The Future of Everything

October 31, 2017

Why economists can’t predict the future

Filed under: Economics, Forecasting — David @ 12:11 pm

NewsweekJapanCover

Cover article in Newsweek Japan on why economists can’t predict the future. Read an extract in Japanese here.

 

Original English version:

 

The quantum physicist Niels Bohr is attributed with the saying that “prediction is hard, especially about the future.” Still, economists seem to have more trouble than most.

For example, mainstream economists uniformly failed to predict the global financial crisis that began in 2007. In fact, that was the case even during the crisis: a study by IMF economists showed the consensus of forecasters in 2008 was that not one of 77 countries considered would be in recession the next year (49 of them were).[1] That is like a weather forecaster saying the storm that is raging outside their window isn’t actually a storm.

In 2014, Haruhiko Kuroda, Governor of the Bank of Japan, predicted that inflation should “reach around the price stability target of 2 percent toward the end of fiscal 2014 through fiscal 2015.”[2] It apparently didn’t get the memo, preferring to remain well under one percent.[3] In Britain, economists confidently predicted that Brexit would cause an immediate economic disaster, which similarly failed to materialise.

This forecasting miss prompted the Bank of England’s Andrew Haldane to call for economics to become more like modern weather forecasting, which has a somewhat better track record at prognostication.[4] So can economists learn from weather forecasters – or is predicting the economy even harder than predicting the weather?

In many respects the comparison with meteorology seems apt, as the two fields have much in common. “Like weather forecasters,” said former Chairman of the US Federal Reserve Ben Bernanke in 2009, “economic forecasters must deal with a system that is extraordinarily complex … and about which our data and understanding will always be imperfect.”[5] The two fields also take a similar mechanistic approach to making predictions – with a few important differences.

Weather models work by dividing the atmosphere up into a 3D grid, and applying Newtonian laws of motion to track its flow. The mathematical models are complicated by things like the formation and dissipation of clouds, which are complex phenomena that can only be approximated by equations. The fact that clouds, and water vapour in general, are one of the most important features of the weather is the main reason weather prediction is so difficult (not the butterfly effect).[6]

Economic models similarly divide the economy into groups or sectors that are modelled with representative consumers and producers, whose homogeneous behaviour is simulated using economic “laws” such as supply and demand. However, unlike the weather which obviously moves around, these “laws” are assumed to drive prices to a stable equilibrium – despite the fact that the word “equilibrium” is hardly what comes to mind when discussing financial storms.

Furthermore, the economy is viewed as a giant barter system, so things like money and debt play no major role – but the global financial crisis was driven by exactly these things. One reason central banks couldn’t predict the 2007 banking crisis was because their model didn’t include banks. And when models do incorporate the effects of money, it is only in the form of “financial frictions” which as the name suggests are minor tweaks that do little to affect the results, and fail to properly reflect the entangled nature of the highly-connected global financial system, where a crisis in one area can propagate instantly across the world.

Predicting the economy using these tools is therefore rather like trying to predict the weather while leaving out water. This omission will seem bizarre to most non-economists, but it makes more sense when we take the subject’s history into account.

Adam Smith, who is usually considered the founding father of economics, assumed that the “invisible hand” of the markets would drive prices of goods or services to reflect their “real intrinsic value” so money was just a distraction.[7] As John Stuart Mill wrote in his 1848 Principles of Political Economy, “There cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money.”[8] According to Paul Samuelson’s “bible” textbook Economics, “if we strip exchange down to its barest essentials and peel off the obscuring layer of money, we find that trade between individuals and nations largely boils down to barter.”[9]

In the 1950s, economists showed – in what is sometimes called the “invisible hand theorem” – that such a barter economy would reach an optimal equilibrium, subject of course to numerous conditions. In the 1960s, efficient market theory argued that financial markets were instantaneously self-correcting equilibrium systems. The theory was used to develop methods for pricing options (contracts to buy or sell assets at a fixed price in the future) which led to an explosion in the use of these and other financial derivatives.

Today, economists use so-called macroeconomic models, which are the equivalent of weather models, to compute the global economic weather, while continuing to ignore or downplay money, debt, and financial derivatives. Given that the quantitative finance expert Paul Wilmott estimated the notional value of all the financial derivatives in 2010 at $1.2 quadrillion (so $1,200,000,000,000,000) this seems a bit of an oversight – especially since it was exactly these derivatives which were at the heart of the crisis (see our book The Money Formula).[10]

Now again, it may seem strange that economists think they can reliably model the whole economy while leaving out such a large amount of it – but it gets stranger. Because according to theory, not only is money not important, but much of it shouldn’t even exist.

Perhaps the most basic thing about money in a modern capitalist economy is that nearly all of it is produced by private banks, when they make loans. For example, when a bank gives you a mortgage, it doesn’t scrape the money together from deposits – it just makes up brand new funds, which get added to the money supply. But you wouldn’t know this from a training in mainstream economics, which treats the financial sector as little more than an intermediary; or until recently from central banks.

According to economist Richard Werner – who first came up with the idea of quantitative easing for Japan in the 1990s – “The topic of bank credit creation has been a virtual taboo for the thousands of researchers of the world’s central banks during the past half century.”[11] The first to break this taboo was the Bank of England, which created a considerable stir in the financial press in 2014 when it explained that most of the money in circulation – some 97% in the UK – is created by private banks in this way.[12] In 2017 the German Bundesbank agreed that “this refutes a popular misconception that banks act simply as intermediaries at the time of lending – ie that banks can only grant credit using funds placed with them previously as deposits by other customers.”[13]

This money creation process is highly dynamic, because it tends to ramp up during boom times and collapse during recessions, and works “instantaneously and discontinuously” as a Bank of England paper notes (their emphasis), which makes it difficult to incorporate in models.[14] The money thus created often goes into real estate or other speculative investments, so may not show up as inflation. And as Vítor Constâncio of the European Central Bank told his audience in a 2017 speech, its omission helped explain why economists failed to predict the crisis: “In the prevalent macro models, the financial sector was absent, considered to have a remote effect on the real economic activity … This ignored the fact that banks create money by extending credit ex nihilo within the limits of their capital ratio.”[15]

So to summarise, ten years after the crisis, central banks are finally admitting that the reason they didn’t predict it was because their models did not include how money is created or used. This is like a weather forecaster admitting a decade after the storm of the century that they couldn’t have predicted it, even in principle, because they had left out all the wet stuff.

Central bankers are also increasingly admitting that they have no satisfactory model of inflation – but that is obvious, because they have no satisfactory model of money.[16] Their policy of near-zero interest rates has created, not the expected inflation, but only asset bubbles and a destabilising global explosion in private sector debt.

How could we have reached this point? One reason, paradoxically, is that economists are all too familiar with the financial sector (who are happy to be kept out of the picture), not through their models but through consulting gigs and other perks, though they tend to be less than up-front about this. A 2012 study in the Cambridge Journal of Economics observed that, “economists almost never reveal their financial associations when they make public pronouncements on issues such as financial regulation.”[17] It also noted that “Perhaps these connections helped explain why few mainstream economists warned about the oncoming financial crisis.” This is like weather forecasters failing to include water or predict a storm because doing so would upset their sponsors.

Another reason, though, is that it is not possible to simply bolt a financial sector onto existing mainstream models, because as discussed above these are based on a mechanistic paradigm which – in part for ideological reasons – assumes that the actions of independent rational agents drive prices to a stable and optimal equilibrium.[18] Money however has remarkable properties which make it fundamentally incompatible with assumptions such as rationality, stability, efficiency, or indeed the entire mechanistic approach.

As we have seen, the creation or transfer of money is not a smooth or continuous process but takes place “instantaneously and discontinuously” which is as easy to model as a lightning strike. Money and debt act as entangling devices by linking debtors and creditors – and derivatives act as a kind of super-entanglement of the global financial system – which means that we cannot treat the system as made up of independent individuals.

Money is fundamentally dualistic in the sense that it combines the real properties of an owned object, with the virtual properties of number, which is why it can take the form of solid things such as coins, or of virtual money transfers as when you tap your card at a store. These dualistic properties, combining ownership and calculation, are what make it such a psychologically active substance. And prices in the economy are fundamentally indeterminate until measured (you don’t know exactly how much your house is worth until you sell it).[19]

To summarise, money is created and transmitted in discrete parcels, it entangles its users, it is dualistic, and prices are indeterminate. Haven’t we seen this before?

Niel Bohr’s speciality of quantum physics was initially inspired by the observation that at the quantum level matter and energy move not in a continuous fashion, but in discrete leaps and jumps. Pairs of quantum particles can become entangled, so they become part of a unified system, and a measurement on one instantaneously affects its entangled twin – an effect Einstein described as “spooky action at a distance.” Bohr’s “principle of complementarity” says that entities such as electrons behave sometimes like “real” particles, and sometimes like virtual waves. And Heisenberg’s uncertainty principle says that quantitites such as location are fundamentally indeterminate.

Bohr’s contemporary, the English economist John Maynard Keynes wrote in 1926, “We are faced at every turn with the problems of Organic Unity, of Discreteness, of Discontinuity – the whole is not equal to the sum of the parts, comparisons of quantity fails us, small changes produce large effects, the assumptions of a uniform and homogeneous continuum are not satisfied.”[20] He was speaking about the economy, but he was inspired also by the developments in physics – he met Einstein, and the title of his General Theory of Employment, Interest and Money was inspired by Einstein’s General Theory of Relativity.

Which leads one to think: if a century ago economics had decided to incorporate some insights from quantum physics instead of aping mechanistic weather models, the economy today might be rather better run.

Or if not, at least we would have a perfect excuse for forecast error: predicting the economy isn’t just harder than predicting the weather, it’s harder than quantum physics.

References

[1] Ahir, H., & Loungani, P. (2014, March). Can economists forecast recessions? Some evidence from the Great Recession. Retrieved from Oracle: forecasters.org/wp/wp-content/uploads/PLoungani_OracleMar2014.pdf.

[2] https://www.boj.or.jp/en/announcements/press/koen_2014/data/ko140320a1.pdf

[3] https://www.reuters.com/article/us-japan-economy-boj-kuroda/bojs-kuroda-still-far-to-go-to-reach-2-percent-inflation-target-idUSKBN18Z2VQ?il=0

[4] Inman, P. (2017, January 5). Chief economist of Bank of England admits errors in Brexit forecasting. The Guardian.

[5] Bernanke, B. (2009, May 22). Commencement address at the Boston College School of Law. Newton, Massachusetts.

[6] Orrell, D. (2007). Apollo’s Arrow: The Science of Prediction and the Future of Everything. Toronto: HarperCollins.

[7] Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. London: W. Strahan & T. Cadell.

[8] Mill, J. S. (1848). Principles of Political Economy. London: Parker.

[9] Samuelson, P. A. (1973). Economics (9th ed.). New York: McGraw-Hill, p. 55.

[10] Wilmott, P., & Orrell, D. (2017). The Money Formula: Dodgy Finance, Pseudo Science, and How Mathematicians Took Over the Markets. Chichester: Wiley.

[11] Werner, R. A. (2016). A lost century in economics: Three theories of banking and the conclusive evidence. International Review of Financial Analysis, 46, 361-379.

[12] McLeay, M., Radia, A., & Thomas, R. (2014, March 14). Money Creation in the Modern Economy. Quarterly Bulletin 2014 Q1. Bank of England.

[13] Deutsche Bundesbank. (2017). How money is created. Retrieved from https://www.bundesbank.de/Redaktion/EN/Topics/2017/2017_04_25_how_money_is_created.html.

[14] Jakab, Z., & Kumhof, M. (2015). Banks are not intermediaries of loanable funds – and why this matters. Bank of England working papers(529), 1.

[15] Constâncio, V. (2017, May 11). Speech at the second ECB Macroprudential Policy and Research Conference, Frankfurt am Main. Retrieved from European Central Bank: https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170511.en.html.

[16] Fleming, S. (2017, October 4). Fed has no reliable theory of inflation, says Tarullo. Financial Times. Giles, C. (2017, October 11). Central bankers face a crisis of confidence as models fail . Financial Times.

[17] Carrick-Hagenbarth, J., & Epstein, G. A. (2012). Dangerous interconnectedness: economists’ conflicts of interest, ideology and financial crisis. Cambridge Journal of Economics, 36(1), 43–63.

[18] Orrell, D. (2017). Economyths: 11 Ways That Economics Gets it Wrong. London: Icon Books.

[19] Orrell, D. (2016). A quantum theory of money and value. Economic Thought, 5(2), 19-36; Orrell, D., & Chlupatý, R. (2016). The Evolution of Money. New York: Columbia University Press.

[20] Keynes, 1926.

 

 

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October 20, 2017

A Quantum Theory of Money and Value, Part 2: The Uncertainty Principle

Filed under: Economics, Forecasting — Tags: — David @ 4:53 pm

New paper in Economic Thought

Abstract: Economic forecasting is famously unreliable. While this problem has traditionally been blamed on theories such as the efficient market hypothesis or even the butterfly effect, an alternative explanation is the role of money – something which is typically downplayed or excluded altogether from economic models. Instead, models tend to treat the economy as a kind of barter system in which money’s only role is as an inert medium of exchange. Prices are assumed to almost perfectly reflect the ‘intrinsic value’ of an asset. This paper argues, however, that money is better seen as an inherently dualistic phenomenon, which merges precise number with the fuzzy concept of value. Prices are not the optimal result of a mechanical, Newtonian process, but are an emergent property of the money system. And just as quantum physics has its uncertainty principle, so the economy is an uncertain process which can only be approximated by mathematical models. Acknowledging the dynamic and paradoxical qualities of money changes our ontological framework for economic modelling, and for making decisions under uncertainty. Applications to areas of risk analysis, forecasting and modelling are discussed, and it is proposed that a greater appreciation of the fundamental causes of uncertainty will help to make the economy a less uncertain place.

Published in Economic Thought Vol 6, No 2, 2017. Read the full paper here.

July 17, 2017

On straw men

Filed under: Uncategorized — David @ 2:59 pm

From the preface to Economyths: 11 Ways Economics Gets It Wrong

As anticipated in the 2010 version of Economyths, many economists have argued that the economyths are an unfair caricature of their field – a ‘straw man’ I am setting up to easily defeat. Four things to add. First, this argument is a little over-used. ‘Read any review of a heterodox book by an economist’, noted Cahal Moran in 2011, and ‘you will find the exact same rhetoric’: the author is ‘attacking straw men, he doesn’t understand economics, etc.’ An external investigation into the economics department at the University of Manitoba in 2015 found that ‘the insistence by the mainstreamers that the heterodox are attacking a straw man could be labelled “gaslighting” [i.e. psychologically manipulating someone into doubting their own sanity]. Even as some heterodox are subject to unfriendly discrimination, ridicule, hostility, and censure, some mainstreamers simply deny it and insist the others are making it all up.’ Call me crazy, but I think they have a point.

Secondly, economists have long deflected criticism by claiming that key assumptions such as the rational behaviour of ‘economic man’, as Lionel Robbins put it in 1932, are ‘only an expository device – a first approximation used very cautiously at one stage in the development of arguments’. (As seen in the Appendix, economists repeat the identical argument today.) But that same ‘economic man’ – which as a view of human behaviour is less a first approximation than a severe distortion – reached perhaps its most gloriously exaggerated form in the Arrow-Debreu model (Chapter 5) well after Robbins dismissed it as a ‘bogey’ (the expression ‘straw man’ was not yet in vogue), and remains at the heart of much economic modelling, which is why eight decades later we could name a book after its impending twilight with no fear of redundancy.

Thirdly, there is also a longstanding tradition in which, as Moran and his co-authors Joe Earle and Zach Ward-Perkins put it in The Econocracy: ‘The concerns of critics are said to be addressed when economists find some way of incorporating their critiques into existing frameworks. The result is often a highly stylised version of what the critic had in mind, and may drop the things that are most important while conforming to certain assumptions that the critic may reject.’ When economists consider small departures from something like equilibrium – they would have to, wouldn’t they? – or arrange patches for the more egregious examples of ‘market failure’ – such as the environmental crisis – they are like the ancient astronomers who added extra epicycles to their geocentric models of the cosmos to better fit observations, while still assuming that the universe was based on circles and the sun went around the earth. In fact it is economists who have set up a highly simplified version of the real world – but instead of destroying it, they hold it up as an ideal to which real economies can only aspire. (And if that is a ‘caricature’ or a ‘straw man’, we will stop attacking it when it stops threatening to blow up the world.)

Finally, I take pains in the book to show that the arguments apply not just to this pure textbook version of the theory, but to anything near it, epicycles and all. And as we’ll see, supposedly sophisticated models may deviate from these foundational assumptions, but they can never stray too far without losing internal consistency – which is exactly why the field finds itself in a state of crisis.

July 16, 2017

Time for critics of economics critics to move on!

Filed under: Uncategorized — David @ 3:28 pm

There is a growing trend for economists to write articles criticising the critics of economics. These articles follow a similar pattern. They start by saying that the criticisms are “both repetitive and increasingly misdirected” as economist Diane Coyle wrote, and might complain that they don’t want to hear one more time Queen Elizabeth’s question, on a 2008 visit to the London School of Economics: “Why did nobody see it coming?”

Economist Noah Smith agrees that “blanket critiques of the economics discipline have been standardized to the point where it’s pretty easy to predict how they’ll proceed.” Unlike the crisis then! “Economists will be castigated for their failure to foresee the Great Recession. Some unrealistic assumptions in mainstream macroeconomic models will be mentioned. Economists will be cast as priests of free-market ideology, whose shortcomings will be vigorously asserted.” And so on.

The articles criticising critics then tell critics it is time to adopt a “more constructive tone” and “focus on what is going right in the economics discipline” (Smith) because “only if today’s critics of economics pay more attention to what economists are actually doing will they be able to make a meaningful contribution to assessing the state of the discipline” (Coyle). If the critics being criticised are not economists, the articles often point out or imply that they don’t know what they are talking about, are attacking a straw man, etc., or even (not these authors) compare them to climate change deniers.

Speaking as an early adopter of the Queen Elizabeth story (in my 2010 book Economyths, recently re-released in extended form), allow me to say that I agree completely with these critic critics. Yes, economists failed to predict the most significant economic event of their lifetimes. Yes, their models couldn’t have predicted it, even in principle, based as they were on the idea that markets are inherently self-stabilising. And yes, economists didn’t just fail to predict the crisis, they helped cause it, through their use of flawed risk models which gave a false sense of security.

But it is time for us critics to move on, and accentuate the positive. Only by doing so can we make a meaningful contribution. And as Smith points out, calls for “humility on the part of economists” are getting old (Tomáš Sedláček, Roman Chlupatý and I wrote Bescheidenheit – für eine neue Ökonomie five years ago). It’s like asking Donald Trump to admit that he once lost at something.

Of course, some people might say that it isn’t up to economists to tell everyone else when they should stop talking about economists’ role in the crisis, or bring up what the former head of the UK Treasury memorably called in 2016 their “monumental collective intellectual error.”

Some stick-in-the-muds note that “No one took any responsibility or blame for a forecasting failure that led to a policy disaster” and have called for a public inquiry into their role in the crisis. Instead of telling everyone else to move on, they argue, it is time for economists to own their mistakes. Well guess what, people – it’s not going to happen! And stop asking for a public apology. Let’s focus on what is going right and hand out some gold stars.

For example, there is the “data revolution” heralded by Smith. As he notes, “econ is paying a lot more attention to data these days.” Sure, economists are literally the last group of researchers on earth to have realised the usefulness of data. In physics the “data revolution” happened back when astronomers like Tycho Brahe pointed their telescopes at the sky and began to question the theories of Aristotle. But better late than never!

Oh, here’s a data point – all the orthodox theories failed during the crisis! But you knew that.

Or there is behavioral economics, which Coyle notes is “one of the most popular areas of the discipline now, among academics and students alike.” Critics again might note that progress in this area has been painfully slow and has had little real impact. Tweaks such as “hyperbolic discounting” are equivalent to ancient astronomers appending epicycles to their models to make them look slightly more realistic. But that rational economic man thing is so over – straw man walking.

Admittedly, there has been less progress on a few things. The equilibrium models used by policy makers, for example, still rely on the concept of equilibrium – and so have nothing to say on the cause or nature of financial crises. Risk models used by banks and other financial institutions still view markets as governed by the independent actions of rational economic man investors, and are more useful for hiding risk than for estimating it, as quant Paul Wilmott and I have argued.

As Paul Krugman noted in 2016, “we really don’t know how to model personal income distribution,” even though social inequality – along with financial instability – is one of the biggest economic issues of our time. Some insiders such as World Bank chief economist Paul Romer – who compared a chain of reasoning in the field of macroeconomics to “blah blah blah” – describe the area as “pseudo-science”. And economics education still concentrates almost solely on the discredited neoclassical approach, complete with rational economic man, according to the student authors of The Econocracy.

But these are details. As Coyle notes, some economists are finally getting to grips with ideas from areas such as “complexity theory, network theory, and agent-based modeling” which of course are exactly those areas that critics have long been suggesting they learn from.

Or the UK’s Economic and Social Research Council recently let it be known that it is setting up a network of experts from different disciplines including “psychology, anthropology, sociology, neuroscience, economic history, political science, biology and physics,” whose task it will be to “revolutionise” the field of economics. Again, that is nice, since Economyths called in its final chapter for just such an intervention by non-economists back in 2010.

So, yes, it is time to celebrate the new dawn of economics! But critics of critics – do try to move on from the same criticisms, we’ve heard it all before, in fact for decades now.

April 13, 2017

Review of The Evolution of Money

Filed under: Books, Economics, Reviews — David @ 8:56 pm

The Evolution of Money is reviewed in News Weekly by Colin Teese, former deputy secretary of the Australian Department of Trade:

“Who would have thought of linking money and quantum physics? Well, Orrell and Chlupaty  have done just that in The Evolution of Money, perhaps the best book on money I have  ever read …

The authors have set themselves the dauntingly difficult task of explaining money, as it  were, from the ground up, cutting the cant that has surrounded the subject for centuries.  Blending a happy combination of skills and experience, they have recorded a satisfying and  entertaining account of how money has impacted, of course, on economics, but no less on  politics and society. But that is not the end of it. They make a persuasive case, at least to this reader’s satisfaction, on how the evolution of money has tracked that of science …

A reasonable and benign dictator might demand that those engaged in activities relating to economic management should, as a condition of employment, be compelled to read The Evolution of Money and pass a written examination based on an understanding of its contents.”

Read the full review at News Weekly.

April 4, 2017

The Money Formula – New Book By Paul Wilmott And David Orrell

Filed under: Books, Economics — Tags: , — David @ 3:09 pm

The Money Formula: Dodgy Finance, Pseudo Science, and How Mathematicians Took Over the Markets

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The Money Formula takes you inside the engine room of the global economy to explore the little-understood world of quantitative finance, and show how the future of our economy rests on the backs of this all-but-impenetrable industry. Written not from a post-crisis perspective – but from a preventative point of view – this book traces the development of financial derivatives from bonds to credit default swaps, and shows how mathematical formulas went beyond pricing to expand their use to the point where they dwarfed the real economy. You’ll learn how the deadly allure of their ice-cold beauty has misled generations of economists and investors, and how continued reliance on these formulas can either assist future economic development, or send the global economy into the financial equivalent of a cardiac arrest.

Rather than rehash tales of post-crisis fallout, this book focuses on preventing the next one. By exploring the heart of the shadow economy, you’ll be better prepared to ride the rough waves of finance into the turbulent future.

  • Delve into one of the world’s least-understood but highest-impact industries
  • Understand the key principles of quantitative finance and the evolution of the field
  • Learn what quantitative finance has become, and how it affects us all
  • Discover how the industry’s next steps dictate the economy’s future

How do you create a quadrillion dollars out of nothing, blow it away and leave a hole so large that even years of “quantitative easing” can’t fill it – and then go back to doing the same thing? Even amidst global recovery, the financial system still has the potential to seize up at any moment. The Money Formula explores the how and why of financial disaster, what must happen to prevent the next one.

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“This book has humor, attitude, clarity, science and common sense; it pulls no punches and takes no prisoners.”
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“There are lots of people who′d prefer you didn′t read this book: financial advisors, pension fund managers, regulators and more than a few politicians. That′s because it makes plain their complicity in a trillion dollar scam that nearly destroyed the global financial system. Insiders Wilmott and Orrell explain how it was done, how to stop it happening again and why those with the power to act are so reluctant to wield it.”
Robert Matthews, Author of Chancing It: The Laws of Chance and How They Can Work for You

“Few contemporary developments are more important and more terrifying than the increasing power of the financial system in the global economy. This book makes it clear that this system is operated either by people who don′t know what they are doing or who are so greed–stricken that they don′t care. Risk is at dangerous levels. Can this be fixed? It can and this book full of healthy skepticism and high expertise shows how.”
Bryan Appleyard, Author and Sunday Times writer

“In a financial world that relies more and more on models that fewer and fewer people understand, this is an essential, deeply insightful as well as entertaining read.”
Joris Luyendijk, Author of Swimming with Sharks: My Journey into the World of the Bankers

“A fresh and lively explanation of modern quantitative finance, its perils and what we might do to protect against a repeat of disasters like 2008–09. This insightful, important and original critique of the financial system is also fun to read.”
Edward O. Thorp, Author of A Man for All Markets and New York Times bestseller Beat the Dealer

April 2, 2017

Why Toronto house prices keep going up

Filed under: Economics — Tags: , — David @ 7:08 pm

Ever wonder why prices in cities such as Toronto keep going up? The reasons given are many – foreign buyers, low interest rates, lack of supply, and so on – but while these are all contributing factors, the real reason is much simpler.

It’s because there is more money.

housepricemoneysupply

The solid line shows the Teranet 6-city index which goes back to 1999, the dashed line is a broad measure of money supply (M2++).

And why is there more money? It’s because house prices have gone up. Most of the money in our economy is generated by bank loans, usually against real estate – and when prices go up, they can make larger loans.

Thus house prices and money supply increase in tandem. Of course, at some point they can also go down in tandem …

February 7, 2017

Big data versus big theory

Filed under: Forecasting — Tags: — David @ 4:05 pm

The Winter 2017 edition of Foresight magazine includes my commentary on the article Changing the Paradigm for Business Forecasting by Michael Gilliland from SAS. Both are behind a paywall (though a longer version of Michael’s argument can be read on his SAS blog), but here is a brief summary.

According to Gilliland, business forecasting is currently dominated by an “offensive” paradigm, which is “characterized by a focus on models, methods, and organizational processes that seek to extract every last fraction of accuracy from our forecasts. More is thought to be better—more data, bigger computers, more complex models—and more elaborate collaborative processes.”

He argues that our “love affair with complexity” can lead to extra effort and cost, while actually reducing forecast accuracy. And while managers have often been seduced by the idea that “big data was going to solve all our forecasting problems”, research shows that even with complex models, forecast accuracy often fails to beat even a no-change forecasting model. His article therefore advocates a paradigm shift towards “defensive” forecasting, which focuses on simplifying the forecasting process, eliminating bad practices, and adding value.

My comment on this (in about 1200 words) is … I agree. But I would argue that the problem is less big data, or even complexity, than big theory.

Our current modelling paradigm is fundamentally reductionist – the idea is to reduce a system to its parts, figure out the laws that govern their interactions, build a giant simulation of the whole thing, and solve. The resulting models are highly complex, and their flexibility makes them good at fitting past data, but they tend to be unstable (or stable in the wrong way) and are poor at making predictions.

If however we recognise that complex systems have emergent properties that resist a reductionist approach, it makes more sense to build models that only attempt to capture some aspect of the system behaviour, instead of reproducing the whole thing.

As an example, consider the question of predicting heart toxicity for new drug compounds, based on ion channel readings. One technique is to employ teams of researchers to build an incredibly complicated mechanistic model of the heart, consisting of hundreds of differential equations, and use the ion channel inputs as inputs. Or you can use a machine learning model. Or, most complicated, you can combine these in a multi-model approach. However my colleague Hitesh Mistry at Systems Forecasting found that a simple model, which simply adds or subtracts the ion channel readings – the only parameters are +1 and -1 – performs just as well as the multi-model approach using three large-scale models plus a machine learning model (see Complexity v Simplicity, the winner is?).

Now, to obtain the simple model Mistry used some fairly sophisticated data analysis tools. But what counts is not the complexity of the methods, but the complexity of the final model. And in general, complexity-based models are often simpler than their reductionist counterparts.

I therefore strongly agree with Michael Gilliland that a “defensive” approach makes sense. But I think the paradigm shift he describes is part of, or related to, a move away from reductionist models, which we are realising don’t work very well for complex systems. With this new paradigm, models will be simpler, but they can also draw on a range of techniques that have developed for the analysis of complex systems.

 

October 10, 2016

More quantum money

Filed under: Economics — Tags: , , — David @ 2:37 pm

New discussion paper at Economic Thought is called A Quantum Theory of Money and Value, Part 2: The Uncertainty Principle.

Here is the abstract:

Economic forecasting is famously unreliable. While this problem has traditionally been blamed on theories such as the efficient market hypothesis or even the butterfly effect, an alternative explanation is the role of money – something which is typically downplayed or excluded altogether from economic models. Instead, models tend to treat the economy as a kind of barter system in which money’s only role is as an inert medium of exchange. Prices are assumed to almost perfectly reflect the ‘intrinsic value’ of an asset. This paper argues, however, that money is better seen as an inherently dualistic phenomenon, which merges precise number with the fuzzy concept of value. Prices are not the optimal result of a mechanical, Newtonian process, but are an emergent property of the money system. And just as quantum physics has its uncertainty principle, so the economy is an uncertain process which can only be approximated by mathematical models. Acknowledging the dynamic and paradoxical qualities of money changes our ontological framework for economic modelling, and for making decisions under uncertainty. Applications to areas of risk analysis and economic forecasting are discussed, and it is proposed that a greater appreciation of the fundamental causes of uncertainty will help to make the economy a less uncertain place.

Download the paper here.

October 8, 2016

Notes on the quantum theory of money and value

Filed under: Economics — Tags: , — David @ 12:38 am

Following the publication in Economic Thought of my paper “A Quantum Theory of Money and Value” I have received a number of interesting comments and questions from readers, and this post is an attempt to clarify some of the points which came up. For a description of the theory, please see the paper, or (for the book version) The Evolution of Money.

What is a money object?

These are objects – either real or virtual – which have a fixed numerical value in currency units. Just as quantum objects have dual real/virtual properties, so do money objects (bitcoins don’t seem like objects, until you lose the hard drive they are located on). Money objects are unique in that they have a fixed numerical price. Other objects or services attain their price by being traded for money objects in markets.

Is money an emergent phenomenon?

Money objects are designed (e.g. by the state) to have a set price. The prices of other things emerge as the by-product of money-based markets, which themselves emerge into being as money objects become commonly used. Therefore prices and markets can be viewed as emergent phenomena, but money itself is better seen as a carefully designed technology. (Of course the way that e.g. cybercurrencies emerge into actual use, as markets develop around them, can also be described as an emergent phenomenon.)

What does money measure?

Nothing. Because prices emerge from the use of money objects, one consequence is that price should not be viewed as an accurate measure of “labor”, “utility”, “economic value”, or any other quantity. Money is better viewed as a fundamental quantity, like electrical charge. Money objects, as used in markets, are a way of attaching numbers to things, but that is not the same as measuring them in some way. Of course market forces tend to align prices with some vague idea of value, but the process is far from exact, and money has its own dynamics (which is one reason CEOs in the US earn over 300 times the median wage of their employees). Note this contradicts the Aristotelian idea, later expressed by Aquinas, that money was “the one thing by which everything should be measured.”

Why quantum?

The comparison with quantum theory comes about because money is treated as a fundamental quantity (from the Latin quantum); and money objects are a way of combining the notions of number and value, which are as different from one another as the dual wave/particle properties of matter. For example, number is stable, while value varies with time. Money objects are therefore fundamentally dualistic.

As mentioned in The Evolution of Money, other authors and economists (and many others) have used the term “quantum” in different ways. One example is Charles Eisenstein’s Sacred Economics, where in an appendix called “Quantum Money and the Reserve Question” he notes “the similarity between fractional-reserve money and the superposition of states of a quantum particle,” in the sense that money can seem to exist in more than one place at the same time. The quantum macroeconomics school, also known as the theory of money emissions, which dates to the 1950s, gained its name from the idea that production is an instantaneous event that quantizes time into discrete units. A completely different concept is quantum money, which exploits quantum physics in an encryption technique.

What inspired the approach?

One thing is the history of money. The most concrete example of a money object is a coin, which consists of a number pressed into a piece of metal. These date to the time when Greek philosophers were developing the first theories of mathematics. Pythagoras believed that the universe was based on number, and money can be seen as a way of making that true by impressing numbers onto the real world. However mixing the properties of number and things produces a strange kind of alchemy. See this presentation for the 2015 Marshall McLuhan lecture at transmediale in Berlin for a discussion.

How does this differ from the usual understanding of the role of money?

One consequence of the theory is that it inverts the usual narrative of mainstream economics. Since the time at least of Adam Smith, economists have downplayed the importance of money, seeing it as a kind of neutral chip that emerged as a way of facilitating barter. But instead of money emerging from markets, it is more accurate to say that the use of money (jumpstarted by the state) prompted the emergence of markets. And far from being an inert chip, money is an active, dualistic substance with powerful and contradictory properties. Putting numbers on things changes the way they behave.

What is the mathematical map or connection between price and value?

In general there is no such map. Price is an emergent property, which means it need not be computable at all. Of course it is possible to come up with some rules of thumb, but there are no fundamental laws as in physics.

What are the implications for economic modelling?

Economic analysis usually assumes that price and value (in the sense of e.g. utility) are one and the same, and then go on to base economic models on ideas such as utility maximization. But according to the theory presented here, prices do not perfectly measure value or anything else. Instead, prices are fundamentally indeterministic. This introduces a profound uncertainty into any kind of economic calculation. (See related article The true value of money at Adbusters.)

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