The financial crisis shows why we should admire Friedrich Hayek

Some people have suggested that the current crisis suggests that ‘free’ markets are dead. Given the high degree of regulatory scrutiny in the financial sector that is not a point of view I hold. However, the neo-classical case for the market economy has certainly become strained,  though the Austrian or Hayekian case has been strengthened.  

Much of the new breed of regulation that appears to have failed has relied on institutions using highly quantitative models and lots of market information. Uniform accountancy standards have been implemented by law in much of the world, based on market values. Data-driven risk models based on patterns repeating themselves in financial markets in predictable ways were encouraged by regulation. These models were adopted widely throughout the world. So, what happens when they fail? The whole financial world – encouraged by regulation to take the same approach to risk management and capital setting – goes pop at the same time.  

Markets, in fact, are a discovery process. It cannot be assumed that market prices are a perfect reflection of economic value at any particular time. Market participants continually discover new information, make errors and respond to errors. It is important that financial institutions are allowed to do things differently so that some (who use better and more efficient methods) succeed and others fail (indeed, it is important that institutions are allowed to fail). When we use data to take financial decisions, decide how much capital to keep and so on, we should be aware that the data we use contains some information but that relationships that hold one day will not hold precisely the next day. We should stand back and think conceptually about the risks that financial institutions are taking.  

The crash gives many more indications that Hayek was right. Hayek argues that unregulated markets develop institutions that ensure that trust and reputation become valuable commodities. But who cares about trust and reputation when we believe that everything will be looked after by the regulators or by deposit insurance? As far as a company is concerned, compliance with regulation has become more important than trust. The market has been allowed to generate crude economic efficiency,  but trust has been crowded out by regulation.  

Hayek suggests too that booms and busts are the product of poor monetary policy. Central banks hold interest rates too low. People consume too much and invest in business projects that would not be profitable at higher levels of interest rates. Resources then get misallocated. And then the whole thing goes bang and we get a recession (in this case accompanied by a banking crisis). 

The socialists can carry on arguing – though they are wrong. But the equation-driven, data-driven neo-classical economists should stand back a bit and admire Hayek. They have a lot to answer for too. They should not lose confidence in the free-market cause, but look for better arguments.

First published on the Daily Telegraph’s Ways and Means blog.

“The whole financial world – encouraged by regulation to take the same approach to risk management and capital setting – goes pop at the same time”Thanks, I’ve been looking for a way to say that for a while. Excellent article. Best regards

Regulators sometimes encourage us to put too much faith in their fallible efforts. My latest book, entitled ‘Margins of Error in Accounting’ describes the four main reasons why published company accounts can never be entirely ‘accurate’. No sensible person in the real world ever thought otherwise. My book was inspired by another Austrian economist, Oskar Morgenstern, who wrote a marvellous book called ‘On the Accuracy of Economic Observations’ half a century ago. He’d have been amused by the huge changes currently being made in ‘predictions’ of Gross Domestic Product in various countries. In many cases even the sign was wrong!

I think you are very much arguing along the right lines. However, I think the notion that people are “consuming too much” is a moralising step too far. People consume what they consume, I don’t think liberals should be judgemental on other people’s tastes. If ultra-easy credit is offered by banks and others to people who don’t have high likelihoods of paying it back then that is the suppliers lookout, after all “seller beware” is as apt as “buyer beware”. The better suppliers of credit often say people know their own creditworthiness very well, although they may not like it. In fact anyone can go on-line and get check their ratings. It is a big business in fact.

For the craziness of the statistical approach to risk measurement I would recommend going to the Institutional Risk Analytics website for one of their recent weekly articles “New Hope for Financial Economics: An Interview with Bill Janeway”:http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=323
The other articles are also often excellent, one other recent one was sensible to point out the Mises Institute recent re-posting of Hayek’s “The Pretence of Knowledge”, where he strongly cautioned about over-reliance on statistics to the exclusion of, as you say, standing back and thinking conceptually about risk.

I should clarify. By “consume too much” I meant that people consumed more than they would have done if interest rates had not been held artificially low by the central bank. Of course, that consumption can be in quasi investment goods (cars, houses etc.).

One of the reasons of 2008 financial turmoil was the principle of the stock exchange that works selling high and then buying chip; or in a reverse direction: first buying chip and then selling high. What is important is that there is huge amount of assets (nearly US$ 20-25 trln. of accumulated pension funds and funds in the stock market, that at least was before the 2008 crisis) that can use these principles. Specifically, when the market went down, all the power of the world economy was used to crush existing financial network, thus making ruins of itself – the free market economy. What can be done is to regulate the markets by accepting standards existing at any stock exchange: to stop trading session if there comes a fall of say more than 10% a day. It must be done on a global scale, having simultaneous actions accepted. It consequently requires global integration of financial markets: powers can meet and work out new rules, previously accepted in various states worldwide.

Market price (under free competition and no politics like Iraq and oil) is clearly the one to be considered as immediate reflection of the market’s demand; so you are fundamentally wrong in this.
The price’s dynamics fundamentally is driven by cyclical consumption, existence of competitors and their aggregate ability to fill-in the market.
“Erros” of the market actually are fluctuations of price due to abovementioned reasons. They are not errors at all. Instead, they are essential cyclic feature of the market.
Trust is a cornerstone for banking, no trust means no banking, no houses, economic development etc.

They’ve been warning about this the whole time…http://www.mises.org
andhttp://www.lewrockwell.com

“The whole financial world – encouraged by regulation to take the same approach to risk management and capital setting – goes pop at the same time”Thanks, I’ve been looking for a way to say that for a while. Excellent article. Best regards

Regulators sometimes encourage us to put too much faith in their fallible efforts. My latest book, entitled ‘Margins of Error in Accounting’ describes the four main reasons why published company accounts can never be entirely ‘accurate’. No sensible person in the real world ever thought otherwise. My book was inspired by another Austrian economist, Oskar Morgenstern, who wrote a marvellous book called ‘On the Accuracy of Economic Observations’ half a century ago. He’d have been amused by the huge changes currently being made in ‘predictions’ of Gross Domestic Product in various countries. In many cases even the sign was wrong!

I think you are very much arguing along the right lines. However, I think the notion that people are “consuming too much” is a moralising step too far. People consume what they consume, I don’t think liberals should be judgemental on other people’s tastes. If ultra-easy credit is offered by banks and others to people who don’t have high likelihoods of paying it back then that is the suppliers lookout, after all “seller beware” is as apt as “buyer beware”. The better suppliers of credit often say people know their own creditworthiness very well, although they may not like it. In fact anyone can go on-line and get check their ratings. It is a big business in fact.

For the craziness of the statistical approach to risk measurement I would recommend going to the Institutional Risk Analytics website for one of their recent weekly articles “New Hope for Financial Economics: An Interview with Bill Janeway”:http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=323
The other articles are also often excellent, one other recent one was sensible to point out the Mises Institute recent re-posting of Hayek’s “The Pretence of Knowledge”, where he strongly cautioned about over-reliance on statistics to the exclusion of, as you say, standing back and thinking conceptually about risk.

I should clarify. By “consume too much” I meant that people consumed more than they would have done if interest rates had not been held artificially low by the central bank. Of course, that consumption can be in quasi investment goods (cars, houses etc.).

One of the reasons of 2008 financial turmoil was the principle of the stock exchange that works selling high and then buying chip; or in a reverse direction: first buying chip and then selling high. What is important is that there is huge amount of assets (nearly US$ 20-25 trln. of accumulated pension funds and funds in the stock market, that at least was before the 2008 crisis) that can use these principles. Specifically, when the market went down, all the power of the world economy was used to crush existing financial network, thus making ruins of itself – the free market economy. What can be done is to regulate the markets by accepting standards existing at any stock exchange: to stop trading session if there comes a fall of say more than 10% a day. It must be done on a global scale, having simultaneous actions accepted. It consequently requires global integration of financial markets: powers can meet and work out new rules, previously accepted in various states worldwide.

Market price (under free competition and no politics like Iraq and oil) is clearly the one to be considered as immediate reflection of the market’s demand; so you are fundamentally wrong in this.
The price’s dynamics fundamentally is driven by cyclical consumption, existence of competitors and their aggregate ability to fill-in the market.
“Erros” of the market actually are fluctuations of price due to abovementioned reasons. They are not errors at all. Instead, they are essential cyclic feature of the market.
Trust is a cornerstone for banking, no trust means no banking, no houses, economic development etc.

They’ve been warning about this the whole time…http://www.mises.org
andhttp://www.lewrockwell.com

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