Newsflash: Central Planning Doesn’t Work

File this one under “Breaking News from 1989”: it turns out that central planning doesn’t work. Who would have guessed?

This news is relayed to us by business columnist Floyd Norris in the New York Times. He doesn’t present it that way, of course. He merely reports on the failure of federal regulators to come up with models that accurately assess risk in the financial system.

Five years ago, the financial regulators of the United States—and more broadly the world—didn’t see the storm coming.

Would they if a new one were brewing now?

The answer to that is far from clear. The regulators have more information now, and they have applied the tools they have to measure risk with more vigor.

But a new assessment from a little-known agency created by the Dodd-Frank law argues that the models used by regulators to assess risk need to be fundamentally changed, and that until they are they are likely to be useful during normal times, but not when they matter the most….

Stress tests take a negative set of economic assumptions and ask how each bank would fare in those circumstances. As such, their usefulness is constrained by how well the assumptions reflect something that might actually happen. If it has never happened before, there is at least some chance that a stress test would not even consider what could be a severe problem.

The usefulness could also be limited by secondary effects not foreseen by those who designed the test.

Norris describes the work of a government bureaucrat who is trying to devise a better way to predict the aftermath of financial crises, but he never acknowledges the bigger point. A financial system and a global economy are enormously complex. There are so many interacting variables, so many unknown factors, so many individual choices that cannot be predicted, that no computer model in a federal bureaucrat’s office is going to be able to sort them all out.

This is the old point made persistently by advocates of the free market and ignored persistently by the would-be Masters of the Universe at the regulatory agencies. There is no way for regulators to gather data about the individual choices and values of millions of people—or in today’s global economy, billions—and to integrate this data together. That is the task that is supposed to be performed by allowing these millions and billions of people to make voluntary transactions in the free market.

This does not produce perfect results; that would imply omniscience and infallibility. But the alternative is to impute that kind of omniscience to regulators, whose hubris is to impose their models and assumptions in place of free transactions in the market. And it gets worse: the purpose of much of this intervention is to deny participants in the free market the information they need to make their own evaluations. The purpose of TARP, for example, was to artificially prop up real estate values, or to foist government bailouts on healthy banks along with the failing ones in order to prevent the market from figuring out which was which.

It should go without saying that there is no basis for regulators to presume that they possess special powers of omniscience and infallibility, and as Norris hints, they are more likely to spend the next few years assuring us that they have prevented financial crises—only to fail to notice when they are precipitating the next one.



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