Tuesday, October 7, 2008

Bullshit And The End of Economics (as we know it)

The slow tottering collapse of the global credit dominoes is so completely similar to the slow motion destruction of wealth that occurred between 1929 and 1932 that it leaves one awestruck at the scale and complexity of the problem now confronting our world.

For this is not merely a bear market or a correction. This is a full fledged 1929-scale disaster, which will send high speed ripples through the monetary ether to rear tsunami-like when they eventually reach retail level. This is the "uh-oh" moment. And in a few years we will wonder how we managed to crawl out from under the wreckage.

But what is interesting about this disaster is that, like the one that preceded it, will, inevitably raise serious questions about the intellectual underpinning of academic economics. In theory this crunch should not really be happening, and the vortex of fear uncertainty and doubt that is sucking down world markets should reach a rational limit before it turns into a giant whirlpool that sucks everyone under. The problem is the theories are wrong. The Lemmings are in charge and Rationality's goose has been thoroughly cooked.

The most respectable theory of the Depression by Friedman and Shwarz increasingly dispensed with the detail of the 1929 meltdown in an effort to refine a model to explain this historical catastrophe in one simple variable: money supply. Money supply contracted so there was a Depression. The somewhat fawning apology of Ben Bernake to the (now) late Milton Friedman in agreement that the latter was correct in his assessment that the Federal Reserve policy was the source of all Depression era ills should, I think come back to haunt the Federal Reserve Chairman. For the obvious rejoinder is that money supply contracted because there was a Depression not the other way round. And it is one thing for Bernake to read about theoretical monsters in books but another thing to meet them up close and personally and what these academics have lost in their analysis is the scent of fear and the sheer awe that a financial whirlpool of this size engenders.

When one reads the views of working economists who witnessed the Depression first hand it is precisely this experience of events spinning out of anyone's ability to predict or control them which makes the biggest impression. The Federal Reserve Board's of both the United States and New York (the biggest market) were simply overwhelmed by the scale of events. And yes they did (New York more slowly than the Fed) cut discount rates down to 2% but it made no impression as markets entered a terminal vicious cycle. The panic of those in the market was simply faster than the ability of regulators to respond.

One also realises that the biggest name of the era - John Maynard Keynes - was essentially nothing more than a strutting columnist with no power and a very acid pen. His famous remedy to unemployment was essentially a PC version of a war economy which didn't happen anywhere. In fact all the nations which did recover from the Depression quickly (eg Japan, USSR,Norway or Sweden) were either directly (Japan, USSR), or indirectly (via Nazi rearmament) profiting from increased militarism. Those that took up Keynes suggestion didn't really recover until World War Two when they were forced to re-arm.

The simple - and perhaps banal - explanation for both the 1929 and the 1987 and the 1998, and the 2008 crises is non-performing loans. In 1929 it was leveraged buy-outs and Florida real-estate. In 1987 it was leveraged buyouts again. In 1998 it was Asian cronyism, and in 2008 it was dodgy mortgages. People have leant others money at rates which are in excess of the borrowers rate of return or ability to pay. This is obviously irrational but what is fascinating is not only that it keeps happening but that we apparently refuse to learn from it. And the problem it seems to me is that economics does not seem to be able to account for bullshit.

Bullshit is the difference between a rational decision and an irrational one. The interesting thing however is that the difference only appears to be relative. That is because we all live lives which incorporate some degree of bullshit (Hands up if you ever bought a designer anything). And when the bullshit mounts up and one is bobbing around in it ( as anyone who bought a house in this country in the past ten years will probably be suspecting at the moment) it becomes very difficult to know the difference between extreme bullshit and just ordinary background bullshit.

I must confess I have a great deal of sympathy for George Soros's on-going struggle to be taken seriously by academic economists. Soros's theory of reflexivity is considered beneath academic contempt because it is not expressed mathematically. However what it does do is account - and account most profitably - for bullshit. Soros's technique is essentially to estimate the latent capacity for bullshit in any market on the way up and the residual levels of bullshit on the way down. He then buys long or short as required, pocketing the difference both ways.

Its a technique that requires his very Hungarian capacity for paranoia, self analysis and honesty. As he says, he is always looking for the flaw, in any system and is only happy when he has found one, because - well because then he has found the bullshit.

And Soros's point, and I think this is his most important one, is that nobody: not market participants, not regulators, not politicians, nor yet academic economists is immune from bullshit. As such he has recently been savagely criticising regulators (and indirectly academics) for buying into the market's bullshit that there was no need for regulations to contain the level of debt and debt hedging risk because the unfettered market will always have a solution to any crisis.

Well I suppose running screaming to taxpayers is a form of solution. It's just not the one they seemed to be talking about when they were bullshitting everyone.

There are still a huge number of issues that this disaster will put into play. The biggest is the question of the future status of the US dollar and whether military hegemony still indeed translates to ownership of the currency of last resort. Over the next few decades I have no doubt that this post-War convention will be replaced with some entirely new monetary convention.

But a more important question will be whether - now that bullshit has so clearly been found to be the foundations of the monetary temple - economics will begin a process of creative destruction on itself and start to incorporate more appreciation of the distorting effects of bullshit on not just prices, but markets themselves.

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