The Magazine

Another Fine Mess

The economic costs of ignorance

Feb 20, 2012, Vol. 17, No. 22 • By MATTHEW CONTINETTI
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Defending himself against charges of corrupting the youth of Athens, Socrates told a story. Chaerephon, one of Socrates’ friends, once visited the Oracle at Delphi and asked, “Is anyone wiser than Socrates?” The reply was unequivocal: “There is none.” The philosopher was puzzled. All he knew for sure was that his knowledge was limited. How, then, could he be judged the wisest man alive? What Socrates concluded was that it was his very understanding of his own ignorance which made him wiser than most men. 

Photo of Representative Barney Frank

Rep. Barney Frank (D-Mass.), September 20, 2011

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“In my investigation in the service of the god I found that those who had the highest reputation were nearly the most deficient,” Socrates said at his trial, “while those who were thought to be inferior were more knowledgeable.” The truly wise man, Socrates was saying, knows just how shallow and worthless his wisdom is.

Human beings expend a tremendous amount of energy papering over the inconvenient fact of our ignorance. Since there is no way to run a controlled experiment with history—it only happens once—we have no certain grasp of socioeconomic causation. Nor do we have any way of knowing what will happen in the future. If we did, we would not be so consistently surprised. We are left, instead, with endlessly divergent interpretations of reality and differing theories of how to preserve or improve it. And each time we act, we set into motion a series of events that we can neither control nor predict.

Consider the financial crisis that paralyzed the world economy in the fall of 2008. Every economist has his own idea of what caused the crisis, why the recession has been so deep, and what ought to be done to solve the problem. Every one of these ideas is informed by a particular economist’s cultural and political biases, which is why the notion that the crisis was a consequence of “market fundamentalism” is
so widespread.

Here come Jeffrey Friedman, a lecturer in political theory at the University of Texas, and Wladimir Kraus, a doctoral candidate in economics at the Université d’Aix-Marseille, to correct that misimpression. Their book is a bucket of ice water thrown in the faces of those professional economists who ascribe the crisis to market failure. They remind the reader that, contrary to what Joseph Stiglitz and Paul Krugman may say, the pre-crisis banking sector and trade in mortgage-backed securities was far from “deregulated.”

Banks are governed by the capital-adequacy standards contained in the international Basel Accords. Securities receive grades from a legally protected oligopoly of credit rating firms. Mark-to-market accounting standards can inspire bank runs and reduced lending when the prices of investments suddenly plunge. All of these rules, and many others, interact in a complex and ceaseless manner with economic and governmental agents. Laissez-faire it ain’t.

When a liberal economist blames “deregulation” for the crisis, he is really saying that the crisis could have been prevented if only we had followed the policies he is now recommending in hindsight. One of the pleasures of this book is the directness with which Friedman and Kraus debunk such myths. Were executive bonuses and greed behind the meltdown? “A banker trying to maximize his or her revenue, heedless of risk, so as to maximize his or her performance compensation, never would have purchased agency bonds or triple-A bonds instead of bonds with higher coupons due to lower ratings. Yet that is what commercial bankers did.”

What about the shadow banking system of hedge funds and unregulated derivatives? Investment banks alone, the authors point out, could not have been responsible for a panic in commercial banking. Nor was it the derivatives themselves that shocked the system, but defaults in the subprime mortgages those derivatives were meant to insure.

Too big to fail? Well, moral hazard may cause trouble down the road. But remember, prior to the TARP bailout, there was no explicit guarantee that the government would rescue collapsing financial institutions. Bankers had to live with the possibility that they might suffer the fate of Lehman Brothers. Which is why they invested so heavily in highly rated securities.

Another fashion in economics is to attribute behavior to “irrationality,” as though we are all nutjobs trucking and bartering aluminum foil hats. Friedman and Kraus won’t stand for it: 

Only if we conflate rationality with the possession of perfect information, and then conflate the possession of perfect information with perfect reasoning abilities, does a rejection of the perfect-information assumption appear to entail “irrationality” as the alternative.

A much simpler, more charitable, and, dare one say, more reasonable explanation for private and public failure is mistaken assumptions grounded in human ignorance.

It was such ignorance about the future that led regulators in 1988 and 2005 to impose international banking standards which required banks to hold more capital for commercial loans than mortgages; the 2001 Recourse Rule that led banks to load their balance sheets with AA- and AAA-rated mortgage-backed securities; the 1975 rule that securities could receive ratings from only Moody’s, S&P, or Fitch; and the 1993 “fair-value” accounting standard that spread panic when the ratings oligopoly turned out to be mistaken and the banks became saddled with bad debt. No one possibly could have known how these various laws would interact, first encouraging the housing bubble and later pressuring it to pop. Nor does anyone have the faintest clue about the other time bombs lurking in the 150,000-page Code of Federal Regulations and three-million-page Federal Register.

Friedman and Kraus’s examination of the 2008 financial crisis ends with a broader critique of economic policy in the administrative state. The role of government in the early 21st century is to acknowledge and “solve” the problems identified by public opinion and mass media. But since the world is infinitely complex, the people and their representatives delegate authority to experts in the civil service, whose business at places like the Federal Reserve, Commodity Futures Trading Commission, Office of the Comptroller of the Currency, Environmental Protection Agency, and elsewhere is to simplify problems and implement rules. In the final analysis, however, the experts are just as ignorant of the future as the rest of us, and each new rule has unintended consequences that may interact with the other rules in dangerous and unknown ways.

Most of us never look at the role ignorance and regulation play in financial panics because we hold capitalism to a standard of utter perfection. Every deviation from this standard becomes a reason for further policies that set into motion the cycle of rule-making and unintended consequences. And so the latest round of Basel Accords encourages purchases of sovereign debt—look how that’s working out—and the Dodd-Frank finance bill instructs regulators to write 70 studies and make 240 rules. Meanwhile, President Obama circumvented the Senate and the Constitution so that the former attorney general of Ohio can muck around in the consumer financial product sector. Despite all this, I believe I can safely predict that, when the next panic arrives, it will be blamed on unregulated markets and rapacious capitalism.

Engineering the Financial Crisis is not an easy read. It is technical and contains too many acronyms and italicized words. But it is also the most important book on the 2008 crisis that I have encountered. Has any other title proposed such an original and compelling interpretation of the events of 2007 and 2008? Is there any other book that courageously raises the problem of human ignorance for democratic policymaking?

As the oracle might say, “There is none.”

Matthew Continetti is a contributing editor to The Weekly Standard and editor in chief of the Washington Free Beacon.