Anyone Else Awake? Is the Knowledge System Broken?


I’m so awake I could lace on my running shoes and do twenty laps around Central Park. I know they say this is the city that never sleeps, but from what I can see, looking out the window, that too is just media hype. The lights are off, the streets are empty, and I guess everyone but me is snoring soundly. 

Well, for anyone else who’s awake–Istanbul friends? You up?–Hernando de Soto just sent me a link to his latest piece in the New York Times, which is really interesting. (Yes! Hernando de Soto sent an e-mail to me, personally! I don’t care if I’m just on his assistant’s mailing list. It made my day.)

Here we are, three years into the global financial crisis, and we’re still flying blind. We don’t even know what we don’t know. What we do know is that we’re stuck in a huge contraction of private credit; no one is making enough loans and investments to expand or start businesses and get the economy growing. The remedies applied by U.S. and European governments tried to treat the symptoms — bad debts, shaky banks, floundering businesses, people losing their homes, rising unemployment, currency wars — and not the disease.

Had those symptoms been the real cause of the crisis, “vulture capitalists” should have swept in by now. They should have spotted the signals that send knowledge of who is in trouble and — following the laws of supply and demand — picked up on the cheap the potentially lucrative remains of the nonperforming assets and transactions, correcting the deficiencies that led to them.

They would have bought a block of old houses and revamped it into a 20-story high-rise with two restaurants and ample parking.

They would have taken over an airline unable to fill its first-class section and rearranged it into a discount, no-frills option with twice the number of seats per plane. That hasn’t happened to any significant degree. Why?

Why indeed? Here’s his answer: The knowledge system is broken.

You could say that the knowledge organized by property and transaction records plays the same role in credit that DNA plays in biology: it stores the long-term, measurable information that governs how the different cells of the body come together.

Balance sheets that once clearly signaled facts, allowing outsiders to infer what that company owned — and owed — have too often been mutilated. Some companies in difficult financial situations can legally resort to “off balance sheet accounting”— transferring the bad news to less visible ledgers, called Special Purpose Entities (SPEs) — or to sweeping information regarding their debts into illegible footnotes. When Enron collapsed, it had 3,500 SPEs.  …

Economic activity has been allowed to cross from the rule-bound system of property, where facts and interests are recorded and built into useful knowledge, into the incomplete legal space of global finance, where arbitrary interests trump facts and paper swirls mindlessly …

How can anyone be comfortable extending loans if balance sheets don’t signal all the facts? If those who hold the assets and the risks cannot be easily located? How do you know which banks and countries are solvent, if you cannot determine how many toxic assets they hold; if the legal owners of mortgages can’t be found; if banks can’t clear their books because courts continue to stop foreclosures because titling is unclear; if there is little information on whether those who claim they can cover risk defaults have the assets to do so? …

As tragic as it was that a number of homeowners of modest means couldn’t meet their mortgage payments and some were forced to turn over their houses to their creditors, nonperforming debts estimated to be worth less than a trillion dollars were hardly enough to trigger a historic, persistent credit contraction. But they did, because the credit that was contracting was not anchored in bills and coins but in the knowledge contained in property reporting and signaling systems, which had deteriorated.

When that paper ceases to be reliable, when it no longer functions as a signal for collateral, as an enforceable guarantee, a credible assurance, or a reasonable measure of risk, then — Whoosh! — private credit vanishes. Just as your identity does when you step up to the immigration counter and discover you’ve lost your passport.

That’s what happened when the subprime crisis exploded. The derivatives that financed the nonperforming sub-prime mortgages were rapidly losing value, threatening to cause a run on the banks because there was — and remains— so little property knowledge about them.

Read the whole thing. What do you think? Is he right?

If so, how do we fix it?

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  1. Profile Photo Inactive

    I have an intuition that this article gets to the heart of the matter, but don’t feel that I’ve spent nearly enough time studying the “downturn” to state with any certainty that he is correct. I would offer my own anecdotes about broken knowledge systems, but that would compromise my precious anonymity.

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  2. Profile Photo Inactive

    While I think he makes some valuable points, I think he too is noticing a symptom not the problem. If it is merely a case of knowledge, if the knowledge needed to invest or grow a business is murky, there would still be those welling to try their luck and some of them would be going under and others would be stumbling on gold mines.

    I think the real problem is manipulation. If houses are being kept at their current value through intervention, then the houses aren’t really worth what is being asked for them. If anything, it isn’t a lack of knowledge that is keeping people out of the markets, it is the knowledge that what is in the market is over valued, it is not a good deal.

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  3. Profile Photo Member

    I suspect he is right. With all the various bailouts, subsidies, forgivenesses, etc., throughout various sectors of various economies (in the U.S., finance and housing, in particular, as y’all mention), it’s got to be very hard to figure out what the actual market prices of assets are, and as Hayek, von Mises or, say, Misha Gorbachev could tell you, without real prices to signal the relative availability of and demand for stuff, economies function very, very poorly.

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  4. Profile Photo Inactive

    Well I’m up, and I can state Chicago is as lifeless at this time as New York.

    I’m not a financial expert, of any sort, so I can’t say one way or another, but it sounds like the thrust of the article is probably true. We build a system of credit on the assumption that we knew what peoples assets and liabilities were. This system though was and is riddled with falsehoods, smoke screens, lies, and creative accounting…such that by the end no one knows for certain who owns what.

    Well why do we have government if not to settle the disputes between private interests. We can just set up an auditing system to decide who actually owns what and what all this paper means. If there is no simple clear indication of who owns what then we can just hand out the property to people, until it is all in private hands. Then we abolish all previous claims and the markets can resume again, this time with more transparent accounting guidelines.

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  5. Profile Photo Inactive

    I got the feeling that the problem was that we have paper assets which are ambiguous in what they represent. These assets right now are liabilities for the banks and governments that hold them. Fear about what these things actually are and what they are worth are freezing up credit. Because, these things are the basis of a lot of wealth on paper, but no one is sure they are actually worth anything because no one knows what they really are. Thus if you own these things you are not certain if you have money or not, you just hope you do.

    Thus we need to settle as an economy what all of these papers mean. Then people will once again know who owns what and how much. With that knowledge it will be easier to know what one can afford to lend and borrow, thus allowing the credit market to restart.

    I could be way of base here…but that’s what I think he was getting at.

    To do this settling, we need political action, because only the government can settle definitively who owns what.

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  6. Profile Photo Inactive

    I’m not sure if he’s right about the knowledge system being the ongoing cause, but I do think it can be significantly improved. One of the drawbacks to federalism is that recording is done at a state or lower level, making tracking, recording, and perfecting assets and secured interests more difficult. A nationwide recording system for certain assets or real estate could help with uncertainty surrounding ownership or priority.

    Kind of along the lines of what Valiuth is saying, it may require government involvement through modifying existing rules. Perhaps a period of actual possession of property, not constructive, followed by a freshly recorded property system could help reestablish order. Again, I don’t know how much this uncertainty weighs on purchasing decisions since I’m pretty far from financing or buying anything worth more than $500, but if he’s right that it’s a problem, I think a one-time “census” with a shortened period to contest could do the trick. One advantage to this is that third parties do the enforcing, while the government is only responsible for recording.

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  7. Profile Photo Inactive

    To me it is simple, this all started with the Clinton administration.

    The community reinvestment act and no red lining of loans.

    Democratic policy turned capitalism into crony capitalism and this is what happens when socialists get involved in the market.

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  8. Profile Photo Inactive

    Isn’t the “knowledge system” just another way of saying “the market?”

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  9. Profile Photo Member

    Seriously, Claire, you’re turning this over to the 2 a.m. people? Really?

    I think he’s right in a narrow sense. However, when you have quasi-gov’t agencies implicated in concealing the problem, and exacerbating it, does it seem likely that more gov’t intervention is the solution?

    What are the 3 C’s of lending? The frontline local lender knows his borrower, and can determine how much weight to assign to the third C. That might swing his decision either way in an iffy case. Repackaged loans at a remove can’t possibly contain that sort of knowledge.

    I don’t pretend to know very much about the current recession. But when I was administering SBA-guaranteed loans back in the 90’s, I was ruthless about getting all the documentation necessary to my company for due diligence, in part because that’s just the kind of guy I am, and in part because it was institutionally bad to have to invoke the SBA guarantee.

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  10. Profile Photo Inactive

    Politicians by and large don’t want accurate information about the consequences of what they are doing or what they have done. How else can they keep spreading the wealth that doesn’t exist? Lying is endemic in everything government touches. Omission of important information. Manipulation of the rest. HIding bad news allows problems to mushroom. Even at the local levels: unsustainable pension and other liabilities just aren’t mentioned to the taxpayers because self-interest of those who should be reporting the facts is involved. Warnings by those who figure out what’s going on are ignored and not reported by media champions of the politicians in power. And they have willing collaborators in the private sector who see a way to make a buck. When things blow up the malefactors are long gone and the new boys in power kick the can down the road for somewhat else to deal with — if they can. The situation gets worse the more government intrudes into every aspect of life. The morality of truth telling is so old-fashioned.

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  11. Profile Photo Inactive

    From 2000 through 2007 total world debt, public and private, grew by a factor of more than four. Unfortunately most of this was not spent on productive activities. For a brief period of time in 2008 the markets began to signal the cost of servicing this debt was too great. The message at that time was clear. The actions of central banks and governments distorted this message, but it is still the same today. When entities, be they private or public, begin to rely on borrowing instead of productive output to pay interest on existing debt they have entered a downward spiral. Only a basic knowledge of compound interest is needed to understand this. This is the situation today. There are only two possibilities; the debt will be extinguished through hyper-inflation or deflation or a way will be found to grow productive output by a large factor while restoring fiscal sanity. The message the markets are sending today is deflation that may change. The message is clear, but no one real wants to accept it. The idea that there is not enough debt as this gentleman suggests is ludacris.

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  12. Profile Photo Inactive

    I think that a lot of this has to do with bondholder — those that are actually supplying the funding for credit — getting hosed really badly as of late. It’s already been bad for those people who lend money; the interest rates have been manipulated downward for far too long and it’s not like the dividend/interest payment tax treatment on lenders has been all that just considering government has played favorites with the other asset classes (equities and particulary residential properties). Combine this with fears that future inflation is coming and that this is going to further cut into the real returns on holding debt instruments and it’s no wonder lending isn’t where it should be.

    But, de Soto is making this about knowledge. And since he’s far smarter than I am I’ll have to defer to him that this is where the real problem lies. Maybe it’s because borrowers have such lax consumer protection laws that enable them to hid their past behaviors that show to what extent that they honor their commitments. Only seven years of history can be maintained by reporting agencies‽ Is bankruptcy too easy?

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  13. Profile Photo Inactive

    I also cannot help but think that when society starts believing that lenders are the bad guys just because they’re wealthy [and use their wealth-enabled leverage to earn more] and that borrowers who renege on their obligations to repay loans under the original terms are the victims, the lenders are eventually going to go ‘John Galt’ on those borrowers who won’t provide more ‘knowledge’ than they otherwise are legislatively protected from providing.

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  14. Profile Photo Inactive

    In 1980, Thomas Sowell published Knowledge and Decisions. Thirty years ago he saw this problem building and warned about it

    We have a government that has off budget costs that are almost as expensive as the on budget expenses. How can we expect and demand businesses to maintain correct accounting when our own government won’t do it?

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  15. Profile Photo Inactive

    I think Pili is on the right track. Perhaps ‘trickle-down dishonesty’ is the problem. Potential investors are indeed receiving the signal they need: “given the dishonesty of today’s balance sheets, I cannot know what I need to know.” That is knowledge. Not the time to invest. When the government can pretend that ‘off-budget’ liabilities approaching 10x on budget liabilities do not exist, how does one make financial sense of the world.

    Also, there is great confusion between economics and finance. Economics pertains at actual wealth (which has increased in linear fashion). Finance describes paper claims against that wealth. Those have risen exponentially. This, too is a form of dishonesty.

    Once upon a time, an investor sought to create a business he hoped would outlive him; it would provide for subsequent generations. Now, one invests long-term at his peril. One arbitrary politically-motivated rule change, and your creation dies and risk is not only unrewarded but one may well be ruined. Live fiscal quarter to the next. Cash out. This fact is known. So, sufficient knowledge is being communicated. It says this is not the time for risk. Private property and economic liberty are under assault.

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  16. Profile Photo Inactive

    Read “The Big Short” whose basic premise was that a few smart guys figured out that everybody had been dumbstruck by the wave of knowledge loss.

    • #16
  17. Profile Photo Inactive

    I was up when you posted, but my brain goes into “Read-only” mode between 11 p.m. and 7 a.m. Back in Read-Write mode now.

    Nothing’s going to change as long as congresspeople of borth parties can make fortunes trading on insider information and one set of union buddies (GM) can get a reversal of the order of creditors thereby shafting another set of unionists (Ohio public worker’s pension funds).

    Too much money to be made, few who could change it have the incentive to do so.

    • #17
  18. Profile Photo Inactive
    Bill Walsh: I suspect he is right. With all the various bailouts, subsidies, forgivenesses, etc., throughout various sectors of various economies (in the U.S., finance and housing, in particular, as y’all mention), it’s got to be very hard to figure out what the actual market prices of assets are, and as Hayek, von Mises or, say, Misha Gorbachev could tell you, without real prices to signal the relative availability of and demand for stuff, economies function very, very poorly. · Dec 3 at 12:37am

    IMHO, the knowledge system is broken because of

    1. Bad government policies

    2. A culture which produces too many college graduates with no real skills

    3. A culture which encourages people not to give a damn about areas outside their field of expertise. I don’t want to go off the deep end on this, and highly specialized training is obviously very important. I think Victor Davis Hanson has touched on what I’m talking about here, and it isn’t just professors with attitudes like this: (continued)

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  19. Profile Photo Inactive

    When it hit 110 and the air conditioning went out in our building, profs sighed and damned “them” who couldn’t even keep us cool. (None had been on a roof at 120 or wondered how a compressor ran at all — or how a guy could spend four hours up there in Sahara-like conditions with all sorts of sockets and wrenches before his skull melted. [Note well, the campus machines worked far better than did the idea of graduating literate BAs.]) In the world of the professor, offshore drilling rigs can be started and stopped, come and go, sort of like an evening seminar.

    My experience with government databases has me firmly convinced that something is definitely broken.

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  20. Profile Photo Member

    Well, from the inside of the mess it looks to me like we had a knowledge bubble. Like an asset bubble you think tou have something of value when you really do not. The smart people built really complicated models that supposedly told us the future. But wait, the didn’t. I used to work at a bank where the CEO would publicly ridicule you if you ever brought him anything that even smelled like a regression model. Smart guy.

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  21. Profile Photo Contributor

    This is a wonderful post, and the comments are no less good.

    • #21
  22. Profile Photo Member

    In my humble opinion, the knowledge system is working fine. People are taking into account massive regulatory increases, disruptive government policies, successful rent seeking, increasing government market distortions (green jobs for one), massive government debt without a prayer of being repaid, and they come to the correct conclusion that the current economy is about to collapse. Our federal, state and local governments are unwilling and unable to take the required corrective actions so collapse is inevitable. This is why the smart money is hunkered down. The knowledge is there and they are acting on it.

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  23. Profile Photo Inactive

    So we took the rope that Lenin handed back to us, bound ourselves to the chinese communists, and jumped off the cliff together ? Well we certainly screwed that up ! We were supposed to hang ourselves. Who hits first cushions the one on top .

    • #23
  24. Profile Photo Inactive

    Or, the promise of still more Obama economy ahead keeps everyone on the sidelines. The article is interesting, but it ignores the fact that knowledge wasn’t “perfect” before, or ever, especially for small entrepreneurs. Also, conflating Europe and America is a red flag that Hernandez isn’t thinking clearly.

    • #24
  25. Profile Photo Member

    In the mid-nineties, I began to realize just how much of our economy was a house of cards, built largely of fictions given substance only by the general will to believe them. This realization upset me to the point that I flirted with survivalism for a couple of years

    Meanwhile, new fictions were being stacked ever higher. Some of these fictions have now been exposed as such. In a sense the problem isn’t what we don’t know, as much as what we did know that just wasn’t so.

    The powers-that-be have been trying to re-stack the cards but are finding many of them are now limp and useless. We’d all be better off in the long run building the house using an erector set, but that would require sweeping away the rest of the cards that are still standing. The public wouldn’t stand for it, even if the financiers and politicians wanted to try it (they don’t).

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  26. Profile Photo Member

    (double post)

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  27. Profile Photo Contributor

    I read Hernando de Soto’s masterful The Mystery of Capital on my second trip to Ethiopia. Each day, as I visited patients living in corrugated aluminum sheds, I asked questions prompted by the prior night’s reading. I quickly discovered that a key reason for the unrelenting squalor was the lack of secure, acknowledged private property rights, just as de Soto explained.

    Each tenant pays “house rent” to the person who constructed their leaking 6 x 10 foot residence. A tenant improvement, perhaps performed by an I-can-fix-anything American know-it-all actually hurts, since the newly watertight residence commands more rent, which is demanded at the next monthly landlord visit. Unable to pay any more, my patient would then be forcibly evicted.

    The entire ghetto is a “moon village” constructed illegally by night years earlier atop government-owned land dedicated for a future sports stadium. Officials tolerate the status quo, but nobody–neither tenant nor landlord–has any secure right in or knowledge about anything. So all improvements must pay back instantly and credit is unknown.

    On my most recent visit to Ethiopia, I learned that Moon Village is scheduled for demolition early next year. Possibly.

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  28. Profile Photo Contributor

    Uncertainty is our problem. Banks are privately-owned but quasi-publicly controlled; regulations are specifically uncertain but certainly tighter, somehow; assets have uncertain chains of title and intrinsic value; recourse to collateral in the event of default is newly obscure but certainly problematic in an increasingly populist Occupy Everything world.

    Instead of Ethiopian economic chaos trending towards western capitalistic order of the sort described by de Soto, sadly we see the reverse.

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  29. Profile Photo Contributor
    Claire Berlinski, Ed.

    (Yes! Hernando de Soto sent an e-mail to me, personally! I don’t care if I’m just on his assistant’s mailing list. It made my day.)

    Ooh, I’m jealous, Claire. Green with envy (that is, greener than snakes usually are).

    Late Boomer: Well, from the inside of the mess it looks to me like we had a knowledge bubble… The smart people built really complicated models that supposedly told us the future. But wait, the[y] didn’t.

    That sounds less like a knowledge bubble and more like a misinformation bubble to me. And it sounds to me like “misinformation bubble” is what de Soto is describing.

    Maybe it depends on whether you define knowledge as being restricted to true information, or whether your definition includes misinformation, too. I think either definition could work, depending on circumstances. But there are inherent problems with counting misinformation as knowledge, no?

    Or you could call what you describe a hubris bubble…

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  30. Profile Photo Member

    I think de Soto has a point. Investment banks did not have to comply with laws requiring them to report information as was the case with commercial banks. No one knew how leveraged they were and to whom they owed money. This was very much the case with Lehman Brothers. You need to have uniform regulations for the banks and impose capital requirements on leveraging that will keep this kind of bubble from getting as big as it did. You also have to eliminate the moral hazard that encourages risky lending.

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