Musings Report #9 3-2-13 Why Isn't There a Demonstrably Correct Economic Theory?
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Why Isn't There a Demonstrably Correct Economic Theory?
Correspondent C.G.D. recently asked what I consider a very profound question: why isn't there a demonstrably correct economic theory?
"My wife has asked me a 'simple' question that I can not answer. After 2000 years, why do we not know which economic theory is correct: Keynesian or Hayek-Friedman? Surely, there is a demonstrably, statistically correct answer."
Let's add Marxism to the short list of contenders, and then consider why we have cargo-cult faiths (Keynesianism) instead of demonstrably correct models of economic behavior.
Many others have noted the obvious, that economics is a pseudo-science rather than a real science: beneath the fancy quantification and math, economics is fundamentally the study of human behavior, and that complex mix of dynamics cannot be reduced to a tidy model that spits out accurate predictions.
One key element of science is that the results must be reproduceable, that is, the same experiment/conditions should yield the same results time and again. I suspect that economic models are not applicable across all times and situations; a model might "work" in one era and in a very specific set of circumstances, but fail in another era or in a similar set of circumstances.
Since human behavior is based in culture as well as in naturally selected (genetically driven) behavior, then cultural milieus and values obviously play critical roles in shaping economic behaviors. So presenting an economic model as "scientific" and quantifiable is in effect claiming that the bubbling stew of human culture can be reduced to quantifiable models that will yield predictions that are accurate in the real world. This is clearly false, as culture is not a static set of objects, it is a constantly shifting interplay of feedback loops.
This helps explain why human behavior is so unpredictable. Virtually no one successfully predicted World War I in 1909, and no one predicted the collapse of the U.S.S.R. in 1985. If we cannot predict mass behavior a mere five years ahead, is it plausible to claim economic models will "work" as expected?
Another reason all economic theories fail as scientifically verifiable models is that economics boils down to a very simple dynamic: those in power issue financial claims on resources as a "shortcut" way of gaining control of the resources without actually having to produce or earn wealth via labor and innovation. I think this is the one fundamental dynamic of economics, and it does not lend itself to reductionist models.
We can understand this dynamic by stripping down the process of expropriation to its basics.
In the bad old days of rampaging hordes and empires, those in power simply took what resources and wealth they wanted after defeating the defending army: gold, women, wine, jewels, etc. were simply grabbed by the conquerors and hauled off.
The advent of finance enabled new and less overt forms of expropriation.
Let's say that two traders enter a great trading fair seeking to buy goods to sell elsewhere for a fat profit. That is, after all, the purpose of the fair: to enable buyers and sellers to mutually profit.
One trader uses the time-honored method of letters of credit: he buys and sells during the fair by exchanging letters of credit which are settled at the end of the fair via payment of balances due with gold or silver.
Ultimately, the trader's purchases are limited by the amount of silver/gold (i.e. real money) he possesses.
Trader #2 has access to leveraged credit, meaning that he has borrowed 100 units of gold with a mere 10 units of gold as collateral and the promise of paying interest on the borrowed 90 units.
This trader can buy 10 times more goods than Trader #1, and thus reap 10 times more profit. After paying 10% in interest, Trader #2 reaps 9 times more profit based on the credit-based expansion of his claim on resources.
The issuance of paper money is an even more astonishing shortcut claim on real-world resources. Trader #3 brings a printing press to the fair and prints off "money" which is a claim on resources. The paper is intrinsically worthless, but if sellers at the fair accept its claimed value, then they exchange real resources for this paper claim of value.
Needless to say, those with access to leveraged credit and the issuance of fiat money have the power to make claims on resources without actually having produced anything of value or earned tangible forms of wealth. Those with political power and wealth naturally have monopolies on the issuance of credit and paper money, as these enable the acquisition of real wealth without actually having to produce or earn the wealth.
This system is instrinsically unstable, as the financial claims of credit and fiat money on limited real-world resources and wealth eventually far exceed real-world resources, and the system of claims collapses in a heap. Though this end-state can easily be predicted, the actual moment of collapse is not predictable, as those holding power have a vast menu of ways to mask their expropriation and keep the game going.
Market Musings
It was a volatile week. After the sharp decline in stocks on Monday, the NYMO (spike down) and VIX (spike up) were signalling a short-term bottom, so I bought calls on the SPX and exited that position the following day for a modest profit. Gold and the miners rallied during the brief "risk-off" period but subsequently the miners hit new multi-year lows on Friday. My calls on natural gas did well and I exited for a 70% gain.
When any sector drops by as much as the gold miners have over a short time, I start looking for a contrarian position. Is the cause of the decline sentiment or fundamentals? Judging by the ratio of gold to the price of miners, it appears to be mostly sentiment, as this ratio has reached multi-year extremes. In other words, the disconnect between the price of gold and the valuation of gold miners has widened to extremes.
Over the years I've noticed that few declines last longer than five months. Gold and the miners have declined sharply for 5 months. I don't know whether gold is heading to $2,000/ounce or $1,000/ounce, but I do expect some sort of countertrend rally here, or a reversal of trend. There are multiple gaps in GDXJ, the junior miners ETF, for example, that basic technical analysis suggest will get filled. The fact that conventional analysts see the charts as very bearish is interesting to me, because right now almost everyone is on one side of the boat here, and that is rarely the profitable trade for long. Many are expecting further declines in March because historically it has been a poor month for gold. They may be right, or alternatively, everyone has shorted gold and is expecting an "easy" profit from this seasonal trade. Trades with everyone on one side tend to capsize and all those counting on "easy profits" have their heads handed to them on a platter.
Put another way: what everyone already knows has zero value in the market.
Although gold may well decline as deflation kicks in, there is always another force at work, which is "safe haven" buying as people lose faith/trust in financial assets. I have no idea which force will dominate, but it's a good idea to remember inflation/deflation is not the only dynamic in play.
What I am doing: building long positions in junior gold miners, in cash looking to re-enter the short trade on SPX.
What I would do if I were managing $1 billion: closed out the short position on SPX for a gain, continue building positions in JO (coffee), sugar and gold miners.
From Left Field
About that law degree: BigLaw Growth is Dead: Here's What's Next--big law firms are scrambling as billings decline. Yet another "sure-thing" career bites the dust....
A Robot Didn’t Steal Your Job: a contrarian view of robotics. My sense is the writer has never hired or managed a single employee or started a business....
The Arcane Rules That Keep Low-Income Kids Out of College: The labyrinth surrounding scholarships and admissions doesn't account for the messy realities of poor families' lives.
Study finds unsafe mercury levels in 84 percent of all fish sold in the U.S.: (via Maoxian) note that Americans mostly consume predator fish that are very high up the food chain: tuna, salmon, etc. Fish that eat plants rather than other fish (i.e. at the bottom of the food chain) have correspondingly less mercury. In other words, sardines rather than tuna....
Thanks for reading--
charles
