It seems counterintuitive, but “trying harder” doesn’t always work. A famous experiment asked groups of people for and against capital punishment to evaluate two separate studies, one for capital punishment and the other against. Th e group in favour of capital punishment found the study in favour to be more valid, while the group against capital punishment found the study against to be more valid, and that after reading each report, each group’s prior beliefs were strengthened as was their hostility to the other. What I found especially fascinating was that when the study was rerun only this time the experimenters explicitly told the subjects to be “strictly unbiased in their judgement” (i.e. “try harder”) the eff ect was to make the polarisation even more pronounced!
It is this aspect to those studies I want to think about here, the incorrect application of faulty models. In essence, that is all that study was really about. Subjects applied a faulty model – a mental algorithm saying “accept only supporting evidence” – which resulted in a biased assessment of the evidence. “Trying harder” did not work because the problem was the faulty model, not the lack of eff ort and applying that faulty model with more determination just caused an even bigger error. Psychologists have a name for this. Th ey call it the “lost pilot eff ect” after the lost pilot trying to reassure his passengers by saying, “I have no idea where we’re going, but we are making good time!”
Flawed thinking got us into this mess, but rather than changing that fl awed thinking, our policy makers are applying it with even more rigour. We have more debt for insolvent borrowers, more fi nancial engineering, more complicated banking regulations, more blaming speculators for everything, more monetary experimentation by central banks. Our policy makers have absolutely no idea what they’re doing, but they’re giving it a go!
The latest from the Fed provides a wonderful example. Undeterred by the latest calamitous failure of Consumer Price Index (CPI) targeting regimes (a brief history of which will be presented below) it has announced an explicit 2% inflation target. But why? Would an explicit target have made any difference to the last crisis? Will it prevent the next one? And where did this 2% come from? We don’t know, but we suspect that past uninformed capital market tinkering has failed to control the uncontrollable, and we are pretty sure these ones will too.
In fact, if such tinkering has in the past been the primary cause of crises, then why won’t this latest attempt – the 2% inflation target – be the cause of the next one? There are certainly precedents. Targeting stable “prices” isn’t a new idea. The first experiment was actually conducted in the US in the 1920s, and apparently it was successful. Indeed, so stable were consumer prices then that the authorities assumed there was no inflationary threat. Moreover, so enamoured were they with this brilliant new idea that stable consumer prices were both a necessary and sufficient condition for economic stability, that the NY Fed adopted it as a policy objective. On January 11th 1925, then-Governor Benjamin Strong wrote to a friend:
“That it was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed towards the stability of prices so far as it was possible for us to influence prices.”
During the 1927 Stabilization hearings before the Committee on Banking and Currency regarding a Bill to amend the Federal Reserve Act to provide for the “stabilization of the price level for commodities in general”, the governor was asked if the Fed could stabilize prices more than it had done in the past. Strong replied:
“I personally think that the administration of the Federal Reserve System since the reaction of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very object”