Friday, July 3, 2009

A Crisis of Politics, Not Economics: Complexity, Ignorance & Policy Failure

Critical Review is publishing a special issue on the financial crisis. Economist Jeffrey Friedman writes in his introduction:
"...if we take seriously the possibility that market participants are making cognitive rather than incentives-based errors, the case for regulation loses considerable force."
"Indeed, what may have saved the world from complete economic chaos in 2008 was the fact that the regulations were loose enough that many investors and many bankers had resisted buying the "safe" securities that most banks seem to have bought. Heterogeneous behavior like that, however, is allowed for, encouraged, and rewarded by capitalism; and is either discouraged or prohibited by regulation, depending on how tight the regulations are."
Economist Arnold Kling interprets Friedman:
"Which is more vulnerable to catastrophic failure: a relatively unregulated system, in which participants pursue diverse strategies; or a strongly regulated system? For Friedman, the latter is more vulnerable, because of the risk of promoting homogeneous behavior, so that one mistake affects everyone."

"All of us have our intellectual hobby horses. Friedman's hobby horse seems to be the existence of cognitive weakness or ignorance. He is constantly asking what happens if leaders have cognitive biases or information gaps. In general, I think when you take that problem seriously, you fear strong government."