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 Comments
[…] Lloyd Morgan: The Truth About Markets […]
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.
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.