The Wittgenstein test

I usually start off my PowerPoint presentations as follows:

“Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?”

Then I explain how the crisis of 2008 wasn’t what most people (on both sides of the ideological spectrum) assume it was. I end up with this slide:

Wittgenstein: Tell me, why do people always say it’s natural to assume the Great Recession was caused by the financial crisis of 2008?

Friend: Well, obviously because it looks as though the Great Recession was caused by the financial crisis of 2008.

Wittgenstein: Well, what would it have looked like if it looked as though it had been caused by Fed and ECB policy errors, which allowed nominal GDP to fall at the sharpest rate since 1938, especially during a time when banks were already stressed by the subprime fiasco, and when the resources for repaying nominal debts come from nominal income?

Where else can we apply this way of thinking? I can think of at least 5 more examples, and would appreciate any other suggestions.

1. What would it look like if it looked as though interest rates fell for some reason other than the Fed cutting interest rates with an expansionary monetary policy?

2. What would it look like if it looked as though there were no asset price bubbles?

3. What would it look like if it looked as though no one was smart enough to beat the market?

4. What would it look like if it looked as though a financial crisis was caused by FDIC-created moral hazard?

5. What would it look like if it looked like an economic catastrophe in a capitalist economy was not caused by unregulated capitalism?

For case #1, August 2007 to May 2008 will do just fine. The Fed did not inject any new money into the economy. The base was level at about $855 to $860 billion. Interest rates fell from 5% to 2%, but not because of the “liquidity effect” associated with an expansionary monetary policy. Instead, market interest rates fell for the exact same reason they often fell before 1913, i.e. before the Fed was created. Market interest rates fell because of a decline in the demand for credit. The Fed simply adjusted its official target rate to correspond to those falling market rates. The Fed did nothing to cause lower interest rates. And yet if you polled economists I’d guess at least 90% would say that rates fell because the Fed “eased” policy. Most economists probably think we fell into recession in December 2007 because velocity fell, whereas it was because the Fed suddenly stopped increasing the base—base velocity actually rose 1.6% between August 2007 and May 2008. Why do so many people think the recession was triggered by a fall in velocity? Because the Fed was rapidly cutting rates (so they think), and hence the money supply must have been increasing.

2. What would it look like if there were no asset bubbles? If prices rose sharply in an asset market, then from that point forward prices would be equally likely to rise further, level off, or fall back. And that’s exactly what happened to the global housing market in the first 14 years of this century. Prices rose sharply in most markets from 2000 to 2006, and then moved randomly after the sharp run-up. Many markets saw further appreciation. Many saw prices level off, and many saw prices fall. Thus the global housing market in the early 2000s looks exactly like a market would look if bubbles do not exist. And yet may people assume it somehow proves the existence of bubbles.

3. If no one was smart enough to beat the market, then 500,000 of each million investors would outperform the market average during any given year, 250,000 would outperform for two consecutive years, 125,000 for three consecutive years, and 1 in a million would outperform in 20 consecutive years. This may not be precisely what we observe, but it’s pretty close. In other words, if no one were smart enough to beat the market, then we’d expect to observe a very small number of investors such as Warren Buffett. And we do.

4. Moral hazard works in very subtle ways. Suppose someone loaned you $30 million dollars for a week. But then you had to repay the loan, unless you had lost it all in a casino. What would you do? One option would be to put $1 million on each of numbers 1 through 30 in roulette. There’s a pretty good chance you’d win $35 million. After repaying the loan you’d be $5 million ahead. In 8 cases out of 38 you’d lose on your bet, and be unable to repay the loan. That basically explains the 1980s S&L crisis, and also the more recent banking crisis. Most of the time the bettor wins, and most of the time banks making risky loans come out ahead. But what would it look like if they did not come out ahead? It would look like the specific factors that lead to a bad outcome on that particular occasion (people too naive to know that housing prices sometimes fall, government policies, evil bankers–pick your favorite villain) had caused the crisis. After all, those seemed to be the proximate cause, and FDIC was generating moral hazard in other decades, where things did not go poorly. So why this time?

Bad luck? I know that’s not very satisfying, but what would be your explanation if you put $1 million dollars on each of numbers 1 through 30, and the bouncing ball landed on #34? Would you blame the evil casino? When moral hazard creates financial crises, it never looks like moral hazard is creating financial crises. I’ll bet most people could not even envision in their mind’s eye what a moral hazard-caused financial crisis looked like.

5. The last one is directed at (American) liberals, who have a sort of knee-jerk reaction that “free market fundamentalism” is to blame for any crisis in a capitalist economy. I’d ask them to consider this question: What would a crisis in a capitalist economy look like if it looked as though it was caused by the indirect effects of well-intentioned government regulations? I spent the years 1977 through 1980 at the University of Chicago, being provided with hundreds of answers to that question.