Tag Archives: Chaos Theory

Darwinism and EU Economic Theory

The European Union is languishing in a perpetual economic autumn whilst bankers, with the connivance of politicians, apply rudimentary quack remedies such as Quantitative Easing in the vain hope that somehow they’ll skip a couple of seasons and as if by miracle, an economic  summer will materialise out of the murk.

Last year I wrote that modern global economics owes as much to Chaos Theory as it does to Keynes and has mutated beyond the competence of mere politicians. Economic evolution has overtaken the ability of those who traditionally administer the remedies when economic sickness hits.

The mechanisms which are needed to be put in place to even begin to have any effect on economies are so diverse and complex as to make present economic theory, especially that tainted by political dogma, almost redundant. The best that a politician and his advisers can do is to prod a small corner of the economic matrix in the hope that eventually a positive effect is somehow brought-about.

It is fair to say that politicians are no longer shapers of an economy but have now been diminished to mere observers.

The post-war years have seen such an incredible acceleration in all the factors which affect us – from technology to global financing, that it is only now becoming apparent that old solutions will NOT cure new problems. Sometime in the not-too-distant past, the “butterfly effect” became the wing-flap of the American Eagle – until the eagle itself became subject to bouts of economic coma .

Now it is probably the hot-breath of the Chinese dragon which will burn economies.

It has been universally established (even by China and Russia) that Capitalism is the way forward. However, it is no longer the gung-ho, asset-and-natural-resource-stripping capitalism of the past. A democratic and more ethically accountable flavour of capitalism is now needed.

For instance,  “business” ought to be an activity which strives to maximise market share and commercial efficiency, i.e  it should be inwardly-focused with profits as the essential by-product which is then used to  disseminate wealth.

What we currently have is a business model where the rationale  is primarily concerned with the maximisation of shareholder profits which concentrates wealth into  comparatively few hands. Hence the 21st century craze for moving money in order to generate money without the added old-fashioned complication of production. A virtual world generates virtual money with a virtual value.

“Ah!” you’re thinking. Socialist!! Nothing could be further from the truth.

Let’s keep it simple and look at the two extremes.

The Left (Socialism, Labour, U.S. Democrats, EU) dreams of public or community ownership and what you might call “forced distribution” which unfortunately needs to be underpinned by bureaucratic control and masses of public expenditure.

The Right (Conservatives, Republicans) dreams of privatisation. That has absolutely nothing to do with the individual. It is to do with corporate power.

So, at one extreme, we have unsustainable and forever expanding bureaucracy and on the other we have unacceptable (to the individual) accelerating corporate power.

Western political systems have now become nothing more than a tension between those two extremes. For instance, witness the “Punch and Judy” politics of America and the United Kingdom, as currently exemplified by the quality of the United Kingdom’s EU referendum debate and the  antagonistically offensive quality of the USA’s 2016 Presidential campaign.

Currently, there isn’t a better example of extreme corporate power than that exhibited by the banking system. A debt-fuelled crisis, which was accidentally engineered by the banking system ………aided and abetted by politicians  who continue to have absolutely NO idea how to deal with it, except by assuming that the problem has gone away.  They have adopted the “rabbit-staring -into-headlights” technique and have even been reduced to appealing to the bankers better nature, by inviting central banks into the economic driving seat!!

Paradoxically, the only people who will be able to clean-up the financial mess are financiers. Unfortunately, the type of financier that is needed is not the traditional self-serving, avaricious, unprincipled type which we have all come to love.

It is an as yet undiscovered species. The socially responsible financier who, with the assistance of the politician can generate new ideas which will, in turn, evolve into a NEW Capitalism which places the individual and not the corporation at its nucleus.

The financial crisis happened in spite of politics  and will eventually cure itself  in spite of politics. Chaos has its own mysterious mechanisms.

It is obvious though that the Darwinian aspects of world economics have outstripped the development of both our politicians and our economic theories.

…..and as China is demonstrating….it is the Survival of the Fittest…..and as the #EU is clearly demonstrating, the answers do not lie in organisational chaos, bureaucracy and huddling for political and economic warmth with people you wouldn’t normally invite into your home.

ECONOMIC CHAOS ?

The piece below is over 2000 words long and I have just completed it for a client .

It is about the random nature of an economic system.

Have you ever wondered why ALL economic predictions are wrong? Have you noticed that in spite of a proven record of error, economists and politicians continue to bang their heads against the forecast-wall and refuse to do anything else but continue to predict outcomes which by now, they must realise will be incorrect?

They certainly use all the latest computer models which have been empirically derived and used for many years.

So, are there any incorrect assumptions about “fundamentals”?

Is the economic process Stochastic (a sequence of random variables)? Or is it Deterministic (when the output of a system is totally dependent on its initial state and  subsequent inputs – and therefore, predictable)?

(Mind you, to add to the confusion, deterministic systems may occasionally produce random  and therefore unpredictable results. )

Is economics a question of Stochasticity v Determinism?

Why do I ask the question? Because there appears to be a total absence the ‘stable equilibrium’ predicted by classical economists.

On the contrary, Market Economics behaves like a collection of dynamically unstable systems. The instability is attributed to external ‘shocks’ rather that any fault in the basic concept. There is what can only be described as ‘non lineality’.

One solution to this ‘non-lineality’ is CHAOS THEORY!

So far, no real evidence has been produced of ‘low – dimensional’ Chaos in economic processes but there are definitely discrepancies between the ‘expected’ according to classic economic models and the ‘observed’. Just look at any economic prediction within your memory. It was probably incorrect.

We still have a ‘mechanistic’ view of the world and economics as a ‘hangover’ from 18th century SCIENCE.

Scientific thinking is very simple: ‘Measure, predict and adjust until you no longer have any more surprises. Then keep measuring to confirm that what you measured in the first place can be replicated’.

Economics was conceived on that same principle . It was established as a ‘science’. That’s where the Determinism crept in.

It was at this time that man first considered the possibility of his own intellect being so unconstrained that he would eventually understand the ‘Universe and everything’ through the medium of scientific reasoning.

This principle was applied to all sorts of activities and thinking – including economics.

The so-called ‘Enlightenment Policy’ would help man in his pursuit of happiness. Especially in the sciences. Science was cool and now in the early 21st Century it is enjoying a bit of a revival.

Of all the subjects on offer, Physics became the admired Paragon for Enlightenment and so it continues.

The way Physics works is simple: Carefully describe an environment and you should be able to predict the outcomes of any experiment conducted within that environment.

Likewise in Economics:  Know the initial environment and you should be able to predict outcomes based on subsequent inputs.

The belief stemming from that philosophy is that EVERYTHING is governed by ‘NATURAL LAWS’ which are a set of ‘cause-effect’ regularities. That means that everything can be predicted.

These same principles have been applied to Economics.

A simple scientific rule is that ‘The state of any system is a consequence of what it was in the preceding moment…..and so on.’

In the beginning, random occurrences had no place in such linear thinking. Everything was governed by Mathematics and Laws.

However, there is one major flaw in the way that we ‘do’ science: That is our ignorance of the CAUSES which generate phenomena and events.

For instance, we know the effects of gravity – which we can measure but we don’t really know the CAUSE.

However, in spite of our ignorance of the exact causes of events added to the imperfection of our analyses, we still cannot have 100% certainty about the vast majority of phenomena.

Economists also appear to have forgotten both the imperfection of analysis and their ignorance or (at best) of the exact CAUSES of events.

What is the solution? What is to be done about our comparative blindness?

Our ‘crutch’ is the science of probability. Chance.

Current economic thinking is a throwback. In economics, the world is still viewed as totally deterministic.

‘STOCHASTIC’ is non-existent – as is uncertainty because uncertainty is treated as ignorance or a failure to understand the deterministic rules of a very complex system.

Yet, with ALL our processing power, no-one has yet been able to establish those rules which should  predict outcomes.

So, as Chaucer wondered in The Nonnes Priest Tale – Travelling from A to B:  Freewill or Predestination?

Looking at the unpredictability of economic outcome, we move from linear to non-linear dynamics, from certainty to probability, from Economic Theory to Chaos Theory.

Theories of economics have been shaped by the assumption of ‘Rational Man’ who behaves in accordance with a known set of rules.

The evolution of economics into a science was ‘booted’ into becoming a science when it was ‘mathematicised’. Formulae arrived and suddenly, it became a bona fide branch of Applied Mathematics.

Many of the original people who translated economics into a mathematical form were physicists, engineers and mathematicians…… and it still shows. At that time, their view of the world was ‘linear’.

Does that work in economics? The short answer is ‘no’. That is why economists are struggling, interpreting and making excuses.

Marshall in his ‘PRICIPLES’ compared the study of economics to the study of tides. The number of variables affecting tides means it is impossible to create a consistent dynamic picture.

Even nowadays, there isn’t enough processing power to generate an accurate picture of such a dynamic system, especially as the number of variables affecting such a system is, for all intents and purposes – infinite.

Imagine random stones being thrown into the sea or small outcrops of rock or variations in the seabed. They all have an effect on the ‘shape’ and speed of the tide.

And so it is with an economic system: lots of rocks, stones and other variables.

It is not possible to formulate or predict a picture of such an infinitely dynamic system.

Currently, economic theory appears to predict that any shock to such a dynamic system will (obviously) have an effect on the system but that it will ultimately converge-to or seek either a new equilibrium or ‘tend’ towards its original equilibrium because, after all – that’s what ‘systems’ are supposed to do!

Economic Theory assumes a tendency towards stability and equilibrium with certain ‘oscillatory happenings’ on the way.

So we have a situation where economic thought was (and still is, in most cases) linear, deterministic and quasi-dynamic. That is to say, the ‘set-in-concrete’ notions of certainty, invariant economic laws and sameness……………..rather than approximation, probability and infinite variety.

For instance, the Bank of England  predicts an inflation rate one year ahead, based more on hope than fact or perceived fact. But when such predictions are (always!) wrong, there is no revisiting of the thought process, merely another prediction with little or no basis in anything-in-particular.

Often, both ‘inputs’ and predicted outcomes are decided by committee and vote!

All predictions appear to be based on an assumption of an ultimate convergence of economic process to stability, via those periodic cycles which, although not understood are treated with a certain sense of fatalism.

Chancellors are so locked into predictions based on erroneous facts that they will even massage their outcomes in order to land somewhere near the expected landing point – purely in order to retain credibility not only for themselves but also for ‘the system’.

What cannot possibly be countenanced are the random fluctuations of what is most likely a permanently unstable economic system. We don’t do that sort of thing because it may suggest a lack of control!

Let’s have a look at non-linear Economic Dynamics.

Actual (REAL) economic results indicate little resonance with the symmetry and regularity suggested by a linear mechanistic dynamic system. (Something that moves predictably along a pre-determined path).

On the contrary, fluctuations and movements are totally unpredictable. That means that regular Deterministic Laws cannot apply.

If we look at an economic situation in say, the Eurozone at a particular point in time, we may try to predict an outcome in say, 10 years’ time.

However, a small variant or an incorrect assumption in our analysis of the initial economic situation will have an effect on the ultimate outcome. The earlier that variation occurs, the more devastating will the effect be.

For instance Greece’s hidden debt at the time of its accession to the Eurozone, undetected at the time, is having a huge effect on the Eurozone’s economic outcome.

Meanwhile,  the economists, bankers and politicians crave and need the comfort of ‘stability’.  They know that the further the Eurozone travels from the initial conditions at Greece’s entry into the Euro, the more anomalies“The Greek Effect” will generate. It’s a self-amplifying issue.

Consequently, the bulk of the  work of Eurozone politicians is  now concentrated on creating a series of ‘faux’ stabilities.

It is the fallout from Stochasticity which is causing  fear with Determinism being their comfort and shelter.

It was only 60 years-or-so ago that stochastic considerations were appended to classical economic theory.

But the so-called New Classical Macroeconomics was no more than a compromise. “Let’s introduce a Factor X because we can no longer ignore it.”

Yet, the economists still needed their ‘models’ – because deep down they were still the mathematicians and physicists of old.

A formula was devised (SLUTSKY) which took the linear dynamic business cycle model and added random (not necessarily economic) terms which attempted to explain the real ‘actualités’!

At last, an attempt had been made to explain ‘exogenous shocks’ to an economic system by the introduction of nothing more than random error terms.

But  what was REALLY missing in classical economic reasoning was the concept of  NON-LINEARITY.

So, the battle was between a Linear Model with a Stochastic Term (a fiddle factor) versus a pure Non-Linear Model.

Obviously by now – 200 years from the beginning, we have to assume that the evidence for linearity in economics has been overestimated!

So, if we agree that we do need a new non-linear model of econonomics, what are we searching for? What are the other ingredients and how do we ‘work them in’?

Do we want a synthesis of economics, psychology, politics and sociology? Or do we simply stick to the notion of determinism?

Human evolution is viewed as a random process (although the way it is often expressed makes it seem as if scientists view it an ‘inevitable linear’).

The evolution of an economic system is also pretty random, except that, applying psychology, politics and sociology, it can never be a system that can develop naturally. (For example, Survival of the Economically Fittest).

Mind you, economists have already had several attempts at introducing the concept of non-linear economics.

Followers of Keynes developed theories which generated Real Business Cycle Theory but any exogenous shocks to the new non-linear system were considered as merely ad hoc disturbances.

Economists could NOT break away from LINEAR THINKING. Linear thinking was being applied in an attempt to imprison a loose and free system, which tended to CHAOS.

The result? More economic models that you can shake a stick at!

It is only fair to say that our understanding of economic phenomena has been greatly enhanced by all these models and formulae…… but still no cigar. No General Theory of Economics. No equivalent of E =mc2….+εe

So Chianella, Pun, Goodwin, Kaldor, Baldrin, Woodford, Barmal, Benhabib etc have all done their bit but we’re still NOT QUITE there.

Unfortunately, for all intents and purposes, many of the models did no more than introduce the concept of economic ‘white-noise’.

Chaotic systems generate their own randomness without need for external input. Therefore in a chaotic system, predictions can ONLY be very short term and even if there were deterministic rules within such a chaotic system, an inability or failure to 100% ‘book’ the initial conditions of the system will always yield forecasting errors.

This all suggests that economic forecasting (except that on a very short time-scale) is a nonsense. PLUS – the bigger the system, the bigger the CHAOS.

That would suggest that a proposal such as a EUROPEAN ECONOMY is a flawed concept because there is very likely to be an exponential amplification of Chaos.

The dynamic of a mega-economy is very different to a housewife balancing the books at home – although economists are still applying the same principles to both.

Unfortunately so far, classical economists continue to resist economic chaotic concepts.

The reason for this apparent intransigence is simple: it is very difficult to extract evidence of chaotic dynamics from economic data – especially on a meaningful scale. Especially if another dose of chaos is injected into the ‘mix’ by erroneous or spurious data.

In order to predict in a chaotic system a VAST (infinite) amount of data is required – far more than is normally available and so far, the search for Chaos in economics has not been successful.

Meanwhile it is Chaos which is making long-term economic forecasting totally impossible and increasingly sophisticated and precise measurement of ‘initial conditions’ incredibly difficult and potentially prohibitively costly.

If we imagine an economy to be like a cloud – subject to all those forces that clouds are subject to, we can  see the impossibility of a mathematical model which can predict the size, shape and exact direction of the cloud or even its shape and volume as it travels.

Its ultimate shape will always remain a mystery.

Politicians, bankers and economists ought to be able to say ‘I don’t know’ without us constantly expecting magic answers which do not exist.

For example: ‘Mr Chancellor or Mr Banker – what will be the effect on the economy of billions in Quantitative Easing?’ Correct answer? ‘We don’t know.’

“The initial conditions of a system are always uncertain, while Chaos guarantees that these uncertainties make prediction impossible.”  (Heisenberg)

THAT is the essence of Chaos within an Economics System.

Butterfly Economics

“There’s a lot we haven’t seen yet.”

Modern economics thinking should owe as much to Chaos Theory as it does to Keynes or Friedman. Can we therefore assume that the ongoing banking crisis could never have been predicted?

If it could have been predicted – who is to blame? Politicians, Accountants, Economists, Bankers?

The only thing that most of us know of Chaos Theory is the so-called “Butterfly Effect” and that does indeed lie at the very centre of Chaos Theory. If a system is sensitive to a slight variation in its initial condition then its ultimate outcome is said to be unpredictable. That is why weather forecasting is so difficult because, for instance, small variations in air currents (e.g the flap of a butterfly’s wing) may ultimately produce weather effects which are totally unpredictable.

We can therefore assume that weather is unpredictable, no matter how much data is accumulated in the weather forecaster’s computer.

So what about the Stock Exchange? Can we apply the same Chaos principles to the behaviour of investments? After all, pundits are constantly predicting trends. Experts are lining up to tell us that they’re feeling optimistic. There are thousands of analysts who have the benefit of all known facts. They predict yet they are often wrong.

If you have all  the facts and they are the  right facts, you should be able to predict or extrapolate pretty accurately. The sad fact is that there is absolutely no way that you can ever have perfect knowledge of the future. That must mean that future stock market prices or the future patterns of stock market values are random and accidental because every known fact has already been incorporated into the prediction.  Unknown, invisible and  random events are constantly influencing the movement of share and commodity prices. Some may be as seemingly insignificant as a secretary resigning  whilst others may be a crooked trader confusing his clients’ money with his own.

The other “fly in the ointment” is the fact that all events are ultimately interconnected and everything that we do is permeated by cause and effect.

Lew Ranieri was a college dropout and decided that he wanted to be a chef. Unfortunately his asthma meant that he had to find himself a new job because it was possible that the smoky kitchen atmosphere would eventually kill him. Soon he was working part-time in Salomon Brothers’ post room. Butterfly Effect? Ranieri went on to invent Mortgage -Backed Securities (MBS) and became Vice Chairman of Salomon Brothers. It was 1982 when Ranieri had the idea of MBS and it was the market in mutated Mortgage-Backed Securities which was at the core of the bank meltdown of 2008.

Lew Ranieri developed the concept of loan securitisation with John Meriwether, one of his Salomon Brothers contemporaries.

John Merriwether has recently closed his hedge-fund,  JWM Partners after losing 44% of its value between September 2007 and February 2009. His previous venture,  Long-Term Capital Management collapsed, he had to accept a $3.6 billion bailout from U.S. banks and caused the 1998 global financial crisis.

So here we have two experts who between them can be said to be most-directly responsible for the current financial chaos, yet they themselves have been influenced by events which were totally out of their control – so we cannot really blame them. So who is responsible?

The economists need equations to predict and they are still using the wrong equations and asking the wrong questions. Should the accountants have seen it coming? Maybe, but if you’d spent four years in a darkened room reciting “Every debit has a credit” in order to achieve a qualification, you may be excused for sometimes not being able to distinguish between a debit and a credit – especially if they’re practically indistinguishable.

That leaves the politicians and the bankers. Can we blame them? No, but only in so far as they really  had no idea or concept of what was happening.

There is a saying: ” There are those who make things happen” (The Traders). “There are those who watch things happen” (Economists and Accountants)  and “There are those who wonder what happened.”  (Politicians and Bankers).

The only comfort is that they were all doing no more than what was expected of them.

Now you understand why we are constantly hearing “hoping” and “probably” but when you are predicting the most “likely” scenario, your own political and economic views tend to creep into the mix.

While Mr Subjectivity rears his ugly head and hopes that it will all be good, Mr Chaos Theory sits on your shoulder and whispers that it is just as likely to be bad.