Kling on Cognitive Hubris

Just posted this over at LvMIC:

Arnold Kling, a member of the Financial Markets Working Group at the Mercatus Center at George Mason University, is out with a new article in the The American highlighting the all-important lesson Hayek taught in “The Use of Knowledge in Society.“  In regards to cognitive hubris, the tendency for individuals to believe their interpretation of how the world works is correct beyond a reasonable doubt, Kling applies it to its use in public policy and the unintended consequences such creates:

Cognitive psychologist Daniel Kahneman’s new book, Thinking Fast and Slow, is a capstone to a distinguished career spent documenting the systematic flaws in human reasoning. He finds it useful to describe us as having two systems for thinking.
System One, as he calls it, is quick, intuitive, and decisive. It may be described as often wrong but never in doubt. System One is always active and plays a role in every decision that we make because it operates rapidly and unconsciously.
System Two is deliberative and logical. In principle, System Two can detect and correct the errors of System One. However, System Two has limited capacity, and often we do not invoke it before arriving at a conclusion. Even worse, we may deploy System Two to rationalize the conclusions of System One, rather than to question those conclusions and suggest appropriate changes.
Suppose you were to ask yourself how well you understand the world around you. How accurate is your map of reality?
If you interrogate System Two, it might reply, “There are many phenomena about which I know little. In the grand scheme of things, I am just blindly groping through a world that is far too complex for me to possibly understand.”
However, if you were to interrogate System One, it might reply, “My map is terrific. Why, I am very nearly omniscient!”

In applying such reasoning to the recent financial crisis, Kling writes:

Political scientist Jeffrey Friedman uses the term “radical ignorance” to describe what he sees as the low quality of maps that all of us have in our complex social environment. He contrasts this radical ignorance with the assumptions that economists make, in which market participants and policymakers possess nearly perfect information.  Indeed, this year’s Nobel Prize in economics once again reinforced the popularity in mainstream economics of “rational expectations,” a particularly stringent assumption that economic actors possess uniformly high quality information.

Largely unwilling to consider ignorance, economists usually fall back on incentives as explanations for phenomena. For example, economists explain the buildup of risk in banks’ portfolios in the years leading up to the crisis of 2008 as resulting from moral hazard, in which bankers knew that they were going to be bailed out if things went poorly. However, Friedman points out that if they had truly been seeking out high returns with high risk, they would not have been obsessed with obtaining the securities with the most pristine risk rating: AAA. Low-rated securities would have been used to exploit moral hazard even more effectively, since they paid much greater yields than higher-rated securities.

Rather than focus on incentives, Friedman’s narrative would emphasize what I have been calling cognitive hubris. Mortgage lenders believed that new underwriting tools, especially credit scoring, allowed them to assess borrower risk with greater accuracy than ever before. Such knowledge was thought to enable lenders to discriminate carefully enough to price for risk in subprime markets, rather than avoid lending altogether. On top of this, financial engineers claimed to be able to build security structures that could produce predictable, low levels of default even when the underlying loans were riskier than the traditional prime mortgage.
Regulators, too, fell victim to the combination of cognitive hubris and radical ignorance. They believed in the quality of bank risk management using the new tools.  They also believed in the effectiveness of their own rules and practices.

Kling’s reasoning, though sound on many levels, leaves out another major factor that contributed to the crisis.  He doesn’t apply the cognitive hubris problems that plagued the buildup of the housing bubble to the Federal Reserve’s easy credit policies that set the stage for the crisis in the early 2000′s.  Though I follow Kling sporadically, I haven’t seen him come out in full endorsement of applying the Austrian Business Cycle Theory to the housing bubble.

When it comes to cognitive hubris, it definitely pertains to the Fed’s low interest rates policies which incentivize entrepreneurs, investors, etc. that it’s profitable to engage in long term investment, thus elongating the structure of production without a corresponding decrease in consumption in capital goods.  Here is
Rothbard summarizing:

In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time.  The “boom-bust” cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. Let us suppose an economy with a given supply of money. Some of the money is spent in consumption; the rest is saved and invested in a mighty structure of capital, in various orders of production. The proportion of consumption to saving or investment is determined by people’s time preferences — the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference rate be, and the lower therefore will be the pure interest rate, which is determined by the time preferences of the individuals in society. A lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and a building-up of capital. Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption. The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components. Varying degrees of entrepreneurial risk bring about a structure of interest rates instead of a single uniform one, and purchasing-power components reflect changes in the purchasing power of the dollar, as well as in the specific position of an entrepreneur in relation to price changes. The crucial factor, however, is the pure interest rate. This interest rate first manifests itself in the “natural rate” or what is generally called the going “rate of profit.” This going rate is reflected in the interest rate on the loan market, a rate which is determined by the going profit rate.

Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business?  The new money pours forth on the loan market and lowers the loan rate of interest. It looks as if the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. Now, when saved funds increase, businessmen invest in “longer processes of production,” i.e., the capital structure is lengthened, especially in the “higher orders” most remote from the consumer. Businessmen take their newly acquired funds and bid up the prices of capital and other producers’ goods, and this stimulates a shift of investment from the “lower” (near the consumer) to the “higher” orders of production (furthest from the consumer) — from consumer goods to capital goods industries.

If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained. But this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, and there is no reason to think that they have, people will rush to spend the higher incomes in the old consumption-investment proportions. In short, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.

In application to the housing bubble, see Robert Murphy.

With the Fed’s policies, many investors were duped into the believing that housing prices would continue to go up.  The same applied to many middle class individuals who were able to take out mortgages at relatively low cost (or no immediate cost at all with down payments waived).  In short, the Fed’s policies drove a “buy low, sell high” mentality on Wall Street that was a direct result of cognitive hubris via artificially low interest rate policies.  Certainly the federal government’s housing policy involving GSEs Fannie Mae and Freddie Mac exacerbated the situation.

It’s unfortunate Kling doesn’t recognize how apt applying cognitive hubris to the Fed’s policies really is.  While entrepreneurs and businessmen specialize in forecasting, they are bound by limited knowledge on both future market conditions and the extent of the Fed’s policies.

Despite this, Kling still recognizes that limited knowledge provides a much better argument in favor of limited government over increased regulation:

The cognitive biases documented by Kahneman have been interpreted by a number of thinkers, including Kahneman himself, as providing a justification for government intervention. After all, if people are far from the well-informed, rational calculators assumed in economic models, then presumably the classical economic analysis underlying laissez-faire economic policy is wrong. Instead, it must be better to “nudge” people for their own good.

However, I draw different implications from the hypothesis of cognitive hubris combined with radical ignorance. If social phenomena are too complex for any of us to understand, and if individuals consistently overestimate their knowledge of these phenomena, then prudence would dictate trying to find institutional arrangements that minimize the potential risks and costs that any individual can impose on society through his own ignorance. To me, this is an argument for limited government.

Indeed, government is only ever composed of the same fallible, imperfect individuals that make up the rest of the society.  They don’t hold any unique knowledge over planning society beyond the “legislative whip” they use to manipulate individuals to their liking.  Those economists who endorse the fallacious belief in all-knowing bureaucrats leave themselves open to humanity’s unpredictable tendencies.  They essentially fall victim to their own cognitive hubris.  As Hayek noted:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

Kling’s piece is highly recommended.