An Epistemological Crisis February 10, 2009Posted by Dwight Furrow in Current Events, Dwight Furrow's Posts, Philosophy.
Why is there so much financial instability given the fact that it is in everyone’s interest to have stability. Are we just irrational and unable to ascertain or act on our interests. Is it greed, excessive risk taking, or the inevitable result of tumultuous competition getting rid of the less efficient? All of these explanations play a role. But the more fundamental problem is epistemological.
Buying stocks is like professional gambling—the people who are good at it are good at assessing risk. But precise risk assessment is always impossible. We cannot carve up the future in manageable bits and assign probabilities to them. The world often changes in ways we did not anticipate and sheer complexity overwhelms any attempt to discover useable regularities. The investment instruments devised by investment banks to securitize mortgage and consumer loans were so complex that no one understood their true value and the great unraveling was far more precipitous than anyone predicted.
When risk assessments collapse and we are confronted with uncertainty we tend to rely on habits or do what has worked in the past. So in the run up to our current crisis we believed platitudes like the stock market always trends upward in the long run or housing prices will never fall. These were propositions for which there was some evidence. But this reliance on habit and convention is a fatal error when the unexpected happens—what has worked in the past is ill equipped to respond to novelty.
What we needed in our recent past, especially from business and government, was skepticism, more distrust in our ability to calculate the future, which would have encouraged more saving, more scrutiny, more caution, less leverage. It was not exactly irrational to believe in our ability to assess risk. It wasn’t a matter of assessing evidence well. After all, you don’t know what you don’t know. You can’t really have evidence for the unexpected. (See Taleb on this point) Instead we needed epistemological virtue—a recognition of the limits of knowledge, reticence about believing in our powers of prediction. Especially because much of the uncertainty was of our own making
Much of the blame for our lack of epistemological virtue should be placed at the feet of modern economics. The dominant, free-market equilibrium model assumes that prices (including the price of risk) always find an equilibrium and that markets are fully efficient when there are no externalities. And we are encouraged to think that our mathematical wizards can describe this equilibrium regardless of the complexities of the situation and capture all externalities in the price. Mathematicians designed most of the securities that caused such a problem in the credit markets; and decisions to buy and sell stock, made by large institutional investors, are generated by complex mathematical models with little human intervention.
This fascination with mathematical models assumes that behind the imperfections of the messy world we live in there is a world of perfection with formulaic harmonies that can be known with the certainty. And through our efforts we can aspire to this ideal. But there is no such world.
Platonism still lives in the cubicles of Wall Street offices. And we cannot defend ourselves from black swans and white ravens until we are rid of Platonism.