Knowledge Problem and the US Housing Bubble

The great Austrian economist Friedrich August von Hayek explained of the fundamental reason why central planning can’t work: the knowledge problem—or the limitations on what people can know.

In his Nobel Prize speech “The Pretense of Knowledge” Mr. Hayek said, (bold mine)

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants. There is danger in the exuberant feeling of ever growing power which the advance of the physical sciences has engendered and which tempts man to try, "dizzy with success", to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will. The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society - a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

Alex Pollock, of the American Enterprise of Institute writing at The American exposes on such knowledge problem by political authorities who blatantly misdiagnosed and consistently made failed predictions during the recent US housing bubble.

How much can you trust the word of government officials? How much about the financial future can central bankers or anybody know? Consider the lessons of the following 10 quotations:

1. About whether Fannie and Freddie’s debt was backed by the government: “There is no guarantee. There’s no explicit guarantee. There’s no implicit guarantee. There’s no wink-and-nod guarantee. Invest and you’re on your own.” — Barney Frank, senior Democratic congressman, notable Fannie supporter, later chairman of the House Financial Services Committee

It would be difficult to imagine a statement more wrong.

2. “We do not believe there is any government guarantee, and we go out of our way to say there is not a government guarantee.” — John Snow, Republican and secretary of the Treasury

Saying it did not make it so, unfortunately.

3. “The facts are that Fannie and Freddie are in sound situations.” — Christopher Dodd, senior Democratic senator, prominent Fannie supporter, chairman of the Senate Banking Committee

Pronounced two months before Fannie and Freddie collapsed.

4. “We have no plans to insert money into either of those two institutions [Fannie and Freddie].” — Henry Paulson, Republican and secretary of the Treasury

Stated one month before the Treasury started inserting money into Fannie and Freddie.

5. “Home prices could recede. A sharp decline, the consequences of a bursting bubble, however, seems most unlikely.” — Alan Greenspan, chairman of the Federal Reserve Board

The common wisdom of the bubble years. At the time of this statement in 2003, the Fed was in the process of dramatically reducing short-term interest rates and stimulating house-price increases.

6. “Global economic risks [have] declined.” — International Monetary Fund

Observed four months before the international financial panic started in August 2007.

7. “More than 99 percent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.” — Federal Deposit Insurance Corporation

This statement was made in the second quarter of 2006, at the peak of the housing bubble. More than 400 such institutions later failed and others were bailed out in the ensuing bust. The FDIC failed its own required capital ratio, reporting negative net worth.

8. “The risk to the government from a potential default on GSE [Fannie and Freddie] debt is effectively zero.” — Joseph Stiglitz, Nobel Prize–winning economist, Peter Orszag, a future White House budget director, and Jonathan Orszag

Conclusion after considering “millions of potential future scenarios” — but obviously not the scenario which then actually happened.

9. "'Not only didn’t we see it coming,' but once the crisis started, central bankers 'had trouble' understanding what was happening." — Remarks by Donald Kohn, vice chairman of the Federal Reserve Board

A candid statement of the truth.

10. Finally: “Libenter homines id quod volunt credunt.” That is: “People easily believe that which they want to believe.” — Julius Caesar

Nothing has changed in this respect since Caesar’s day, and his dictum applies to government officials, central bankers, economists, and experts — just as it does to you and me.