Monday, January 05, 2009

Economics—the infantile science

At the start of the 21st Century, it shouldn’t take a Nobel-Prize-winning mind to understand that all dynamic systems need regulation in order to function and last.

The first steam engines ran away with themselves and blew up. Physicists and engineers came up with a simple, elegant, and totally non-controversial solution. They added a governor, a device that throttled back the flow of steam into the engine when it revved up too much.

No 18th Century Ronald Reagan emerged, to my knowledge, to argue that steam engines were being over-regulated, and that the world could power more trains and ships by de-regulating their engines and pouring on more coal.

Biologists and physicians have learned that the human body is an intricate network of dynamic systems, every one of which is held closely in check by one or more “governors”—negative feedback loops.

Flexing your biceps stretches your triceps. That sends a nerve signal that keeps your biceps from contracting too much. If that feedback fails, your muscles can break your bones.

Down a sugar-laden dessert and your blood sugar level surges. In response, your pancreatic islet cells pour insulin into your bloodstream. The insulin drives your blood sugar back into a healthy range. If the feedback fails, you develop diabetes.

Did you ever wonder how it is that your body temperature stays so close to 98.6 degrees? Or how all those variables that show up on your blood test results stay in a normal range?

It doesn’t happen by accident, nor from the intervention of some “invisible hand.” It happens because every system in your body is regulated, kept within its functional range, by negative feedback loops.

Cells in your skin, your gut, your liver and your bones are constantly dying and being replaced. Those billions of reproducing cells are held in check by multiple inhibitory loops. If enough of those feedback loops fail, the result is cancer, and often, death.

Do doctors wish away these intricate regulatory pathways? Do they yearn for the days when they didn’t have to think about how the body regulates itself? Do they encourage you to eat all the sugar you want, spend unprotected hours in the sun, or dose yourself with carcinogens?

Of course not. They devote themselves to understanding and working with those vital regulatory loops. If systems are out-of-whack, they try to tweak them back into range. If they are broken, they try to replicate their functions with carefully controlled doses of medication.

Is this news to anyone? It was, when the dynamics of diabetes were first understood. That was in 1901.

Actually, you don’t need to know anything about physics, biology or medicine to understand the need for regulation.

Think about any game, from marbles to NFL football. Every game has its rules and regulations, and—beyond the elementary school playground—its referees and commissioners. Without rules, and rules that are enforced, games stop being fun or even playable. They degenerate into chaos.

So how is it that the brilliant minds that have been in charge of our markets—arguably the biggest and most important game around--over the past 30 years convinced themselves and tried their damnedest to convince the rest of us that markets not only could function without regulation and regulators, but would automatically create more and more wealth and prosperity as more and more regulatory loops were disabled?

As an aside, it’s worth noting that this isn’t the first time that experts got important things dead wrong.

Learned doctors kept bleeding patients, and supporting rivers of blood-letting with elegant arguments, for centuries.

Other leading physicians shunned the innovator Ignaz Semmelweis and his reality-based demand that they scrub their hands on the way from the autopsy table to the delivery room. By doing so, they condemned hundreds of thousands of women to needless death from “childbed fever,” a deadly disease whose occurrence they “explained” without reference to their filthy hands by a plethora of passionately defended theories.

One of America's “best and brightest,” Robert McNamara, truly believed that revving up the bombing of Vietnam would win the war. The more it didn't work, the more he believed it.

And of course we should not forget the highly experienced, Olympic Class Captain, Edward J. Smith, whose “full speed ahead” order doomed the Titanic.

Many pundits have offered “explanations” for the expert insanity of the people who have just run the global financial system into the iceberg of reality.

--Greed, for one, and short-sightedness for another. By report, the entire system was rigged to grossly reward people for any scheme they could come up with that would produce impressive short-term gains and disguise risk.

To hell with the future, and the public be damned.

--Others have noted a self-reinforcing coterie of economists pursuing the same agenda and lauding each other’s brilliance, up to and including the experts who have awarded a series of Nobel Prizes in economics for a set of abstruse theories about how markets function and how risk should be calculated, all of which were based on the assumption that market moves follow a normal distribution, like height, weight, or IQ.

Unfortunately, that fundamental assumption is blatantly wrong. As we have just seen for ourselves, market moves can be enormous, the equivalent of finding a person who is a mile tall, or has an IQ of 10,000.

The result, it seems, was a self-reinforcing system of theories and the financial instruments that flowed from them, all based on a grossly flawed assumption. Both the theory-builders and the traders who applied them were, and continue to be, more-than-amply awarded.

--Not to mention that even the scattered and tattered regulations that had survived thirty years of regulatory clear-cutting were not enforced for the biggest players, for example, Bernard Maddoff and his $50 billion Ponzi scheme.

Too bad that it was all a house of cards, and that the house collapsed, and that we all live in that house.

Although greed, short-sightedness, and institutionalized arrogance all played their role, I think that a more accurate assessment of how our economic and financial experts got all this so very wrong is that economics remains not just a dismal but an infantile science.

Infants live in a world of magical thinking. They imagine that they have unlimited power to shape reality to their will; that every wish will be fulfilled. If they were infant philosophers, they might even invent an “invisible hand” that feeds them when they are hungry, sooths them when they are upset, and will continue to do so forever.

Growing up means leaving magical thinking behind, accepting that people can’t fly (at least without building airplanes equipped with thousands of carefully designed feedback loops), that there’s no Santa Claus, no free lunch.

Growing up means living within the limits of nature and accepting the need for rules.

That’s pretty much what the great deregulator, Alan Greenspan, admitted when he told Congress on October 23, “I made a mistake.”

That mistake, by this very brilliant and remarkably wrong-headed man, and his colleagues, cost U.S. investors about $7 trillion, and investors worldwide perhaps $30 trillion, so far.

That’s almost $23,000 for each man, woman and child in the U.S., or $4,450 for every inhabitant of the world.

During the last few weeks of 2008, the S&P 500 index jittered around a 40% loss for the year.

That means that 40% of the value that almost everyone believed those stocks represented on January 1, 2008, was hot air.

If the stock market was a gleaming, 100-story tower on January 1, 2008, with more floors fully expected, on December 31 it was a smoldering wreck, with the top 40 stories pancaked into shards and dust.

And, as we saw on September 11, 2001, it will be something of a miracle if the whole tower doesn’t come crashing down.

(Note March 10, 2009) As of the stock market close yesterday, the major indexes have lost over 25% of their value so far this year. So make that 55 stories gone; 45 to go. In the crash of 1929, the market pancaked to 10% of its pre-crash peak, and took until the 1950s to climb back to that level!

If the current financial collapse teaches us anything, it’s that it is time for economists, theoretical and applied, to grow up, and fast.

Want a watch that keeps good time? Buy one with good feedback loops.

Want a car whose engine doesn’t blow up? Buy one with good feedback loops.

Want your computer to keep working? Buy a good voltage regulator.

Want traffic to keep flowing? Keep paying for those pesky traffic lights and peskier cops.

Want the world’s financial markets to work long term? 

We, voters and investors, need to grow up and not buy castles in the air.

And, to make sure that the world’s markets and the people who run them act like grownups, regulate them, regulate them well, and enforce the damn rules, especially for the biggest players.