In Finance, the Blind Spots Will Always Be With You

“Where are our blind spots?” is an excellent question to ask about systemic risk, one I recently was asked to speak on at the U.S. Treasury. Naturally, we don’t know where the blind spots are, but they are assuredly there, and there will always be darkness when it comes to the financial future.

Finance and Politics

The first reason is that all finance is intertwined with politics. Banking scholar Charles Calomiris concludes that every banking system is a deal between the politicians and the bankers. This is so true. As far as banking and finance go, the 19th century had a better name for what we call “economics”—they called it “political economy.”

There will always be political bind spots—risk issues too politically sensitive to address, or which conflict with the desire of politicians to direct credit to favored borrowers. This is notably the case with housing finance and sovereign debt.

The fatal flaw of the Financial Stability Oversight Council (FSOC) is that being part of the government, lodged right here in the Treasury Department, it is unable to address the risks and systemic risks created by the government itself—and the government, including its central bank—is a huge creator of systemic financial risk.

For example, consider “Systemically Important Financial Institutions” or SIFIs. It is obvious to anyone who thinks about it for at least a minute that the government mortgage institutions Fannie Mae and Freddie Mac are SIFIs. If they are not SIFIs, then no one in the world is a SIFI. Yet FSOC has not designated them as such. Why not? Of course the answer is contained in one word: politics.

A further political problem with systemic financial risk is that governments, including their central banks, are always tempted to lie, and often do, when problems are mounting. The reason is that they are afraid that if they tell the truth, they may themselves set off the financial panic they fear and wish at all costs to avoid. As Jean-Claude Juncker of the European Union so frankly said about financial crises, “When it becomes serious, you have to lie.”

Uncertainty and the Unknowable

We often consider “known unknowns” and “unknown unknowns.” Far more interesting and important are “unknowable unknowns.” For the financial future is inherently not only unknown but unknowable: in other words, it is marked by fundamental and ineradicable uncertainty. Uncertainty is far more difficult to deal with and much more intellectually interesting than risk. I remind you that, as famously discussed by Frank Knight, risk means you do not know what the outcome will be, but you do know the odds; while uncertainty means that you do not even know the odds, and moreover you cannot know them. Of course, you can make your best guess at odds, so you can run your models, but that doesn’t mean that you know them.

Needless to say, prices and the ability of prices to change are central to all markets and to the amazing productivity of the market economy.

But a price has no sustainable existence. As we know so well with asset prices in particular, the last price, or even all the former prices together, do not tell you what the next price will be.

With housing finance audiences, I like to illustrate the risk problem with the following question: What is the collateral for a mortgage loan? Most people say, “The house, of course.” That is wrong. The right answer is that it is the price of the house. In the case of the borrower’s default, it is only through the price of the house that the lender can collect anything.

The next question is: How much can a price change? Here the answer is: More than you think. It can go up more in a boom, and down a lot more in a bust than you ever imagined.

One key factor always influencing current asset prices is the expectation of what the future prices will be, and that expectation is influenced by what the recent behavior of the prices has been. Here is an important and unavoidable recursiveness or self-reference, and we know that self-reference generates paradoxes. For example, the more people believe that house prices will always rise, the more certain it is that they will fall. The more people believe that they cannot fall very much, the more likely it is that they will fall a lot.

The Nature of Financial Reality

Financial reality is a fascinating kind of reality. It is not mechanical; it is inherently uncertain, not only risky; it is not organic; it is full of interacting feedback relationships, thus recursive or reflexive (to use George Soros’ term); unlike physics, it does not lend itself to precise mathematical predictions.

Therefore we observe everybody’s failure to consistently predict the financial future with success. This failure is not a matter of intelligence or education or diligence. Hundreds of Ph.D. economists armed with all the computers they want do not succeed.

The problem is not the quality of the minds that are trying to know the financial future, but of the strange nature of the thing they are trying to know.

Another troublesome aspect of financial reality is its recurring discontinuous behavior. “Soft landings” are continuous, but “hard landings” are discontinuous. Finance has plenty of hard landings.

From this odd nature of financial reality there follows a hugely important conclusion: Everybody is inside the recursive set of interacting strategies and actions. No one is outside it, let alone above it, looking down with celestial perspective. The regulators, central bankers and risk oversight committees are all inside the interactions along with everybody else, contributing to the uncertainty. Their own actions generate unforeseen combinations of changes in the expectations and strategies of other actors, so they cannot know what the results of their actions will be.

Another way to say this is that there are no financial philosopher-kings and there can never be any, in central banks or anywhere else. No artificial intelligence system can ever be a philosopher-king either.

Odin’s Sight

We can conclude that blind spots are inevitable, because of politics, and because of the unknowability of the outcomes of reflexive, expectational, interacting, feedback-rich combinations of strategies and actions.

I will close with a story of Odin, the king of the Norse gods. Odin was worried about the looming final battle with the giants, the destruction of Valhalla, and the twilight of the gods. Of course he wanted to prevent it, and he heard that the King of the Trolls had the secret of how to do so. Searching out this king by a deep pool in a dark forest, he asked for the secret. “Such a great secret has a very high price,” the troll replied, “one of your eyes.” Odin considered what was at stake, and decided to pluck out one of his eyes, which he handed over.

“The secret is,” said the King of the Trolls, “Watch with both eyes!”

When it comes to seeing the financial future, like Odin, we have to keep doing our best to watch with both eyes, even though we have only one.

Reader Discussion

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.

on January 16, 2019 at 12:53:48 pm

"When it comes to seeing the financial future, like Odin, we have to keep doing our best to watch with both eyes, even though we have only one."

And THAT eye is bespectacled with the lens of institutional self-interest among other prescriptions.

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Guttenburgs Press and Brewery
on January 16, 2019 at 13:30:12 pm

Financial forecasters make pronouncements of witch doctors respectable.

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on January 16, 2019 at 15:19:14 pm

Hey, wait a minute here:

MY witch doctor doubles as my stock analyst. should I be concerned?

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on January 16, 2019 at 15:20:39 pm

In my review of U.S. financial history, probably the only institutions whose failure caused systemic shock were Fannie and Freddie and the Second Bank of the United States. All of them GSEs, and all used their GSE status to obtain an outsized position in the national economy.

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Wayne Abernathy
on January 16, 2019 at 17:32:45 pm

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.