Pride and The Inevitable Falls

Goodhart's Law

The pride of humanism is a fearsome thing to behold. Autonomous man—free, secular, materialistic humanity—believes itself powerful enough to shape all things. However, the proverb is damning: pride goeth before a fall. When men overreach themselves, bad unintended consequences follow.

It is a necessary part of wisdom to know one's limitations and to have a realistic assessment of one's limited abilities. The same is true of collective humanity: the more wise a society is, the more it is aware of its limited ability to shape and transform reality.

Recently we came across Goodhart's Law. Professor Charles Goodhart was Chief Advisor to the Bank of England. He is credited with stating what has become known as Goodhart's Law, which arose in the context of central banking and the regulation of the monetary system. Since the arcane activities of central banks are once again creating world headlines, it may be useful to rehearse Goodhart's Law.

It can be found in several versions. One version states: “As soon as the government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends.” How often we have seen this law at work! What the Law states is that when a government or central bank tries to set monetary or economic policy by referring to various economic or market indicators, by that very action the indicators weaken and lose their worth.

Remember the Monetary Conditions Index (MCI) run for several years by the Reserve Bank of New Zealand? It sought to combine together the rate of interest, plus currency to measure the “true” value of monetary conditions in New Zealand. Then the Reserve Bank used that indicator to set monetary policy for several years. Of course, as soon as the market twigged to this, it anticipated how the Reserve Bank would be setting interest rates and monetary policy and acted accordingly. This so distorted market interest rates and the exchange rate that the MCI became worthless and was later abandoned.

Another example is playing out right now. The Reserve Bank likes to control monetary policy by influencing very short term interest rates. The market, anticipating this, has increasingly favoured longer term, fixed borrowings. This has substantially snookered the Reserve Bank, so that manipulation of the short term interest rates are now far less influential and effective than ten years ago. Short term interest rates have become unreliable guides as to present and future economic conditions. The Reserve Bank is increasingly in the dark. Goodhart's Law is at work.

Professor Goodhart restated his law in a more generic form later in life. The restatement reads: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” All central bankers and governments should read this and shudder. Goodhart's Law is effectively stating that the ability of governments and regulators to regulate economic affairs is very limited—and even if successful, it will only be for the short term.

It is instructive that Ben Bernanke, Chairman of the Federal Reserve, has recently called for a complete rethink of how the Fed measures credit and monetary and economic conditions. The indicators that guided Fed policy have completely broken down over the past eight years—resulting in the credit crisis and recession. What Bernanke is acknowledging is that Goodhart's Law is alive and well. So the Fed and other monetary authorities will go through the exercise of developing different models by which monetary policy will be set. They will claim, once deployed, that their new models are more sophisticated and address the limitations and weaknesses of the past.

But they will not escape Goodhart's Law. Within a very short time, the markets will have worked out the measures and models of the Fed, and will be anticipating its actions and adjusting their behaviour accordingly—and the models will eventually break down, leading to yet another financial, monetary, and economic crisis.

Goodhart's Law has gone through another iteration. Professor Marilyn Strathern has restated it more generically as: “When a measure becomes a target it ceases to be a good measure.” Well said. No-one is going on to state the obvious corollary of Goodhart's Law, however, which is: central banks and monetary authorities as we understand them are doomed to repeated failure.

As someone pointed out, Goodhart's Law is a “sociological analogue” of Heisenberg's uncertainty principle in quantum mechanics. Measuring a system—particularly measuring it precisely and finitely—disturbs the system such that the measurement becomes inexact and distorted.

It is the part of wisdom to recognize and acknowledge this phenomenon—and to cease offering the utopian dream of being able to regulate and tweak to nirvana. Modern western society would take a huge step forward if it were able to accept its limitations with gladness, and eschew opposite views with disdain.

But while the humanist world view retains its thralldom over modern man this will not happen. Hubris and wisdom are not compatible.