The ECONOMIST on Economic Blogs

Interesting stuff, but what does one do with it?

The in a “Briefing” under the title “Marginal revolutionaries: The crisis and the blogosphere have opened mainstream economics up to new attack,” the ECONOMIST (12/31/2010) magazine commented on the “heterodox” nature of economic blogs. In typical media fashion it restricts its briefing to macroeconomic, specifically policy-related, issues. That isn’t a criticism. The “Briefing’s” focus is consistent with the magazine’s focus and the reason people (including The Hedged Economist) read the magazine.

However, it really only scratches the surface. As readers of this blog may have sensed, economics can and should inform individuals’ microeconomic decisions. The blog is written in the belief that for most individuals the benefits of applying economics to personal financial decisions will have far great impact on the reader’s well-being than government policies. It isn’t as interesting as policy debates, and thus would be totally inappropriate if The Hedged Economist aspired to mass circulation.

Yet, often policy discussions that incorporate forward looking statements and/or impact analyses are so analytically flawed or preposterous that a posting highlighting them is the proverbial “low hanging fruit.” It’s an easy way for a blogger to provide useful information even if it’s only marginally useful.

To illustrate, this blog originated from a discussion of banking reform. Anyone who acted on the belief that bank reform would eliminate systemic risk undoubtedly found the last few years (especially 2011) difficult. The justifications for skepticism in the initial postings during the first few months of 2010 certainly provided individuals with a better foundation for their thinking. Similarly, heaven help the individual who acted aggressively based on analyses of the fiscal stimulus without realizing how tenuous the assumptions in the analysis were.

There is no doubt debunking policy analysis is low hanging fruit. Even the best policy analysis is almost always peppered with underlying assumptions that when made explicit are absurd. Their absurdity has implications for individual investors. Pointing out the silly assumptions, however, doesn’t make the implications for personal budgeting (and therefore consumption) and investment decisions obvious. It can often necessitate delving into the theoretical underpinning and mathematical expression of the theory.

However, the ECONOMIST tries to discuss the difference in a number of theories about how policy works without addressing some fundamental methodological issues. The reader is free to consult the article to form a judgment about the value of that approach.

One thing is clear from the ECONOMIST’s coverage: in order to take the approach it uses, the author had to totally ignore many methodological issues. Two are particularly important issues from an individual investor’s perspective. Again, that isn’t a criticism; the ECONOMIST’s briefing is interesting. There is no reason the ECONOMIST should have to focus on issues that interest The Hedged Economist.

The first issue the article largely ignores is path dependence. It discusses the different theories largely in terms of end states or stable trajectories. It relies on each theory’s description of how the end state is achieved without any discussion of the impact on the end state of deviations from the hypothesized path. A reasonably imaginative person can envision deviations from each theory’s description of how the economy adjusts that would result in a disastrous end state even if the theory is right.

If you think path doesn’t matter, consider the personal investment implication of this statement of fact. The Dow Jones Industrial average finished the year up about 5% plus dividends. Now ask yourself: Would the economic and stock market outlook for 2012 be the same if that result had been achieved as a smooth path from start to finish?

From a personal finance perspective, deviation from a smooth adjustment could have a substantial impact of how much is available to invest in 2012. To illustrate, some people preferred to sit out the market rather than endure the volatility (a perfectly legitimate responds). The result is they don’t have the market gain to invest in 2012.

Another example concerns options. There are option strategies that make sense for even the most conservative investors. (They’ll be discussed in more detail in a subsequent posting). Volatility in markets makes them more profitable than just buying or selling stocks. More adventurous investors could enhance the profitability of options by using the market’s path dependence. It required also remembering a point made in the first posting on the Fed’s quantitative easing, “Speak Softly But Carry a Big Stick, Dr. Bernanke.” That posting noted that “While the jury is still out, one can at least make a coherent defense of the proposition that liquidity-driven asset price cycles should create covariances that converge over an extraordinarily large set of asset classes and national borders.” In a liquidity-dominated cycle, the volatility can be used to buy target stocks at a discount and sell only at a premium.

Never mind which theory is “right.” Leave that to the ECONOMIST to discuss. Methodologically they all share the same shortcoming. The current state of the economy is not just dependent on current conditions. It also depends upon how those conditions came about. That dependence includes how it will respond to various policies. Often an individual can enhance return by adjusting to how the economy and markets will get where they’re going without risking a big bet on one’s judgment on where it is they’re going.

The second issue the ECONOMIST’s Briefing overlooks is that all of the theories could be right some times and wrong other times while there are other times when none of them apply. Each of the theories is very good at explaining certain observable historical facts; thus right some of the time. But, none of the theories explain all of the observable historical facts; thus wrong some of the time. For the individual the implication is clear. Basically an individual should be very cautious about using the forward-looking implication of any of the theories the ECONOMIST discusses. By contrast, rigorously applying them to understand how the economy got where it is can be productive.

Economists like to think of themselves as scientists. Consequently, the “both right and wrong” is uncomfortable. It seems that they find it (i.e., both wrong and right) harder to admit than to continue arguing. That general aspiration to scientific stature is compounded by the positive returns (both psychic returns of not having to question one’s own beliefs and financial return of aligning with an ideological sponsor). Thus, economists focus on finding an excuse for instances when a theory isn’t supported by events rather than define the boundaries over which the theory can be useful. Excuses are a lot more comfortable than trying to figure out ahead of time what model is appropriate at any given point.

However, even physical sciences have to deal with uncertainty. At the most micro level, the physical sciences have taken to discussing waves of probability. That’s true even though physical scientists deal with phenomena that we assume are stable across space and time. Economists have to deal with phenomena that may not rigorously conform to that model.

Neuroeconomics and behavioral economics (two specialties in economics) have added information that has implications for even the most macro policy analysis. Yet, to date much of the focus of neuro and behavioral economics has been on individuals’ market behaviors, and even there the research tends to hint at implications rather than subject them to extensive testing at the market level. One thing is very clear: in economics, stability over time is limited, and if space is equivalent to context, stability across space doesn’t exist.

Both specialties provide ample evidence supporting this blog’s frequent references to the fallacy of assuming consistent (i.e., linear) responses to policies. To illustrate using an obvious example, both specialties (as well as stock market lore) provide evidence that potential gain and potential loss are not handled the same. Behavioral economics indicates reactions and behavior are different depending on whether the current situation is perceived as resulting from previous gain or previous loss. The market lore is that loss avoidance trades (whether selling or short covering) are more abrupt than the pursuit of gains. Neuroeconomics indicates fear of loss isn’t even processed in the same part of the brain as expectations of gains.

Interestingly, some econometricians have tried to address this asymmetry by estimating the relationships separately for upward and downward changes. That’s just one example. It’s getting to be very clear that macroeconomists are going to have to tighten their definitions of when their theories (i.e., models) apply. In other words, they need to be far more diligent about defining ALL the assumptions they are making. Most importantly, they need to acknowledge the evidence they ignore. One can’t know the future, but one can measure the present including what people are presently saying about the future. Often looking very closely at assumptions can assist an investor in judging how to interpret that information.

For the individual, the broader implication is quite simple: be very careful about assuming that what has worked in the past is going to work in the future. Any investment approach should be back-tested. However, investors should be careful how they use the results. Investing is about the future.

There is a very delightful book entitled THE HERETICS OF FINANCE by Andrew W. Lo and Jasmina Hasanhodzic. (Andrew Lo’s name may seem familiar to followers of this blog. His book entitled A NON-RANDOM WALK DOWN WALL STREET is one source this blog cited for econometric data illustrating the limitation of financial economics). The subtitle of HERETICS is “Conversations with Leading Practitioners of Technical Analysis.” It’s “delightful” because it provides examples of different approaches that most practitioners characterize as working until they stop working. That’s a useful insight when considering the value of back-casts.

In summary, the ECONOMIST’s briefing ignores two points individual investors should never ignore: first, adjustment paths can determine end states, and second, economists can add information. Economics can inform an investor about the present, but it can’t do much to reduce the uncertainty of the future. That’s the individual investor’s responsibility.