Resilient to Criticism

Thursday, August 27th, 2009

The larger the system, the more resilient it is to criticism of any sort, Eric Falkenstein argues:

If the system is successful, in terms of shuttle flights or mortgage default rates, it doesn’t matter what your ‘theory’ is as to why certain risks are too great — these risks will be explained away because in any complex system, the theory as to how one thing affects the entire system is tenuous. There are too many interest groups benefiting from the systems current state, and they will find good reason to dismiss concerns as evidence of envy, selfish interest, ideology or muck-raking sensationalism. The larger the system, the more resilient it is to criticism of any sort.

A good current example of a trend that cannot continue, yet there is no data against it, is government debt. While the official debt-to-GDP ratio is manageable, about 26th or so worldwide. But the off-balance sheet liabilities, thing like Medicaid, Social Security, increase our debt 5 fold (to around $60 trillion, compared to on-balance sheet debt of 10 trillion.). Ever since the passage of the unified budget act during the Nixon administration, the government has had the privilege of spending the Social Security funds by transferring the money into the general fund, from which Congress can spend on whatever pork projects they wish.

Many government entities, city and state, keep increasing their off-balance sheet liabilities at a rate that implies preposterous tax rates or reneging on promises, but no one worries because this has been going on for a while. You would go to jail if you did this in the private sector, yet it is OK because it seems to work.

Stein’s law states that trends that can not continue, won’t, which implies the government will either have to default, reneg on benefits, or pressure the Fed to inflate. Those noting this risk of this strategy have been proven wrong by absence of any failure in this area. When the future budget crisis hits in this area, it will dwarf our current crisis by a factor of 10.

I don’t see how the risk of a complex system can be correctly calibrated without massive failure, because there are just too many incentives to rationalize risks as being under control as long as the system is working, and so it just continues until failure. They are an endogenous risks to our system, so the economy will never achieve a steady state, which given over a hundred years of business cycles, is a pretty safe forecast. The bigger question is, in my mind, is why don’t large systems fail more often. That is, the average annual corporate default rate in the US is around 1.4%, over good and bad times, which is pretty low.

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