Posted by: Dirk | January 9, 2012

The Open Society and Its Enemies (I): Sociological laws and the ECB

“It is impossible to derive a sentence stating a norm or a decision or, say, a proposal for a policy from a sentence stating a fact; this is only another way of saying that it is impossible to derive norms or decision or proposals from facts.” (p.66)

Popper here examines the major problem of mankind: we have choices, and it is not so clear how those choices are ranked. We cannot derive from facts directly which policies to follow. Therefore, it is not surprising that the people on this planet do not share the same norms. We speak different languages, listen to different kinds of music, enjoy (watching) different kinds of sports, are ruled through different kinds of institutional setups, have decided to install more or less generous welfare states, and so on. It cannot be said that one institutional arrangement is better than the other, since that all depends on what “better” means. Better for whom?

This, however, should not lead to despair. There are some sociological laws which seem to be in operation. Popper thinks of “modern economic theories, for instance, the theory of international trade, or the theory of the trade cycle.” (p.69) He does not elaborate on this point, but I think he would think along the following lines. People in modern society exploit the division of labour, and therefore need to sell most of their produce. (In the old days, farmer were consuming what they produced.) It is only natural that they are looking for the highest price when selling. Due to differences in endowments of skills and/or endowments of factors of production, the price of a product in different locations will vary. In case of barter, the amount of products received in exchange for a given product will vary. People seem to engage in so-called arbitrage: they prefer to buy cheap, and sell dear. Arbitrage then would be what Popper calls a sociological law.

The second example is that of the theory of the trade cycle. Sentiments of optimism and pessimism drive the trade cycle, with the economy moving from boom to bust and bust to boom. During times of optimism, entrepreneurs use the cash flow to increase investments. We live in a world governed by profit-maximizing firms. During times of depression, entrepreneurs use the cash flow to repay external debt in order to avoid bankruptcy. We live in a world governed by firms repairing their balance sheets. Again, this seems to be a sociological law as defined by Popper. Let me quote a longer passage of Popper’s text (p. 69):

“These laws play a rôle in our social life corresponding to the rôle played in mechanical engineering by, say, the principle of the lever. For institutions, like levers, are needed if we want to achieve anything which goes beyond the power of our muscles. Like machines, they need intelligent supervision by someone who understands their way of functioning, and, most of all, their purpose, since we cannot build them so that they work automatically. Furthermore, their construction needs some knowledge of social regularities which impose limitations upon what can be achieved by institutions.”

From this paragraph it can be inferred that central banks can be seen as institutions which should mitigate the trade cycle, which follows sociological laws. Social regularities like “animal spirits” will limit the potential success of central banks, but nevertheless a central bank might be useful nevertheless. Historically, central banks have been used to stop the financial system from de-leveraging completely. In a bust, all firms might try to sell their financial assets at the same time. There would be no buyers in the market, which would lead to reductions in the price of financial assets. In the extreme, this can lead to wide-spread bankruptcy.

Central banks can discount financials assets (“bills”, in the 19th century) and provide liquid funds (“money”) until the depression has stopped. The banks can then buy back their assets with the money, returning to the situation before the bust. This works only when the problem is one of liquidity, and not widespread insolvency, with lots of non-performing loans producing losses for those that hold them. This function of a central bank is called “lender of last resort”.

The European Central Bank (ECB) is an institution that was constructed to provide a currency for a group of nation states. It was built without the “lender of last resort” function in mind: normally the financial assets discounted in emergency liquidity provisions during times of crisis are sovereign bonds. However, the idea of the ECB financing sovereign bonds of nation states was discarded as not politically convenient. Governments should not be able to rely on the printing press when levels of national debt would rise to dangerous levels. The ECB is the only central bank in the Western world that lacks the lender of last resort function. That is why we have the real estate boom in Ireland and Spain play out mostly as a sovereign debt crisis. In order to bail out banks, governments took over large chunks of debt. This debt included many non-performing loans. Now, sovereigns themselves are in trouble.

In the words of Popper, the designers of the euro did not understand the social regularities of the trade cycle. In the 1990s, when the ECB was designed, the dominating theory was that of Real Business Cycles (RBC). Business cycles are started by exogenous “shocks” in the real economy, either on the supply side or the demand side. Culprit number one is the government, which might shock the economy by discretionary monetary and/or fiscal policy. In the model, the interest rate regulates consumption and saving over time. Shocks can be mitigated by rational households if only markets are competitive. However, the model failed to understand that business cycles can develop endogenously. It also failed to see that booms and busts depend very much on conditions in the financial markets. Last but not least, the interest rate does not coordinate saving and consumption over time. Aggregate demand plays a large role, especially during the downturn, when households prefer the repayment of debt to consumption.

Apparently, intelligent supervision has been lacking also, since the ECB did not change itself much during the crisis. It did change some rules and became a lender of last resort of some kind, but the idea of shifting the burden of adjustment back to politics has failed. Those supervising the ECB are Europe’s politicians, so not all blame should be put on the back of the ECB.However, the behaviour of the ECB during the crisis was unwise. It has become a Dr Jekyll and Mr Hide, with its insistence on not bailing out sovereigns while at the same time providing liquidity to those sovereigns it was supposedly not bailing out. Instead of acting independently, the ECB let politicians get away with the “Greece story” of a sovereign debt crisis when in reality a crisis of capital misallocation in the European financial system occurred. Capital was not only burned inside the euro zone, but also through investing in assets connected to the real estate bubble in the US and the Ponzi-scheme like banking sector of Iceland.

Deriving policy from fact is not possible, according to Popper. However, some sociological laws do exist that need to be taken into account. It is the task of science in general and economics in the field of social interactions to find those (sociological) laws and highlight their consequences for policy. On this account, the discipline of economics has been a failure.


  1. […] the previous post we have followed Popper’s argument that the understanding of sociological laws can help us […]

  2. […] Social institutions […]

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