Further Pretensions of Knowledge

The Economist‘s second article in its series on “seminal economic ideas” is about Hyman Minsky’s theory that “booms sow the seeds of busts”:

Having grown up during the Depression, Minsky was minded to dwell on disaster. Over the years he came back to the same fundamental problem again and again. He wanted to understand why financial crises occurred. . . .

Minsky . . . developed his “financial-instability hypothesis”. It is an examination of how long stretches of prosperity sow the seeds of the next crisis, an important lens for understanding the tumult of the past decade. . . .

Minsky started with an explanation of investment. It is, in essence, an exchange of money today for money tomorrow. A firm pays now for the construction of a factory; profits from running the facility will, all going well, translate into money for it in coming years. Put crudely, money today can come from one of two sources: the firm’s own cash or that of others (for example, if the firm borrows from a bank). The balance between the two is the key question for the financial system.

Minsky distinguished between three kinds of financing. The first, which he called “hedge financing”, is the safest: firms rely on their future cashflow to repay all their borrowings. For this to work, they need to have very limited borrowings and healthy profits. The second, speculative financing, is a bit riskier: firms rely on their cashflow to repay the interest on their borrowings but must roll over their debt to repay the principal. This should be manageable as long as the economy functions smoothly, but a downturn could cause distress. The third, Ponzi financing, is the most dangerous. Cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough to cover their liabilities. If that fails to happen, they will be left exposed.

Economies dominated by hedge financing—that is, those with strong cashflows and low debt levels—are the most stable. When speculative and, especially, Ponzi financing come to the fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms. They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility. . . .

[A]s an outsider in the sometimes cloistered world of economics, Minsky’s influence was, until recently, limited. Investors were faster than professors to latch onto his views. More than anyone else it was Paul McCulley of PIMCO, a fund-management group, who popularised his ideas. He coined the term “Minsky moment” to describe a situation when debt levels reach breaking-point and asset prices across the board start plunging. Mr McCulley initially used the term in explaining the Russian financial crisis of 1998. Since the global turmoil of 2008, it has become ubiquitous. For investment analysts and fund managers, a “Minsky moment” is now virtually synonymous with a financial crisis. . . .

. . . In a speech in 2009, before she became head of the Federal Reserve, Janet Yellen said Minsky’s work had “become required reading”. In a 2013 speech, made while he was governor of the Bank of England, Mervyn King agreed with Minsky’s view that stability in credit markets leads to exuberance and eventually to instability. Mark Carney, Lord King’s successor, has referred to Minsky moments on at least two occasions.Will the moment last? Minsky’s own theory suggests it will eventually peter out. Economic growth is still shaky and the scars of the global financial crisis visible. In the Minskyan trajectory, this is when firms and banks are at their most cautious, wary of repeating past mistakes and determined to fortify their balance-sheets. But in time, memories of the 2008 turmoil will dim. Firms will again race to expand, banks to fund them and regulators to loosen constraints. The warnings of Minsky will fade away. The further we move on from the last crisis, the less we want to hear from those who see another one coming.

I am left with this question: Is the Minskyan trajectory a bad thing or a good thing? Is there a better, feasible way to finance economic growth? Or is the alternative some kind of government-enforced algorithm in which one-size-fits-all-regulation fosters hyper-bubbles (as with the directive to lend more to poor, minority mortgagors) or hypo-bubbles (in which rising investment is stifled long before it becomes a bubble).

Government doesn’t have a good track record when it comes to fine-tuning the economy. It’s true that the economy has been somewhat more stable since the creation of the Federal Reserve in 1913. But the price of stability is high; namely, it is inversely related to long-run economic growth. And the two deepest economic downturns in America’s history — the Great Depression and the Great Recession — happened on the Fed’s watch, and can be blamed (in part, at least) on the Fed.

Economics can be a powerfully descriptive discipline. But its power to describe is far from infallible, as Arnold Kling shows in his must-read tome, Specialization and Trade: A Re-introduction to Economics. Among many things, Kling explains why the Keynesian multiplier — the hoariest of fine-tuning ideas — is a terrible idea. (I heartily agree with Kling.)

Even if economics were an infallibly descriptive discipline, it shouldn’t be taken as an infallibly prescriptive one. Friedrich Hayek put it this way in his Nobel Prize Lecture, “The Pretence of Knowledge“:

It is true that . . . systems of equations describing the pattern of a market equilibrium are so framed that if we were able to fill in all the blanks of the abstract formulae, i.e. if we knew all the parameters of these equations, we could calculate the prices and quantities of all commodities and services sold. But, as Vilfredo Pareto, one of the founders of this theory, clearly stated, its purpose cannot be “to arrive at a numerical calculation of prices”, because, as he said, it would be “absurd” to assume that we could ascertain all the data. . . .  I sometimes wish that our mathematical economists would take this to heart. I must confess that I still doubt whether their search for measurable magnitudes has made significant contributions to our theoretical understanding of economic phenomena – as distinct from their value as a description of particular situations. Nor am I prepared to accept the excuse that this branch of research is still very young: Sir William Petty, the founder of econometrics, was after all a somewhat senior colleague of Sir Isaac Newton in the Royal Society!

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. . . .

. . . To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the over-confident because their experiments may after all produce some new insights. But in the social field the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. We are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based – a communications system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed.

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.

(This post offers more on this subject of the limitations of knowledge, and the implications for economic policy.)

The ability to describe a phenomenon in a general way is far from knowing how to improve on it. In fact, the ability to describe a phenomenon in a general way says nothing about whether it can be improved on. Such things as investment bubbles, market failure, and winners and losers from trade are the normative judgments of observers who simply don’t like what they see and believe (mistakenly) that they know how to “make things right.”