Archive for November, 2010

November 30, 2010


November 30, 2010


BY WSJ : Finding a Post-Crash Economic Model –

Physicist Doyne Farmer thinks we should analyze the economy the way we do epidemics and traffic.

Psychoanalyst David Tuckett believes the key to markets’ gyrations can be found in the works of Sigmund Freud.

Economist Roman Frydman thinks we can never forecast the economy with any accuracy.

Disparate as their ideas may seem, all three are grappling with a riddle that they hope will catalyze a revolution in economics: How can we understand a world that has proven far more complex than the most advanced economic models assumed?

The question is far from academic. For decades, most economists, including the world’s most powerful central bankers, have supposed that people are rational enough, and the working of markets smooth enough, that the whole economy can be reduced to a handful of equations. They assemble the equations into mathematical models that attempt to mimic the behavior of the economy. From Washington to Frankfurt to Tokyo, the models inform crucial decisions about everything from the right level of interest rates to how to regulate banks.

Global Economic SymposiumDavid Tuckett is working on new models.

NewEconIn the wake of a financial crisis and punishing recession that the models failed to capture, a growing number of economists are beginning to question the intellectual foundations on which the models are built. Researchers, some of whom spent years on the academic margins, are offering up a barrage of ideas that they hope could form the building blocks of a new paradigm.

“We’re in the ‘let a thousand flowers bloom’ stage,” says Robert Johnson, president of the Institute for New Economic Thinking, launched last year with $50 million from financier George Soros, a big donor to liberal causes who has long been a vocal critic of mainstream economics. The institute so far has approved funding for more than 27 projects, including efforts by Messrs. Farmer and Tuckett aimed at developing new ways to model the economy.

Some of academia’s most authoritative figures say the new ideas are out of the mainstream for a good reason: They’re still very far from producing a model that demonstrably improves on the status quo.

“I guess I’ll wait until I see these models and what they can and cannot do,” says Robert Lucas, an economist at the University of Chicago who won the Nobel Prize for his work on “rational expectations,” the concept at the very heart of modern orthodoxy.

New York University’s Mark Gertler, who with now-Federal Reserve Chairman Ben Bernanke did ground-breaking work in the 1980s on how financial troubles can trip up the economy, says economists already have many of the tools they need to fix the current models.

“It strikes me as not productive to say that all we have done is a complete waste,” he says. “The profession is extremely competitive. If you have a better idea, it’s going to win out.”

Today’s models emerged from a revolution of their own. In the 1970s, economists were struggling to figure out how policy moves, such as raising taxes or cutting interest rates, could change how people behave. They were also eager to subject their own reasoning to the unforgiving judge of mathematical logic.

Decoding the Model


So they populated their models with rational people who can calculate the value of various possible moves and choose the optimal path. A person deciding whether to buy a car, for example, would take into account the potential return on investing the money, the probability that car prices will rise, and the chances that an increase in tax rates will cut into her disposable income.

By translating peoples’ preferences into equations, and finding the point at which they meet those of firms and other players, the models forecast an exact trajectory for the economy. That feature makes them very attractive to economists, who can plug in a change in interest rates and see precisely how the move might affect an entire country’s output for the next few years.

The problem, says Mr. Farmer, is that the models bear too little relation to reality. People aren’t quite as rational as models assume, he says. Advocates of traditional economics acknowledge that not all decisions are driven by pure reason.

Mr. Farmer sees a perhaps greater flaw in the models’ mathematical structure. A typical “dynamic stochastic general equilibrium” model—so called for its efforts to incorporate time and random change—consists of anywhere from a few to dozens of interlinked equations, which must agree before the model can spit out a solution. If the equations get too complex, or if there are too many elements, the models have a hard time finding the point at which all the players’ preferences meet.

To keep things simple, economists leave out large chunks of reality. Before the crisis, most models didn’t have banks, defaults or capital markets, a fact that proved problematic when the financial crisis hit. They tend to include only households, firms, central banks and the government. They also commonly use a single equation to represent each player, impairing the models’ ability to explain the unexpected outcomes that can emerge when millions of different people interact.

“You are limited by what you can solve,” says Mr. Farmer. “It puts the whole enterprise in a straitjacket.”

His proposal: Create a richly complex, computer-based simulation of the economy like those scientists use to model weather patterns, epidemics and traffic. Given enough computing power, such “agent-based” models can include millions of individual players, who don’t have to be rational or agree with one another. Instead of equations that must be solved, the players have open-ended rules of behavior, such as, “If I’ve just turned 55 and I’m feeling blue, I’ll buy a sports car.”

A leading expert on complex systems at the Santa Fe Institute, a nonprofit think tank, the 58-year-old Mr. Farmer has spent much of his life trying to figure out how to predict the future.

In the 1970s, he and a group of graduate students from the University of California at Santa Cruz managed to outsmart Las Vegas casinos, developing software and portable computers that clocked the velocity of the ball and rotor on roulette wheels. Later, he made a small fortune as a partner in Prediction Company, which applied some of what he learned at the roulette table to financial markets and was ultimately sold to the Swiss bank UBS AG.

Some policy makers believe the agent-based approach to modeling the economy has promise. “I think the whole profession is much more open to these new approaches than it has been at any time in the past 20 years,” says Simon Potter, director of economic research at the Federal Reserve Bank of New York.

The tough part is coming up with rules that bear some relation to reality. To that end, Mr. Farmer and three economists—Robert Axtell of George Mason University, John Geanakoplos of Yale University and Peter Howitt of Brown University—are hoping to involve dozens of experts on the behavior of consumers, investors and firms in a massive model-building project. Inputs could include everything from historical data to interviews.

“It’s going to be a very hard job that will require a lot of time and persistence,” says Mr. Farmer. He estimates that a proper agent-based model could take many years to build, but would cost a tiny fraction of the $1 billion a year the government spends on the National Weather Service. “This is not something you can do in your kitchen.”

Writing better rules for human behavior will require researchers to dig deeper into the human psyche, says Mr. Tuckett, a professor at University College London. Specifically, he’s looking into how unconscious needs and fears can cause big swings in financial markets.

The field of economics has already borrowed from psychology to help explain the sometimes irrational behavior of people and markets. Psychologist Daniel Kahneman shared a Nobel Prize in 2002 for his work identifying the ways in which humans systematically overestimate or underestimate risk.

Mr. Tuckett goes one leap further. Extensive interviews with money managers have led him to posit that because certain financial instruments are so volatile and hard to value, they trigger humans’ tendency to fantasize. Borrowing language from Sigmund Freud, he calls such financial assets “phantastic objects,” which people see alternately as capable of fulfilling their dreams of wealth and power or utterly worthless and repulsive.

Economic models, argues Mr. Tuckett, need to account for the way peoples’ behavior changes with the psychological context. When they’re in fantasy mode, they’ll place astronomical values on anything from Dutch tulips to dot-com stocks to complex mortgage securities. When they realize the folly of their ways, they’ll focus only on the flaws. He hopes to create a survey of investors’ state of mind, which could be used as an input for an agent-based model such as the one Mr. Farmer is developing.

The 63-year-old psychoanalyst, who is working with Manchester Business School finance professor Richard Taffler to develop a new field of “emotional finance,” says it could be a long time before his ideas reach the mainstream.

“Economists have been terrified of psychology,” says Mr. Tuckett. “They believe that if they take it on board, they’ll have to go interviewing people and will never be able to make generalizations.”

Mr. Frydman, a professor at New York University, is accustomed to the role of an outsider. The 62-year-old economist says that even as a graduate student in the 1970s at Columbia University, he didn’t buy into the concept of rational expectations—a stance that has left him to pursue a career on the academic margins for more than three decades.

The main flaw in the dominant models, he says, is the same feature that makes them so attractive to policy makers: Their ability to make precise predictions. To generate their predictions, the models assume that people, firms and other players always make decisions in the same way. The players must also share the same beliefs about the exact probabilities of various outcomes, such as a rise in car prices or tax rates.

“It’s like socialist planning,” says Mr. Frydman. “If we really knew that much, we could have Communism and God knows what.” Capitalism works better than other systems, he says, because it lets people disagree about the future and profit from their insights—rational behavior that models don’t accommodate.

Mr. Frydman doesn’t offer a better way to make predictions. Rather, he believes economists and policy makers must come to terms with the limits of their knowledge.

Consider the housing market. If prices far exceed historical averages, as they did in 2006, we can know there’s an elevated risk of a crash. What we can’t know, says Mr. Frydman, is when that crash will occur, how exactly consumers will respond, or how much a given decrease in interest rates might help.

In Mr. Frydman’s view, the best that policy makers can do is try to limit extreme swings. A central bank might, for example, set indicative parameters for the prices of assets such as stocks, bonds and houses. If prices exceed those parameters, potential buyers will be forewarned that they’re taking on added risk of a big loss—and might even think twice about doing so.

Developed with economist Michael Goldberg of the University of New Hampshire, Mr. Frydman’s concept of “imperfect knowledge economics” has some influential admirers, including Nobel Prize-winning economist Edmund Phelps of Columbia University.

The ideas of Messrs. Farmer, Tuckett and Frydman are just a few of the myriad being hatched around the globe.

Many economists think the next big idea will more likely come from the ranks of younger Ph.D candidates, who are producing reams of work examining the financial crisis. Established academics—such as Mr. Gertler, Nobuhiro Kiyotaki of Princeton, Marcus Brunnermeier of Princeton, Michael Woodford of Columbia and Robert Hall of Stanford—are making progress on including banks, financial markets and even a bit of irrationality in traditional models.

Mr. Farmer says he thinks the traditional models will always be useful for certain types of analysis, but isn’t optimistic they’ll provide the whole solution. “Economic forecasts have never been very good, and it’s not clear that if we stick with the methods we’re pursuing we’ll do any better,” he says. “We need to try something new.”


November 29, 2010


BY WSJ : Russ Roberts: Hayek: An Economist’s Comeback –

He was born in the 19th century, wrote his most influential book more than 65 years ago, and he’s not quite as well known or beloved as the sexy Mexican actress who shares his last name. Yet somehow, Friedrich Hayek is on the rise.

When Glenn Beck recently explored Hayek’s classic, “The Road to Serfdom,” on his TV show, the book went to No. 1 on Amazon and remains in the top 10. Hayek’s persona co-starred with his old sparring partner John Maynard Keynes in a rap video “Fear the Boom and Bust” that has been viewed over 1.4 million times on YouTube and subtitled in 10 languages.

Why the sudden interest in the ideas of a Vienna-born, Nobel Prize-winning economist largely forgotten by mainstream economists?

CorbisFriedrich Augustus Von Hayek, ca. 1940.


Hayek is not the only dead economist to have garnered new attention. Most of the living ones lost credibility when the Great Recession ended the much-hyped Great Moderation. And fears of another Great Depression caused a natural look to the past. When Federal Reserve Chairman Ben Bernanke zealously expanded the Fed’s balance sheet, he was surely remembering Milton Friedman’s indictment of the Fed’s inaction in the 1930s. On the fiscal side, Keynes was also suddenly in vogue again. The stimulus package was passed with much talk of Keynesian multipliers and boosting aggregate demand.

But now that the stimulus has barely dented the unemployment rate, and with government spending and deficits soaring, it’s natural to turn to Hayek. He championed four important ideas worth thinking about in these troubled times.

First, he and fellow Austrian School economists such as Ludwig Von Mises argued that the economy is more complicated than the simple Keynesian story. Boosting aggregate demand by keeping school teachers employed will do little to help the construction workers and manufacturing workers who have borne the brunt of the current downturn. If those school teachers aren’t buying more houses, construction workers are still going to take a while to find work. Keynesians like to claim that even digging holes and filling them is better than doing nothing because it gets money into the economy. But the main effect can be to raise the wages of ditch-diggers with limited effects outside that sector.

Second, Hayek highlighted the Fed’s role in the business cycle. Former Fed Chairman Alan Greenspan’s artificially low rates of 2002-2004 played a crucial role in inflating the housing bubble and distorting other investment decisions. Current monetary policy postpones the adjustments needed to heal the housing market.

Third, as Hayek contended in “The Road to Serfdom,” political freedom and economic freedom are inextricably intertwined. In a centrally planned economy, the state inevitably infringes on what we do, what we enjoy, and where we live. When the state has the final say on the economy, the political opposition needs the permission of the state to act, speak and write. Economic control becomes political control.

Even when the state tries to steer only part of the economy in the name of the “public good,” the power of the state corrupts those who wield that power. Hayek pointed out that powerful bureaucracies don’t attract angels—they attract people who enjoy running the lives of others. They tend to take care of their friends before taking care of others. And they find increasing that power attractive. Crony capitalism shouldn’t be confused with the real thing.

The fourth timely idea of Hayek’s is that order can emerge not just from the top down but from the bottom up. The American people are suffering from top-down fatigue. President Obama has expanded federal control of health care. He’d like to do the same with the energy market. Through Fannie and Freddie, the government is running the mortgage market. It now also owns shares in flagship American companies. The president flouts the rule of law by extracting promises from BP rather than letting the courts do their job. By increasing the size of government, he has left fewer resources for the rest of us to direct through our own decisions.

Hayek understood that the opposite of top-down collectivism was not selfishness and egotism. A free modern society is all about cooperation. We join with others to produce the goods and services we enjoy, all without top-down direction. The same is true in every sphere of activity that makes life meaningful—when we sing and when we dance, when we play and when we pray. Leaving us free to join with others as we see fit—in our work and in our play—is the road to true and lasting prosperity. Hayek gave us that map.

Despite the caricatures of his critics, Hayek never said that totalitarianism was the inevitable result of expanding government’s role in the economy. He simply warned us of the possibility and the costs of heading in that direction. We should heed his warning. I don’t know if we’re on the road to serfdom, but wherever we’re headed, Hayek would certainly counsel us to turn around.

Mr. Roberts teaches economics at George Mason University and co-created the “Fear the Boom and Bust” rap video with filmmaker John Papola. His latest book is “The Price of Everything” (Princeton, 2009).

November 26, 2010




November 26, 2010


BY ZEROHEDGE : Flip, Flop Friday – This Week It’s Europe! | zero hedge

Ah, you guys fall for it every time, don’t you?

They take it up for BS reason, they take it down for BS reasons and, somehow, they get you to commit to some thing or another that goes the wrong way within a day or two. And you guys wonder why I like cash… You can’t leave anything on the table in this market! Today’s reason du jure for the markets pulling back is Europe again and, as we laid out for you weeks ago – it’s now on to Portugal as the next “crisis” in the making.

It looks like almost all of Wednesday’s gains will be wiped out by the time we open but let’s keep in mind all this EU nonsense is nothing but hyena attacks as most of these countries are not in that bad shape overall – certainly no worse than we are (maybe we’re next!). Anyone can be next. If you want to attack a country, you can attack any country where you can get traction on rumors that POTENTIAL bank losses exceed GDP – that’s a banking failure.

Once you get just a small amount of people to believe the banks may fail, then the rates start going up (and big investors can give them a little push artificially, of course, to get the ball rolling). Once the banks have to borrow at higher rates, then they need more capital reserves and then you can scream that they were lying about their capital requirements and call for “investigations” and that will convince more people they are hiding something and then the rates go higher and they need more capital and the bears can then parade on TV saying that they knew all along and that the banks are insolvent and they can EXTRAPOLATE that, at the rate things are going – the whole country will be bust in X amount of time…

You can do this to anyone, anytime. Only if we stop the speculators from profiting from this game will it ever end. The reason that there are no runs on banks in China and Russia isn’t because their banks are more solid – I’ll bet there are Chinese banks who have nothing but a fortune cookie in their vault – but the difference is in Russia or China they will cut your head off if you try to run their banks.  In America, when you cause a run on the banks, all they care about is how much you made so they can laud you as the next celebrity fund manager.

Nonetheless, our motto at PSW is “We don’t care IF the game is rigged, as long as we can figure out HOW the game is rigged and place our bets accordingly.”  I may express my outrage at these various market scams in my posts but, once the market opens, we play to win!  As I mentioned in Wednesday morning’s post, our plan with our Members was to let the market move up and then we would short it.  We grabbed an aggressive December TZA spread out of the box in the Morning Alert and then played the SPY Dec 3rd $119 puts at .90 (average) and we went back to naked on our DIA Mattress Play (fairly bearish) and added the USO $35 puts at .65 as oil spiked up.  We also found 3 longer-term bullish plays but those are well hedged as we’re just looking for a little balance – nothing like our aggressive short side.

With the Euro plunging to $1.32 early this morning and the Pound back at $1.56 – we finally have our Dollar pop over $80 and, of course, the commodity pushers don’t like that one bit and even the expected Rent-A-Rebel attack on an oil tanker and more crazy talk from North Korea couldn’t hold oil at the $84 mark against a rising dollar. As I said in yesterday’s post, which I called “Thanksgiving Thursday – Stuffing the Futures,” as we got more ridiculous pumping while the US markets were closed:

I’d feel better about ignoring the plight of this nation’s 20M unemployed and underemployed people if it wasn’t for the fact that consumable commodities have gotten so high. I don’t care how much money Donald Trump has but the World Record for corn eating is 46 ears in a sitting so, no matter how hard The Donald tries, he can’t consume enough corn to make up for the millions of people who have to cut back this holiday season. While 3D TVs and IPhones and Mercedes only need a few million customers to have a good year – it doesn’t make sense for broadly consumable commodities to assume the bottom 80% can continue to buy at these prices.

Of course, don’t go getting too bearish now.  We’ll be taking our bearish money and running this morning as we have a $45Bn money drop scheduled by the Fed next week and, while I don’t think it’s going to be enough to turn the tide if the Dollar keeps rising, I don’t think it’s worth risking much to fight it.

As usual, we will get back to cool, liquid cash and simply ride the waves, looking for the next opportunity to dip our toes into.  The EU needs to get their act together but if you take a look at this video of UK’s Godfrey Bloom calling Germany’s Martin Schultz “an undemocratic fascist” and getting ejected from the meeting – you’ll see that they aren’t all that close on coming to a general agreement on how to deal with their little PIIGies.  Here’s another “must see” video, an impassioned speech by UK’s Nigel Farage condemning the entire proceeding!

Man I love European Politics!  You might think that the EU spiraling out of control and a possible war in Korea would be great for gold but then you wouldn’t be a PSW Member because we know it’s ALL about the dollar and money flying out of the Euro doesn’t go to gold, it goes to Dollars and Yen and a rising dollar is NOT good for gold and we’ll get a nice move down there as the dollar moves back up.  Our re-entry point on gold is $1,150 so we have about $200 to go, which is 14%, which is about Dollar 88 so that will be fun to watch if the Dollar gets a real squeeze but, at the moment, we are only counting on the Dollar hitting 82 as that’s the 200 dma but woe unto the commodity pushers if it breaks over that mark so stabilizing the Euro will be critical this weekend for commodity bulls.  Hopefully Bloom and Schultz will work out their differences by then (end extreme sarcasm font).

Spanish Prime Minister Zapatero must be a PSW Member as he is taking my advice this morning and going directly after bond speculators, “ABSOLUTELY” ruling out an EU rescue of Spain, saying: “I should warn those investors who are short-selling Spain that they are going to be wrong and will go against their own interests.” Meanwhile, Portugal has denied a report that several EU countries as well as the ECB are pressuring the country to apply for a bailout. Separately, Portugal’s finance minister says the EU cannot force his government to accept a bailout. The spread between Portuguese debt and German debt now stands at 444 basis points – that’s 4.44% MORE for Portugal to borrow money than Germany.

The EU Commission is now (8am) suggesting doubling the size of its $588Bn bailout and that is boosting EU markets, who were down close to 2% going into lunch and are now recovering slightly on that news. That’s how quickly things can change around here.  Did I mention how much I like cash lately.  Those dollars are getting more valuable every day!

So it will be take the money and run this morning, especially if our Dollar fails to hold 80.50, which would be disappointing on such bad news from Europe.  We’ll be watching copper between $3.70 and $3.75 to give us a directional signal as well as oil at the $82.50 line, which would be tragic if it fails.  Natural gas has been our lagging commodity of choice and they are finally getting themselves together with a pop to $4.44 as LNG is once again being touted as driving future demand.  It’s all nonsense, of course – all LNG does is enable a two year supply of natural gas to be shoved into frozen storage but TBoone and his industry buddies have suckered enough governments and investors to buy into this nonsense that it has taken on a life of it’s own and we are just going with the flow.  CHK is the way to play Nat Gas long-term and they are quite a deal at $22.

Of course it’s Black Friday and it’s all about Retail Sales today and expectations are through the roof for a FANTASTIC holiday shopping season because all the people on TV (average salary $200,000) and all the analysts (average salary $250,000) and all the Retail CEOs (average salary $2.5M) and all the shopping mall owners (hanging on by a thread and will say anything it takes) say it’s going to be a great holiday because everything is fine and all of their neighbors who haven’t lost their homes yet are planning to buy something.  Isn’t that special?

Members, please take the time to participate in the 2010 PSW Holiday Shopping Survey. Last year we were able to accurately predict what turned out to be disappointing retail sales from our observations – we have a lot of very sharp people with a wealth of experience to draw on and I urge you to read last year’s post and comments to get an idea of what we’re looking for.

Have a great weekend,