Sunday, July 12, 2009

Rational Animal Spirits

In a previous post, Politics for Dummies, I said:
If you are trying to eliminate the effects of a particular problem, do you think it would ever help to understand the causes that give rise to the effects? For example, if a building were on fire, do you think it would help that the firemen in charge understood what tends to fuel a fire and what tends to extinguish it? If they did not understand the causes, wouldn't they be as likely to throw a ham sandwich on the fire as to pour water upon it? ...Obviously, if one does not understand the causes, the solution may actually be worse than the problem itself. At best, the supposed solution can only mitigate or eliminate effects through random chance.
To see this point in reality, consider two different takes on the present financial crisis.

One which I enjoyed immensely was
John Alllison's lecture on the financial crisis. According to Titanic Deck Chairs, when the lecture was given at a Chicago conference, it resulted in "the entire room of hundreds of high-powered financial people [giving] a rousing standing ovation...while the members of the Fed sat motionless." Allison's thirty-eight years of experience in the banking business including serving as the current CEO of BB&T gives him unique, detailed knowledge of the causes of the financial crisis. His detailed analysis of the Federal Reserves manipulation of interest rates, government policies that forced banks to lend to sub prime customers, and the government apparatus enacted to encourage underwriting such as Fannie and Freddie lays the blame for the crisis squarely on government policies and "misregulation" of the banking industry which, contrary to popular belief, is the most heavily regulated industry in America.

Since I already understood the role of the Fed and the GSE's in causing the crisis, what I found even more interesting were the not so obvious ways in which government policy caused the crisis. For example, Allison details how regulators became obsessed with mathematical models of risk in the 1990's. Such models are inherently flawed as they are based on simple statistical assumptions that can not account for real world risks which are non-normal and virtually impossible to model. Based on these models, which had been fitted to a benign environment, banks were forced to lower loan loss reserve assumptions which encouraged leverage and risk taking. (There is a deeper factor related to this observation concerning the philosophy of "empiricism" which I will discuss in another post.)

Another interesting detail was related to FASB accounting rules enforced by the government which force so-called "fair value accounting" standards on banks. Since a bank must mark its portfolio to actual real time bids rather than the economic value of the portfolio, liquidity for these securities dried up as banks feared that even though they would get a good deal, the accounting standard would force them into bankruptcy. To understand this, imagine the government made you value your home at the price you would get if you absolutely had to sell it tomorrow. Would that price make sense on a balance sheet?

Allison derives the correct conclusion: that it is the government, not the market, that is to blame. What's interesting is that many other bankers and economists who have access to the same observations as Allison have not drawn this conclusion. Why was Allison able to derive the appropriate conclusion from these facts?

One needs to be able to think in principle in order to abstract a generalization from facts. Such a process entails the integration of these facts with all other known facts in a non-contradictory fashion. Allison's integration of economics, politics, ethics, epistemology and metaphysics allowed him to know without even understanding the details of his own profession, that government intervention in the economy would lead to disaster. Given his breadth of knowledge in his own field, he could readily take the observed facts and show how they support his position that it is government and not markets that are to blame.

This example demonstrates that understanding "economics" is not enough to draw the proper generalization. The evidence for this is overwhelming. Brilliant businessmen, scientists, economists, etc. have access to the same facts of reality but only a few draw the proper conclusion.

Consider the vast power of principles. Rather than analyzing the minutia of every conceivable intervention into the economy - schools, roads, medicine, energy, cosmetology, etc. one simply needs to grasp that, in principle, government intervention must lead to disaster. Yet, modern intellectuals, react to the consequences of these programs with surprise and bewilderment each time they fail. Like a non-conceptual dog, who jumps for joy each time his master comes home, modern intellectuals are unable to abstract the common denominator.

To further grasp how the lack of principles affects the world on a daily basis consider these statements made by famous academic economists in this
Bloomberg article:

The worst recession in half a century may be prolonged because consumers see few signs job losses and declines in home prices are ending, economists Nouriel Roubini and Robert Shiller said.

“The fundamental problem, as Franklin Delano Roosevelt said in 1933, is fear,” Shiller, a Yale University professor, said yesterday on Bloomberg Radio’s “Surveillance.” The Great Depression was deepened by a “sense of lost confidence or animal spirits that was a self-fulfilling prophecy. The worry is that we will have the same kind of issue arising again,” he said.

While it is certainly true that "fear" will result in a loss of confidence or "animal spirits" and decrease risk taking and severely restrict economic growth the real question is why are people scared. What is the cause of the fear? Shiller seems to be suggesting that this "fear" is a disembodied, ethereal entity which in and of itself can cause a downward economic spiral.

Of course, fear is not a primary. Presently, it is caused by uncertainty in government policy as it relates to taxation, health care, energy, and the banking system to name a few. The federal government has embarked on trillion dollar spending programs that siphon productive capital from private markets, increase the rate of taxation, and threaten the specter of hyperinflation. The House just passed a 1200 page "climate change bill" that threatens to completely upend the lifeblood of American commerce: the energy markets by increasing costs, dramatically increasing regulation and making the source of supplies uncertain. They are now threatening to further government intervention into health care, which is the source of tremendous cost and anxiety for American businesses and individuals.

The idea that the economy is governed by mysterious forces that we can not understand or control appears to be the essential guiding theory of modern economists - an observation I blogged about here. In that post, I discussed Fed Chairman Bernanke's arbitrary claim that the economy would likely get better by the end of the year.

...Fed Chairman Bernanke can claim he thinks the recession will be over by year end, as if in the midst of trillions of dollars of debt, government nationalization of the banking system, regulations that make the productive into criminals, strangling environmental policies, confiscatory tax rates on virtually every aspect of existence, suddenly it will just all be “over”.

In this post in which I debunked Obama's claim that things must get worse before they get better I said:

In other words, they appear to be making this claim on the premise that it is a metaphysical absolute that things must get worse before they get better. It's almost as if they believe there is a mystical force shadowing the nations' economy which necessitates recession and malaise and which can not be understood or resisted.

Shiller and Roubini are men who have spent their entire lives devoted to the economics profession at the highest levels. They certainly have access to the same facts as Allison, yet what is their argument: we have nothing to fear but fear itself...? Well, besides fear, they do have another explanation:

Both Shiller and Roubini said a lack of regulation allowed banks to take unmanageable risks, leading to the government’s takeover of American International Group Inc. and the collapse of Lehman Brothers Holdings Inc.

This is a complete evasion of reality and/or utter intellectual negligence. As Allison pointed out, banks are the most regulated industry in the country and it was government policy that encouraged and even demanded that banks take these risks. What could lead to such a ridiculous claim? I think at root it has to do with Platonism. I believe that such academics believe that Platonic Philosopher Kings able to access true reality (such as themselves), are always in a better position to know what to do as opposed to mere businessmen who are tainted by the base, selfish pursuit of material wealth.

Why does Bernanke predict a recovery and Obama claim things will get worse? In the past, they observe that, statistically, recovery takes place after X amount of time. They never ask why the economy recovered in the past or seek to examine the causes of those busts and what factors led to recovery. Shouldn't they be asking themselves what are the causes of the current crisis and are these government policies making it better or worse? Quoting the article:

Home prices in 10 major U.S. metropolitan areas fell 0.7 percent in April, the least since June 2008, according to a S&P/Case-Shiller home-price index, the latest sign that the worst of the housing slump may be passing. Sales of existing homes increased in April and May, while new construction rose in May from a record low.

“A slowing in the rate of decline is good news, and it suggests that it will continue to slow in coming months,” Shiller said.

He sees the numbers and extrapolates a trend. Send him the Nobel Prize.

Now, perhaps, these academics do understand that "affordable housing" programs that provide incentives for excessive leverage and loans to people that can not afford them are a bad thing. But, they might conclude that such programs are "noble" since they are based on altruism so they reject the claim that such programs be prohibited. Sure, they might understand that inflation acts as an insidious tax and violate the liberty of individuals, but so what, if the program is "well-intentioned"? Or, they may reject the idea of principles and causality altogether and base their theories on empirical studies that demonstrate a statistical relationship between psychological studies of fear and GDP.

If these academics embrace this type of non-conceptual approach to knowledge, they are at the level of animals that regard each experience as an entirely new phenomena. At best, they can grasp at relationships that appear to be related (like fear and recession), although they would not even think to trace cause and effect. So, if these non-principled, non-conceptual economists are called in to "analyze" the crisis, what is likely to be their recommendation? Could they grasp that only a removal of the causes of the crisis will indeed result in true recovery? Will they advocate economic freedom, repeal of regulations, abolition of the Federal Reserve, and a return to hard money?

The U.S. needs another stimulus package because President Barack Obama’s initial $787 billion plan hasn’t been implemented fast enough, according to Shiller. Roubini, an economics professor at New York University, said more spending is necessary to avoid stagnation like Japan’s in the 1990s.

So there you have it - they advocate the causes of the crisis to solve the crisis. Of course, this is worse than throwing a ham sandwich on a fire. Their "solution" is equivalent to throwing gasoline.


Harold said...

"I think at root it has to do with Platonism. I believe that such academics believe that Platonic Philosopher Kings able to access true reality (such as themselves), are always in a better position to know what to do than mere businessmen who are tainted by the base, selfish pursuit of material wealth."

I think that's absolutely true. Many of these guys come to the table with certain emotional and political motivations and they are just looking for "reasons" to have more restrictive policies enacted.

"So there you have it - they advocate the causes of the crisis to solve the crisis. Of course, this is worse than throwing a ham sandwich on a fire. This is equivalent to throwing gasoline."

And then they'll call the ensuing explosion a "market failure" because the market (voluntary exchange of values) didn't conform to their wishes. This naturally will necessitate more controls to add "stability" and repair "consumer confidence".

And speaking of which, I think another problem (and it may be just a language issue) is how trade is dichotomized into consumption and production. As if there are those who just build things and those who just use them.

Very interested to hear your thoughts on empiricism.

Realist Theorist said...

Two (unrelated) comments:

1) Reading about the reception that Allison got, and also reading a transcript of a talk by fund manager Robert L. Rodriguez, it struck me that there are few but enough people in the financial industry who understand the problem and the real solution. They probably disagree on other things, and I suppose there is nothing that brings these people together as a single voice to effect change.

2) Standards have their advantages. The notion that firms should stick to an enforced common standard of accounting is flawed. It is probably based on the false notion of enforced "free competition", and enforced easy access to information. over the weekend, I was reading about a bank in the later 1800s that would move an entire loan to "reserve for doubtful" if a payment was 24 hours late! Some might think that understates current income; however, it is not the government's call.

Doug Reich said...


Re production vs. consumption, I blogged about that at link below in "Production and the Primacy of Existence":

Far from just semantics, you have identified a key issue which is the core of the Keynesian vs. Austrian (reality) argument.

Doug Reich said...


Good observations. thanks.

There are many in financial arena that are very sympathetic to capitalism and free markets and sense or understand that the government is the problem. What I have found, however, is that when you dig deeper, these same people embody the typical problem with the right: lack of principle. So, they will be for "capitalism" generally, but still think "some regulation" is needed or think there is a "limit", etc. Most of them are highly pragmatic (in a bad way) and don't understand the more fundamental moral, political, and epistemological problems. That is why they are continually baffled as to why they are losing everything which further echos the point of my post.

Re "standards", that is a really interesting fact about the 19th century bank which would not surprise me at all.

Government regulations end up in less safety because firms lose the marginal competitive advantage of being more careful as all tend towards the uniform standard. As long as the public thinks the government has some enforced standard, they tend to not value as highly their own independent judgement of a firm's risk controls.

This is true not only of finance/accounting standards but also of drugs under the FDA and medicine generally. In the absence of government, you get private industry organizations that give a stamp of approval but at the same time puts the onus on the consumer to know what they are doing. This further increases the value of "reputation" in the market place as a precious value which a business must fight to protect.

Standards do emerge in a free market but they are rational because they are market driven as opposed to standards set and enforced by bureacrats with political motivations.