China’s Present, the World’s Future, and the Pretense of Knowledge

Last Tuesday I attended the Economist’s Bellwether Europe conference in London.  Several speakers raised ideas that made me want to follow up Philippe’s latest piece “Has China Peaked?”.

At the conference, many speakers and panelist (from regulators like the FSA’s Martin Wheatley, to economists like Roubini’s Arnab Das, to portfolio managers like Blackrock’s Richard Kushel) linked the future stability of the Eurozone and the prosperity of America to the continued growth of China.  Niall Ferguson was even more explicit, saying at one point that “The governor of the PBOC has far more control over the future of the US and European economies than either Ben Bernanke or Jean-Claude Trichet”.  I tend to agree that US and EU economic stability is tied to Chinese growth, but am worried by that fact,  and skeptical about Chinese “control” of their economy either through their Central Bank or through “administrative measures”.

The People's Bank

The image evoked by statements such as Ferguson’s (even though I am sure he is too smart to have intended it) is of a carefully calculating Zhou Xiachuan sitting behind a desk in Beijing pressing buttons and pulling levers – a man in commanding a linear, essentially Newtonian system.  The same tends to happen when people talk about the powers and actions of the Fed and the ECB.  Even so-called “centrally planned” economies don’t work like that.  Economies are not not machines, and they are not linear in the sense that once the behavior of its component pieces are understood individually, one simply needs to add them up to predict – and control via a Central Bank or other bureaucracy – the behavior of the whole.

A point which is not original but which bears repeating because it is so often forgotten is that Economics is not Physics, it’s a “Social Science” (a false metaphor if there ever was one).  As one scholar says “God gave Physics the easy problems” and the behavior of economies is non-linear rather than additive.

This idea is not new. It is what underpinned Hayek’s idea of catallaxy.   It also stood behind his 1974 Nobel Prize lecture “The Pretense of Knowledge”.  As Hayek said there, it is a mistake to grant economics “the dignity and prestige of the physical sciences”.  (As I explored in Constructing Cassandra intelligence analysts are prone to make the same error, and slip towards scientism:  “An exaggerated trust in the efficacy of the methods of natural science applied to all areas of investigation, as in philosophy, the social sciences, and the humanities.”)

In a key paragraph, Hayek said:

“Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable.”

Which brings me back to China and the conference.  I was especially struck by the charts displayed by the EIU from their new Whitepaper “Building Rome in a day: The sustainability of China’s housing boom”.  Here are two:

Looking at these, one might be able to think of lots of explanations of why This Time is Different, and why despite its relative poverty (even measured by PPP), China has built so much residential floor space.  If you can’t think of any, the EIU’s whitepaper helpfully points out:  “a number of noteworthy characteristics in Chinese society that may account for the country’s housing exuberance,” and offers a menu of pre-rationalized explanatory options.

Is there a bubble in Chinese housing that could ripple through China’s – and the world’s – economy? I can’t say for certain.  But like Hayek, I believe that there are “aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones.”  This is especially so in a place like China, which has an economy at least partly predicated on central planning, with no independent political or press checks and balances, rife with perverse incentives and selective enforcement of  laws, and moderately high corruption (despite regular executions to prevent it).  And then there are anomalies that would trouble most experienced investors, like the fact that Beijing land prices have risen over 800% in the last seven years.

By the way:  if you’re wondering whether Philippe’s “Uses of history for decision makers”  is merely an academic exercise, I suggest the Jamestown Foundation’s series of pieces on how the Chinese leadership views the collapse of the Soviet Union.  The Chinese leadership not only drew their own lessons from History, but they made sure that the Chinese people drew the “right” lessons by producing an eight-part television series called “Preparing for Danger in Times of Safety—Historic Lessons Learned from the Demise of Soviet Communism.”

I suspect the Chinese leadership knows that the potential for a  non-linear disruption in China is not trivial.  Maybe if Newtonian metaphors to describe economies are inevitable, the best one for China’s economy is a bus that dares not drop below a certain speed.

If you are interested in this topic, take a look at Philippe’s post: Has China peaked? An exercise in forecasting using Neustadt and May’s History framework.

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