I have avoided posting on the financial crisis until now, not wanting to add more negativity to the bail-out proposals, however now it is clear it’s not preventing asset declines, I feel OK to use it as a jumping off point for a theoretical discussion on the role of theory.
Theory has an uneasy relationship to data, and this is no more evident than in economics and climate science. In particular, what you see in data is largely determined by your preconcieved theory, and even more so determine your actions. But if your theory is wrong, then your actions can make matters worse than if you had no theory at all.
For example, consider this comment by Ron Paul on the “Austrian” school of economics
F.A. Hayek won the Nobel Prize for showing how central banks’ manipulation of interest rates creates the boom-bust cycle with which we are sadly familiar. In 1932, in the depths of the Great Depression, he described the foolish policies being pursued in his day â€“ and which are being proposed, just as destructively, in our own:
Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansionâ€¦.
To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection â€“ a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an endâ€¦. It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression.
It’s the same destructive strategy that government tried during the Great Depression: prop up prices all costs. The Depression went on for over a decade. On the other hand, when liquidation was allowed to occur in the equally devastating downturn of 1921, the economy recovered within less than a year.
The only thing we learn from history, I am afraid, is that we do not learn from history.
Doesn’t “forced credit expansion” sound like the bail-out plan? But the theory is embedded in the solutions.
Consider Mike “Mish” Shedlock’s post, Pushing on a String In Academic Wonderland.
Keynesian theory suggests the Fed is in a dreaded “liquidity trap”. The reality is there is no such thing as a “liquidity trap”, at least in Austrian economic terms. There is no trap, because it is impossible to prevent the liquidation of credit boom malinvestments.
Purging of bad debts must take place before a lasting recovery can begin. The mistake the Fed is making is attempting to force liquidity down the throat of a market that does not need it and cannot use it.
The credit markets are choking on credit, yet Bernanke is attempting to force more credit down everyone’s throats. Logic dictates the solution cannot be the same as the problem.
Trapped in academic wonderland, such simple logic is far too complex for Bernanke to understand. Sadly, we are all forced to watch Bernanke flop about like a fish out of water attempting to solve a solvency problem with ridiculous liquidity schemes like the TAF, PDCF, TSLF, TARP, and the ABCPMMMFLF.
On the climate front, Ferenc Miskolczi posted a relevant comment yesterday. Critics of his theory have been worried by the stated relationships of the observations to theory; especially the virial theorem and Kirchhoff’s Law.
Telling the truth, in the original versions of the manuscript only the empirical facts were presented. However, one Hungarian astrophysicist (reviewer of the Idojaras journal ) insisted on giving reference or theoretical support for the new equations. He accepted the Su=OLR/f based on the mathematical proof in the Appendix B , but he thought that the other relationships needs some kind of theoretical backing (Su=Ed/A, Su=3OLR/2, Su=2Eu (Earth) and Su=3OLR/(2+Ta) and Su=3Eu/(2(1-Ta)) (Mars). Since no reference existed in the literature for the above relationships I had to create the new â€˜lawsâ€™. At that time I was not happy about his arguments since new empirical facts alone used to be published, but know I am very grateful to him that he forced me to look deeper into the reasonings behind the equations and found some theoretical explanation.
This is a fair and honest comment, but the reviewer was right also in demanding a context for the empirical relationships, as both observation and theory must agree in science. But as Ferenc then notes, this relationship is not always clear:
However, this is not a â€˜perfectâ€™ greenhouse theory, (in science nothing is settled forever, no matter what IPCC believes) but could be a contribution to the better understanding of the radiative processes in the atmosphere.
There are many instances of empirical relationships only given a strong theoretical basis decades or even centuries later. Manning’s formula comes to mind, a hydrological relationship in open channels developed by an Irish accountant two centuries ago that is still used today, and only recently was justified by chaotic flow considerations.
But what about greenhouse and economic theory? Does the current crisis ‘falsify’ the current economic model? What of the solution offered by Austrian economists — abolish the Fed and let the failing banks be absorbed into the big four? The only alternative seems to be liquidation via government resumption with consequent loss of shareholder equity anyway.
Does the stabilization of global temperatures ‘falsify’ the IPCC conclusions? If the sensitivity of temperature to CO2 doubling turns out to be below the lowest value of the IPCC forecast range (1.5C) shouldn’t the IPCC be abolished?