“Assume a Spherical Cow”

Anyone who has managed money for more than about a nanosecond recognizes that the idea that the markets are efficient is a myth, especially in times of crisis, real or perceived. Despite claims of scientific objectivity, economics is as prone to human frailty as anything else. As Seth Godin wrote this week: “Your first mistake might be assuming that people are rational.” For example, on my birthday in 2008, the S&P 500 lost over 9 percent, over a trillion dollars in value, on account of (per CNN) nothing more definitive than “recession talk.” That’s hardly evidence of rationality.

The consistently engaging 3 Quarks Daily has a new piece up this week on economics as religion rather than science. It’s hardly a novel concept, but the argument is an interesting one.  However, author Ben Schreckinger missed or ignored some of the best available evidence, which I’ll get to in a bit of a roundabout way.

The above cartoon (from Abstruse Goose) riffs on a classic physics joke that goes something like this:

“Milk production at a dairy farm was low, so a farmer wrote to the local university to ask for help. A multidisciplinary team of professors was assembled, headed by a theoretical physicist, and two weeks of intensive on-site investigation took place. The scholars then returned to the university, notebooks crammed with data, where the task of writing the report was left to the team leader. Shortly thereafter the physicist returned to the farm, and advised the farmer, “I have the solution, but it only works in the case of spherical cows in a vacuum.”

Thus “spherical cow” has become a metaphor for highly (overly!) simplified scientific models of complex real life phenomena. Economists may be even worse offenders than theoretical physicists. As Hale Stewart wrote yesterday, “complex models that claim to model the entire US economy just aren’t worth the time of day no matter how good the algorithms backing it up. “That economists so frequently suffer from “physics envy” makes for a delightful bit of irony. Yet an even worse offense by economists is their all-too-frequent willingness to elevate a favored ideology ahead of the actual facts. People are routinely driven by their ideologies and their behavioral biases rather than facts and data, of course, but economists claim to be acting as scientists, with a delineated method designed to root out such things. If only.

For example, consider this paper by Mark Rubinstein of the University of California, Berkeley wherein he attempts to explain away all the evidence against the efficient markets hypothesis.  Notice that he begins with a testimony of ideological commitment.

“When I went to financial economist training school, I was taught The Prime Directive. That is, as a trained financial economist, with the special knowledge about financial markets and statistics that I had learned, enhanced with the new high-tech computers, databases and software, I would have to be careful how I used this power. Whatever else I would do, I should follow The Prime Directive:

“Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behavior.

“One has the feeling from the burgeoning behavioralist literature that it has lost all the constraints of this directive – that whatever anomalies are discovered, illusory or not, behavioralists will come up with an explanation grounded in systematic irrational investor behavior.”

Thus Rubinstein sets out to explain reality by basing his work on a manifest falsehood that he assumes (no less than our spherical cow) to be true.  Sadly, it isn’t an unusual occurrence.

To go all geeky for a bit in order to illustrate, it has been common in trading algorithms and options pricing generally to assume that asset price movements have a Gaussian (bell curve) distribution. That can seem like a reasonable approximation because the Central Limit Theorem avers that an ensemble of arbitrary probability distributions will tend toward a Gaussian distribution as the size of the ensemble increases without bound. But the evidence (due to Benoit Mandelbrot and popularized by Taleb in The Black Swan)establishes that asset price movements instead have a power law distribution, with the “tail” effect turning out to be much more important than most of the folks on Wall Street had suspected.  And that’s the 2008-2009 financial crisis in an (oversimplified) nutshell.

Some of our current leader-high priest economists suffer from the same malady. In 2003, Nobel laureate Robert E. Lucas Jr. began his presidential address to the American Economic Association by proclaiming that macroeconomics “has succeeded: Its central problem of depression prevention has been solved.” As it turned out, his triumphalism was more than a bit premature.

Indeed, many mainstream economists subscribed to the common pre-2008 delusion that market stability and efficiency were guaranteed by the wonders of modern financial engineering. Current Fed Chair Ben Bernanke helped to publicize the alleged “Great Moderation” in a 2004 speech. Low levels of inflation, long periods of economic growth and low levels of employment volatility were viewed as unquestioned proof of success. In 2005, three Fed economists proposed that the success of financial innovation was at the root thereof.

“Improved assessment and pricing of risk, expanded lending to households without strong collateral, more widespread securitization of loans, and the development of markets for riskier corporate debt have enhanced the ability of households and businesses to borrow funds,” they wrote.

 

“Greater use of credit could foster a reduction in economic volatility by lessening the sensitivity of household and business spending to downturns in income and cash flow.”

Just last month Bernanke noted that “one cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of calm lulled investors, financial firms and financial regulators into paying insufficient attention to building risks must have some truth in it.” Of course, asking is not the same as conceding the (utterly obvious) point.

Even so, Bernanke isn’t willing to go against his ideological commitments. As Floyd Norris has reported in The New York Times, economist Steve Keen, following Minsky, suggested (pre-crisis) that lending standards would be gradually reduced, and asset prices would rise, as confidence grew that “the future is assured, and therefore that most investments will succeed.” Eventually, the income-earning ability of an asset would seem less important than the expected capital gains. Buyers would thus pay high prices and finance their purchases with ever-rising amounts of debt.

When the market turned over, as it inevitably would, an immediate need for liquidity would cause financiers to try to sell assets immediately. “The asset market becomes flooded,” Keen wrote, “and the euphoria becomes a panic, the boom becomes a slump.” Minsky argued that could end without disaster, if inflation bailed everyone out. But if it happened in a period of low inflation, it could feed upon itself and lead to depression. “The chaotic dynamics explored in this paper,” Keen concluded, “should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm.” Talk about prescience?!  Meanwhile, Bernanke, in his 2000 book “Essays on the Great Depression,” briefly mentioned, and dismissed, both Minsky and Charles Kindleberger, author of Manias, Panics and Crashes. They had “argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior.” In a footnote, he added, “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.”

But by pushing the efficiency/rationality model, mainstream economics ended up missing the boat entirely. As CalTech system scientist John C. Doyle has established, a wide variety of systems, both natural and man-made, are robust in the face of large changes in environment and system components, and yet they are still potentially fragile to even small perturbations. Such ”robust yet fragile” networks are ubiquitous in our world. They are “robust” in that small shocks do not typically spread very far in the system.  However, since they are “fragile,” a tiny adverse event can bring down the entire system.

Such systems are efficiently fine-tuned and thus appear almost boringly robust despite the potential for major perturbations and fluctuations. As a consequence, systemic complexity and fragility are largely hidden, often revealed only by rare catastrophic failures.  Modern institutions and technologies facilitate robustness and efficiency, but they also enable catastrophes on a scale unimaginable without them — from network and market crashes to war, epidemics, and global warming. That so many economists reject such thoughts as a matter of ideology makes things even worse.

Chaos, criticality, and related ideas from statistical physics have inspired a completely different view of complexity in that behaviors that are typically unpredictable and fragile “emerge” from simple and usually random interconnections among homogeneous components.  Since complexity science demonstrates that financial markets are unpredictable and fragile, the risks to investors and to the markets as a whole are both obvious and enormous, no matter how strongly the economics orthodoxy wishes to deny it.

While there are great benefits to complexity as it empowers globalization, interconnectedness and technological advance, there are unforeseen and sometimes unforeseeable yet potentially catastrophic consequences too.   Higher and higher levels of complexity mean that we live in an age of inherent and, according to the science, increasing surprise and disruption. The rare (but growing less rare) high impact, low-frequency disruptions are simply part of systems that are increasingly fragile and susceptible to sudden, spectacular collapse.

We are thus almost literally (modifying Andrew Zolli‘s telling phrase slightly) tap dancing in a minefield to a tune played by neo-classical economics that doesn’t even pretend to be based upon reality. We just don’t quite know when our next step is going to result in a monumental explosion. Mandelbrot is clear that a “wild randomness” prevails: risk is concentrated in a few rare, hard-to-predict, but extreme, market events.

Rama Cont, whose background (again) is in physics: “When I first became interested in economics, I was surprised by the deductive, rather than inductive, approach of many economists.”  In science, practitioners are supposed to observe empirical data and then build a hypothesis to explain their observations, “many economic studies typically start with a theory and eventually attempt to fit the data to their model.”

Economics remains lost in an imaginary and mythical world where people are rational and the markets are efficient.  That’s their story and they’re sticking to it with religious conviction if not fervor. That so many people will be forced to pay for that ideological failure — when market fragility inevitably rears its ugly again — is unfortunate in the extreme.