The Epistemology of the Financial Crisis: Complexity, Causation, Law, and Judgment

Abstract:     
The focus on complexity as a problem of the financial meltdown of 2008-09 suggests that crisis is in part epistemological: we now know enough about financial and economic systems to be threatened by their complexity, but not enough to relieve our fears and anxieties about them. What marks the current crisis is anxiety that the financial world has evolved to the point that there are hidden structures, like concentrated "too big to fail" institutions and mechanisms, or like credit default swaps, that have widespread and adverse downsides. I propose an analogy between medicine and law in the sense of "regulatory technology." If bubbles are the disease, then the analogy is to bipolar syndrome - exuberance, or even a little hypomania is okay on the upswing, but true mania is bad, as is the resulting swing to depression. Good regulation, then, would be something like lithium, which keeps us on an even keel. There are two questions. The first is really whether we understand the forces well enough to regulate them. Regulation is a function of prediction; prediction is a function of observed regularity; observed regularities invoke the problem of scientific (not legal) causation; causation returns us to the question whether the human system being analyzed is capable of being reduced to helpful predictive models. The second question is who does the understanding. What we are dealing with instead is a crisis of confidence in those who purport to be experts in what we cannot fathom merely through common sense. The conundrum, of course, is that if it takes an expert to see the problem caused by complexity, how are we, possessing merely common sense, supposed to do anything but rely on their judgment? The epistemological crisis arises from our own judgments to rely on, believe in, trust, or have faith in, that judgment.

Keywords: financial crisis, subprime, CDO, credit default swap, epistemology, philosophy of social science, causation, judgment, Hume, Kant

JEL Classifications: B25, K0

Working Paper Series