Friday, 16 January 2015

Why Our Central Planners Are Breeding Failure

Success, we’re constantly told, breeds success. And success breeds stability. The way to avoid failure is to copy successful people and strategies. The way to continue succeeding is to do more of what has been successful.

This line of thinking is so intuitively compelling that we wonder what other basis for success can there be other than 'success'?

As counter-intuitive as it may sound, success rather reliably leads to failure and destabilization. Instead, it’s the close study of failure and the role of luck that leads to success.

In the macro-economic arena, I think it highly likely that the monetary and fiscal policies of the past six years that are conventionally viewed as successful will lead to spectacular political and financial failures in 2015 and 2016.

How can success breed failure?  It turns out there are a number of dynamics at work.

Survivorship Bias

Survivorship Bias is the natural tendency to look at the survivors for the keys to success rather than to examine those who didn’t survive, many of which disappear without a trace. If 100 restaurants are founded and five of the new eateries achieve rip-roaring success, business schools usually study the decisions and strategies of the five survivors, not the 95 failures which closed their doors and left no trail of decisions and strategies to study.

As David McRaney observes in his excellent account of survivorship bias, by focusing solely on survivors rather than those who failed, the causes of failure become invisible. And if the causes of failure are invisible, the critical factors that determine success also become invisible.

Even worse, we draw faulty conclusions from the decisions of the survivors, as we naturally assume their decisions led to success, when the success might have been the result of luck or a confluence of factors that cannot be reasonably duplicated.

We are often reassured by the financially successful that perseverance and the willingness to accept risk are the key factors in success.  But as McRaney explains, this is the equivalent of asking the one actor from a rural state who achieved Hollywood stardom for the key factors of his success, on the assumption that anyone else following the same path will reach stardom.

But magazines never track down the 100 other aspiring actors from the same region who went to Hollywood and persevered and took risks but who failed to become stars. 

Examining the few hundred miners who succeeded in finding enough gold in the Klondike in 1898 and returning with enough of their newfound wealth to make a difference in their life prospects while ignoring the experiences and decisions of the 100,000 who set off for the gold fields and the 30,000 who reached the Klondike but who returned home penniless (if they survived the harsh conditions) will yield a variety of false conclusions, for luck is never introduced as the deciding factor.

The narrative that success breeds success has no role for luck, which is by definition semi-random and therefore uncorrelated to the stratagems of the survivors. Here is McRaney’s summary of the role of luck:
In short, the advice business is a monopoly run by survivors. As the psychologist Daniel Kahneman writes in his book Thinking Fast and Slow, “A stupid decision that works out well becomes a brilliant decision in hindsight.” The things a great company like Microsoft or Google or Apple did right are like the (World War II) planes with bullet holes in the wings. The companies that burned all the way to the ground after taking massive damage fade from memory. Before you emulate the history of a famous company, Kahneman says, you should imagine going back in time when that company was just getting by and ask yourself if the outcome of its decisions were in any way predictable. If not, you are probably seeing patterns in hindsight where there was only chaos in the moment. He sums it up like so, “If you group successes together and look for what makes them similar, the only real answer will be luck.”

Drawing Over-Arching Conclusions from Single Examples

A similar form of bias appears when commentators attribute China’s great developmental success to its command economy, or Silicon Valley’s enduring role as a center of innovation to America’s military-industrial-academic-research complex and the U.S. culture’s broad acceptance of risk-taking.

Who can say with certainty that another model of development might have duplicated China’s growth record but avoided the endemic corruption, environmental destruction and widening wealth inequality that are the negative consequences of the command-economy model?  No one can say, as there are no other Chinas to refer to for comparison.

If duplicating Silicon Valley were just a matter of government support of research and close ties between corporations and universities, there would be dozens of Silicon Valley rivals, as billions of dollars have been expended globally to duplicate the Silicon Valley model. But Silicon Valley remains in a class of its own.  Clearly, Northern California’s engine of innovation cannot be distilled down to a simplistic model that can be duplicated by policies and investment.

The conventional conclusion that the major central banks—the Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of China—succeeded in saving the global economy from depression in 2008-09 is another example of drawing over-arching conclusions about success from single examples.

Since each nation/region is unique, any claim that the policies of any one central bank can be applied to other nations/regions with equivalent success is a highly questionable assumption.  Since there is only one European Union, Japan, China and U.S.A., there are no opportunities to test the assumption that the central bank recipe used in 2008-09 can be applied with equal success in future financial crises in these very different economies.

Previous Policies Have Changed Conditions

One reason we cannot draw over-arching conclusions about the drastic monetary policies enacted in 2008-09 is that those policies have changed the financial-political landscape. As a result, what worked in 2008-09 may not succeed in the next financial crisis because those policies only worked in the specific set of conditions of that crisis. If the conditions have changed, then the strategies that were 'successful' in the previous set of conditions will not yield the same outcome.

For example, central banks lowered interest rates to near-zero in 2008-09 to spark borrowing and refinancing of existing debt. Now that rates are still near-zero, this policy and outcome cannot be duplicated.  Lessons drawn from successes that cannot be repeated are suspect.

Previously successful policies may fail in the next crisis due to diminishing returns: for example, policies that extend credit to marginal borrowers to bring demand forward (i.e. subprime auto loans) eventually reach all but the riskiest borrowers.  Extending those policies essentially guarantees rising defaults as people with no business borrowing money are given credit to maintain consumption.

As defaults soar, lenders record losses and sales decline, as consumption was already brought forward.

Due to diminishing returns, a policy that was successful at first fails when extended.
In effect, successful policies may be time-stamped; not only do they only work in specific circumstances, they only work for a limited length of time in those specific conditions. Beyond those conditions and timeline, the supposed factors of success no longer work.

Are the Outcomes of Monetary Policies Truly Predictable?

As noted above, any policy identified as the difference between success and failure must pass a basic test: When the policy is applied, is the outcome predictable?  For example, if central banks inject liquidity and buy assets (quantitative easing) in the next financial crisis, will those policies duplicate the results seen in 2008-14?

The current set of fiscal and monetary policies pursued by central banks and states are all based on lessons drawn from the Great Depression of the 1930s. The successful (if slow and uneven) “recovery” since the 2008-09 global financial meltdown is being touted as evidence that the key determinants of success drawn from the Great Depression are still valid: the Keynesian (or neo-Keynesian) policies of massive deficit spending by central states and extreme monetary easing policies by central banks.

Are the present-day conditions identical to those of the Great Depression? If not, then how can anyone conclude that the lessons drawn from that era will be valid in an entirely different set of conditions?

We need only consider Japan’s remarkably unsuccessful 25-year pursuit of these policies to wonder if the outcomes of these sacrosanct monetary and fiscal policies are truly predictable, or whether the key determinants of macro-economic success and failure have yet to be identified.

The Seeds of Failure Are Sown in the Initial Flush of Success

Even more troubling is the possibility that these monetary policies have sown the seeds of systemic failure in their pursuit of the extremes that yielded the initial flush of success.

That this initial success might be brief and transitory rather than enduring is rarely considered.  If this is the case—and the slowing global “recovery” suggests this is indeed so—then the success of these extreme policies is illusory, and the truly key determinants of success and failure remain elusive.

In Part 2: The 6 Reasons The Next Economic Rescue Will Fail, we examine why the current unstable "recovery" must topple despite the central planners' best efforts to sustain it. They simply don't have an accurate awareness of the true situation, nor have the right tools and skills to address it -- and so, in their ignorance and fear, are pulling levers that are inconsequential (at best) or will hasten the destabilization of the system.


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