about "things we do not know" in his 1974 Nobel address:

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences - an attempt which in our field may lead to outright error. It is an approach which has come to be described as the "scientistic" attitude - an attitude which, as I defined it some thirty years ago, "is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed."1 I want today to begin by explaining how some of the gravest errors of recent economic policy are a direct consequence of this scientistic error....

Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.

It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world....

...the confidence in the unlimited power of science is only too often based on a false belief that the scientific method consists in the application of a ready-made technique, or in imitating the form rather than the substance of scientific procedure, as if one needed only to follow some cooking recipes to solve all social problems. It sometimes almost seems as if the techniques of science were more easily learnt than the thinking that shows us what the problems are and how to approach them....

The chief point we must remember is that the great and rapid advance of the physical sciences took place in fields where it proved that explanation and prediction could be based on laws which accounted for the observed phenomena as functions of comparatively few variables - either particular facts or relative frequencies of events....

A theory of essentially complex phenomena must refer to a large number of particular facts; and to derive a prediction from it, or to test it, we have to ascertain all these particular facts. Once we succeeded in this there should be no particular difficulty about deriving testable predictions - with the help of modern computers it should be easy enough to insert these data into the appropriate blanks of the theoretical formulae and to derive a prediction. The real difficulty, to the solution of which science has little to contribute, and which is sometimes indeed insoluble, consists in the ascertainment of the particular facts....

Often all that we shall be able to predict will be some abstract characteristic of the pattern that will appear - relations between kinds of elements about which individually we know very little. Yet, as I am anxious to repeat, we will still achieve predictions which can be falsified and which therefore are of empirical significance....

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants. There is danger in the exuberant feeling of ever growing power which the advance of the physical sciences has engendered and which tempts man to try, "dizzy with success", to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will. The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society - a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

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