August 16, 2014

How do we not forget or ignore the creative sparks of the past?

Sir, Gillian Tett asks “So what inspires the ‘aha’ moment? And can anybody set out to replicate moments like this in other areas?”, “How to ignite creative spark” August 16.

I would say that even as that is an important question, even more important is the one of “How do we not forget or ignore the creative sparks of the past?” 

Frank H. Knight, in 1921, in “Risk, uncertainty and profit” reminded us of that Hans Karl Emil von Mangoldt, in 1855, gave the example of how “the bursting of bottles does not introduce an uncertainty or hazard into the business of producing champagne; since in the operations of any producer a practically constant and known proportion of the bottles burst, it does not especially matter even whether the proportion is large and small. The loss becomes a fixed cost in the industry and is passed on to the consumer, like the outlays for labor or material or any other.”

And yet, around 150 years later, our too creative bank regulators decided something akin to that if a bank was going to produce champagne using “risky” champagne bottles, it needed to hold much more capital (equity) than if it was going to produce milk using safer milk bottles… and all as if the banks did not already internalize in their interest rates, the size of exposures and other terms, the ex ante perceived credit risks of their borrowers.

And so, ignoring von Mangoldt’s spark, meant that regulators forced the banks into a double consideration of perceived credit risks, something which of course distorted all common sense out of the allocation of bank credit in the real economy.