Two very interesting articles in my latest issue of New Scientist (July 19-25,2008). I will break them up into a few posts, to make them more readable.

Crunchonomics: Why Cling To An Economic Theory That Gets It So Wrong?

It is hard to find a chunk of light in the financial gloom looming over the U.S. Last week, U.S. federal regulators seized control of IndyMac, one of the nation's largest savings banks, after a crippling run on its deposits. Then the government announced plans to inject billions into the nation's two largest mortgage-finance companies amid panic over their massive debts and dwindling reserves. Just a few years ago we were told that the unprecedented sophistication of modern financial engineering had systematically reduced market risks, making events of this kind all but impossible. So what happened?

In part, it is a rerun of an old story---a tale of greed and lax oversight fueling a wave of speculative investment that was both unrealistic and unsustainable. Think 1990s dot.com bubble or 17th-century 'tulip-mania'. House prices, as anyone with any historical knowledge could tell you, do not always go up, yet many seem to have bought into the idea that they would. Some got rich by perpetuating that notion and playing the market with other people's money.

The crisis also seems to have been worsened by a woefully archaic theoretical understanding of markets. In assessing market risks, regulators still rely on what is called 'equilibrium theory', whose conceptual roots lie in 19th-century physics. This holds that market behavior reflects a balance between forces. Market values change, the theory says, only in response to external influences---new information about a company, for example, or a real change in the housing supply. Beyond these forces, markets have no real internal dynamics of their own.

Given how rumors drive markets up and down, and the way investors flock like sheep and follow the words of various gurus, this is clearly unrealistic. While some economists acknowledge as much, and focus their study on 'puzzling' deviations from equilibrium, only a few researchers have actually tried to build new foundations and move beyond the restrictions of equilibrium thinking. They have pioneered computer models that mimic markets by simulating the behavior of individuals, banks, hedge funds and other players, including regulators. These 'agent-based' models do not assume equilibrium from the outset, but instead let market behavior emerge naturally from the actions of interacting participants. As a result, the modelers can experiment with raising interest rates, say, or adjusting regulations to ease credit, and then see what happens.

One potentially pertinent insight from such models is that too much easy credit can be a dangerous thing. [LeRoy: Surely this is classic understatement.] As participants borrow ever larger sums of money to amplify the potential profit from their investments, their actions tie the fates of different participants ever more closely together. This pushes the market toward greater instability, making collective financial meltdown an almost inevitable consequence. [LeRoy: I have always said that too much leverage creates a 'house of cards' economy.]

Agent-based modelers admit their simulated markets need improvement. The most vexing problem remains validation---ensuring that the models give legitimate insight into real markets. Even so, [agent-based models already] outperform traditional ones in predicting core market features such as the statistics of daily or weekly price fluctuations.

It is odd then that most economists seem uninterested, and only a small minority have embraced the new approach. This hesitation appears to stem in large part from cultural inertia. While most of science is embracing the power of computer simulations to gain insights into complex systems with many interacting components, most economists remain dismissive of any work that is not based on strict mathematical proof.

Although the present crisis was not caused by poor economic models [LeRoy: I beg to differ with this remark!], those models have extended its reach by nurturing the complacent view that markets are inherently stable. And while no one should expect better models alone to prevent future crises, they may give regulators better ways to assess market dynamics, detect early signs of trouble and police markets. The cultural inertia of academic economics should not block anything that helps shed light on the markets that exert such a powerful influence over our lives. The regulation of markets ought to be based on the very best science [LeRoy: I would say ALL public policy should be based on the best science available!], even if that does mean abandoning some of economists' most cherished ideas.

LeRoy: More to follow.

One man's "external force" is another man's "internal force". I don't see how the author intends to clearly differentiate. Why aren't the "gurus" considered external to the system?

Mandelbrott suggests that the market is chaotic and is essentially not predictable, except statistically, in the form of a probability distribution. However, that's probably good enough when it lies outside of the real economy. What needs to be done is to decouple the real economy from the financial world so the bad choices don't leak through. OK; so I expressed that really badly! If you are smart enough, you will know what I mean (wink. wink.).

Phil: One man's "external force" is another man's "internal force". I don't see how the author intends to clearly differentiate. Why aren't the "gurus" considered external to the system?

LeRoy: I am thinking you may understand this better once you read the full article which I posted above this one. In that article, the author describes three influences on an investor's decision-making: (1) Public information (what gets reported in newspapers and magazines, e.g.); (2) Private information (any information that the investor has themselves); and (3) What is heard through the investor's 'social network', which essentially corresponds to 'herd behavior' or 'flocking behavior', and which traditional economics has really never tried to model (which may surprise you but is nonetheless true). Following the advice of some 'guru' corresponds to herd behavior.

Phil: Mandelbrott suggests that the market is chaotic and is essentially not predictable, except statistically, in the form of a probability distribution.

LeRoy: I think that Mandelbrot is essentially in this same line of new thinking about how financial markets work. Like the researchers cited in the full article, he is disputing the classical model of equilibrium economics. [In fact, I think it is a bit surprising that his work is not cited in the article.] The central point being made is that the probability distribution is not a normal Gaussian bell-curve distribution.

Phil: What needs to be done is to decouple the real economy from the financial world so the bad choices don't leak through.

LeRoy: However, I do not think this is really possible. The real economy and the financial economy are bound to affect each other. What we need is to find better ways to stabilize the financial economy...such as by minimizing the amount of leverage that is possible...

The details of the future are essentially unknowable, as there are too many variables to consider, and we don't know the likely outcome of all the variables, let alone how they will interact with each other. But as far as general market direction, certain indicators may be helpful. Two that I've read about are Sentiment Analysis and Technical Analysis (TA). The former indicates that the majority are on the right side of a trade until a market turning point--at which point they will be on the wrong side of a trade. For example, when the Dow and other stock indices bottomed in 1982, general sentiment about the market was extremely negative, and most people had given up on stocks. When the indices peaked in early 2000, general sentiment about the market was extremely optimistic. It was the "new era", and the Dow was goint to 36,000. TA looks at price points for individual stocks or indices and terms them "support" or "resistance". It labels certain movements as "double" or "triple" tops or bottoms, or a "head and shoulders" configuration. It also looks at trading volumes. Regardless of whether or not you subscribe to TA, the fact is that many/most traders do, and they help move markets. One of the worrying things about the present market is that the indices have broken "support", and seem to show a head and shoulders configuration--indicating further moves downwards. Extreme pessimism at this point could be a contrary indicator implying that we are bottoming; alternatively, sanguinity in the face of the market retreat would probably indicate that not everyone has thrown in the towel, but will do so as the market dissapoints them.

While SA and TA seem to me good common sense tools for the stock market and microeconomics, Credit would seem to apply to the economy and macroeconomics, as well as microeconomics. Nevertheless, perhaps SA and TA could be used to predict macro-movements in say, housing. One ominous sign for housing may be that nearly everyone was expecting a shorter and shallower recession in housing sales and prices than has actually occurred. The actions of regulators such as Bernanke and Paulson may have also instilled some disbelief and even panic to market players (see my recent post on Paulson's credibility problem).

Or maybe not.

Leroy:

Read my post here. I believe you have to understand how we arrived at today's events before you can pick a solution: <link> Well . . .

and here: <link> "Lipstick On A Pig"

We seem horribly deficient in understanding the history of how we arrived at today. Unless you understand it, then how can you create a better way. Which I understand to be the issue today.

I particularly 'enjoyed' the following highly ironic quote from your 'Lipstick On A Pig' post:

Thomas Theobald, then vice chairman of Citicorp, argues that three "outside checks" on corporate misbehavior had emerged since 1933: "a very effective" SEC; knowledgeable investors, and "very sophisticated" rating agencies."

LeRoy: We have a Cox in charge of the henhouse at the SEC; we have investors who apparently have never heard of boom/bust cycles or financial bubbles; and our 'very sophisticated' ratings agencies were stamping sliced-and-diced sub-prime mortgage CDOs with their highest grades.

If you're interested in financial models based on human herding behaviour, check out Robert Prechter's socionomics at elliottwave.com. Such discussions also occur regularly at The Automatic Earth (http://theautomaticearth.blog­spot.com), where you can find coverage of the credit crunch seven days a week.

Human herding behaviour makes markets probabilistically predictable, within a framework of positive feedback at all degrees of trend. The fundamentals have remarkably little to do with market prices, and the notion that markets are inherently stable, or efficient for that matter, is patently ridiculous.

Most economic models, which merely extrapolate current trends forward, amount to trying to drive while looking only in the rearview mirror. Even minor obstacles on the road can cause an accident as they are never seen in time. In contrast, human herding behaviour analysis watches bandwagons form, become popular and die, anticipating trend changes using sentiment indicators, in combination with fractal geometry (as Mandelbrot discusses).

The credit crunch is the result of the largest credit bubble in history, but still has much in common in terms of internal dynamics with previous historical bubbles. All such events involve the rediscovery of leverage and a collective delusion that this time the outcome will be different. Ordinary people with no specialist knowledge appear to 'win' during a mania, but as they always hold on for too long, they always collectively end up holding the empty bag. They are nothing more than the bottom layer of a classic pyramid scheme, destined to be fleeced in order for the upper layers to cash out before a crash.

A crash is fast approaching as deleveraging, and the destruction of credit, pick up momentum. Credit only functions as a money-equivalent during the expansion phase of a bubble. Once expansion morphs into contraction, credit evaporates, leaving only actual money, which is currently much less than 1% of the effective money supply. This is deflation by definition (the contraction of the sum of money and credit relative to available goods and services), and it will be much more severe than the 1930s as the excesses which led to it have been more extreme.

We should see a rapid deflationary debt implosion, as happened in the wake of other historical bubbles. The South Sea Bubble, for instance, reached great heights, but collapsed in only a couple of years in the early 1720s. That event is the closest approximation to what we are facing today in terms of the manic excess preceding the crash. The resulting economic fallout from financial collapse lasted for decades and culminated politically in a spate of revolutions near the end of the eighteenth century.

I will check out the links you suggested. I have heard of Robert Prechter's name before, but am not very familiar with his work.

I agree with your analysis of the credit bubble and the inevitable credit crunch following in its wake. We discuss these kinds of issues frequently here on Bottom Line; you may find this to be an interesting site.

I'm sure I will find it interesting.

Market analysis based on human herding behaviour is not a new idea. Prechter has been doing it since the 1970s, following in the footsteps of many others, and it has been a particular fascination of mine for about 15 years. Prechter's DVD History's Hidden Engine is a good introduction to the topic. It may still be available free on the net.

Essentially it means that all market moves are grounded in destabilizing positive feedback. Markets appear chaotic as movements at all degrees of trend are operating simultaneously (hence the application of fractals), but they are actually quite patterned, if you know what to look for. Patterning allows for probabilistic market timing by anticipating trend changes. Looking at internal market dynamics imparts vital information that an analysis of economic fundamentals completely misses.

I looked around and found the link for that documentary. You can download it for free from: <link>

I see little evidence to support such a prediction. Of course, one must always consider something like a big disruption as from war, diplomatic explosion, bankruptcy or foreign-debt repudiation, crop-failure, widespread terror, etc. But such events have very low frequency and are not stochastic (can be wiggled out from), except crop-failure.

A colossal crash is -- moreover -- not in the interests of super-rich world-movers like the TLC. Perhaps there are some other conspirators you have in mind. The GOP seems intent suddenly on painting Russia that way.

I myself forecast merely a steady fall in USA lower 80% standard-of-living, plus an inflation reflecting the higher costs of energy and water, as well as higher world demand from Asia. Capital has won. Labor is generally worthless.

Energy breakthrough discoveries and workouts are possible, to the detriment of oil.

But population is still rising, accelerated by USA religious whacko politics. Hence WAR pressures intensify.

Inflation is not increasing prices, nor is deflation the reverse. Inflation is an increase in the supply of money and credit relative to available goods and services, which is not what is unfolding at all. Credit is disappearing rapidly while money supply measures show a flight to safety rather than monetary growth. deflation has already begun, and it doesn't play out as a slow squeeze.

Not only am I forecasting a crash, but I think the first phase of it is imminent. Equities stand on the brink of a very large scale decline, oil and precious metals have topped, and the dollar has begun a significant rally that should last for months. This is exactly the set-up you would expect in a deflationary crash.

A crash does not require an external impetus, although something will be rationalized as the cause after the fact. A crash is imminent as a result of internal market dynamics, not because any particular geopolitical event is likely to occur. There is no need to suggest a conspiracy. We are simply reaching the logical conclusion of pyramid dynamics, but this is not a pyramid that was consciously implemented by anyone. It is the aggregate result of unbridled greed and short-termism over a period of decades, with the real economy becoming ever more hollowed out. Essentially, this is Enron an a vastly larger scale.

It doesn't matter what is in the interests of the super-rich either. They have no way to prevent a crash from occurring, any more than they could order a hurricane not to strike just because their property might be damaged. They've been busy extracting profits from the bubble, but have been swallowing their own propaganda about perpetual prosperity for a long time now. Most of them playing the leverage game think they're smart enough to get out in time, but they aren't. During a crash, most investors can only stand on the sidelines and watch in horror as the trading mechanisms are overwhelmed and trades cannot be executed.

On the energy front, demand destruction due to deflation will cause a temporary glut of oil, weakening the impetus to look for alternatives, especially in a capital -constrained world. In any case, none of the alternatives scale up or have a reasonable EROEI (energy returned on energy invested), and so none could hope to replace the role of oil (or natural gas) in the longer term.

Credit is created at will. Borrowing can't be forced on private parties, but govt can just print money and spend it, perhaps on power plants or even artwork.

You have an idea of an effect but not yet a credible cause.

Let us imagine a crash scenario where real estate falls 50% across the board and the largest banks fail. As soon as that happens, government will merely print up money and put the banks back in business.

To cripple an economy, physical events must occur. In postwar Germany, the economy grew rapidly even then, after it was physically crippled.

Internal market dynamics ARE looking ominous, as at Fannie-Freddie, which COULD collapse imminently; but the result would be buffered by first wiping out stockholders and then various schemes akin to printing money or forgiving debt.

It would be instructive if you would post a reply illustrating some key events in the chain leading up to your predicted collapse. I myself envisage merely a gradual slide in living standards for 80% of USA people. I see the slide in the 2% a year range, until there is an energy breakthrough.

Printing money is not a solution. That would merely cause the cost of government borrowing (and by extension all other borrowing) to go so high as to be the equivalent of hitting the 'emergency stop' button on the economy. The bond market is incredibly powerful, and will remain so until the international debt financing model finally collapses.

In addition, the Fed is a private institution that is highly unlikely to throw away the source of its own wealth and power by attempting to inflate the currency. In any case, potential money printers would not be able to keep up with the pace of credit destruction during a deflationary crash. As credit comprises over 99% of the effective money supply, and is already disappearing at a very rapid rate before the heart of the storm even strikes, that dynamic is well underway.

There is a crucial distinction between credit hyperexpansion and currency hyperinflation. The former, which we have recently lived through, is a naturally self-limiting phenomenon. Whereas currency inflation effectively cuts the underlying wealth pie into smaller and smaller pieces (a form of forced loss sharing), a credit expansion creates multiple and mutually exclusive claims to the same pieces of pie. Credit expansion proceeds until the burden of the underlying debt becomes too great for the economy to sustain, at which point the debt bubble implodes, extinguishing the majority of wealth claims. The implosion becomes very rapid once a tipping point is reached, as it is grounded in destabilizing positive feedback.

This cannot be compensated for either by currency printing or by lowering interest rates. Additional liquidity will simply be taken off the table and hoarded by anyone in a position to do so, causing the velocity of money to slow dramatically. The psychology of hoarding the scarce is very deeply ingrained in human nature, and it is cash that will be scarce in coming years. As for interest rates, even if nominal rates fall to zero, as in Japan, real interest rates will still be punishingly high where inflation is negative (the real rate will be the nominal rate minus negative inflation during a deflationary crash). Welcome to the liquidity trap.

For my take on the developing credit crunch as it began a year ago, see The Resurgence of Risk - A Primer on the Developing Credit Crunch at <link> For on-going coverage see <link>