Laplace’s Hammer: The End of Economics

Clever Man, Stupid Idea

Simon-Pierre Laplace was a Very Clever Man who did many Very Clever Things. Unfortunately, like many clever men, having got hold of a Brilliant Idea he was rather inclined to go off and use it on everything in sight, which led to a number of Very Odd Conclusions. In fact as far as science goes, he may well have been the original man with a hammer; taking aim at every problem as though it was a nail.

As is the way of these things economists got hold of Laplace’s ideas, converted them to their own and started developing delicate and intricate webs of theories and practices. Unfortunately, over the succeeding three hundred years they’ve failed to keep up with advances in physics and biology, rather leaving economists as the only believers in an approach that suggests we have no free will, a position from which they’re having to be dug out and defused, one unexploded theorist at a time.

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Risk, Stone Age Economics and the Affect Heuristic

Real Risk Management

Meet Grunt, a Stone Age economist. Grunt spends his time assessing risks. Usually these involve delicate decisions that may end up having quite important consequences – like whether he’s alive at the end of the day or not. Whether it’s attempting to impress a potential mate or ingratiating himself with the alpha males or simply choosing not to eat that odd smelling fruit he’s constantly having to weight risks and probabilities.

Grunt, however, isn’t blessed with modern economic theory and probability analysis is unknown to him. Although his grasp of number theory that doesn’t run much beyond one, two, err … a whole load he has a mechanism that’s been honed over hundreds of generations. Rather than rationality Grunt relies on the Affect Heuristic.

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Capitalism Rising: The Lessons of Lepanto

The First Shot

The 7th October 1571 is a date that ought to be engraved on the hearts of free-marketeers everywhere. The naval Battle of Lepanto, between the Ottoman Empire and the Western Holy Alliance, marks the first occasion on which a military battle was won not by weight of arms or tactical cunning but by investment banking.

Arguably the eventual triumph of capitalism was inevitable anyway, but history doesn’t run on tramlines. Had the nascent capitalist powers of the West lost that battle there may never have been the full flourishing of the Enlightenment. An all-powerful and mighty empire took on a fragmented and vaguely farcical alliance of emerging semi-states and lost, because the other side had the best financiers.

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Money Matters, Your Opinion Doesn’t

Blame the French

Our brave new world is filled with a cacophony of opinions; everyone’s an expert. The proliferation of media channels, accompanied by ever more desperate attempts to keep up with social networking and inclusivity trends, is leading to a world governed by the lowest common denominator. Now get this: I want to be informed by people who actually understand what they’re talking about, even while reserving the right to disagree with them, rather than by someone whose main skill is in double-jointed thumbery and text messaging.

Aliens viewing the output of terrestrial media from afar are probably wondering what type of disease is decimating the intelligence of the average Earthling. This babble of uninformed opinions is swamping the already low level of intelligent comment available and nowhere is the problem greater than in finance where people start with the view that possession of a small amount of capital and an internet connection makes them gifted and talented investors. Still, if nothing else, we can probably blame the French.

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Complexity in Financial Systems

What's Complexity?

We can probably all agree that modern day financial systems are complex, but what that actually means isn’t something that everyone agrees on. Typically, though, a system characterised by complexity isn’t something that anyone’s designed – it emerges, it adapts spontaneously and it produces stunningly unexpected outcomes when no one’s expecting them.

Which, let’s face it, sounds a lot like modern finance. The problem is that many economists are focusing on how they manage this system when, in reality, it’s impossible to do so. It’s like trying to contain swine flu using a butterfly net.

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Fall of the Machines

IT Illiterates Beware

A while ago in a piece named “Rise of the Machines” I suggested that automated algorithmic trading systems were a problem waiting to happen. Sadly this was wrong because the problems had already happened. As this article from the Financial Times shows, these systems had been misbehaving even before Wall Street freaked on May 6th 2010.

What’s really worrying, though, is that the FT article poses the question: “…has technology reached the point where machines pose systemic risks if they go berserk?” The answer’s pretty obvious to anyone who’s ever crafted a program more complex than the obligatory “Hlelo wrold” initiation, but perhaps the leaders of the financial world are really IT illiterates? Just in case, here’s a primer.

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Why Markets Crash

An Unsteady Aim

Oddly there’s little agreement amongst the experts about why markets crash. Although given that experts in fields without objective measures of success are generally less accurate than a drunk in a ship’s urinal during a storm that’s not really surprising. Still, if the best that the world of investment has to offer doesn’t know when stuff’s overvalued then how can we possibly hope for an end to boom and bust?

There’s no getting away from the reality that the inability of analysts to know whether markets are overvalued or not leads to serious problems. Pundits, who have a record of prediction that makes amateur astrologers look like geniuses, are delighted to proclaim the inadequacies of regulators and analysts but, frankly, have nothing better to offer. Sadly, history doesn’t offer much in the way of solace: it’s only hindsight that gives us superior knowledge.

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Memes, Money, Madness

Meme Machines

The appearance and disappearance of investment themes over time is a fact of life – remember “you can’t lose with the railways”? Me, neither, but in the 1840’s it was a guaranteed winner until it wasn’t.

Other dubious ideas have more legs, like the Efficient Market Hypothesis and the theory that most analysts can figure out which shoe goes on which foot. All of these ideas influence markets and participants and help move prices, sometimes with startling synchronicity. A popular theory of how this happens is based on the idea of the meme, a cultural equivalent of the gene, propagating itself through human brains and influencing group behaviour. So are we meme machines, buying stocks at the whim of transient ideas?

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Herd of Investors

Bovine and Asinine

It seems sort of obvious that investors, a generally bovine group when not in asinine mood, will tend to congregate in herds and then charge about randomly, often over the edge of the nearest cliff. If this is true, however, it poses a set of puzzles that it’s not clear that any of the current approaches to understanding mass market behaviour can properly explain.

Certainly this behaviour isn’t efficient in the sense of obtaining the right price for a security, because deciding what to do based on the person running about in ever-decreasing circles next to you doesn’t come close to propagating useful information. However, if investors are irrational in herds then this implies that somehow their behaviour is synchronised and it’s certainly not clear that the simple set of isolated psychological biases that analysts currently work with is anywhere near sufficient to explain this.

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