On April 12, in an article that appeared on the opposite page, on the Raghuram Rajan Committee’s report on financial sector reforms (“Strong report, weak foundations”), I had pointed out the underlying weaknesses in its logical foundations. The report, I complained, used induction as its main method and thus effortlessly went from the particular to the general.

But on occasion it also used deduction, which is the opposite method of going from the general to the particular. It also confused correlation with causation, something which the best economists and econometricians take great pains to avoid doing.

A few people told me that they couldn’t quite get my drift and that perhaps I should write another article explaining what I meant. I will not do that in this space but I would like to re-emphasise that policy prescriptions that flow from mono-causality are of very limited value, and usually cannot be implemented.

For example, there is a small group of economists who think that the key to heaven lies in total financial liberalisation — now, at once, this very moment. But if you reflect a little, you will see how the financial liberalisers are guilty of the same sort of mono-causality of which, say, P C Mahalanobis was. He thought that the production of capital goods would deliver India from poverty. They think total financial decontrol will do the same thing. The fault, as Brutus may have said, lies in the method.

The newest working paper* on the BIS website by Claudio Borio of its Monetary and Economic Department, inadvertently underscores this point. Borio has attempted a detailed forensic of the current financial crisis in the developed countries. As you read through it — which you must — it becomes clear that what the porcupine said to the monkey as the latter made love to it — “there is no pleasure without pain, dear” — is very true.

Borio says that the turmoil was the result of “generalised and aggressive risk-taking” and that “it represents the archetypal example of financial instability” which are “arguably symptoms of more fundamental common causes.” He identifies these causes generically and politely as “idiosyncratic weaknesses”.

Borio says what many others are saying very rudely: it was greed that caused the problem because greedy fellows in a completely liberalised financial setting came up with wheezes that have “brought to light some limitations of the originate-and-distribute model as it had developed over the last few years…During the build-up, they probably helped to weaken underwriting standards and to lull participants into a false sense of security…Together, they explain the single most surprising element of the current turmoil, viz, the unprecedented amplitude of the involuntary reintermediation wave that threatened financial institutions, with its immediate and long-lasting dislocations to the inter-bank markets.”

In other words, they were lending against nothing, and that is why if you don’t control the financial wizards, they can cause you grievous harm. The consequences have been dramatic.

“…History suggests that the aftermath of such conditions can result in costly financial strains for the macroeconomy…. At the root of such tendencies lie self-reinforcing processes within the financial system and between the financial system and the real economy as well as limitations in risk perceptions and in incentives.”

This is the polite way of saying that the game is taken over by fools and knaves in equal proportions.

So what should be done? Borio gives a list that will have the liberalisers reaching for their smelling salts. Let me quote: “…more transparency, including with specific reference to measures of the uncertainty that surrounds point estimates of value, multi-dimensional rating classifications and to liquidity risks; encouraging improvements in risk management systems, not least seeking to limit the procyclicality of risk measures; reflecting further on how to promote more prudent compensation schemes; strengthening the macroprudential orientation of prudential frameworks, building on the important improvements in minimum capital regulation yielded by Basel II; and refining monetary policy frameworks so as to take better account of both the build-up and unwinding of financial imbalances, including by ensuring effective liquidity.”

In short, if you want to avoid mayhem, no mono-causality, please, and no uni-dimensional view of the world, either.

*BIS Working Paper No 251— The financial turmoil of 2007: a preliminary assessment and some policy considerations; www.bis.org/publ/work251.htm