Willravel

It seems fairly evident to this layman that traditional economics is basically incapable of accurately representing the complexity of modern financial markets. I've been waiting for some brilliant economist to invent a new model, a new "school" of the science in order to perhaps compensate or even possibly explain. Maybe some millionaire investor, upon retirement, will bestow his ingenious theories upon the world. It turns out Benoît Mandelbrot, the father of fractal mathematics, seems to have had an interesting solution for quite some time: financial markets follow their own internal logic not necessarily related to actual economic factors.

Imagine my surprise reading this. Despite not having any formal training beyond a simple BA, I fancy myself a lover of science and I've always felt that science is the best tool to explain everything in the world around us. Economics is a science, kinda, so I guess I assumed that there will eventually be some wonderful algorithm or fractal which can, within a certain margin, predict the markets. It would seem this was an unwise assumption, and one I seem to share with everyone from beginning investors to Novel Prize winning economists.

Benoît Mandelbrot seems to have developed an extremely well supported conclusion that instead of "mild randomness" in the market, there is in fact "wild randomness", randomness so wild, in fact, that it's doubtful that a mathematical model can be developed which can accurately predict results. So, to sum up and simplify, the key to conquering the financial markets and pulling in huge sums of money is rooted a four letter word: luck.

Wild Randomness by Guy Sorman, City Journal Summer 2009

dippin

Ill add more to this later, as the whole notion of formal mathematical models within economics is part of a century old struggle that is deeply involved in most of the political questions of the day, but I just wanted to mention a quote by Kenneth Boulding: "Mathematics brought rigor to Economics. Unfortunately, it also brought mortis."

Willravel

Ha! I like that.

filtherton

I feel like economics, as it's practiced by some folks in politics, is more religion than science. A recent interview I heard with the Heritage Foundation's senior tax policy analyst, Curtis Dubay is informative. When asked if he had any solid proof that raising tax rates is harmful to the economy he said something along the lines of "No, I don't have proof, it's just basic economic theory."

I'm not sure what Dubay's game is (though I could take a guess), but regardless of whether his basic premises are correct, accurately representing reality with them doesn't seem to be too high his list. In his world, theory determines reality, whereas in most science, reality determines theory.

As for math sufficient to describe economic systems accurately, I'm not optimistic. Seems like a classic example of the complex system. I'm not an expert on complex systems, but I've gotten the impression that, while the basic principles of these system can be fairly easily understood, the inner workings can be pretty tricky to make sense of.

For example, evolution is a complex process, and it is relatively easy to understand the basic premises of evolutionary theory. What isn't easy is making accurate evolutionary predictions.

eribrav

Will have you read Nassim Taleb's The Black Swan?
If not, jump it up to the top of your reading list.
It is definitely a game-changer, and much of it is derived from the work you cite above.

Willravel

I'll check that out, eribrav.

Baraka_Guru

Speaking of economics as a science, you have to remember it's a social science, not a hard science. The thing with predicting economic trends is that there are so many variables, and they're either impossible to control or difficult to extrapolate, or both. It's not like you can have a scientific experiment in economics in a controlled environment to learn things. You're always learning things in the field. That's why it's part science and part art.

This is also why I'll never believe that markets are rational.

__________________
Knowing that death is certain and that the time of death is uncertain, what's the most important thing?
—Bhikkhuni Pema Chödrön

Humankind cannot bear very much reality.
—From "Burnt Norton," Four Quartets (1936), T. S. Eliot

aberkok

Just to be clear, nobody thinks that the function of Economics is to predict the market, do they?

Turning 30 and being a musician was a big wake up call to start learning about this stuff, and the best thing I've found to give myself a fighting chance is NPR's Planet Money. Bit by bit I'm getting a sense of economics and finance. All kept in terms the layperson can understand.

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Baraka_Guru

It's not just about predicting the market, though they do try that. Economists look at a number of factors, which may or may not explain what's happening in markets. Also, there is more than one measure of the market: S&P 500, NASDAQ, Dow Jones, etc. Each one is a different measure. But what economists concern themselves with are economic indicators: GDP, employment rate, inflation rate, interest rates, housing starts, inventory levels, wage levels, labour pool levels, the consumer price index, etc. Basically they analyze and predict where we are in the business cycle. Though that's fairly difficult as well. What the Dow Jones did in a day is just a slice of what economists are concerned with.

Investors, on the other hand, would sell their souls to be able to predict the market. Some do with relative success, but are also miserably wrong at times. Some are speculators, others are value investors. Either way, the market will always humble you eventually. It's not an exact science, there isn't just one way to do it, and if someone tries to pass themselves off as a hotshot, don't give them your money.

Both economists and investors find themselves in the wrong. The case with economists is that they can usually predict things within a small degree of error. It's only when there's extreme and unusual outside factors that they get blindsided (read: 2008). But they try to learn and not make the same mistakes more than once.

Investors, on the other hand, they tend to be cyclical with their mistakes. Greed and fear override reason. Except for the good ones, of course.

Economics (macro/micro) and personal finance are two entirely different subjects. No matter how connected they are.

Watching economic news while leafing through your portfolio is usually a bad idea.

__________________
Knowing that death is certain and that the time of death is uncertain, what's the most important thing?
—Bhikkhuni Pema Chödrön

Humankind cannot bear very much reality.
—From "Burnt Norton," Four Quartets (1936), T. S. Eliot

filtherton

Don't tell the pundits. They know exactly what will happen in the future, because they have a firm grasp of "basic economic theory."

eribrav

Really?
Let's take a well known economist like, say, Alan Greenspan.
What are some things that he predicted accurately in his last 10 years as Fed chairman?

Baraka_Guru

I can't speak for Greenspan, but there are economists who have had relatively decent track records when they forecast month-to-month changes to key economic indicators. Some of the economists in the Big 5 in Canada are examples. They aren't always right, but they're not always far off the mark either.

__________________
Knowing that death is certain and that the time of death is uncertain, what's the most important thing?
—Bhikkhuni Pema Chödrön

Humankind cannot bear very much reality.
—From "Burnt Norton," Four Quartets (1936), T. S. Eliot

Willravel

Greenspan is that funny, Bush-esque combination of hopelessly retarded and deeply corrupt.

Anyway, as someone that got his degree in a social science, I can tell you I have a lot more faith in a psychologist than I would in an economist.

Baraka_Guru

But the question is: would you rather do without economists?

See, that's the thing. There is no alternative, so we must stick with what we have and continue to improve it. Now that we're in the information age, one can only hope it will get easier.

__________________
Knowing that death is certain and that the time of death is uncertain, what's the most important thing?
—Bhikkhuni Pema Chödrön

Humankind cannot bear very much reality.
—From "Burnt Norton," Four Quartets (1936), T. S. Eliot

filtherton

I think we'd all be better off without the types of economists who make predictions they have no business making.

Baraka_Guru

What sort of economists would that be? What sort of predictions?

__________________
Knowing that death is certain and that the time of death is uncertain, what's the most important thing?
—Bhikkhuni Pema Chödrön

Humankind cannot bear very much reality.
—From "Burnt Norton," Four Quartets (1936), T. S. Eliot

Kingruv

The deleterious affect of confidence artists on the economy, economists and America.


When is an economist not an economist? When they become a fund manager.
(no matter what the fund is, local, state, federal, or private/public)

A man owns a coal mine.
As he looks over his operation he sees what he thinks is right.
Production is as good as he could expect. Prices are good.
Safety, always a concern, is good with low lost hours over time.
Labor problems and employee satisfaction are in pretty good shape.
Being an engineer he thinks, "There's always room for improvement" More production in less time. Better efficiency and lower maintenance costs.
"How do we gain here, trim there?"
So he calls his accountant and says, "What do the books say?" "How can we improve profitability?"
The accountant says "I'll have a look, give me a few days"
The accountant goes over all his ledgers and sees everything is in place as he knew it would be.
The next day he talks to the manager and says "Do you have time to give me a tour of the site? The boss wants to see where we can improve profits. I thought it might help if I actually knew more about whats going on. I don't know much about mining, labor, production and all you do. I'm just a book keeper."
The manager agrees and says "It might help to have a fresh pair of eyes on things"
The next day they go around every part of the mine site, from the mine shafts where miners are cutting away at veins to the pump houses and maintenance shops.
The accountant takes everything in, making notes, keeping his own counsel, asking questions only when he doesn't understand what he sees.
He notices that on one of the sections the coal trolleys bump where there is a bend in tracks spliced a bit off at the cutout to the old tunnel. There are chunks of coal laying to both sides of the track.
He walks over to the track as the trolley comes by and picks up a fist sized piece. The manager says, "I need to get that fixed, a lot gets knocked off here that miners don't get paid for." The accountant drops the chunks makes a note with a smile and a nod. They get to the surface and he says, "Thanks for the tour."
He thanks the manager and walks back to his office.

He goes over his notes looking at what the miners get per load and figures out how much might be getting lost they aren't getting paid for.
He looks at prices and thinks, "Hmmmm, in a few months thats quite a bit going nowhere."
Since the owner isn't around a lot and has a good crew and management, he is off and about, here, there and everywhere.
The next time he's in he asks his accountant how he liked the tour. "Did you learn anything? Do you have any recommendations?"
"Oh yes, I learned a lot about what goes on I never knew before. I'm still looking at things, but it seems like there is a high degree of optimization here. I'm not sure what can be improved." the accountant responded.
The owner thanks him for looking and says "Next time I'm in, we'll have to go play a round of golf, my treat." "Yes sir, thank you for the invitation. I'll look forward to it."
The owner leaves. The accountant writes a memo to the manager saying,:

"The time down for track repair is too expensive to justify for the small loss in coal. Once a week, have a different miner stop by and shovel the knocked off coal into the trolley waiting there. Send it up top for dumping."

He sends a memo to the yard manager. "There is a sampling program to begin now. Mark an older trolley with red paint on the corners and send it down to the junction of the new shaft and old cutout every Thursday. When it comes back full, deposit it in a cordoned area separate from the main dumps.
A special truck will come by for this once a month."

He calls his brother-in-law and asks, "Do you still have that old dump truck you bought from the sale here?" "Sure, What do you need hauled?" is his response.
"We're putting a special program in place. We need to keep certain loads separate and delivered on request. Can you use a little extra cash?"
"Always" he comes back.

The accountant draws up papers for a new business. "Oldfield Coal Corporation" files them with the state and he's the sole proprietor.
No one except the accountant knows everything happening. His brother-in-law knows a little, but isn't going to tell, he's getting his part.
The manager knows they are looking for little improvements so he thinks nothing of it. He's busy with everything else.
The yard manager knows there's all sorts of regulations so a sampling program seems reasonable.
The miners are rotated so often they rarely comment about 15 minutes early to get closer to the surface, maybe once day in 90. They get a little boost in pay without digging, so much the better.
The owner is too busy to know anything new is going on.

The above story is a fiction, (So far as I know).

BUT, THIS IS WHAT I SEE GOING ON IN THE ECONOMY, AND HAS BEEN FOR YEARS. Derivatives, hedge funds, all sorts of speculative investment offerings and hidden funds that are a real gamble, UNLESS you have some inside knowledge of what someone is going to do. Some losses can be expected most anywhere. When there are so many people involved pushing paper involving siphoning off money, it can only go for so long before there is a collision.
Notice, I didn't say, what the market will do, but what someone is going to do.
Market forces and personal actions are intertwined always. This goes to Will's comment about trusting psychologists. They deal with the whole person; greed, ambition, deceit, all the best and worst motives.
Economists think in terms, This is what we have, this is the way it works, this therefore is the model. Certainly, they expect greed and avarice.
But how can you anticipate deceit, conspiracy, hidden plans. You can't, therefore regulation is needed to remove this factor or at least penalize it to make it less volatile.
When you have the rule writers, regulators and financial bagmen all in the same club, going to the same class reunions, it's hard for the outsider to know whats going on let alone stop.
I'm not blaming every trader and fund manager for this. But there are way to many pirates now.
I know the story above is a over-simplification, but so much hidden in markets could barely be explained by the ones stealing it. I don't have a problem with small numbers calculus being used to get more out of whats there. But this is largely a case of the system being gamed and the public being conned.
By the time new rules are in place, they have a new con going. (Thats easy if the rule writers tell you whats going to be done ahead of time.)
If an economist starts getting it right all the time, the feds are going to start looking at him or her rather hard. I believe before it gets that far, the cons in trading have already sniffed out the wily economists and are offering “gainful” employment.
Just remember, in these days of anti-production, a lot of high brow types look on making money using almost nothing but words and paper as being heroic.

Guru, how much of my analogy affects the market?
I think it has brought the markets to critical mass. Like fission there is either capture and conversion to useful energy or melt-down or worse, explosion.
I know it is complex, complicated and interdependent, but I also know there is a cross-segment stealing America blind.
If this isn't stopped, WS will lose whatever semblance of integrity it has left. Some of it has been as serious as treason. (for the record I am a free-market libertarian, but dishonest markets aren't free)

If any of you have yet to read Halx essay on Understanding capitalism, do it now. It is excellent.

You will have found his post informative.

Xerxys

^^ I have found that post informative!

Baraka_Guru

Kingruv, I don't see how a handful of bad derivative trades or a hidden market could cause enough damage to bring a meltdown to the system at large. When you look at the sheer volume of what trades above board, it's mind boggling to think that what goes beneath the radar even comes close.

Greed will always exist in the system. But the others do what they can to limit what the greedy can get away with. It's easy to think there are more of them than there really are, but when you look at the numbers, it's a shame to let the few make you believe they can bring about an economic cataclysm.

In terms of the overall effect on the market, I'm sure one would have a better time criticizing the deregulation of the U.S. banking system starting in the Regan era than criticizing the effect of secret markets and rogue traders.

If we go too far in your direction, we might end up chasing bogeymen. I'm not sure that's the best way to go if we were to put political and regulatory resources to work at making the system more fair and adequately functional.

__________________
Knowing that death is certain and that the time of death is uncertain, what's the most important thing?
—Bhikkhuni Pema Chödrön

Humankind cannot bear very much reality.
—From "Burnt Norton," Four Quartets (1936), T. S. Eliot

tisonlyi

Willravel, and anyone who finds Mr Mandelbrot appealing, take the advice of... 'evril'? and read .

It's a great read, pretty instructive, and holds a convincing narrative backed up with observations...

READ IT.

(Also, it's very easy to find from grey area sources)

__________________
"I do not agree that the dog in a manger has the final right to the manger even though he may have lain there for a very long time. I do not admit that right. I do not admit for instance, that a great wrong has been done to the Red Indians of America or the black people of Australia. I do not admit that a wrong has been done to these people by the fact that a stronger race, a higher-grade race, a more worldly wise race to put it that way, has come in and taken their place." - Winston Churchill, 1937 --{ORLY?}--

filtherton

I made it halfway through that book, tisonlyi. I've been meaning to finish it, but I've gotten hopelessly sidetracked. Even from only halfway through, I second the recommendation.