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The Dangers Of Superficial Knowledge

The Dangers Of Superficial Knowledge

Hugh Pavletich FDIA
Performance Urban Planning
New Zealand

January 7, 2009

Within Our Epistemological Depression — The American, A Magazine of Ideas Jerry Z Muller, Professor of History at the Catholic University of America and the author of The Mind and the Market: Capitalism in Modern European Thought outlines how those in the finance sector failed, because they simply lacked the required knowledge of the risks involved. Professor Muller states –

“A good deal of our current economic travails can be traced to the increasing valuation of purportedly objective criteria, so denoted because they can be expressed and manipulated in mathematical form by people who may be skilled in such manipulation, but who lack “concrete” knowledge or experience of the things being traded. As Niall Ferguson has put it ‘those who the gods want to destroy they first teach math’. The paradigm – and the precursor of our current crisis – was the rise and fall of Long Term Capital Management, founded by two of the fathers of quantitative options financing, Myron Scholes and Robert C Merton. Knowing a great deal about math, but not very much history, they developed trading models that radically underestimated the risk entailed in their financial speculation, leading to a dramatic collapse of the company in the summer of 1998. Attaching a number creates a belief that the information is more solid than is actually the case. This is what I mean by ‘pseudo-objectivity’. In each case, it is a response to what (to recoin a phrase) one might call alienation from the means of production, the attempt to substitute abstract and quantitative knowledge for concrete and qualitative knowledge.”

With greater complexity and diversity, essentially the larger financial institutions have become un-manageable, as those in governance and senior managerial roles, lack the required intimate specialist understanding of the risks involved.

Professor Muller continues –

“This message has not yet taken hold among policy makers. There is much talk about monetary policy and fiscal stimulus. But without financial institutions that people have faith in, a fiscal stimulus is unlikely to have much of a multiplier effect. It is widely assumed that people will have faith in financial institutions, if the Treasury injects capital in to them. But the problem is not just that the financial institutions are short on operating capital: it is that recent experience seems to show that they are incapable of prudently managing the capital they have. In short, economic actors believe that other economic actors don’t know what they are doing. Nor is the problem merely one of isolating ‘bad assets’ – it is of a system that creates bad assets because of misaligned incentives and the fog created by opacity and pseudo-objectivity.

Professor Muller then continues by saying that confidence cannot be created out of thin air – and that the current problems are likely to be exacerbated as diversified firms are forced to amalgamate with other diversified firms. Put simply – if they didn’t understand what they were already managing – how can they be expected to successfully manage something even larger and more complex?

There is of course the example of the Bernie Madoff Ponzi Scheme where the Securities and Exchange Commission failed to act, after being repeatedly informed by Harry Markopolis, a specialist in the field with a deep understanding of the issues. Essentially – the SEC failed because it lacked people with sufficient “concrete knowledge” of the financial instruments involved. Markopolis is of the view that the SEC is “over lawyered” with a serious lack of skilled people with the required knowledge of the finance industry.

The “Dangers of Superficial Knowledge” problem is not one confined to just the finance sector – but is widespread both within the public and private sectors.

The Australian Labour Prime Minister Kevin Rudd for example could be described as a “Specialist in Superficial Knowledge” with his rather amusing “theories on economics – countered effectively by the former Labour Government Treasurer of New South Wales, Michael Costa - Rudd on a dangerous, ill-informed crusade | The Australian.

It is generally widely understood that the current Global Financial Crisis was triggered by the “mortgage meltdown” in the State of California, where housing had “bubbled” out to around 9 times household earnings - with Texas, for example, through this era of “easy money”, staying at 2.5 times earnings (Refer January 08 Dallas Fed Report and recent Reuters recent report on Texas home building market). For a “daily dose” of the latest horror stories out of California (after all – “entertainment” is major industry there – they gave up on “reality” long ago) – check patrick net and Dr Housing Bubble.

California with a population of 37 million and residential stock of some 13 million units median price peaked at in excess of $US500,000 and has slumped to near $US250,000. With the average price being somewhat higher than the median – it is likely some $US4 trillion of “bubble value” has been wiped out of California housing so far – and possibly as much as $US8 trillion of “bubble value” across the 127 million residential stock of the United States to date.

Thankfully however - the economics profession is now aware of its “knowledge gaps – as illustrated by this recent article in the Sydney Morning Herald - A new economic theory is needed for the growing financial crisis, write Andrew Boughton and Michael West. Until very recently – economists were trained that “housing bubbles” were irrelevant and didn’t matter. Little wonder few of them understand markets.

Within a recent Open Letter to Bernard Hickey, a senior New Zealand business journalist and Managing Editor of Interest Co NZ, I did a “rough assessment” of the quantum of “global bubble value” (some $US100 – 200 trillion or 2 to 4 times Gross World Product) that is currently in the process of evaporating.

Yet – economists and allied professions and others appear to have at best a shallow understanding of the significance and consequences of the equity and debt leveraging and deleveraging of specific housing markets globally. And most importantly – that these unnecessary housing bubbles are caused by regulatory failures at the local level, that must be dealt with, to ensure they don’t get underway again.

In reading media reports of “this weeks stimulus” or market intervention – one would get the impression that these are “cost free”. The question is never asked whether they will likely work or not and what the medium to long term consequences will be. Intervene in haste and repent at leisure seems to be the favored approach – as the “establishment” struggles (likely in vain) to protect its political and commercial interests.

The writers field is property development – a field I have studied through 30 years of practical experience. I have limited knowledge of other fields – unlike economists who consider that they understand the wider economy. Within a recent article Housing Bubbles And Market Sense I attempt to sketch out how those with “superficial knowledge” create massive problems – and further to this – why there is an urgent need to get “simple performance measures” (as recommended by the United Nations and World Bank) inculcated in to Local Government culture as quickly as possible. This is set out in “layman’s language” within the rather lengthy paper "Getting performance urban planning in place".

The reality is that those “schooled’ in a subject – but not actually “educated” in it - with a solid track record of practical experience – cannot be expected to have the required skills to participate within or regulate that particular field effectively. This is why - with respect to urban housing markets and local government generally – at least – there is a need for simple performance measures. The Annual Demographia International Housing Affordability Surveys (2009 5th Edition; 2008 4th Edition; 2007 3rd Edition; 2006 2nd Edition) should simply be seen as a useful “first step”.

There are always those who will attempt to “complicate and confuse” as illustrated within this New Zealand Herald article (to which I responded – Interest Co NZ larger version here Scoop NZ here).

Indeed – for public bureaucracies in particular (with the consultants that feed off them) there is a strong incentive to “complicate and confuse” – so that those they are accountable to are “kept in the dark” – particularly with respect to the issue of that particular institutions “performance”.

Within the English speaking world – the British public sector bureaucracies are the “most gifted” at generating complicated and confusing information of little relevance. I enjoy teasing British colleagues that I expect them to generate more “housing reports” this year than actual houses! As an example – this year’s Demographia Survey could not obtain median house price / median household income information for the 3rd Quarter 2008 for the United Kingdom – other than for London and it surrounds. So it had to settle for the regional level this year, with the latest information available, being for the 1st Quarter of 2008. No doubt the British bureaucrats are “overloaded” and “under resourced” – as they repeat the history of the “bureaucratic managed decline” of the 1970’s.

The message is clear. Recovery cannot occur until the real structural issues are dealt with effectively – across the board. And that as individuals in our specialist fields – with a little humility - we recognize just how limited our wider knowledge is.


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