Magazine | July 5, 2010, Issue

It’s Complicated

The world will belong to those who can explain why it must not be entrusted to central planners

The public’s support for vigorous financial regulation is a wake-up call for conservatives who imagined that the tea party signaled the triumph of conservative ideas. Much as with health-care reform, where the public opposed the administration’s bill but supported its promised benefits, a Rasmussen poll in late May found the public opposed to the financial-reform bill, 46 percent to 37 percent, even while an earlier ABC News–Washington Post poll showed that stricter regulation of major financial companies commanded more than two-to-one popular support.

Even more ominously for conservative populism, an April Pew survey found that the central tea-party idea, that modern government is tyrannical, fails to resonate — and that it fails particularly among the college-educated. A mere 34 percent of Americans with a high-school education or less agree that “the government is a major threat to their personal rights and freedoms”; an even smaller proportion of those with some college education agree (31 percent), and a yet smaller proportion of those with college degrees (24 percent) — a 29 percent dropoff between the least- and the most-educated groups. As a record 70 percent of all young Americans now get at least some college education, the implication for the future of conservative populism is dire.

In a subsequent poll, Pew asked for one-word assessments of the tea party, and more respondents offered negative than positive answers, starting with “ridiculous” and working their way down through “stupid,” “ignorant,” and “nuts.” Why would people respond so harshly? It is not because they aren’t worried about government overspending; the polling shows that nearly everyone is worried about that. No, it is because Americans are problem solvers par excellence; the appeal of activist, progressive government has always been its dedication to “solving the problems of ordinary Americans.” The tea party, in contrast, elevates the principle of individual freedom above pragmatism. In the face of the greatest economic problem since the Great Depression, doggedly resisting “problem solving” government action as a violation of individual freedom strikes most people as blinkered or downright crazy — because most people think that the financial crisis was caused by too much individual freedom. Protesting “big government” in the wake of a crisis of “laissez-faire capitalism” seems ideological, unsophisticated, and uninformed to the non-tea-party majority.

This is merely to say that the financial crisis is the defining event of our era. An April Rasmussen survey found that only 60 percent of Americans now believe that capitalism is better than socialism. Among those under 30, socialism and capitalism are nearly tied at 33 percent and 37 percent.

This situation can be blamed, in part, on conservative intellectuals, who were flummoxed by the financial crisis and still haven’t recovered. The story of the financial crisis is also a story of conservative intellectual crisis — but also opportunity.

Neither conservative nor liberal intellectuals performed well in understanding the crisis; both sides have produced simplistic and, in fact, populist analyses of what went wrong that bear little connection to the facts. Intellectuals who are willing to think outside the box, however, face a unique moment. The financial crisis lays bare what most intellectuals have been ignoring for more than a century: the complexity of modern society. The future belongs to anyone who can think through the implications of that.

Unfortunately, too many conservatives formed their view of the crisis relatively early, in September and October of 2008, when everyone assumed that it was a “subprime crisis.” Conservatives therefore focused on Fannie, Freddie, and the Fed, all of which did contribute to the housing bubble and the prevalence of subprime and nonprime mortgages. But a popped housing bubble would not, in itself, have caused the biggest worldwide recession since 1929. The real problem was that, as Steve Forbes and Brian Wesbury have pointed out, commercial banks are required by law to “mark to market” the current value of their assets, even if they have no intention of selling them anytime soon. In July 2007, the market prices of mortgage-backed securities owned by commercial banks began to fall, and so did business lending. Mark-to-market accounting forced banks to contract lending; otherwise, they would have fallen under their legal capital requirements. The events of September 2008 were the denouement of this process, which caused the recession.

#page#To their credit, liberal analysts realized from the start that the cause of the recession was a banking crisis, not a housing crisis. In explaining the banking crisis, however, liberals used a theory drawn straight from the rotten core of contemporary social science: the theory of “moral hazard.” It suddenly became conventional wisdom that the crisis had been caused by banks that rewarded successful employees with big bonuses but failed to penalize losses. This was said to have encouraged recklessness. Later, conservatives came up with their own variant of moral hazard, according to which bankers took too many risks because they knew that their banks, being “too big to fail,” would be bailed out if their bets turned sour; so why not make the riskiest, most lucrative bets?

The intellectual bankruptcy of these theories lies in their assumption that the bankers knew they were making “reckless” bets. This assumption is demonstrably false: Ninety-three percent of the mortgage-backed bonds acquired by commercial banks either were rated AAA — the safest possible rating — or were issued by Fannie and Freddie, giving them an implicit government guarantee. Because of their perceived lack of risk, these bonds offered lower interest rates than did bonds with worse ratings. Revenue-hungry bankers who were oblivious to risk never would have bought Fannie, Freddie, or triple-A bonds; more lucrative double-A, single-A, and lower-rated mortgage-backed bonds were always available. Both the liberal and the conservative moral-hazard theories are therefore wrong. For the most part, the bankers didn’t deliberately take big risks, or they would have taken big risks that paid a higher yield.

The deeper problem with moral-hazard theory, as with so much of modern economics, is that it does not allow for economic actors to make unwitting mistakes. The errors caused by human ignorance are unpredictable, so economists simply ignore them. The result is a “model” of the economy in which people are essentially omniscient; everyone knows what he needs to know. In such a world, however, nobody would ever lose money. It is a simple world that can be elegantly modeled only because it is wildly unrealistic.

In this respect, the other social sciences are almost as simplistic as economics. Political scientists tend to believe that the solutions to social problems are self-evident to “the people”; otherwise, why democracy? This has been the progressive assumption from the start: The answer to the problems of ordinary people is to enact “commonsense” social legislation, meaning laws that the electorate perceives as obviously needed. In this view, the barrier to solving social problems is not our ignorance of how to do so, but special interests that malignly oppose the “obviously” needed reforms. Again, the result is a picture of the world that is so simple as to be absurd: Everyone knows what should be done to serve the common good; all we need is someone in Washington who has not been corrupted by the special interests, and who therefore will do the people’s bidding. Note how friendly this worldview is to populism: Not only is modern society portrayed as easy enough for anyone to understand, but evil people are all that stops us from solving social problems. Like the risk-seeking bankers of moral-hazard theory, the special interests deliberately oppose the common good. This preoccupation with people’s good or bad intentions is well suited to moralizing and sanctimony, but antithetical to the sine qua non of a sophisticated social science: the explanation of unintended consequences.

Even when political scientists concede that technical problems, such as financial regulation, are beyond popular comprehension, they tend to assume that with the help of “experts,” regulatory agencies will figure out how to solve technical problems. This assumption again oversimplifies, as we discover by noticing that experts routinely disagree with one another. Moreover, even expert consensuses are regularly proven wrong. The financial crisis underscores the latter fact, if one is willing to do some historical digging. It turns out that in 2001, the Fed, the FDIC, the comptroller of the currency, and the Office of Thrift Supervision issued the Recourse Rule. An amendment to the international Basel I accords on bank capital, the Recourse Rule required banks to retain 80 percent more capital for business loans or corporate securities than for asset-backed bonds, including mortgage-backed bonds — as long as the bonds either were rated AAA or AA or were issued by a government-sponsored enterprise, such as Fannie and Freddie. No wonder commercial banks overinvested in these bonds!

#page#Why did the regulators issue the Recourse Rule? Were they deliberately sabotaging the banking system? Of course not. But there was a consensus among economists that asset-backed bonds were far safer than ordinary loans or corporate securities. Unfortunately, neither the economists nor the regulators — nor most bankers — predicted what would happen to asset-backed bonds if the assets were mortgages issued during what turned out to be a housing bubble. The experts, the regulators, and the bankers were ignorant of a risk caused by a complication that hadn’t occurred to them. They were wrong, but they were not evil. They were simply outwitted by a complex world.

Capitalists (such as bankers) are as human as regulators and academics, and they just as regularly err. But markets have a mechanism that tends to mitigate the effects of capitalists’ errors: competition. The prescient capitalists make money; the ones who misjudge the future lose money. This is not an open-and-shut case for capitalism, however, because the conditions under which competition works well need to be studied, not assumed. For instance, herd behavior among capitalists reduces the advantage of competition: If all bankers learn the same ideas in business school, systemic risk increases, since what they learn may be wrong. On the other hand, regulation inherently increases systemic risk by imposing one theory on all market participants. If the theory is wrong, the whole system is at risk. The Recourse Rule is an example of this.

Austrian-school economists have long wanted to reform their discipline to make it more attuned to the ignorance and error caused by complexity. Their time is now, and the opportunity is ripe. The main competitor for the status of a more realistic brand of economics is the economics of irrationality, not ignorance. But irrationally exuberant (or irrationally downcast) people do not live in a complex world; they live in a world that is simple enough for them to understand clearly if they can just get a grip on their emotions. The Austrians should have a field day against such weak competition, but they may be so committed to libertarian philosophy, or so preoccupied by a peripheral aspect of Austrian economics (Hayek’s business-cycle theory, explained by Gary Wolfram on page 28), that they neglect the opportunity to propose Hayek’s main insight — human ignorance in the face of complexity — as a cure for what ails their discipline.

Regardless of what happens in economics, a recognition of the central role of ignorance could restructure the other social sciences. In my field, political science, there is already a huge literature on the public’s underinformed and often incoherent ideas, but it is methodologically naïve in failing to trace the problem to the complexity of the society that modern politics tries to regulate. A more sophisticated approach would attend to the fallible ideas not just of voters but of bureaucrats, legislators, and judges — and to the roots of these ideas, both mass and elite, in cultural sources of (mis)information and ideology, such as the mass media and formal education. Philip E. Converse, a University of Michigan political scientist, suggested in the founding document of modern public-opinion research that “the broad contours of elite decisions over time can depend in a vital way upon currents in what is loosely called ‘the history of ideas.’ These decisions in turn have effects upon the mass of more common citizens” — itself a very Hayekian idea. Political scientists have not taken up Converse’s suggestion, but there is no reason they can’t. Historians, sociologists, and legal scholars can similarly explore the roots of the ideas that shape our perceptions of a complex reality, and the flawed laws that we therefore make.

The masses probably will not be moved by “Hayekian” thought. Hayek tries to understand error, not condemn those who err, but politics is about mobilization, not understanding. It is hard to mobilize people against an opposition that is merely mistaken, not evil. Besides, Hayek’s epistemology is difficult to slap on a placard (but here’s a try: “They don’t know what they’re doing!”).

As conservatives recognize, however, ideas have consequences, even if the initial consequences are confined to the universities. No educated American would disagree that the world is complex, or that we are therefore ignorant of much that is important — and that, in consequence, we may err. But “ignorance” and “complexity” were abstractions before the financial crisis. Few of us have forgotten that the “experts” now being tasked with preventing another crisis were clueless about the last one. Hayekian social theory not only is more sophisticated than the academic intellectual mainstream, but it captures the anxiety of every thoughtful person after the calamity that has affected us all.

– Mr. Friedman edits Critical Review and directs the Hayek Project (www.hayekproject.org). He is also the editor of What Caused the Financial Crisis and co-author of Engineering the Perfect Storm, both forthcoming from the University of Pennsylvania Press.

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