Barry Ritholz of Big Picture, asks: Do Capital Markets Create Their Own Fuel?
Economic forecasters sometimes describe capital markets as a leading economic indicator.....
But can capital markets actually create or destroy the very economic conditions that their participants are anticipating? ....
Are the participants in capital markets (investors) buying or selling in anticipation of future economic conditions AND thus contributing to the anticipated economic condition? Do capital markets have an inherent self-fulfilling prophecy effect? Do capital markets create their own fuel?
....
These are not rhetorical questions. I would like some education. I’m a CFP with an MBA but certifications and degrees don’t help me (or anyone) as much as the study of philosophy, which makes me fully aware of my own ignorance.
Please join me after the jump: where I explore the answer and its implications.
If you haven't already read it, I highly recommend Thomas Kuhn's "The Structure of Scientific Revolutions"
Just to make things easier (for me), I'm going to use the terms "Finance" and "Financial Markets" to refer to everything related to the flow of money in the economy: consumer spending, economic activity, stock market trading, banking, etc.
"Science", "Finance" and "Financial Markets" are social institutions: they are composed of people and the rules that people make. So these highly quantitative disciplines are, at their core, social systems. The scientific theories and financial models that they generate are "socially derived system models". These models are used to predict and exploit the behavior of the external systems which they study. In the case of scientific theories, the external system being studied is the physical world. In the case of financial theories, the external system being studied is the economic system.
Kuhn coined a now famous term for these "socially derived system models": they are called "paradigms".
From a philosophical point of view, these paradigms impose an order upon the chaosof the systems they study.
In both science and finance, the paradigms being used to study their respective systems have inherent biases which skew the acquisition and perception of data. This is because paradigms are LITERALLY imposing an order on how we perceive the data. Kuhn has explained how such biases operate in the social system that is called "Science". In the world of finance, "Marxism" and the "Efficient Market Hypothesis" are examples of paradigms which impose their own biases on data acquisition and analysis.
In the literal and philosophical sense: how the world looks, depends upon your point of view. Because they are the products of social systems, paradigmatic biases reflect the biases of the social institutions which generated them.
Beyond these biases of perspective, there are also interactions between the observer and the observed. At the most basic and fundamental level of physics, this interaction is quantified as "The Heisenberg Uncertainty Principle". The HUP operates this way: if you want to know an electron's state, then you measure it, by bouncing a photon against it. But when you do this, some of the photon's momentum is transferred to the electron: that changes the electron's momentum. So the act of observing the photon's state is changing the state being observed. You can minimize this energy transfer, by using less energetic photons.
But low energy photons have longer wavelengths; which yield a less precise measure of the photon's location. If you want to have arbitrarily precise information about a photon's momentum, you have to accept less precision about its location. If you want arbitrarily precise information about a photon's location, you have to accept less precision about its momentum.
This uncertainty relation is quantified as:
(dp*dx) >= h/(4*pi)
dp = uncertainty of momentum
dx = uncertainty of location
h = Planck's Constant
So, we have two ways in which our paradigms will affect the systems being studied.
- Paradigms introduce biases which affect the way we interact with the system
- No matter what paradigm is used, the interactions themselves will perturb the system
In "The Money Game", Adam Smith explored precisely these kinds of issues. He showed that the theories of Technical Analysis being employed at the time, had inherent biases that affected how trader's approached the market. He also showed how these approaches could, in turn, affect overall market behavior.
So Capital Market paradigms have two effects upon the economic system:
- They impose biases affecting how traders CHOOSE to interact with the economic system
- These interactions will change the dynamics of the economic system itself
As it is currently structured, the financial system is highly susceptible to the mechanisms of "self fulfilling prophecies". For example: Enron's high market value had no basis in reality; it was quite literally a figment of the market's collective imagination. This capacity for self-delusion is extremely dangerous, because Enron serves as a metaphor for our current economic system.
The structural deficiencies in our current economic system are unsustainable. Resource depletion, global warming and environmental despoliation are all "Repo 105's" which artificially and temporarily inflate corporate profits. The physical world's limits cannot be deferred, amortized or depreciated indefinitely....at some point, these debts will come due and the system that is the real world will be demanding immediate repayment.
When these debts are finally "deleveraged", we won't be able to cover them with any TARP.