Jeff Friedman's Response to Comments on Engineering the Financial Crisis

Interesting post at "Coordination Problem."

"I haven't wanted to interrupt all of these kind words, but thank you, Pete and everyone else.

Engineering the Financial Crisis was indeed inspired by what I take to be the core Austrian insight: the ubiquity of human ignorance. Popper makes a very similar point: the ubiquity of human error.

To me, Austrian economics is distinctive because it opens the door to saying, as Mises did in the socialist calculation debate: People may err because they don't know what they should know. Speaking for myself, not Wladimir Kraus, I’m not so sure about the rest of Austrian economics, but then, I am not an economist of any kind.

I agree that it's kind of absurd to have to *theorize* ignorance-based error, as Anthony Evans and I do in our recent “Critical Review” paper, but mainstream economists really do seem to have trouble with the concept, and it was this trouble that also led Wlad and me to write “Engineering the Financial Crisis.” For example, the book notes that Stiglitz asserts repeatedly that the crisis was *not* the result of anyone's errors. But we also note, following Pete Boettke's 1997 “Critical Review” article, “Where Did Economics Go Wrong?” that whether it's Stiglitz on the left or Stigler on the right, such assertions are commonplace among mainstream economists, clearing the way for them to claim that incentives, as opposed to ignorance, explain (or rather explain away) errors.

The Evans and Friedman paper linked to above suggests that Austrians seize the moment to criticize that tendency among mainstream economists. Austrians might be able to reform their discipline in this golden moment of opportunity if they show that an ignorance-based economics has a much firmer purchase on the empirical realities of the crisis than the evidence-free assertions of Stiglitz and virtually all other economists who have written about the disaster. That's what Engineering the Financial Crisis” tries to do.

The book is also an exercise in “Austrian political science.” Just as Mises asked how central planners would know what they'd need to know if they were to avoid errors, an Austrian political theory would ask how political actors are to know what they need to know, and an Austrian political science would examine political actors' actual sources of information, the gaps therein, and the theoretical and ideological biases therein.

Thus, Wlad and I find that banking regulators were in the grip of the same economistic ideology gripping Stigler and Stiglitz. They thought that deposit insurance created misaligned incentives for bankers (a moral hazard), such that bankers would now want to take wild bets. Therefore capital cushions had to be mandated by law, and the details of those mandates incentivized bankers to pile into what regulators thought were "safe" securities: those rated AAA. (Incidentally, the regulations provided an even greater incentive to pile into sovereign debt.)

Similarly, the accounting regulators thought corporate executives faced the moral hazard of profiting by hiding losses from shareholders. So they mandated mark-to-market accounting on the grounds that market prices "tell the truth" by "aggregating information" (. . . even Hayek was fallible . . .), rather than aggregating the fallible decisions of buyers and sellers. Mark-to-market accounting therefore writes down corporate assets that are experiencing an ignorance-based market panic, which happened to AAA mortgage bonds in 2007 and 2008, and this directly translates into dollar for dollar reductions in capital. If the corporation is a bank, this dramatically shrinks lending power, and thus may have transformed the financial-market panic into the Great Recession.

The "information," ideas, theories, and ideologies that prompt political action have long been studied in political science, so those who study it face none of the high hurdles to career success that face Austrian economists. The Critical Review Foundation has been running occasional seminars since 1995 to encourage young scholars of Austrian bent to go into political science. Two of those young scholars are now tenure-track political scientists at Yale. If you may be interested in this career path, please contact me through the Critical Review website, http://www.criticalreview.com/crf/

Finally, Wlad and I have a blog where we've posted updated data on the actually risk averse (but regulation-following) behavior of bankers prior to the crisis: http://causesofthecrisis.blogspot.com/2011/10/new-data-on-bankers-risk-aversion.html We'd be happy to debate the theses of the book there."