The Truth About Markets

My cur­rent read, The Truth About Mar­kets/Cul­ture and Prosper­ity (UK/US title respect­ively), is a thor­oughly enjoyable—if occa­sion­ally dense and dry—introduction to eco­nom­ic the­or­ies and applic­a­tions. Pub­lished in 2003, it’s aged fairly well.

I felt the need to share this two-para­graph excerpt from a sec­tion dis­cuss­ing “large mod­els pur­portedly descript­ive of entire eco­nom­ic sys­tems” (pp. 193–194):

The error of principle—the reas­on these mod­els will nev­er be useful—is best exposed by Jorge Luis Borges’ story of map­makers who com­peted to build the best pos­sible map. They even­tu­ally under­stood that the most accur­ate map simply rep­lic­ated the world. The search for real­ism des­troyed the pur­pose of the map. A map is valu­able pre­cisely because it sim­pli­fies and omits. Eco­nom­ic mod­els are maps for the mar­ket eco­nomy. A map can be false but nev­er true. Our cri­terion for select­ing among maps that are not false is use­ful­ness, and a map can be too detailed or not detailed enough. We seek the simplest map adap­ted to our pur­pose, and it is a dif­fer­ent map if we are walk­ing or driv­ing: not bet­ter or worse, but more fit­ted for its use. The Lon­don Under­ground map is a bril­liant design for its pur­pose but use­less to ped­es­tri­ans. The ‘little stor­ies’, or eco­nom­ic mod­els, of this book are to be judged in the same way.

I once debated the rela­tion­ship between the social sci­ences with some anthro­po­lo­gists. We adjourned to the pub, and someone bought a round of drinks: the dis­cus­sion nat­ur­ally turned to the reas­ons why. For the eco­nom­ists, the explan­a­tion was obvi­ous: the prac­tice of buy­ing rounds min­im­ized trans­ac­tion costs, redu­cing the num­ber of exchanges between the pat­rons and the bar staff. The anthro­po­lo­gists saw it as an example of ritu­al gift exchange and described the many tribes that had developed sim­il­ar cus­toms. I pro­posed a test between the com­pet­ing hypo­theses: did you feel cheated or vic­tori­ous if you bought more rounds than had been bought for you? Unfor­tu­nately, the eco­nom­ists and the anthro­po­lo­gists gave dif­fer­ent answers to that ques­tion.

3 thoughts on “The Truth About Markets

  1. Pingback: TheTradingReport » Blog Archive » links for 2009-04-19

  2. Neil B ♪

    But the prob­lem with the eco­nom­ic mod­els is deep­er than that. The make *false* sim­pli­fy­ing assump­tions, such as that eco­nom­ic agents are fully informed and fully “ration­al.” Fur­ther­more, there is the idea that all are motiv­ated equally by self-interest and that SI is “good” per se – that without it, we wouldn’t have a pro­duct­ive eco­nomy. But that is a fal­la­cious mis­un­der­stand­ing of the actu­al prin­ciple behind mar­kets and the IH: that whatever SI there is will be best channeled into net pro­duc­tion for the good of all. But mak­ing best use of X giv­en as much as there is, is not logic­ally equi­val­ent to wheth­er X all by itself versus X + Y or even Y would be the best to have star­ted with. (Think about alloys in metal­lurgy.) IMHO, with less SI the agents waste less effort strug­gling and cheat­ing and pro­duce more and are hap­pi­er as well.

  3. Jussi H

    Actu­ally, the prob­lems are even worse than that. Mar­ket par­ti­cipant beha­vi­or can cre­ate feed­back pro­cesses that are non-lin­ear and com­pletely unpre­dict­able.

    For example: in the 00’s, Wall Street began using then-new Cred­it Default Swaps to assess and pre­dict the risk of bond and loan defaults through the so-called Gaus­si­an Cop­ula Function.Simply put, you expec­ted the prices of CDS pro­tec­tion to reflect the under­ly­ing risk; the high­er the price, the big­ger the risk.

    There were two prob­lems with this:

    1)Credit Default Swaps were fairly new, so you couldn’t tell from such a small his­tor­ic­al sample wheth­er they were liable to non-stand­ard devi­ations (see:AIG).

    2)If it made sense for the banks to assess risk by look­ing at CDS prices, it also had to make sense for CDS investors to assess their future returns by look­ing at bond prices. You could invert the Cop­ula! The res­ult, in the­ory at least, can be a per­fect feed­back loop: investors on the long side have con­fid­ence because of lack of con­fid­ence on the short side; investors on the short side have lack of con­fid­ence because the long side is con­fid­ent etc.

    Of course, in the long run, fun­da­ment­als have to cor­rect mar­ket irra­tion­al­ity. Unfor­tu­nately, what the pro­moters of Port­fo­lio the­ory, Gaus­si­an Cop­ula, “Wis­dom of the crowds” etc. don’t under­stand is that wide­spread adapt­a­tion of mar­ket-fol­low­ing tech­niques can rein­force exist­ing errors and irra­tion­al­it­ies.

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