The economic policies of the Second World War and our recovery from it present an opportunity for us to see where history rhymes.
Finance and Philosophy: Why We’re Always Surprised is a short, brilliant book. It is meant to be an easy read, and it is (except that footnotes and actual citations would have been useful instead of naked quotes). Author Alex J. Pollock is a former major in philosophy, banker, and CEO of a Federal Home Loan Bank (Congress-created cooperatives of local banks)—and is currently a distinguished senior fellow at the R Street Institute. He knows what he is talking about.
Philosophy of Finance
And he asks good questions. For example, what is real? In the bubble preceding the Great Recession of late 2007 to 2009, “much of the profit and wealth turned out to be illusory,” Pollock observes. The collateral for a mortgage loan is not really the house itself, a real thing (in a sense), “but the price of the house,” which “has no objective existence.” The same goes for “liquidity.” What is it? It disappears when a financial bubble—such as the increase in house prices that preceded the Great Recession—bursts. Liquidity “is about group behavior and group belief in the solvency of counterparties and the reliability of prices.”
The entities that accounting deals with are not facts, but opinions. Accounting figures are based on subjective estimates of unknowable future events, theories about these events, and even political influences (when accounting standards are decided). Pollock quotes an expert in accounting theory, Professor Baruch Lev: “Despite widely held beliefs that corporate financial statements convey historical, objective facts, practically every material item on the balance sheet and income statement, with the exception of cash, is based on subjective estimates about future events.”
One might add that even cash is not a tangible thing. It consists of short-term, liquid financial instruments (from currency to bank deposits to Treasury bonds) whose value can crash because, in people’s opinions, these instruments are worth less than previously thought.
These are good reasons to distinguish economics from a science like physics, which can predict events. Writes Pollock: “The motions of heavenly bodies and the bubbles and shrivels of financial markets are two different types of reality.” (His emphasis.) Economists, or at least macroeconomists, are victim to what F.A. Hayek called “the pretense of knowledge.”
Yet, Pollock notes, even astronomy cannot predict millions of years ahead. If, as he says, economics “will never be able to rise to the scientific level of dentistry,” it is mainly in the realm of control: a planner cannot control the economy like a dentist repairs teeth in the mouth of his patient. Philosopher and historian Pollock should squarely admit that at least microeconomics tell us a lot about what will happen given certain circumstances—say, what will happen to the price of a good if its consumers’ preferences change. This would keep him consistent with Hayek and improve his demonstrations.
Crises Are Unavoidable
As Pollock explains, the main reason why economic and financial crises happen is the same as why economics does not predict as well as physics: fundamental uncertainty in the sense of Frank Knight. This is due to the “infinite regress of interacting beliefs and actions” among individuals: “everybody’s behavior is based on predicting everybody else’s prediction of everybody else’s behavior.” A crucial fact emphasized by Pollock is that this uncertainty applies to government regulators and central banks, too: “Your model works until it doesn’t.”
Mistakes are thus inevitable. They show up in recurring booms and busts. As an economic boom persists, we forget Murphy’s Law, which tells us that whatever can go wrong, will go wrong, given enough time. So “all financial systems will crash, given enough time.” The problem is not mainly incentives (although they play a role, including when government intervention creates moral hazard), the “far bigger problem is uncertainty.”
Lots of banking crises—usually the worst form or stage of a financial crisis—happen. In the 20th century, 130 countries experienced one or more banking crises; on average, 2.6 banking crises happened somewhere in the world every year. When a financial crisis strikes, the government’s dilemma is between doing nothing or creating moral hazard for the future. It nearly always does the latter.
As a result of the Great Recession and the squeeze of interest rates by the Fed, Pollock estimates that American savers lost $2.4 trillion between 2008 and mid-2017. Something similar happened in Europe. These events were just a repeat of history. The value destroyed in a crash must be lost by somebody, and interventionist governments decide by whom. It is usually taxpayers or savers, although equity investors (as opposed to lenders and bond holders) typically lose something, too.
Governments Make Them Worse
A crucial point illuminated by Finance and Philosophy is that regulators and central banks don’t know the unknowable future better than do other market participants. When a crisis hits, their own interventions usually, if not typically, create the conditions for future crises. Paul Volker, the Fed chairman under Jimmy Carter and Ronald Reagan, finally broke the inflation of the 1970s but, Pollock reminds us, “this was the inflation the Federal Reserve itself had created.”
He calls the Fed “the most dangerous financial institution in the world,” the most systematically dangerous institution. It has a terrible record, going back to its foundation. Because of the (slow but regular) inflation the central bank generated or accommodated, the U.S. dollar’s purchasing power is down to about 10 percent of what it was in 1947. The Fed arguably shoulders part of the blame for the increase in the money supply that preceded the housing bubble of the 2000s. After its intervention in the crisis that followed, the Fed now owns $1.7 trillion of mortgage securities and $2.5 trillion of long-term Treasury bonds.
The Fed’s activities constitute “an ongoing attempt at central planning and price-fixing by committee.” It is “an independent governmental fiefdom of alleged Platonic economic guardians.” Pollock persuasively argues that this philosopher-king institution should not be independent.
The Fed’s independence is a relatively new doctrine, born after the inflation of the 1970s was generated by political pressures. This inflation in turn generated the savings-and-loans debacle of the 1980s. Pollock doesn’t squarely deal with the unattractive alternative of a monetary policy run by politicians.
Governments often generate financial crises by defaulting on their debt. As Pollock notes, “the problem with a sovereign power is that it may simply decide not to pay as it has agreed.” The world has known an average of one sovereign debt default every year since 1800. The Greek government’s default in 2012 was the latest major one. Several American states defaulted in the 19th century.
Inflation is an indirect way for governments to default on their debt. Other ways exist. In the 4th century BC, the tyrant Dionysius of Syracuse forced his subjects, under penalty of death, to bring him all their silver coins, which he reminted for twice their nominal value for the same silver content. He was thus able to keep half their value—which he used to repay loans from his subjects! In short, he did not repay the loans.
The U.S. government did something similar in 1933 by reneging on its explicit contractual promise to repay its gold bonds in gold; it repaid them in devalued dollars. Moreover, “the U.S. government forced all Americans to turn in their gold, under threat of criminal punishment, just as Dionysius did in his day.” While the government was actively defrauding its lenders, its spokesmen lied through their teeth (not to say “our collective teeth”), as Pollock vividly documents. In 1971, the Nixon administration abandoned the gold peg on the dollar, repudiating the international Bretton Woods Agreement.
The result of all this was that the Fed gained the power to create money ex nihilo, which led to permanent government deficits and to the 1970s inflation, and contributed to recurring financial crises. Pollock’s demonstration is eloquent: Don’t count on governments, including the U.S. government, to foresee or prevent financial crisis!
Growth and Cycles
Recurring crises are also partly due to the fact that individuals die, history is forgotten, and the new financiers and governmental actors just repeat the errors of their forebears.
Is it possible to keep continuing economic growth, which requires entrepreneurship and mistakes, without the business cycle? Pollock thinks the answer is no. Fundamental uncertainty means that mistakes will be made, including by governments. But economic growth is worth this cost.
What should government do? Pollock argues that it should follow Adam Smith’s non-interventionism 90 percent of the time, and John Maynard Keynes’s interventionism 10 percent of the time—that is, during crises. The trick, Pollock recognizes, is to discontinue the intervention after the crisis has subsided, like Cincinnatus who went back to his farm after saving Rome. This problem, the “Cincinnatian problem,” is not easy to solve and, indeed, has shown up once again after the Great Recession ended in 2009: The government and the Fed have still not retreated. The current administration even argues for more stimulus.
Alas Pollock’s instructive book ends on an anticlimax. First, it proposes the creation of a governmental body of “systemic risk advisors” (philosophers-non-kings, as it were) who would be schooled in financial history and would be tasked with warning the government and financial actors about systemic risks, including risks from government. These advisors must “never—no matter how serious the situation is—lie for the greater good.” Pollock partly redeems himself by saying he is not too optimistic that his solution would work, but it “is worth a try.” It would however generate more misplaced confidence.
Strangely, the author of Philosophy and Finance does not consider the solution of removing the government from finance and macroeconomic management, and letting crises run their course so as to generate the right incentives for future prudence. If we cannot avoid uncertainty, why compound it with the government’s own coercive and fraudulent sort of uncertainty?
The second aspect of the anti-climactic conclusion of Philosophy and Finance is that, beyond the proposal of a body of advisors, it offers only moral and philosophical advice: Bankers and financiers should cultivate the virtues of loyalty, integrity, and prudence. In the last paragraph of his book, Pollock writes that “those of us in any kind of financial responsibility,” “constrained by limits to our knowledge, fundamental uncertainty, and inevitable mistakes,” “should strive at all times to practice” these virtues, which “demand constant effort, by precept and by example.” I have emphasized the word “should,” assuming that Pollock is not proposing a government mandate, which would be worse than an anti-climax.
John Kay, a well-known economist and Financial Times columnist, who defends the same virtues and is praised by Pollock, obviously wants to go further. Pollock quotes Kay: “The guiding purpose of the legal and regulatory framework should be to impose and enforce the obligations of loyalty and prudence, personal and institutional, that go with the management of other people’s money.” To have government enforce virtue? LOL!
Hopefully, the more philosophical and prudent Pollock does not share Kay’s political naïveté.