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The Equilibrium Delusion


Economics is a discipline for quiet times. The profession, it turns out, … has no grip on understanding how the abnormal grows out of the normal and what happens next, its practitioners like weather forecasters who don’t understand storms.

–Will Hutton, journalist The Observer, London

Our post on August 18, 2017, “The Financial Crisis Inquiry Report as a Harbinger,” quoted Warren Buffett, Ben Bernanke, and other luminaries on the causes of the financial and economic crisis of 2007–09. The report itself, in seeking to pinpoint the cause(s), seems to have overlooked an elementary question: How had a tumultuous history of crises and disruptions in economics and finance going back almost 400 years so miraculously ended in what was then called the “Great Moderation”? Self-regulation and the tendency toward equilibrium, co-opted from the natural sciences, became the beguiling buzzwords for the prior decade of delusions.

Some 30 years earlier, Friedrich Hayek warned in “The Pretense of Knowledge,” his 1974 acceptance speech for the Nobel Prize in economics, that it is foolish to believe we can shape the economic world around us by applying laws like those in the physical sciences to the essentially complex system of economics. Our forecasts will fail because economic laws are not universal but rather dependent on the moral lesson at the end arrangement, or organization, of individual elements of an economy. We have no quantitative capacity to access that situation. This critique echoed the “fatal conceit” of which he accused central planners.

Equilibrium & the Expectation of Negative Feedback

Three years after the Financial Crisis Inquiry Report was made public, Mark Buchanan,[1] a physicist, pointed out the fatal conceit of many economists. With the arm’s-length independence of someone grounded in the physical sciences, Buchanan noted that economics in general—and finance in particular—has long been based on notions of balance and equilibrium. The field maintains that the economy at large, and financial markets in particular, naturally tend toward a state of balance. Any disturbance or shock is thought to stir forces—negative feedbacks—that will bring the system back to equilibrium. Negative feedback, like the force of gravity on a pendulum, will cause the swinging weight to eventually revert to its position at rest. Markets, economists insist, work in similar fashion.

Belief in equilibrium confers a sense of safety and predictability. It also reflects a conviction in the capacity of human logic to understand (and thus control) natural systems. These assumptions restrict the kinds of things economists can imagine happening in the world. Bernanke told the Financial Crisis Inquiry Commission “a perfect storm” had occurred that regulators could not have anticipated.[2] This limitation on the range of possibilities likely explains why the commission sought to describe the financial crisis as the result of something exceptional and abnormal. It just could not have come from the ordinary internal workings of the markets, which are always supposed to remain in stable equilibrium.

Except when they don’t.

The Power of Positive Feedback

Most days have weather that allows us to go about our lives undisturbed. Yet hundreds of tornadoes form in Kansas every year. We don’t know if or where they will touch down, but they are the result of perfectly ordinary atmospheric processes in which one event builds upon another. Buchanan tells us that scientists call these progressions “positive feedbacks,” the consequences of which our human minds find hard to integrate into everyday behavior.

For example, most laypersons—although certainly not readers of this post—react with disbelief when the answer to this question is provided. If someone gives you a penny on the first day of a month, then doubles the amount every day thereafter, how much money will you have after 31 days? Individuals questioned often do the math in their heads for, say, the first 10 days: $.01, $.02, $.04, $.08, $.16, $.32, $.64, $1.28, $2.56 and $5.12. The answer is $21.5 million, which includes the $10.7 million accumulated on the first 30 days plus the final payment of $10.7 million on the 31st.

None other than Albert Einstein declared that compound interest is the most powerful force in the universe, the eighth wonder of the world. The second half of the quote is not as well known, but it’s no less germane: “He who understands it, earns it … he who doesn’t … pays it.”

According to Buchanan, even though the history of economics is largely a history of surprises that have emerged out of positive feedbacks, the phenomenon is rarely, if ever, considered as a possible explanation of economic events. Having been an observer of financial markets since 1966, I’ve seen the subtle presence of what George Soros has called positive feedback loops,[3] which have always and everywhere been apparent. Anything as complex as the markets, dependent upon the interactions of millions of capricious individuals, cannot be expected to miraculously reach an efficient and stable state of balance.

When Wisdom Is Not

Academic inertia is daunting indeed to overcome. Nowhere is this more apparent than in the presumed Wisdom of Crowds,[4] the non-mathematical intellectual bedrock of the so-called efficient market hypothesis. Admittedly, we’re all biased in similar ways, and crowds—and markets, as examples of crowds—are likely to be similarly biased.

But there’s another factor that should actually make the reliability of crowds and markets much worse. Whether in fashion, language, or investment choices, people tend to copy one another. This well-tested proclivity can make committees, crowds, and especially markets very unwise indeed. “What the wise do in the beginning, the fools do in the end,” Warren Buffett has observed.

Nassim Taleb complements Buchanan’s work, noting that

man-made complex systems tend to develop cascades and runaway chains of reactions that decrease, even eliminate, predictability and cause outsized events. So the modern world may be increasing in technological knowledge, but, paradoxically, it is making things a lot more unpredictable.[5]

According to Taleb, as we move away from natural models, such as those in the physical realm and add complications to the design of virtually everything, we end up with less robust systems in which the role of unexpectedly catastrophic outcomes is increasing.[6] Facebook is a case in point. How will that genie be put back in the bottle?

Disequilibrium as Model for Markets

In the capital markets, an intellectual blind spot to the power of positive feedbacks has been the bane of investors for centuries. Understanding, and perhaps even embracing, systems of disequilibrium (i.e., systems that maintain a rhythm of relative “calm” obscuring extreme distortions that result in periods of great upheaval) make us less intellectually fearful of accepting the fundamental nature of history, technology, geology, epistemology … everything.

Disequilibrium was at the heart of the flash crash (2010), the subprime crisis (2008), the quant meltdown (2007), the Long-Term Capital Management fiasco of 1998, and the Crash of 1987, among the many financial crises of history, to say nothing of what unknowable peril might lie ahead. In such circumstances the question arises: Where was wisdom when it was needed, long before things got out of hand? Regardless of its form—be it the Tea Party or Occupy Wall Street—that is always the question of the crowd in the midst of crisis. And members of the crowd are right to ask, but they’re invariably too late. Who and where are the wise men today?

Sadly, the “sophisticated”—possessed of asymmetrical information—are too often prone to amplify these trends rather than check them, and in their wake the unsuspecting are lured into traps of deceit. Central bankers? Professors? The commentators of the morning finance newsreel? I don’t hope to conclusively answer such a weighty query, but it seems to me that tempered voices are always audible if our ears are so attuned.

We have written extensively on the cumulative effect of positive feedback loops that have metastasized in relative calm. They have obscured extreme distortions that will result in future periods of great upheaval. Unfortunately, only history yet to be will demonstrate the strength and proper tone of arguments in the present.

[1] Mark Buchanan, Forecast: What Physics, Meteorology, and the Natural Sciences Can Teach Us About Economics (Bloomsbury Publishing, 2013), Kindle Locations 37–40.

[2] Fed Chairman Ben Bernanke was frequently wrong but seldom in doubt. As Friedrich Hayek suggested, such “fatal conceit” is endemic to central planners. Six months before the onset of the Great Recession, on May 17, 2007, Bernanke observed: “All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

[3] George Soros, “General Theory of Reflexivity.” Lecture, Central European University, Budapest, 2009.

[4] James Surowiecki, The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations (Doubleday, 2004).

[5] Nassim Nicholas Taleb, Antifragile: Things That Gain from Disorder (Random House, 2012).

[6] Ibid.

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