The pretense of knowledge – Friedrich Hayek


Well, who is this avuncular man and why did I choose to talk about him in my first post? He is Friedrich August von Hayek (1899-1992), one of the leading proponents of the Austrian School of economics.

The Austrian school of economics is of many schools of thought in economics. You might ask why there are multiple schools of thought in the first place. We usually don’t have multiple versions of theories to explain the same phenomenon in the physical sciences in contrast. In the physical sciences hypotheses are built, experiments are conducted and conclusions are made. But in physical sciences the phenomena studied are not complicated like those in the social sciences of which economics is one example. Hence cause and effect is much easily established in situations with lesser variables to be studied in the physical sciences. Economics is a social science where all the actors have intrinsic behaviour with interdependence on other actors. In a nutshell, it makes study more complicated. An obvious problem then surfaces. Different economists have different points of view of what is the right way to measure, what the linkages are and what effect stems from what cause. Thus the many schools of thought. At different times in history different schools of thought have been in ascendancy.

The financial crisis of 2008 raised many questions about prevailing economic wisdom. It was plain to see that the system was broken. The Austrian school of economics had been relegated to the background for most of the latter part of the 20th century. It again received quite some attention for it seemed to explain at least some of what went wrong.

Friedrich Hayek received the Nobel prize for Economics in 1974 jointly with Gunnar Myrdal for “for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena”. Now what you will read ahead are excerpts from Friedrich Hayek’s Nobel acceptance speech.

And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes. It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world.

He then goes on to say the following.

There may be few instances in which the superstition that only measurable magnitudes can be important has done positive harm in the economic field: but the present inflation and employment problems are a very serious one. Its effect has been that what is probably the true cause of extensive unemployment has been disregarded by the scientistically minded majority of economists, because its operation could not be confirmed by directly observable relations between measurable magnitudes, and that an almost exclusive concentration on quantitatively measurable surface phenomena has produced a policy which has made matters worse.

Clearly he states that we cannot claim to have a handle on everything. And there is a risk in rejecting causal explanations which fit with common sense but don’t fit to “scientific” tests for the sheer fact that the “scientific” tests are only valid in restricted scenarios where only certain variables are measured.

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.

The last sentence has striking resemblance to the blind reliance on opaque models preceding the crash of 2008. Many of these models were used to justify the dangerous creations of the investment banks like CDOs and the truly absurd CDO squareds.

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.

Why I love this part is that it perfectly applies to stock analysis too. The most well-built financial models come to naught in a case like the Satyam scam where there were other warning signs which went unheeded.

To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.

What more needs to be said to the central bankers of today who are perpetuating the same follies that got us here in the first place. In a world addicted to debt, is adding more debt going to solve the problem? That’s like pumping another dose of heroin into an addict’s veins to make him better. But it is as if we are doomed to repeat the mistakes. Like Karl Marx said,

History may not repeat itself but it rhymes.

The takeaways from this speech are manifold and apply to macroeconomics and investing alike. In investing we do not know all the facts that can affect the investment outcome. Arrogant belief in the limited facts that are building a great story about a stock in your head is an easy way out. It is precisely what we need to strive to avoid.

I urge you to read the speech yourself. It will be worth your time! Here’s to better investing with healthy humility about what we do not know.

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