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Dec 23, 2014

Part III:

Bill Miller

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the workings of which we do not understand.”
-John Maynard Keynes, Essays in Persuasion, “The Great Slump of 1930”

Well, we did it again in 2007-2008. I had a meeting with former Federal Reserve Board Chairman Ben Bernanke just before he took on that role, while he was still in the Bush administration. One of the things we talked about was central bank policy, and he noted that one of the roles of the Federal Reserve was to take out the tails of distribution. In plain language: to prevent the worst case, such as another Depression or a financial collapse, from happening. Leaving the meeting, I thought it was a plus that the incoming Chairman of the Federal Reserve was the world’s foremost expert on the Great Depression, and that if anyone knew how to prevent that from happening again, it was Chairman Bernanke.

As the financial system was collapsing in September 2008, Greg Mankiw, a distinguished economist at Harvard, opined that while the economics profession might know how to prevent a re-run of the 1930’s Depression, it might not know how to prevent one whose sources were different from those that caused that Depression. Maybe it could prevent that one from happening again, but maybe it cannot prevent this one.

In his excellent recent book Forecast: What Physics, Meteorology and Natural Science Can Teach Us About Economics, physicist Mark Buchanan pins the tail of the economic donkey directly on trying to create an equilibrium theory of the economy, arguing (correctly in my opinion) that the economy is not such a system and any attempt to model it as such is bound to lead to exactly the problems we have experienced. Going further, he thinks it may be futile to even attempt to formulate a comprehensive economic theory. The economy is just too complex to be understood in a comprehensive theoretical way.

He notes that meteorology is similar to economics in that it tries to understand the weather and make useful predictions about what is likely to happen. Weather is a complex system, but one that is non-adaptive. Our beliefs about the weather do not change what the weather is going to be, unlike our beliefs about the economy. So it is a much simpler system.

Weather forecasts, as he shows in his book, have improved dramatically over the past decades as our understanding of how the variables affecting weather has grown, and we have brought ever greater computational power to the task of constructing models. The result is that short term forecasts of the weather have gotten pretty good. But long term forecasts—such as how many hurricanes will form this season and of what magnitude - are still mostly guess work.

Most importantly, I think, is that he notes all this improvement has occurred without any thought about theory. We do not have a weather theory. We have an understanding of most of what goes on in the physical system that constitutes the weather, we have data, and we have computational power. We use these to make predictions, and these predictions have grown steadily better as our knowledge has increased. A theory would be great, but we do not have one and we do not need one to improve our ability to predict the weather.

I think the situation is quite similar in economics and finance. The theory that we have is mathematically elegant, but of limited predictive value to practitioners. And even when it is pretty good, politicians routinely ignore it — a topic for another time. One of the objections to the findings of social psychology and behavioral finance is that they are inadequate because they are not part of a larger theory. True enough. But to practitioners, that is irrelevant. The issue for us is can they help us navigate what Keynes called this “delicate machine, the workings of which we do not understand.” The answer is emphatically yes, and how will be the topic of the next post.

As a side note, the original intent of this 3-part series was to recap a presentation bound by time limits. However, in reality, this is a much larger and longer discussion about fundamental shifts in the ways we think about the economy and investing. So, instead of limiting the discussion to three posts, we’re going to keep going.

Read the series:
Part I: Time Travel in the Minsky Moment
Part II: The Shifting Paradigm

For further reading:
Forecast: What Physics, Meteorology and Natural Science Can Teach Us About Economics by: Mark Buchanan

The views expressed in this commentary reflect those of LMM LLC (LMM) portfolio manager(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading on behalf of any portfolio. Any data cited is from sources believed to be reliable, but is not guaranteed as to accuracy or completeness.

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