Thursday, March 12, 2009

Free markets? Part 1

I want to connect two seemingly unrelated intellectual points: evolutionism and Nobel Prizes in financial economics. What do they have in common? They both are founded on a belief in reason; a belief that math and science can explain everything.

Let’s start with evolutionism.

In Darwin’s Dangerous Idea, Daniel Dennett takes a philosophical and mathematical journey. This book is not for the faint of heart, but contains a couple of really challenging ideas as they pertain to faith and evolution. To begin, Dennett’s epistemology is Charles Darwin. This is the rail that his train runs upon. Darwin’s theory of natural selection posits that organic life is continually interacting with its environment and adapting to survive. To prove that humans evolved through this process, Dennett makes the following argument:
  1. Life is a near infinite mathematical game of chance. Just as it is possible to produce a winner of a contest to correctly “call heads or tails” 1,000 times, the Homo sapiens is indeed the outcome of a truly monumental decision tree.
  2. Dennett points out that over the course of millions of years, millions of “human-like” species were constantly trying to survive. 99 .999999999999999999999999999% failed.
  3. We are the outcome of this effort. We have existed for 10,000 of the earth’s hundreds of millions years.

Now this argument is nearly flawless in its simplicity. While it may be true that it does not deal with “why” life continued to press towards intelligence, consciousness and speech, I believe Dennett would argue that it was indeed random and not purposeful.

Dennett uses a fascinating theoretical example to prove his point. He says that chimpanzees have been taught to type on a typewriter (press keys). If an infinite number of chimpanzees were put in front of an infinite number of typewriters and proceeded to randomly press keys on the QWERTY keypad, Dennett argues that they would randomly generate The Canterbury Tales, the Old Testament, War & Peace, etc. They would also generate versions with minor errors. They would also produce meaningless babble. This is his proof that we evolved from a random experiment of trial, survival or death.

Let us now turn to economics and financial markets.
So what about the application of calculus and physics to modeling the behavior of financial markets? Well here I will give you a personal reflection. As a student seeking my MBA from Wharton in 1988, we were all introduced to the Black-Scholes mathematical model of the market for a stock equity, in which the equity's price is a stochastic process. It was used extensively in valuing put and call options. We were introduced to Markowitz, whose work on Efficient Market Theory won one of the first Nobel in economics for this approach. We were told, and for the most part, we believed that we could break down the “crude market” and its financial instruments, into discreet parts and by doing so, predict cause and effect through probabilistic outcomes.

  • As an example, bonds were originally pretty straight forward. A debt issuer (public or private) would receive a lump sum of money (the coupon) from a debt buyer in exchange for a promise to pay interest upon that amount, and then one day repays it. “Back in the old days,” a debt buyer would receive a certificate which had coupons around the border which were detached and sent into the debt issuer for payment. Upon maturity, the coupon would be returned for redemption. But when I was in school, new markets had started in the 1980s which separated the interest payments from the repayment of the “lump-sum.” The “coupons for interest” were “stripped” off the certificate and sold to a buyer who wanted just the stream of payments. There were called “strips.” The certificate leftover was called a “zero coupon bond,” and would be sold to someone who needed a “lump-sum” payment in the future.
  • This is just one example, but suffice it to say that “straddles” “swaps,” “puts,” “calls,” and all the other “financially engineered” products took off in the 1990s.
  • For home mortgages, FNMA, GNMA and FDMA were all established to lower the risk for banks lending to consumers. They allowed banks to sell off to these institutions those mortgages which conformed to certain standards – namely as 20% cash down payment and a fixed rate 30 year term. The bank would originate the mortgage locally. The government would bundle thousands together into the equivalent of a huge bond, and then markets would again split up the interest rates and the principle repayment. Imagine further how complex this became when the markets introduced variable rates!

I recall that most of my corporate finance and capital market professors worked as consultants on Wall Street and were trying to find ways to reduce risk, increase return, and basically try to tailor products to the exact needs of different types of clients. Well-intended, but as we now know, unsuccessful. The belief and early performance of these products led to an overconfidence. With the fall in REAL assets, like home values, and with REAL default due to poor lending practices, the confidence collapsed. All the rocket sciences could no longer understand the complexity of the system that they created…not in a systematic way. Rather, much like Mr. Dennett’s argument, the global financial marketplace evolved randomly. Each action was purposeful, but in aggregate they came together in ways that were not coordinated nor understood.

For me personally, I spoke frequently in the fall of 2008 about how the world economy and the financial marketplace would “learn and adapt.” I cited the savings & loan crisis of 1983-85, the Eastern European currency crisis of 1998, the “Asian Contagion” of 2003 caused by the collapse of Long Term Credit. For the US and world economy withstood the challenges and evolved. I’m not certain today. I am not as optimistic.

So how do parts one and two relate? Perhaps it is self-evident, and if it is not, my apologies.

Dennett argues that nature randomly generates something as unique as life. The corollary to economics is that a “completely free market” will generate perfect outcomes for all participants. Both are wrong.

The belief that everything is either determined by human reason – through math and science – to create and control “completely free markets” is also flawed.

So do we quit? No. We eat some humble pie, and we find the balance of freedom and regulation.

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