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Symposium 2015

Proposal - Overcoming Four Illusions to Foster Healthy Design of a Financial System

The Challenge

In the aftermath of the global financial crisis, most countries have seen a wave of new regulatory initiatives aimed at increasing financial stability and resilience. However, the implementation of re ...

In the aftermath of the global financial crisis, most countries have seen a wave of new regulatory initiatives aimed at increasing financial stability and resilience. However, the implementation of reforms is still in progress, and financial systems worldwide are far from being immune to another financial crisis.

The implementation of Basel III, for instance, leads to a gradual increase in capital requirements for banks, though many economists still consider these requirements as too low. Another envisioned goal, the partial separation of "traditional" and "hedge" banking, has not yet been achieved. We are also far away from a global harmonization of standards, best practices, and supervision. Moreover, there might even be the temptation to misjudge the partial implementation of regulatory reforms as finished. In fact, we might need more fundamental changes in the structure of the financial sector to prevent a future financial crisis.

 

The Global Financial System is currently governed by an evolving system of technocratic rules and institutions that are founded on four illusions.  Not even Harry Houdini could sustain his magic spell over public policy for as long as finance has, with its aura of complexity and power.  To look merely at the rules on the table in the regulatory process of the BIS, Central Banks and FSB and ranking or deciding amongst them, or examining their evolution over time with an eye toward progress entirely misses the point.  We need to fundamentally rethink our framework in light of one simple fact.  We cannot see the future.  Radical Uncertainty and the fallibility of expectations which are not anchored in a known future lead to a system of behavior that is markedly different than that used in orthodox finance, money and banking texts, and regulatory conversations.  The context of this exercise is sufficiently unscientific so as to raise questions about legitimacy of this entire endeavor.   To pretend that this system is under control serves the vested interests of finance to the detriment of society.

I perceive three core illusions in the financial system of today, and a fourth that pervades the whole context.  The fourth is that the governance of the financial system is independent of politics.  Technocrats rarely act technically.  They are not free to choose.  Their very appointment in the modern capitalist economy depends upon their compatibility with private interests who they govern.

In addition, vested interests in finance have a real stake in convincing society that this sector is under control.   And, ironically,  society may have a stake in acting “as if” it is true that finance, with all of its imported rocket science, is in fact controllable.   The alternative is too frightening to consider.  Belief in a paternalistic system of management (private sector) and governance calms the nerves, at least until it is revealed to be unwarranted.  Thereafter, for a while, the impetus to reform is quite intense.  But after a time, as has been the case in recent years, the pressures to reform subside, often owing to the power of finance to thwart meaningful reforms of the sector.

As regards finance itself, the first core illusion is the illusion of efficiency in the financial sector.  This presumption that regulations introduce waste and create inefficiency justifies deregulation and is often accompanied by the assertion that finance is too complex for the layman to understand.   The pervasiveness of misaligned incentives, (the Heads I win and tails someone else (the taxpayer) loses) makes mockery of these bold assertions.    Said in another way, the financial sector leans on society and it is difficult to understand what it does for society to justify our bearing of this burden of a safety net for them.  .   The scope and scale of the social contract between society and finance is far out of balance, as Andy Haldane of the Bank of England has documented in his fine paper, “Banking on the State”.   It is very difficult to see how this entire system of support and guarantees can be justified as so much of finance and banking is unrelated to the growth of the productivity and prosperity of society.  That the financial sector can “take us down with them” is ground for preventative medicine restricting their excesses to make sure they don’t wreck the nonfinancial economy.  It is not a legitimate basis for massive guarantees and subsidies.  The latter is akin to society being held hostage.

Surely misaligned incentives, a research agenda that many have pursued, led by Joseph Stiglitz, George Akerlof, and most powerfully in the realm of finance, Ed Kane, plays a role in the excesses we have experienced.  Misaligned incentives are not a coincidence.  The structure of the rules and their enforcement is a very contentious arena, which violently challenges the illusion of the separation of markets(finance) from politics.   Vested interests swarm all over this realm and, as Mancur Olson described in his book entitled, “The Logic of Collective Action”, concentrated financial interests consistently overwhelm the common good. Perhaps this is why society has a stake in believing in the illusions of financial control.  It is a tragic outgrowth of being helpless to stop the financial sector from dominating the design of its own interface with society. Michael Hudson’s analogy from biology of the parasite killing the host is only a mild exaggeration.

The second core illusion is the assumption of control of money and credit by the authorities, particularly Central Banks.   . Monetary control is presumed despite the deeper questions raised by thinkers from Knut Wicksell, to Adair Turner about the endogenous creation of credit that challenges that presupposition.  These authors ask  “do authorities control what they assert they control or are they playing a confidence game with society?  If so, to what end?”  It may, in the illusory sense, be of some value to calming of social nerves to pretend the Central Bank is in control of something it cannot control.

The third illusion is the technocratic assumption of structural stability and the ability of officials to predict the future.  Particularly suspect is the elaborate ritual of statistical measurement of financial expectations of the future.  Is this aura of high level research and subsequent control justified by the appearance of sophisticated technical inquiry?  It fosters the belief in the ability of both financial managers and their regulators, most notably Central Banks, to see into the future and guide the system toward stability.  To my mind this is the most dangerous anesthetic that can be applied to our social inquiry into the structure of finance in society.     Can society really rest assured that all of these people within the sector and their governors are measuring anything that gives us insight into the future?  Recent work by Roman Frydman, Michael Goldberg and their colleagues at the University of Copenhagen who examine the structure of the data casts real doubt upon the integrity of these methods.  Hiding behind technique is not the same as providing insight and service to humanity. When these technical exercises are hard for the layman to interpret there, there is a huge market for snake oil salesmen right behind the door.

As Freidrich August von Hayek said in his Nobel Prize lecture in 1974 entitled “The Pretence of Knowledge”,

“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.”

I believe that some of the breast beating around these technocratic efforts to determine what the future looks like are akin to what writers like Herman Melville and Mark Twain, and more recently, Maria Konnikova have called “Confidence Games.”

To break from the mindset of this false precision and pretense of control would send us all back to the drawing board to design a financial system that was a lot less free, a lot less capable of predation, and a lot less capable of endogenously creating manmade risk and the ensuing calamities.  It is ironic that at the times of greatest uncertainty and anxiety that the social yearning for stability in control is greatest.   It is also dangerous to succumb to such demagoguery.  As Voltaire once said,

“Uncertainty is an uncomfortable position. But certainty is an absurd one.”

Solution Proposals

  1. Remove the financial incentives in politics from the rule making for democratic governance of the economy, most notably in finance.
  2. Stop the pretending that financial regulators and monetary officials are clairvoyant.  They are looking into the fog just like us.
  3. Structure the financial system with the recognition that the credit allocation system is a pubic good, not merely a private playground for enrichment of the few.
  4. Question financial theories and statistical methods that presume we can see and forecast the future.  Even the Bank of England has shown that we are sailing in the fog (Fan Diagrams)
  5. Recognize what Joseph Schumpeter once said when asked what economics was about.  He replied,  “Three things:  Politics, Politics and Politics.