BOOM AND BUST

Dick Pountain/20 October 2008 14:36/Idealog 171

I don't often receive hate mail for this column but on the few occasions that I have it seemed always to be from Thatcherite professors of economics accusing me of stupidity for the opinion I've expressed several times here that markets are not infallible. After the economy-shaking events of the past few months only a saint or a superhero could forgo a quick gloat and I, alas, am all-too human so "I TOLD YOU SO!" Phew that was good, almost as good as sex. For some reason the efforts of the US and UK governments to dig out our overpaid investment banking community from the pit they've dug for us all reminds me of a very un-PC joke I was told recently: an Irish father walks in on his son who is snorting a line of cocaine and shouts "If I catch you doing that again I'll rub your nose in it!" Similarly it would appear that the cure for spending too much of other peoples' money is to give them even more of other people's money...

But enough of this populist rabble-rousing, which is rather unbecoming. I'm that most unfashionable of beings, an unreconstructed Keynesian (remember him, the bloke who saved the world last time around), and we Keynesians do have to accept that massive public spending may be necessary to unpick the sticky mess that results when unregulated markets crash and refuse to play any more. Talking of populism, if you want to really understand the ideology that lead us into this mess, the best book by far is Thomas Frank's 2001 work "One Nation Under God: Extreme Capitalism, Market Populism, and the End of Economic Democracy". Frank explains how Wall Street financiers stole the Left's populist rhetoric to stoke a hugely popular investment boom, the ultimate beneficiaries of which were themselves via grossly inflated bonuses, rather than the suckers whose pensions, mortgages and mutual funds end up worthless.

I must hasten to add that I'm not in favour of abolishing markets altogether in favour of any sort of command economy. There is much truth in the theory of free markets: they really do distribute the social product more effectively than bureaucrats pulling prices out of thin air could ever do. The problem arises when you fetishise markets, attribute God-like prescience to them, make mad claims about them aggregating all possible information with perfect efficiency. Markets are not concrete entities that could possess properties like that - they're the net effect of billions of human interactions, and humans are not entirely rational but also emotional creatures. Keynes understood this, that confidence was one of the most valuable commodities of all. To overlook the emotional content of market behaviour is to fatally over-simplify the way markets work, making them appear to be always self-correcting, always seeking a stable equilibrium. No such luck. Now and again a panic turns into a self-reinforcing downward spiral which will never correct itself without hands-on Keynesian intervention (and lots of other peoples' money). 

Markets are complex oscillatory systems that share some aspects of their behaviour with other such systems like car suspensions, computer circuits and musical instruments. Over the years I've studied the technology of computer, motorcycle and hi-fi design, and the lesson these apparently disparate fields teach is that they're all difficult and sometimes unpredictably unpredictable. What does that mean? In an unpredictable system you have little idea what it will do next, as with the flow of water in a mountain stream considered at the scale of millimetres. A predictable system's behaviour can be predicted with reasonable accuracy, like the flow of that stream at the scale of metres and kilometres. An unpredictably unpredictable system is predictable most of the time, but rarely and without warning goes radically unstable due to a resonance. Poor violins are like that, where the instability is called a "wolf note". A car suspension wobbles dangerously under certain rare conditions. Markets crash.

The answer is damping, but knowing how and where to apply it is often as much of an art as a science. Certain people - a Stradivarius, a Steve Wozniak - have an intuitive feel for the behaviour of oscillatory systems that often achieves better optimised solutions than a digital simulation can. Designing a graphics chip, tuning a Formula One car suspension, making a great-sounding guitar or hi-fi speaker, all require a feel for damped oscillation and people who're good at it get paid lots of money. In the financial markets these are not the nerds with particle physics degrees who pushed the envelope of Excel add-ons to devise ever more complex derivatives contracts (whose future value is so chaotic that they still can't calculate how much some of those broken banks are owed...). No, they're old troopers like Warren Buffet and George Soros who consistently make big money by seeing through the illusions that distract other traders.

Soros has recently written a book called "The New Paradigm For Markets" in which he describes how feedback loops operate between market traders' perceptions and the reality: prices are determined by what people *think* is happening, which alters what actually does happen, which then affects their perceptions, and so on. This feedback is most often negative and self-stabilising, but now and again it becomes positive and deadly, a far cry from the "rational expectations" that won Milton Friedman his Nobel Prize...

[Dick Pountain would prefer to be paid for this column with tins of baked beans, to be delivered to his concrete bunker under Monte Favalto]