Could Macro-Economics Use a Linear Audit Trail?

Paul Krugman's essay in the NY Times, already referenced in my earlier posting today, has attracted quite a lot of commentary including an interesting piece by John Lounsbury which is available here.

John Lounsbury cites research work done by Dirk J. Bezemer at Groningen University which, it is claimed, may contain the seeds of a new paradigm for macro-economists. Bezemer's flow of cash model which is sketched out in Lounsbury's piece just might, it is alleged, enable macro-economists to be less inept at understanding and anticipating large moves in markets, asset valuations and business confidence. Indeed it is the highlighting of their current incompetence which is the essence of Krugman's piece.

Lounsbury summarizes the possible contribution that Bezemer's flow of cash approach could make as follows:

Bezemer pointed out that the critical elements of human behavior and confidence are not reflected in macro economic equilibrium models. In other words, there were no factors for herd mentality, or booms, busts and panics. He did find that they (the behavioral factors) are amenable to modeling in a flow-of-cash model. He did not propose that macro models be discarded; he felt they should be supplemented and expanded to include flow-of-cash factors. Bezemer proposed that principles of accounting, the tool of finance, be folded into the static macro economic models.

It is hard to disagree with the first two sentences but my suspicion is that it is not the equilibrium assumptions of neo-classical economic economic theory per se that are the root cause of that theory's failures to account for the modern economy's proneness to accidents. It is not even the fact that we do not have a complete audit trail to follow as seems to be implied in the flow of cash modeling assumptions and which Lounsbury alludes to with the next observation:

"If one can see all the states of motion from one position to the next, the true function of the subject can be understood. The quality of motion is fundamentally related to effectiveness of function."

The real problem is that even an all encompassing audit trail would suffer from the same intellectual problems which currently haunt the overly mathematical approach that most macro-economists have taken. In my estimation there is no underlying linear logic to the motion or trajectory of asset prices. The same gestalt switches which can allow us to see a glass as half full at one moment and half empty an instant later are at the basis of the indeterminacy of any valuation exercises and that is why, to put it rather simply, we get bubbles and recessions. There are no continuous functions for mathematicians or accountants to understand and/or track. Price gaps on charts and liquidity meltdowns and crashes only highlight and underline the fundamental "discontinuities" in the way that investors perceive the financial world especially during critical episodes.

I would suggest that there are essentially non-linear dynamics at work where tipping points and critical contagion episodes are inherently part of the fabric of economic life and this is what constitutes the "irrationality" of markets. More precisely it constitutes the non-quantifiabilty of some of the key assumptions of macro-economists such as overall market liquidity and the magnitude of the "animal spirits"(surely it was the lack of any measurable quality that Keynes was driving at in using such terminology).

For me Krugman's observation about the lack of liquidity in the baby sitting coop was quite illuminating and, to take as benign a view as one can about current shenanigans with High Frequency Trading, this may well be the real requirement for financial policy-makers i.e. how to promote liquidity in a market place where collective trust and unfettered collateral have been exhausted.

Comments

[Moon Kil Woong:]

I think you hit it on the head with this statement, "Trading, this may well be the real requirement for financial policy-makers i.e. how to promote liquidity in a market place where collective trust and unfettered collateral have been exhausted."

It is my contention, although I am just another voice in the crowd, that what caused the final meltdown in the great depression and is treatening here, is not the collapse but the persistent government intervention without and fundamental sign of recovery. A long term downturn is much worse than a short one no matter how severe it is.

It saps both hope and government intervention leads to market distortions and worse yet the feeling, arbitrainess, inefficiency, and an unfair other people are getting something at the cost of your demise (which they usually are). This is the cement that sets the stage of complete lack of faith in the capitalist system; both monetarily and politically.

In the Great Depression the government did try to support the economy until people got fed up and said no more. And in the Great Depression all that support failed. We can learn a lot by comparing today with the past. Comparatives wit the great depression are extremely valuable if it is not just line charts about the stock market collapse or liquidity, etc. The fundamentals of that one and what we see today are similar: A government with decreasing credibility. A government trying to spend their way out of the recession with short term solutions that make no long term fiscal sense thus becoming more and more strapped when they realy need it (when the economy gets stuck in a rut and needs real Keynsian stimulus). Little faith we will recover anytime soon. A lingering collapse in real income. Countries that recover who clearly are taking protectionist means to export their weakness (leading to eeryone sooner or later mirroring them). And a lack of faith and trust in their currency (When that happens it all melts down. During the great Depression it was when countries found out they were writing money backed by gold without the gold).

The jury is still out as to whether or not this downturn gets worse. It will not be based on government spending but by the extent that people loose faith and hope in the economy, the political system, our monetary system, and our government and business leaders.

When people say its a confidence issue, in reality it's a trust issue. Measuring it on that scale the US has been making one big mistake after another.

We need to restore trust in our stock market by regulating HFT, dark pools, CDS and other deivatives, etc. Instead, making rules to hide bank losses, not disclose HFT positions, and let brokerage/banks off the hook only lowers trust even further. We need to restore trust in our currency by reining in deficit spending and the QE needed since we can't get enough buyers to buy our bonds at the low rates we have today. We need to let bad banks fail and withdraw support of quasi government institutions. We need to prevent the Federal Reserve from keeping interest rates at zirp or low rates in upturns and constantly flooding the market with destabilizing money flows (QE and backstops today since they already had employed every other method already). We need to prosecute those who lied to their shareholders and squandered bank assets illegally.

Sure such laws, rules, enfocement, will hurt the market. But much less than lingering downturns and a loss in the trust and honesty of what remains of our capitalist economy. Anyway, thanks for listening.

Sep 07 01:25 AM

[Ink:]

I think moon is onto something. From a psychological aspect what the government is doing is counterproductive if not destructive to the psyche of the average American. It certainly is for me. Regardless of economics, when corruption, lies, unjust, and unfair actions abound controlled by crooks I would say we are digging a bigger grave not diggiong ourselves out of one.

My great grandparent had the same feeling. They buried boxes of gold and cash on their land and didn't trust anyone. How far will this bout of bad behavior take us?

Sep 07 08:41 AM

[John Lounsbury:]

Clive - - -

Thanks for expanding the discussion. Excellent job. At the risk of oversimplification of your arguments, I will attempt a summary:

It is not the flow that disrupts finance and economies, it is the discontinuities.

Sep 07 03:36 PM

[Clive Corcoran:]

Moon,

Your comments are very much in line with my own thinking about stressing the breakdown of trust as the most worrying aspect of the current financial system.

The current malaise is more than just a loss of "animal spirits" it is a disillusionment with a lot of the cultural mythology surrounding our notions of prosperity and a growing disrespect for institutions and political leadership. Real confidence and collective trust will take a very long time to rebuild and the real challenge is for markets to allocate capital to socially useful purposes which generate sustainable income sources for a much wider section of the population. At present most capital seems to be seeking out income transfer opportunities based on different forms of market timing.

A laissez-faire system is far preferable to a command economy but the development of predatory behavior when markets are left completely unregulated is a major contributor to the kinds of unstable dynamics of boom and bust that are scattered across our economic history. Governments often have only made the situations worst on occasion by bad policy and unwillingness to address the fundamental causes of economic crises.

In providing a publicly funded back-stop to systemic risk mismanagement last fall it could be argued that central bankers were averting a situation what could have lead to economic chaos, but the tragic irony is that instead of rescuing the prey it appears, for now at least, that we have only reinvigorated the predators.

Sep 07 04:54 PM

[Clive Corcoran:]

John

You have exemplified the notion that brevity is the application of economics to expression.

Sep 07 04:58 PM

[derryl:]

I agree with Clive that it is the non-linear dynamics of economies and the unquantifiability of human factors that makes reliable economic prediction, essentially, impossible. As John commented, it is not the cash flows but the discontinuities in cash flows that cannot be predicted.

How often have we seen ducks or monkeys beat analysts in picking stocks? Market movements might as well be considered "random" in this environment where it is impossible to quantify the factors that lead to swings, which makes timing those factors equally impossible. Even if everyone agrees the market must come down, it can still double and triple before the downturn actually happens. Nobody knows the future because the future in not a linear function of the past.

In "Blink" Malcolm Gladwell explains why it is so often the case that our first impression or intuition is often more accurate than a carefully analyzed conclusion. Our neurons possess a massive amount of information that we are not aware that we have, and 'intuition' is just the sum total of what our neurons are adding to our overall impression. When we analyze we pick and choose factors that we are consciously aware of, and we weight them according to whatever scales we think apply to the situation, and we reach conclusions based on this highly selective bit of reasoning, always biased by our experiences of the recent past. Our intuition is a more "holistic" snapshot of our knowledge, though of course that doesn't mean it will be right either.

Awhile back on SA we were discussing the fact that nobody, including economists, can predict the future. The future is uncertain so the lesson should be to tread carefully because you never now what's around the next corner. I think the mistake we make is related to Minsky's observation that stability causes instability.

Things are flowing smoothly and quite predictably (i.e. linearly) so we start to take excessive risks based on the assumption that this benevolent trend line will continue. The precision of mathematical econometrics (e.g. we will have 2.3% GDP growth next year and 3.1% growth the following year) also lulls us into the belief that somebody knows what the future holds. Then the trend line suddenly reverses and all but a few lucky or intuitive investors are caught with our butts in the breeze.

I have argued that most economists are the humble variety who are good at figuring out and explaining why things happened in the past but who recognize the folly of trying to predict the future. As I recalled during that discussion, in the early 70s the favorite answer of my Econ 101/102 prof was, "It all depends." She knew that she was incapable of accurately weighting all the various factors that might come to play in any real world situation so rather than make hard predictions she would lay out possible if-then scenarios.

Of course humble economists do not make for exciting TV viewing, and a series of if-then statements does not strongly support a preferred government policy choice, so we only hear from the bold predictors who pretend they are 'certain'. Maybe the error is not so much in economics, but in the credibility and faith we give these bold predictors.

Sep 07 09:48 PM

[John Lounsbury:]

derryl - - -

In the past month or two (I may even have put on my Insta blog), someone had a graph comparing the actual course of GDP over time (up and down a lot) and the two year in advance concensus predictions of economists (a slightly wavy line ranging between 2 and 3%).

Predicting the future is very easy except for telling what will happen.

Sep 07 10:17 PM