The pretence of knowledge

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.“ Mark Twain

Reading a recent epistle from Convex Strategies I came across Hayek’s speech on accepting the Nobel Economics prize in 1974 when Bernanke was beginning his “education” in economics at Harvard. One could be forgiven for thinking Hayek’s speech was a contemporary text. He states in the first paragraph, “the economists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue.”

They also referenced Nassim Taleb who said in The Black Swan, “Our predictors may be good at predicting the ordinary, but not the irregular, and this is where they ultimately fail”. Whether it involves economic forecasting or optimized portfolio investment strategies, it comes down to the same issue: “What matters is not how often you are right, but how large your cumulative errors are”. It is the impact (scale), not the frequency (probability), that matters.

Taleb also made this observation. “I have also studied this effect using the mathematics of information: the more detailed knowledge one gets of empirical reality, the more one will see the noise (i.e., the anecdote) and mistake it for actual information.”

They highlighted this with a wonderful chart of a football pitch with the overlays of the Gaussian Normal Distribution curve (the black line) and the Shannon Entropy Curve (the yellow line). The former measures the frequency of outcomes, while the latter measures their impact. Scoring and saving goals define the outcome of the match.

  Source: Convex Strategies

But back to Hayek. Here are some of the passages most relevant to where we find ourselves today. The first is his framework for his theory regarding employment and inflation.

It has, of course, to be readily admitted that the kind of theory which I regard as the true explanation of unemployment is a theory of somewhat limited content because it allows us to make only very general predictions of the kind of events which we must expect in a given situation. But the effects on policy of the more ambitious constructions have not been very fortunate and I confess that I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge that is likely to be false. The credit which the apparent conformity with recognized scientific standards can gain for seemingly simple but false theories may, as the present instance shows, have grave consequences.

He goes on to make the point that we have the effect of lower inflation on employment back to front! Lower inflation doesn’t reduce unemployment it accelerates it!

In fact, in the case discussed, the very measures which the dominant “macro-economic” theory has recommended as a remedy for unemployment, namely the increase of aggregate demand, have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable. The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate.

The fact is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from re-appearing; not because, as this view is sometimes misrepresented, this unemployment is deliberately brought about as a means to combat inflation, but because it is now bound to occur as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerate.

He then says that we heroically assume that the social “sciences” are subject to the same rules as the physical sciences. They are not!

It is indeed true that, in contrast to the exhilaration which the discoveries of the physical sciences tend to produce, the insights which we gain from the study of society more often have a dampening effect on our aspirations; and it is perhaps not surprising that the more impetuous younger members of our profession are not always prepared to accept this. Yet the confidence in the unlimited power of science is only too often based on a false belief that the scientific method consists in the application of a ready-made technique, or in imitating the form rather than the substance of scientific procedure, as if one needed only to follow some cooking recipes to solve all social problems. It sometimes almost seems as if the techniques of science were more easily learnt than the thinking that shows us what the problems are and how to approach them.

He then makes the point that distinguishing between legitimate and illegitimate claims advanced in the name of science is hard, if not impossible, especially for the layman, to do.

The conflict between what in its present mood the public expects science to achieve in satisfaction of popular hopes and what is really in its power is a serious matter because, even if the true scientists should all recognize the limitations of what they can do in the field of human affairs, so long as the public expects more there will always be some who will pretend, and perhaps honestly believe, that they can do more to meet popular demands than is really in their power. It is often difficult enough for the expert, and certainly in many instances impossible for the layman, to distinguish between legitimate and illegitimate claims advanced in the name of science.

If I am not mistaken, psychology, psychiatry and some branches of sociology, not to speak about the so-called philosophy of history, are even more affected by what I have called the scientistic prejudice, and by specious claims of what science can achieve.

If so, then how do we make an informed decision? Karl Popper to the rescue.

If we are to safeguard the reputation of science, and to prevent the arrogation of knowledge based on a superficial similarity of procedure with that of the physical sciences, much effort will have to be directed toward debunking such arrogations, some of which have by now become the vested interests of established university departments. We cannot be grateful enough to such modern philosophers of science as Sir Karl Popper for giving us a test by which we can distinguish between what we may accept as scientific and what not – a test which I am sure some doctrines now widely accepted as scientific would not pass. According to Popper, a theory in the empirical sciences can never be proven, but it can be falsified, meaning that it can (and should) be scrutinised with decisive experiment.

And then the potentially negative effects of our tinkering.

In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the over-confident because their experiments may after all produce some new insights. But in the social field the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. We are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based – a communications system which we call the market, and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed.

And finally, a plea to allow market forces to decide, as they eventually will.

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.

The full text can be found here Friedrich August von Hayek – Prize Lecture - NobelPrize.org

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