Destined to Fail

Most regular visitors to Financial Armageddon know where I stand in regard to the mindset of mainstream economists and their other-worldly views on how things work -- or, should I say, are supposed to work.

While there are many areas of life where the theories of the dismal scientists are proved wrong on a regular basis, the financial markets offer the best examples. Contrary to what the economists say, for instance, there are many occasions when what goes on in the trading pits is other than rational.

Under the circumstances, I couldn't resist highlighting a great post at The Financial Ninja blog, entitled "Policy Based on Failed Economic Theory: Just Stupid." In it, Ben Bittrolff gets to the heart of why many of the things these guys in Washington have been and are doing are destined to fail.

I can't stress how important it is to understand that economists are relying on hugely flawed theories and models when looking at the economy. Economic policy is being made off the neo-classical theory of economics. This is just a fancy way of describing current mainstream economic theory. This neo-classical theory of economics forms the basis for all the crap your politicians and their advisors keep trying. The greatest failed experiment of this theory is the practical implementation Keynesian and Neo-Keynesian economic policy. Today, right now you are witnessing the implementation of Keynesian theory to its absolute maximum limits with a policy of ZIRP and quantitative easing.

Of course this cannot work and it never has. Neo-classical economic theory is fatally flawed from its very first basic premises. They are:

1) People have rational preferences among outcomes that can be identified and associated with a value.
2) Individuals maximize utility and firms maximize profits.
3) People act independently on the basis of full and relevant information.

This entire theory and all the economic policy that is born of it hinges on these three basic premises. The first one is completely ridiculous and obvious to anybody that isn’t a socially inept, ivory tower, academic, economic nerd. (Clearly these guys have never interacted with the female species in person before. Hahaha.) The assumption is that individuals choose the best action according to stable preference functions and constraints facing them. Simply put, if you prefer beer over liquor you’ll consistently drink beer at parties. No flip flopping allowed. No randomizations allowed. No ‘living in the moment’ allowed. This brings me to premise number two. Individuals maximize utility and firms maximize profits. Basically you drink your beer to the point of being pleasantly buzzed and then you stop. You never get smashed because a massive hangover clearly does not maximize utility. The third premise states that you will act independently and have all the relevant information to make the best choices. This means that you happily drink your beer and won’t get persuaded to do a round of shots with your friends. You clearly know that one round leads to two and you’ve got to work tomorrow. When your drunken friend gives you a stock tip you act independently and only after you’ve figured out everything humanly possible about the company and the industry. You aren’t at all persuaded by the fact that all your friends jumped on the stock and are making a killing. You stay completely level headed all the time.

The fact that we keep going thru economic and financial manias, bubbles and busts does not seem to deter the economic eggheads that continue to employ these theories literally like zealot Bible thumpers.

You’d figure that the Tulip Mania, South Sea Bubble, Dot Com Bubble, and the current Real Estate Bubble (to name a few) would be more than enough evidence to absolutely destroy all three of these premises.

The truly successful traders and investors of course know all this already. They thrive in a chaotic, irrational and uncertain environment.

"This Economy Does Not Compute [A New York Times Op-Ed by autthor and theoretical physicist Mark Buchanan]:

“A FEW weeks ago, it seemed the financial crisis wouldn’t spin completely out of control. The government knew what it was doing — at least the economic experts were saying so — and the Treasury had taken a stand against saving failing firms, letting Lehman Brothers file for bankruptcy. But since then we’ve had the rescue of the insurance giant A.I.G., the arranged sale of failing banks and we’ll soon see, in one form or another, the biggest taxpayer bailout of Wall Street in history. It seems clear that no one really knows what is coming next. Why?

Well, part of the reason is that economists still try to understand markets by using ideas from traditional economics, especially so-called equilibrium theory. This theory views markets as reflecting a balance of forces, and says that market values change only in response to new information — the sudden revelation of problems about a company, for example, or a real change in the housing supply. Markets are otherwise supposed to have no real internal dynamics of their own. Too bad for the theory, things don’t seem to work that way.

Nearly two decades ago, a classic economic study found that of the 50 largest single-day price movements since World War II, most happened on days when there was no significant news, and that news in general seemed to account for only about a third of the overall variance in stock returns. A recent study by some physicists found much the same thing — financial news lacked any clear link with the larger movements of stock values.

Certainly, markets have internal dynamics. They’re self-propelling systems driven in large part by what investors believe other investors believe; participants trade on rumors and gossip, on fears and expectations, and traders speak for good reason of the market’s optimism or pessimism. It’s these internal dynamics that make it possible for billions to evaporate from portfolios in a few short months just because people suddenly begin remembering that housing values do not always go up.

Really understanding what’s going on means going beyond equilibrium thinking and getting some insight into the underlying ecology of beliefs and expectations, perceptions and misperceptions, that drive market swings.

Surprisingly, very few economists have actually tried to do this, although that’s now changing — if slowly — through the efforts of pioneers who are building computer models able to mimic market dynamics by simulating their workings from the bottom up.

The idea is to populate virtual markets with artificially intelligent agents who trade and interact and compete with one another much like real people. These “agent based” models do not simply proclaim the truth of market equilibrium, as the standard theory complacently does, but let market behavior emerge naturally from the actions of the interacting participants, which may include individuals, banks, hedge funds and other players, even regulators. What comes out may be a quiet equilibrium, or it may be something else.

For example, an agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

It’s important to stress that this work remains speculative. Yet it is not meant to be realistic in full detail, only to illustrate in a simple setting the kinds of things that may indeed affect real markets. It suggests that the narrative stories we tell in the aftermath of every crisis, about how it started and spread, and about who’s to blame, may lead us to miss the deeper cause entirely.

Financial crises may emerge naturally from the very makeup of markets, as competition between investment enterprises sets up a race for higher leverage, driving markets toward a precipice that we cannot recognize even as we approach it. The model offers a potential explanation of why we have another crisis narrative every few years, with only the names and details changed. And why we’re not likely to avoid future crises with a little fiddling of the regulations, but only by exerting broader control over the leverage that we allow to develop.

Another example is a model explored by the German economist Frank Westerhoff. A contentious idea in economics is that levying very small taxes on transactions in foreign exchange markets, might help to reduce market volatility. (Such volatility has proved disastrous to countries dependent on foreign investment, as huge volumes of outside investment can flow out almost overnight.) A tax of 0.1 percent of the transaction volume, for example, would deter rapid-fire speculation, while preserving currency exchange linked more directly to productive economic purposes.

Economists have argued over this idea for decades, the debate usually driven by ideology. In contrast, Professor Westerhoff and colleagues have used agent models to build realistic markets on which they impose taxes of various kinds to see what happens.

So far they’ve found tentative evidence that a transaction tax may stabilize currency markets, but also that the outcome has a surprising sensitivity to seemingly small details of market mechanics — on precisely how, for example, the market matches buyers and sellers. The model is helping to bring some solid evidence to a debate of extreme importance.

A third example is a model developed by Charles Macal and colleagues at Argonne National Laboratory in Illinois and aimed at providing a realistic simulation of the interacting entities in that state’s electricity market, as well as the electrical power grid. They were hired by Illinois several years ago to use the model in helping the state plan electricity deregulation, and the model simulations were instrumental in exposing several loopholes in early market designs that companies could have exploited to manipulate prices.

Similar models of deregulated electricity markets are being developed by a handful of researchers around the world, who see them as the only way of reckoning intelligently with the design of extremely complex deregulated electricity markets, where faith in the reliability of equilibrium reasoning has already led to several disasters, in California, notoriously, and more recently in Texas.

Sadly, the academic economics profession remains reluctant to embrace this new computational approach (and stubbornly wedded to the traditional equilibrium picture). This seems decidedly peculiar given that every other branch of science from physics to molecular biology has embraced computational modeling as an invaluable tool for gaining insight into complex systems of many interacting parts, where the links between causes and effect can be tortuously convoluted.

Something of the attitude of economic traditionalists spilled out a number of years ago at a conference where economists and physicists met to discuss new approaches to economics. As one physicist who was there tells me, a prominent economist objected that the use of computational models amounted to “cheating” or “peeping behind the curtain,” and that respectable economics, by contrast, had to be pursued through the proof of infallible mathematical theorems.

If we’re really going to avoid crises, we’re going to need something more imaginative, starting with a more open-minded attitude to how science can help us understand how markets really work. Done properly, computer simulation represents a kind of “telescope for the mind,” multiplying human powers of analysis and insight just as a telescope does our powers of vision. With simulations, we can discover relationships that the unaided human mind, or even the human mind aided with the best mathematical analysis, would never grasp.

Better market models alone will not prevent crises, but they may give regulators better ways for assessing market dynamics, and more important, techniques for detecting early signs of trouble. Economic tradition, of all things, shouldn’t be allowed to inhibit economic progress.

Comments

[roger]

Complicated phraseology esoteric explanations usually hide
incompetence & explain nada nothing, if it can not be explained
in plain language its not worth reading,economist like politicians
excel in this art of obfuscation

[Tom K]

Why?

Because of derivatives and swaps. Complicated incomprehensible derivatives. Of gargantuan financial proportions. Unregulated, hidden, no transparency. Spin into a massive web of relationships. Distributing the risks, liabilities and economic consequences to every corner of the world. They have built a class 1 cancer, a financial AIDS epidemic, a WMD, and they have no comprehension, no models, no calculation, and no control.

There is only one thing to do: let the financial WMD spread and blow up everything along the way. Then pick up the pieces and start all over. Let every country sign a new UN treaty banning all derivatives and swaps.

[Fainstadt]

What an incredible article. The scientific approach to economics makes sense to me. The fools running the
ship of state have abandoned their integrity and checked honesty at the cloak room. If this ship makes it
to shore I will be amazed. Bail outs anyone?

[JJL]

As a scientist myself (Molecular Biologist) I especially like the scientific method applied to economic thought. Great post. Have great Thanksgiving!

[RueTheDay]

The answers are in Minsky. Most know him for his "Financial Instability Hypothesis". However, that is just one part of his overall framework. Minsky proposed an entirely different way of looking at "production". In Neoclassical production theory, production is simply an exchange process - the exchange of inputs (labor, capital) for outputs (consumption goods) according to a specified technology. What's missing? Oh, just a few minor things like time, uncertainty, financing, etc. In Minsky's framework, capital investment is necessarily prior to the production of output and financing is necessarily prior to capital investment. A car manufacturer can't begin producing hybrid cars until it has built the plant and equipment to do so, and it can't build the plant and equipment until it has secured the necessary financing to do so, for example. Whether it will secure that financing depends upon BOTH 1) the carmaker's beliefs regarding whether the future cash flows it can generate will cover the debt service and still provide sufficient gross profit as surplus and 2) the financier's (e.g., banker's) beliefs regarding those same cash flows and whether they can enable the loan to be repaid. Both decisions are made under conditions of Knightian uncertainty. If the bet pays off, then their beliefs are validated, more debt is undertaken to provide for more capital investment, and so on and so forth until the payoffs do not cover the debt burden, and then the system reverses course (though the debts still exist and must somehow be serviced). This is just a skeletal view - Minsky weaves in asset markets and their pricing, liquidity preferences, capital accumulation, and labor markets into the grand framework.

Reading Minsky's three main books, one can't help but wonder a few things - how did the economics profession spend more than a decade wringing their hands over New Keynesian rigidities involving sticky wages and prices but completely miss the rigidity inherent in fixed debt payments and how much better off would the profession be had Samuelson's Foundations of Economic Analysis and Arrow/Debreu's Theory of Value never been published. Generations of bright economists wasting (and I do mean wasting) their time on "proving" the existence of unique and stable equilibria in GE systems.

[scott]

A scientific aproach to econonomics huh ? Well, why not start with 'what is economics' and lets say that economics is the process of ppl trading their labor for things that they need or want and then lets be scienticificly efficient about the best and most efficient ways for the laborers to accomplish those things and then lets ponder how all the traders , speculators , gamblers and profit-taking lazy bastards fit into such scientific models, and thus one begins to see why the aforementioned persons might prefer faith and confidence to science and rationality.

[ron]

In real time a business buys equipment costing $8 million dollars that represents the latest technology and saves labor. Problem is so does his competitors and soon all are hiring more sales people and spending additional on advertising to try and create the necessary volume to maintain the business. Now the debt necessary to buy the equipment is spread out over 10 years but the equipment really has a 36 to 60 month life span given the introduction of faster,more efficient equipment into the marketplace. The debt doesn't go away it is rolled into the cost of new equipment and so on it goes. Finally the business cycle breaks down completely since enough volume cannot be generated to keep the machines active enough to cover the business overhead.
Our crisis goes deeper then simple credit availability or what economic theory most economist happen to believe. We live in a ever expanding machine age which will soon wipe out the so called low wage manufacturing emerging countries and put additional strain on direct labor in the advance economies.
Our machines create products at rates that consumers can no longer absorb at a ever expanding rate. Cheap available credit has been the driver necessary to generate the sales velocity necessary to keep the factories operating, we need to understand that this is not sustainable.

[roger]

Destined to Fail: Money, this exchange value as no solid basis,
it is manipulated to the extreme. You have to be a fool to think
it can be controlled and analyzed by a scientific method
To navigate the Oceans you need a grid & a compass to navigate
a solid method based on on "material realty" not some abstract
crackpot ideological theory.

[roger]

sorry: read REALITY

[Mace]

Well you use far too many strawmen about economics to warrant a comprehensive response, but let me point out that many economists, including myself, find Keynesian solutions ludicrous for our current situation. Keynesian solutions are favored by the political class and big government advocates because they result in even more centralized power and even bigger government. Milton Friedman basically tore apart Keynesian theory several decades ago.

As for the California electric deregulation fiasco, I had a front row seat since I worked in one of the regulatory agencies. It was not economics that failed but government. The market was designed by the political class and did not allow a fully functional market. For example, retail customers had their electric rates frozen and were not able to respond to the drastic changes in the underlying wholesale rates. This is not economics or markets discredited, this just simply demonstrates the idiocies of the ruling class.

I think our current economic crisis is the result of government failure as well, not market failure. Besides, what are you going to replace current economic theory with? Socialism??? We're doing that here in California and I'm predicting that this state will go bankrupt sometime next year as a result.

So this is my response to two of your strawmen. Maybe others can pick apart the rest. I don't have the time to undertake such a large task.

[The Coming Depression]

Something everyone must view: the inside bank accounts of every country in the WORLD. Bangladesh has more money than the USA! http://www.thecomingdepression.blogspot.com HAPPY THANKSGIVING USA

[dearieme]

My models are better than your models. He's talking his book.

[i on the ball patriot]

You need to model the deception and corruption that keeps 'regulators' from preventing the deception and corruption. Building that model will reveal that this crisis is an intentional neocon global financial coup perpetrated against foreign and domestic populations that will result in consolidated power and a ruler and ruled, no middle class world.
Its Henry Kissinger's National Security Study Memorandum 200 (NSSM200)on roids.

[Omitted Kingdom]

Late last night i was in the kitchen, wrapping up leftovers. I noticed the empty pumpkin pie aluminum pie pan with a few crumbs. Absentmindedly, i picked it up and turned it, upside-down, over the mincemeat pie, for a trial fit, then I noticed the pumpkin pie was noticeably smaller, this year, than last, about 1/6-1/8th smaller than the mincemeat pie.

[Al]

Mace,

You shouldn't be accusing anyone of strawman arguments if you're going to follow up with drivel.

Keynsian economics are wrong because I and Friedman disagree? Appeal to authority. Of course if you'd read carefully you would have seen that Bittrolff was discrediting Keynsian theory as well. You're both wrong. Under Keynsian theory govt spending goes down to create surpluses during good times to wipe out any debt incurred during the bad (or better still to build reserves.) Given the rampant spending during the good times it is clear that Keynsian theory is not being practiced. The recent stupidity should not be attributed to Keynsian theory.

The Californian electric fiasco. Deregulation failed and the govt stepped in making it worse. It's still an example of deregulation and the market failing. Ever here of Enron? Your front row seat let you see one detail but miss others.

And you think that the current crisis is a govt failure. The central bank that kept interest rates too low is not a govt institution. Did the govt mandate lending institutions to leverage themselves to obscene levels? The govt failed to regulate business, but the first failure was the market's.

And I can't see anything above that makes me think Panzer, Bittrolff or Buchanan is advocating Socialism. Why are you projecting that opinion on them? Why would you even think that discrediting one economic theory requires switching to Socialism? How about switching from one economic theory to another. Say an economic theory that allows for irrationality and excess leverage.

If you have any more drivel, I've got the time to discredit it.

[Joe M.]

They can model forever but it will not change a thing. The damage has already been done. The paper-debt-trade will cease to exist, very soon, and all eCONomist will go the way of the do-do bird.

[roger]

ron you make a very good point.
Mace;Milton Friedman was a wash out,Socialism in CA, you got
to be kidding!

[Pete Murphy]

Any global economic model that is dependent on one nation, the U.S., maintaining a never-ending enormous trade deficit is doomed to failure from the outset.

Pete Murphy
Author, "Five Short Blasts"

[Ralph]

Of course the Keynsian model, like most models is deterministic. Given an initial set of conditions, using concrete principles assumed for each participant, the model can be played forward to its natural end. Though I don't support such models, I would think a Keynsian would argue that a participants decisions are to averaged out? Of course you may occasionally do jello shots, but the likelihood is your bonding with your friends will provide future support in times of strife (such as when you're fired for not getting to work on time the next morning).

I can't believe the theory is so naked as to assume no potential for random events. Such as irrational behavior.

[mistaken borrower]

. . . what is all this "socialism" talk. If any one of the commentators has genuine "socialism" experience, their comments would reflect it.
Up to now all I see is foam at the mouth.
Russian socialism and British socialsm are different. Would it be reasonable to expect American socialism. If so, what is it like ? Is it like a "Black Friday" shopping mall rush ?