Sunday, December 5, 2010

Post Crisis: 3 Mavericks With New Ideas--Part II

As promised, here are the ideas of the 3 brave men attempting to wrestle with the post-crash economy.

Cast of Character: Physicist Doyne Farmer, who thinks we should analyze the economy like we do the weather and epidemics.
Psychoanalyst David Tuckett: The key to market gyrations is found in Freud (monsters from the id?)
Economist Roman Frydman thinks we can never forecast the economy with any accuracy.

Farmer doesn't see people as rational actors, and he definitely doesn't believe current models take into account (how did he put it?) "large chunks of reality." His solution is to create a more complex simulation of the economy like those used to model weather patterns, epidemics and traffic.

Of course, as we all know (those lovable weather people!) there's a large amount of failure built into those models as well. That doesn't make them unsuccessful. Look at baseball. To be a pro you only have to hit 3 times out of 10. Farmer's model would include actors who don't have to agree with one another and who don't act in predetermined ways.

Tuckett seeks to look inside the mind for answers. When I was a tot there was one thing I took to heart: the market is driven by greed and fear. That's plainly illustrated by the attitude toward credit pre- and post- housing crash. Before the crash, mortgage brokers gave money to anyone with a pulse. Afterwards, the money men pulled in their tents, cut credit lines to viable small businesses and in general acted like miserly, prudent schoolmarms.

Tuckett's research led him to believe that some financial instruments (credit default swaps?) "are so volatile and hard to value, they trigger humans' tendency to fantasize." In fantasy mode people will pay anything to acquire the magical powers they themselves have bestowed upon the object (Dutch tulips, potatoes that look like Richard Nixon)--also known in psychological circles as "projection". When the object loses value, people focus on its flaws.

Frydman, the economist, went his own way, butting heads against the idea that all buyers will act in the same way. As discussed in previous post, such logic makes for gorgeous, icy, inexorable mathematics, but it can also be severely misleading.

"Capitalism works better than other systems because it lets people disagree about the future and profit from their insghts. This is rational behavior that the models don't accommodate."

Perhaps the best thing is to recognize the limits of our knowledge. Even if we know a crash is coming, as people like Nouriel Roubini tried to warn, we don't know exactly when it will happen.

Frydman thinks the Central bank can play a huge role in signaling when asset classes like stocks, bonds (what's the par value on that thing?) or houses are getting overheated. No encouragement of irrational exuberance or promotion of adjustable rate mortgages, as previous Central bankers espoused. The idea is to warn buyers about risk so they can factor it into their decisions, thus not only arming the individual but help to prevent systemic failure.

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