Alex J. Pollock (C-Span2, Public domain)
CE Financial Observer: One of the aims of financial market regulations in recent years has been mitigating uncertainty and risk. Is this a realistic approach at all?
Alex J. Pollock: Not only is it unrealistic, but it is also undesirable. The market is inseparably linked to uncertainty about future events and to taking risks. The outstanding economist Frank Knight defined uncertainty as a situation concerning phenomena that not only cannot be predicted, but whose chances of occurrence cannot be calculated. In turn, he understood risk as a concept linked to situations whose probability can be estimated. Capitalism, or rather the entrepreneurial economy — because capitalism is a term used most often by its enemies — creates uncertainty and risk. In contrast, the socialist economy is based on their rejection. The problem is that the rejection of uncertainty and risk necessarily causes stagnation, and the acceptance of uncertainty and risk is a condition for growth, as well as the cause of crises.
Are crises unavoidable in the free market?
Of course! This, in turn, is a view that originates in the thought of the Austrian Joseph Schumpeter, who wrote that the essence of the market economy is the improvement in the quality of life through an endless series of crises, breakdowns and disruptions. You can’t have growth without crises. But it’s worth trying, because ultimately, Schumpeter wrote, the objective of the free market economy is not to provide silk stockings to queens, but to provide them to factory girls. If after some time a normal person can buy more of better quality goods for the same amount of money or amount of work, then capitalism works. And it does work.
But there is no consensus in economics around the view that crises are unavoidable.
It’s not surprising. After all, economics is not a science in the Newtonian sense. It is not possible to formulate concrete and credible forecasts in the same way as, for example, astronomers forecast the exact date and hour of an eclipse of the moon. Actually, economy is the name for a network of human interactions, and attempts to make economics an exact science, describing these relations in strict mathematical terms, must come to nothing. In one of his essays published in the 1930s, Keynes dreamed that economics would become as specialised as dentistry. However, while we can see a huge and real development in dentistry since that time, the same cannot be said for economics. In economics, many disputes which have continued for over two centuries remain unresolved.
So maybe we don’t need economics if it is so vague?
On the contrary! Economics is interesting and important. However, there is no conclusive evidence in it and it is not possible to conduct experiments, because economic phenomena are unique due to the variable circumstances. But it is possible to argue well or badly in economics. Economics is an instructive intellectual exercise. In economics, the concept of rightness is more important than the concept of scientific evidence. There are many things that we can say are right without being able to prove them mathematically or experimentally.
Nevertheless, there are economists, such as Prof. Alvin E. Roth of Stanford University, who are trying to experiment and even find, on the basis of their research, practical applications for economics, such as matching organ donors to transplant patients.
These economists are great and much needed, but it is worth noting that by using economic knowledge they are undertaking entrepreneurial activities — they are producing a kind of product or service, which can, but does not necessarily have to work. And it is precisely this mechanism, the essence of entrepreneurship, which is key for progress.
Let’s return to the unavoidability of crises. Actually, some blame governments for crises, while others blame the free market. The former argue that after removing government, crises will disappear, while the latter claim that this will happen only after the market is subjugated. Both groups fail to notice that bad and good, clever and stupid, hardworking and lazy are found on both sides of the equation. Let’s take the last crisis. On the one hand, banks conducted an irresponsible credit policy, on the other hand governments stimulated excessive borrowing. Crises don’t usually have just one cause, which can be surgically removed to prevent them.
Not prevent, but perhaps at least mitigate or shorten them?
Here my answer is affirmative, the last crisis was very severe, very long and the recovery also lasted very long compared to earlier crises. This is a fact. I believe that an important factor prolonging problems is government intervention. Have you heard about the huge crisis that broke out in USA in the years 1919-1920?
Exactly! And that’s because in 1921 it was already resolved, despite the fact that at the beginning it was comparable to the crash that took place 9 years later and destroyed the economy. The high inflation, unemployment, and fall in production lasted only 2 years, then everything returned to normal. One of the explanations for such a rapid recovery is the lack of government intervention. What’s more, the President of USA at that time, William Harding, cut government spending instead of fiscal intervention. This of course is not a proof, but strong circumstantial evidence in favor of my thesis. Unfortunately, government’s passivity was a historical exception to the rule, and the rule is government intervention. In my career, which I began as a young banker in 1969, there was a minimum of one crisis per decade, and regardless of which political option and ideology dominated, the government always intervened.
Politicians don’t like to be perceived as being passive when everything is burning around them. They are afraid they’ll lose votes.
That’s true. What lies behind government intervention is the conviction that a crisis is too painful for too many people to allow it to run its own course. I can understand this argument; however, I believe its supporters should consider two issues. Firstly, governmental intervention during a crisis is essentially redistribution of its costs and a decision about who should suffer more. So intervention also has costs. Secondly, while curing one crisis, intervention may trigger another one. The American central bank, the Fed, “saved” the economy from the effects of the dotcom bubble bursting in 2001 by lowering interest rates. However, the cut in interest rates triggered the next crisis. So Alan Greenspan, the Chairman of the Fed at that time, beat the downturn in the short term, but lost in the long term.
Claiming an inseparable relation between the occurrence of crises and economic growth is one thing. But how to explain the origin of this relation? Perhaps anthropologically: people are flawed creatures, erring, so the economy — their collective work — must also err? Or, as some argue, the crisis is the effect of a collapse of morals, i.e. violation of the ethical code, greed?
Erring and making mistakes is one thing, intentionally breaking the rules is something different. Walter Bagehot, the author of “Lombard Street”, a book belonging to the classics on banking, argues that people more often err, or simply make mistakes in assessing the situation, than break the rules. Of course, unethical behavior always occurs, particularly during a boom, when it seems to everyone that it is very easy to earn money. However, it is not unethical behavior that triggers crises, but ordinary human misjudgment of the situation. In the United States one of the biggest mistakes in recent decades was the policy of supporting housing. The aim was for as many citizens as possible to own their own homes. Bill Clinton was a particularly strong supporter of this policy in the 1990s. It boiled down to making it easy for people to get mortgages and as a result created a bubble in the market. This bubble was invisible, because for a long time the loans were being repaid. Everyone believed that the policy brought good results and continued to pursue it right up to the crash. Everyone — politicians, businessmen, ordinary citizens — made a mistake in assessing the situation.
So we’re all to blame for the crisis?
To varying degrees, yes. Let’s look at what is happening in Puerto Rico right now. The government is bankrupt. Why? Who is to blame? Some say the politicians, because they borrowed excessively. Others say the investors, because they invested in Puerto Rican bonds, which turned out to be toxic assets. There are also those who blame the US, because it had artificially built up the credibility of those bonds and convinced everyone that Puerto Rico would cope well. However, many of those bonds are in the hands of ordinary Puerto Ricans, who perhaps will end up losing their life savings. How can the situation be resolved? By granting them more loans?
Many point out that the cause of the problems with the financial system is the lack of skin in the game, in other words, system decision-makers do not bear the risk that they create themselves. Do you agree with this diagnosis?
There’s a lot of truth in this. You’ve finally touched on the thing I’m passionate about. Friends joke that I should have “skin in the game” engraved on my grave instead of an epitaph, because I use this expression so often. Unfortunately, it is very difficult to implement it in practice, for example, in politics. Let’s take as an example the system of student loans in USA. The government provides loans to pay for students’ studies, but the students very often fail to repay them. The debt level rises. It’s obvious that it’s the fault of the politicians, but also the students, who enter into this arrangement. However, it is important to identify the key element in the causal chain — in this case it is the universities. In the current system they simply have motivation to widely promote student loans, since thanks to this they earn money — they keep the money even when their graduate is unemployed or has declared consumer bankruptcy. In view of this, we should somehow link the professional achievements of the students with the money of the universities. Since they did not educate the given person well enough to repay the loan on which they, the universities, earned money, they should bear part of the responsibility.
However, we were talking about the mistakes leading to financial crises. Sharing responsibility for the effects of those mistakes could limit them. But how can this be implemented in practice?
The concept of skin in the game in finance and banking is being developed rather dynamically and actually has a chance to reduce the number of mistakes and distortions. One of the charges against the financial sector during the last crisis was, for example, that the CEOs received huge bonuses despite the fact that their companies failed or recorded huge losses. In other words, their salaries were not linked to their performance. Currently, the conclusion is being reached that bonuses should reflect the long-term achievements of the manager. What is meant by this is achievements over a longer part of the business cycle; and so, for example, the results of 5 years are taken into account. The logic is simple: if the company achieved good results for 4 years and you, as the CEO, received bonuses, and in the fifth year it turns out that these results were only derived from overleveraging, from artificial growth, and the firm begins to have problems, these bonuses should be recognized as undue. There are firms who design their remuneration structure so that the undue bonuses can be recovered. It’s worse in the case of implementing the principle of “skin in the game” among political decision-makers. They are cynics, who avoid responsibility at all costs. In the end, as Jean Claude Juncker, currently the President of the European Commission, once said, “when it becomes serious, you have to lie”.
In one of your articles you write that historically, the free market and globalization are a long-term tendency with periodic anomalies. Are we currently in the middle of such an anomaly, or is everything proceeding in accordance with this pro-globalization tendency?
We are in a situation of a threat of an anomaly. Firstly, we are facing the threat of trade wars as a result of Donald Trump’s policy. Secondly, crises occur on average every 10 years. The last one ended more or less in 2012, which means that in a few years the next one could erupt, strengthening anti-market ideologies. However, looking further into the future I am optimistic — people will improve their living standards just as they have been doing for over 200 years. It is precisely this that is the main argument in favor of the free market. I see enormous strength in the internet, which allows a more efficient exchange of information and acquisition of knowledge. It reminds me of the practical implementation of the postulate of the Jesuit philosopher Teilhard de Chardin that evolution does not end with man, but with the noosphere, in other words, humankind understood globally as the spirit of the world, something even beyond the human.
Aren’t you afraid that precisely thanks to this progress humankind will transgress itself and destroy itself, by creating thinking machines?
I don’t think so. Even artificial intelligence would be limited by the same thing as human intelligence: unexplored and unmeasurable uncertainty.
Alex J. Pollock is an American philosopher of economics, and senior fellow at the think tank R Street Institute.