The "Knowledge Problem" and Monetary Policy: You Don't Know What You Don't Know!

You don't know what you don't know.

And that can be a big problem if you're an investor or a central planner.

In this episode of the Money Metals' Midweek Memo, host Mike Maharrey talks about the "knowledge problem" and explains why it, along with hubris, is the Achilles heel of central planning. He applies this truth specifically to Federal Reserve monetary policy with the help of an interesting history lesson.

Mike kicks off the show with an assertion.

You don’t know what you don’t know, right?

And that can cause problems when you’re trying to plan things.

He backs up his point with a personal antidote illustrating how the best-laid plans can quickly unravel.

 I’ll give you an example. A couple of weeks ago, it was a Wednesday, I think. Anyway, I had the day plan. It was scheduled tight – a lot to do. First thing in the morning, I went out and realized I had a tire losing air. So, off I went to the tire store. Long story short, I spent about half the day waiting for them to figure out that the tire was shot, get me a new one, and put it on. This blew up my whole day.

So, I had a great plan, but it was useless because I didn’t know what I didn’t know. I didn’t know my tire would get punctured.

As the saying goes, "The best-laid plans of mice and men often go awry."

"And yet we have people who think they can plan and micromanage an economy. I’m talking about economists, central bankers, politicians and their attending bureaucratic experts."

But Mike argues central planners will always fail due to one unavoidable issue.

"I don’t care how smart they are, how knowledgeable they are, how many Ph.Ds. they have, all central planners face the same problem. They don’t know what they don’t know."

This is what economist Friedrich Hayek called "the knowledge problem."

Mike explains Hayek's thesis and draws the following conclusion.

"Central planning will always fail because it is impossible for the central planners to possess all of the information necessary to factor in all of the ramifications of any given policy.

"I’m talking to you here, Jay Powell!"

Mike goes on to explain how the knowledge problem dooms central bank monetary policy to failure with some help from financial analysts and commentator Jim Grant. 

"I ran across this interview from a few weeks ago and some of the things Grant said got me thinking about the foolishness of central planning and where it’s gotten us."

Mike sets up the discussion by describing the current mindset out there in the mainstream.

"Don’t worry. Everything is fine. The Federal Reserve has things under control. This is the mentality that is driving the markets. It’s why stocks keep racing to new records. No, it’s not because of the greatness of Joe Biden. It’s the promise of easy money coming down the pike because our intrepid central bankers have whipped inflation and we’re heading for good times. 

"I mean, yeah, sure, the Fed lost control of price inflation for a while, but that wasn’t really its fault. It was due to supply chain issues, greedy corporations, and Putin’s price hikes. So, they had to take away the easy money punchbowl and let the party cool down a little. They served a little coffee in the form of low interest rates. But now we’re sobered up and it’s time to crank the party back up. Oh, and we’re going to get a soft landing. They were able to perfectly thread the needle and get things back on track without crashing the economy."

But Mike raises a question:

"Should we really put so much faith in monetary central planning by a handful of men and women at the Federal Reserve? After all, they don’t have a crystal ball. And if we scrutinize their projections, we find their accuracy – shall we say – lacking. In fact, it almost feels like the Fed is running monetary policy based on speculation and wild guesses."

In his interview, Grant pointed out that investors are "in the future business," and when they get a call right, they often feel they are "getting a word from on high." But he warned, "The future doesn’t exist! And It’s important to recognize that, as humbling as humbling as that realization is.”

In other words, beware of hubris!

Mike says it seems like central planners forget this.

"They become so wrapped up in their own sense of intelligence and wisdom that they begin to imagine that they can control the world. Just listen to Jerome Powell talk. You hear a certain level of certainty wrapped in hubris when he speaks about the future."

But one way to help us project into the future is to understand the past. With that in mind, Grant said, “The more you know about 1953, the greater your understanding of 2024.”

Mike goes on to recount Grant's history lesson, contrasting the attitude of the president and the Federal Reserve chairman then and now. In 1953, the Fed chair tried to adopt a policy of non-intervention in the markets and resisted the urge to tinker with interest rates. But today, as Grant put it, "The Fed can’t keep its hands off our markets and interest rates.”

Mike expands on this, giving a quick overview of how the Fed has engaged in unprecedented monetary intervention over the last two decades.

That has had - and will continue to have - consequences, because as Mike notes, "No matter how good the storyline the Fed writes, things never go according to the script."

Unfortunately, hubris blinds people to their fallibility. They begin to believe their poo doesn’t stink.

"Today, everybody has a false sense of security. I think most people sincerely believe the central bankers at the Fed and the central planners in Washington D.C. have everything under control. Things have basically been fine for almost two decades --the pandemic notwithstanding."

Here's how Grant summed it up.

“I think one of the consequences of the Fed’s manipulation of rates and manipulation of expectations lo these many, many years, is that the constructive fear of things going bad is almost conditioned out of the marketplace.”

Mike elaborates.

"They think low interest rates are the norm. They think the post-COVID price inflation was an anomaly and the Fed can go back to creating inflation without reigniting price inflation. They think stocks will go up forever, bubbles don’t pop, and debt doesn’t really matter."

Mike wraps up the show by recounting the Greek myth of Icarus. 

"Every central planner is Icarus. It’s only a matter of time before their wings melt."

So, what does that mean to us?

"The fact that we can’t predict the future is a reason we need to always be prepared for a wide range of eventualities. Who knows what next week will bring? But you can make some educated guesses. Look at the fundamentals. Put the events of the day in that context. And remember your history. The run-up to 2008 is very informative. I’ve said over and over again, I think we’re in about 2007 right now."

That leads to a call to action - have your safe haven hedge in place before you need it!