Fri, Apr 03, 2009 - Page 9 News List

Science of capitalism crashes on the shores of human hubris

By Daniel Cloud

To understand how we got ourselves into our current economic mess, complicated explanations about derivatives, regulatory failure and so on are beside the point. The best answer is both ancient and simple: hubris.

In modern mathematical economics, many people in the rich world decided that we had finally devised a set of scientific tools that could really predict human behavior. These tools were supposed to be as reliable as those used in engineering. Having ushered scientific socialism into its grave at the Cold War’s end, we quickly found ourselves embracing another Science of Man.

Our new beliefs did not stem from some new experiment or unexpected observation, the way a real scientific paradigm shift does. Economists do not typically conduct experiments with real money. When they do, as when Nobel laureate Myron Scholes ran the hedge fund Long Term Capital Management (LTCM), the dangers often outweigh the benefits (a lesson we still don’t seem to have learned.) And, since almost every observation that economists make turns out in a way that wasn’t predicted, no unexpected observation could ever actually change an economic paradigm.

What really produced the change in economics that led to disaster was the simple fact that you could now get away with saying certain kinds of things in public. Some of us honestly thought that history was over. And after all, you can’t have a final, utopian society without having a final, scientific theory of human behavior, together with some mad scientists or philosophes to preside over the whole thing.

The problem is that, no matter how “scientifically” these new beliefs were formulated, they are still false. Capitalism is, among other things, a struggle between individual people over the control of scarce resources. Like boxing and poker, it is a soft, restrained, private form of warfare.

Military strategists have known for centuries that there is, and can be, no final science of war. In a real struggle over things that actually matter, we must assume that we are up against thinking opponents, who may understand some things about us that we don’t know about ourselves. For example, if profit can be made by understanding the model behind a policy, as is surely the case with the models used by the US Federal Reserve, sooner or later so much capital will seek that profit that the tail will begin to wag the dog, as has been happening lately.

The truth is that such models are most useful when they are little known or not universally believed. They progressively lose their predictive value as we all accept and begin to bet on them. But there can be no real predictive science for a system that may change its behavior if we publish a model of it.

Markets might once have been fairly efficient before we had the theory of efficient markets. If investing is simply a matter of allocating money to an index, however, liquidity becomes the sole determinant of prices and valuations go haywire. When a substantial fraction of market participants are simply buying the index, the market’s role in ensuring good corporate governance also disappears.

The formation of large bubbles in recent decades was partly a consequence of the commonness and incorrigibility of the belief that no such thing could ever happen. Our collective belief that markets are efficient helped make them wildly inefficient.

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