The Recession: Volatility and Positive Feedback

I have been thinking a lot about the recession lately. I understand why they call it the "Great Recession." Because frankly compared with the Great Depression based on its impact on unemployment, growth and consumer confidence worldwide, the only thing which is different this time around is that there is no price deflation. Yeah with the enormous amounts of debt on the balance sheets of all developed countries, you can only have inflation. What some people do not realize is that actually there is deflation: in the real value of wages. When inflation is rising the purchasing power of every nominal dollar drops and nominal wages tend to state the same during a crisis, therefore real wages are decreasing. There is deflation, just not everywhere.


We also have unemployment, especially in the developed countries. The problem with recessions is that they tend to overreact to long growing problems. The truth is that some industry simply do not have a future in those countries: they do not have the competitive advantage to operate them. Politically, however, it is very hard to concede that an entire billion dollar industry is dying and should move somewhere else. So hard that the US government would double itself down with trillions of dollars of debt to save the financial and the automobile industry in the country when they have obvious problems staying competitive. The problem with industrialization and affluence is that you cannot go back: a country cannot suddenly have lower wages to allow it to produce competitively in a lower stage of industrialization. What western governments should be doing is looking ahead, not looking back.


I think saving the financial world in 2008 was a bad strategic decision: it sustained an industry that was not producing value added to the economy but actually was hemorrhaging investments. So much of the money investment in Lehman Brother's stock could have gone into tech stock to product real future value. The way the US financial system is operating is extremely inefficient: it does not hedge against uncertainty, it produces systemic risk by overleveraging. The costs of artificially sustaining this industry when its basic principles are no longer valid is increasing every time around. No, it is not profitable any more, no more than the US car industry is: after billion dollars of bailouts, we still got a small 50 billion dollar trading company evaporating last week. It is also not driving market growth, it is producing volatility in the market. The attempts of the big financial companies to exploit minuscule opportunities with leverage are increasing their exposure to government debt (under the funny assumption that it is a riskless asset). This means that there is not only volatility in the bond market but also volatility in the stock market for the stocks of the financial companies. When one or two of those companies go under we have a chaos in the credit default swaps market and systemic risk. Markets freeze and governments are forced to intervene with bailouts to keep the zombie industry afloat. The problem is that there can be no bailouts these time around. The outstanding government debt is just too much.


So let's see the model. We have low regulation and easy credit in the beginning of the 00s. We also have a lot of credit default swaps that make every default very costly for the entire market. Then all we need is a bankruptcy (Lehman's) and volatility starts. We save other companies from going under by borrowing as a country and when we borrow too much, the outstanding debt produces volatility in our government bonds. Then the volatility moves to stocks. So every step of the way we have more volatility. And uncertainty is worse than market drop because if the market goes straight down at least those that are short on it are making money. When we have volatility, however, wealth evaporates. Companies become overleveraged and increase the volatility. I think it is safe to say that we have a nice positive feedback loop - volatility produces more volatility.


The problem with positive feedback is that it tends to explode. And it is simply not possible to do the same kinds of bailouts as last time if there is another Lehman-sized company or country that goes under.


----To Be Continued-------


Previous Economy Related Post: Economy and Math

Economy and Math

Economist have a very strange relationships with mathematics. They love it when it serves their purpose but when it suggest that the current economic system is a complete rubbish they conveniently disregard it. So when they look at the normal distribution and it conveniently predicts that a market meltdown is an outlier, they really love math. However, when it suggests that you cannot just print more money because 0 does not equal 1,000,000,000, they tend to disregard math because it does not help their case.

The problem with the present economic theory is that it is based on the flawed assumption that just because the mathematics of a certain hypothesis is beautiful or ease then it is necessary true. This is based on the erroneous principle called Occam's razor that the easiest explanation is the true one. This assumption works really well to refute a lot of wrong representation of reality that have too many assumptions that invalidate them but it is contradict by a fundamental part of physics theory. The math of quantum mechanics is not easier then the math of the classical mechanics, exactly the opposite, but it is the true one. Just because an explanation since complex from the point of view of ordinary human experience does not make it a priori wrong. The same holds for mathematical beauty: reality is not judged on the basis on how nice the mathematics seems, it is based on the empirical evidence that supports the math.

The problem is that there is empirical evidence that suggests that the normal distribution and the random walk theory are not applicable to the real world (i.e. you cannot really have 25 standard deviation events three days in a row and assume that the model still holds - such events are assumed to happen only once in the history of the human race) but the economist would not abandon their nice assumptions because "it does not make sense" and "it is not logical" or "it contradicts everything we have been taught by now." Well the thing with science is that sometimes everything you have been previously taught is indeed WRONG and instead of "patching" the old theory, one should start from the ground up and challenge all his assumptions.

Economy is a lot like religion: it produces dogmas in which you have to believe even when they contradict experience. The problem is that it affects the lives of all people on this planet in a way in which even the Roman Catholic church couldn't have dreamed of in the Middle Ages.