From Institute for New Economic Thinking:

In a conversation with the Institute for New Economic Thinking, author Alex J. Pollock explains why our flawed thinking leads us into financial and economic error. His new book, Finance and Philosophy: Why We’re Always Surprised, draws on history, philosophy, and Pollock’s own experience in banking to explore why the future is always fundamentally uncertain when it comes to certain human realities.

Lynn Parramore: You focus on the concept of uncertainty. Why is this so hard for people to accept and why does it matter?

Alex Pollock: Uncertainty is important to understand because it tells you that no one is going to create an economic or financial system for you in which you will know exactly how it works.

Economics tries to be physics. It is the dream that an economic or financial system could be understood the way a physical system could be understood – like Isaac Newton making comprehensible and predictable motions of the heavenly bodies. When you try to do that with economic and financial things, it doesn’t work.

LP: You note that Isaac Newton himself lost a great deal of money when the South Sea bubble burst. He didn’t see it coming.

AP: Right! And he was one of the greatest geniuses in history. Intelligence v. stupidity is not is not the issue when it comes to predicting the financial future.

You can look very hard for statistical regularities and so on, but then you’re up Goodhart’s law, named for economist Charles Goodheart. His law is that you find these regularities in your economic or financial data, and that’s nice. You find some correlation. But as soon as you try to use that information to control the system, it breaks down. You’ve impacted the system by trying to use it in ways you don’t expect. Often, people who try to oversee a financial system from on high seek to design it like a machine and run it like a machine. Well, it is not a machine. It is fundamentally different in its essence from a machine, so there is nobody who can run it to get you the nice outcome that you might want.

That is simply the way it is. So don’t put your faith in regulators or central bankers as puppeteers of a puppet show. There are no puppeteers. No one is outside the system looking down. Everyone is inside the system.

LP: You observe that mechanistic metaphors do not apply to financial and economic realities. Why is this so?

AP: Financial interactions are a different kind of reality than philosophical reality. That’s a metaphysical statement. Physical reality is governed by determinative laws and mechanistic in the sense that if you know all the inputs of the laws, you know what will happen. But financial markets and economics relations in general are not governed by knowable laws.

The metaphor of mechanisms is very often used when people are talking about financial things, like the “monetary policy transition mechanism.” Of course, the next thing they say is that the “mechanism” is broken. Doesn’t work the way we thought.

Well, that’s because it’s not a mechanism.

It’s not an organism, either. And it is not a mathematical set of relationships. Instead, it is that very interesting form of reality, which is interactive, expectational, recursive, and involves intense systems of feedback which are inherently unpredictable. That’s just a different mode of reality.

Economic and financial systems are made largely out of human minds, not levers, pulleys and wires. Minds are oriented towards the future, towards predicting and influencing the behavior of others who are trying to do the very same thing. Minds are complex and unpredictable. It’s not that you don’t know the financial and economic future. As economist Frank Knight observed, you cannot know.

LP: You observe that dentistry is much more of a science than economics.

AP: That’s right. Teeth and gums are physical realities. Dentistry can progress in a way that economics can’t. I have a number of friends who are professional economists and they don’t like that observation!

LP: You explore a number of financial crises in the past. Why does financial history get so little attention?

AP: I came to it fairly late in my own life and career when I came to wondering about the failure of Continental Illinois – my previously extremely prestigious and important employer, which failed in 1984. As I was living through that, I got to thinking about whether such things had happened before or what there might be in history. That really opened up my mind.

I can think of a couple of possible reasons why history receives so little attention. One is that finance is forward-looking. Investing, finance, and economics is about what you’re doing going forward — the investment you’re going to make and how it’s going to turn out. The new business you’re going to create and how it’s going to revolutionize part of the world.

Secondly, there’s an issue of history in general, not just financial history, concerning the natural aging and disappearance of the generations. The people who lived through a crisis grow old, retire and die. Things that were very vivid to them disappear. Up come younger people who think they’re smarter. They’re not, and that is one of the great lessons of financial history. It’s natural, of course, that a young person would look back and imagine that someone who had made financial mistakes must have been dumb. Like Newton!

There’s also something I call the “egocentricity of the present,” which is another way of saying that we believe the present is different. We’re somehow more interesting, more dynamic, more confident than people in the past. We act like there’s never been change before. So, we’re all focused very much on the present, and the result is that the longer view gets lost. How much history is history? Is it two years? Three? Five? How about a hundred? I hope to help people to understand things in a longer time frame.

LP: How does this study of history help us understand the present?

AP: There is something very special about the present if by the present we mean the last two hundred years, which is this astonishing age of economic growth. If you think of a span of, say, 50,000 years, this last little bit is one in which ordinary people become amazingly well off, with access to wonderful vaccines and medicines, and foods from all over the world. They can drive cars, get educated.

One of the questions the book poses is, why can this happen? The answer is that the most important economic thing that ever happened is the discovery of science based on mathematics, which has been used by enterprise and innovation.

Another question posed in the book is, can you have that sustained growth without the cycles of boom and bust? I believe the true answer is no, you can’t. You want the growth; you get the cycles. That’s because growth seems to be uncertainty-generating and uncertainty produces cycles – so there we are. It’s a good news/bad news story.

LP: You say that bubbles happen by mistake. But sometimes it appears that those in power may be incentivized to ignore warnings, like Alan Greenspan and Robert Rubin ignoring Brooksley Born’s warnings about a potential meltdown in years leading up to the 2008 collapse. What’s your take on that?

AP: I would say that mistakes are inevitable because uncertainty is fundamental. Whether Brooksley Born’s proposals would have prevented collapse — I don’t think they would have. Looking back, you can always think, well, you could have done this or that. Just like if you think about your investments, you would have a perfect record if you could make them looking backwards and know what to do and what not to do.

As far as bad intent, yes, there are always some evildoers. All of us are sinners to some extent and some people are really egregious ones. But I don’t think the sin is the most important factor. It’s what turns out to be mistakes made by people who think they’re doing something smart and in fact end up doing something stupid.

LP: So in your view, uncertainty would be a bigger factor in the housing bubble than issues like robo-signing or credit ratings agencies giving inflated ratings to securitized mortgages because they were paid to do so?

AP: One of things that happens in any bubble is that asset prices grow exaggerated. In this last case, notably house prices. Back in the early ‘80s there was a great oil bubble. People genuinely believed that price of oil would go up forever. That happened to be wrong – an incorrect belief. When the price of oil went the other way, it caused great financial and economic distress at the time.

This time they believed it about houses. If you believe it, you are tempted to take chances you wouldn’t otherwise take, like making loans without documentation, because you believe that house prices will always go up and while they’re going up, your actions reflecting your belief help them to keep going up — temporarily.

There’s an interaction — the more you lend, the more credit pushes against the asset and the higher the price of the asset goes. The higher it goes, the more someone is willing to lend against it. And if that happens, there are inevitably frauds and swindles which emerge as part of the boom. They help the bubble along, but they don’t drive it. Here we have the fundamental interaction of asset prices and credit in the context of a diminished sense of risk. What is risk? Risk is a feeling. When you get used to something, it ceases to feel risky until something really bad happens. That’s what bubbles are like.

You mention credit ratings agencies. Now, they thought about how to rate pools of mortgages and they had what was basically a stress test of a pool to show them how bad the losses could be and so on. They ran models. In all of these models, there was and still is a parameter called “house price appreciation.” Think about the name: house price appreciation. A better name would be house price change. There’s a feeling in there that on average, the housing market is really all about appreciation. Then comes the belief, and for a long time the belief is self-reinforcing.

As the bubble expands, you get very good behavior of the credits, so defaults are very low and losses on the lending business are very low and profits are high. It looks like to almost everybody like a big success. Who is made happy by all this? Almost everyone, including the politicians, some of whom may be getting some contributions. Of course, the price stops going up, the credit stops, and everything goes into reverse. Then everyone is unhappy and finding scapegoats. There are some genuine fraudsters and guilty parties, but that isn’t the fundamental story. The story is this very intriguing behavior of financial-economic-political systems of interaction.

LP: Can you say a bit about regulation in this world of uncertainty?

AP: With all good intentions and people thinking hard, regulators can still do things which actually help cause the next problems.

At the end of the 1980s, a period of financial catastrophe in this country when over a thousand banks failed, people studied what had happened. There were a series of statutes enacted by Congress and a series of regulatory policies were put in place, such as the encouragement of securitization. Well, securitization contributed to the next crisis. Intelligent people not only miss what the next crisis will be, but do things that actually contribute to it.

We need more humility and more understanding and expectation that we’re dealing with fundamental uncertainty. In my book, I propose an advisory body I call the “systemic risk advisor,” which might be worth a try to help avoid crises. Something like that was done after the last crisis with the Office of Financial Research, but in my opinion they made a big mistake making it part of the Treasury Department, which is a political office.

We want to remember that money is temptation, but we try to inculcate virtue and balance. Among the virtues are prudence and leaving margin for error in what you’re doing. There’s not going to be some kind of manipulator who builds a machine which makes this all work. We have to hope for the continued success of the enterprising economy. It’s not guaranteed. But think of yourself if you were in 1900 trying to imagine how much more economic and technical progress there might be. You have to understand that you’re in this cyclical process. Fortunately, for at least 200 years, we’ve been in an upward trend. Maybe that will continue for an infinite number of years into the future.