History has many examples of people and societies being done in by a failure to revisit their basic assumptions. Are we about to make the same mistake, that of assuming that past performance IS a guarantee of future success?
Three examples will suffice to make our point. The first, a fool-proof mathematical model, gives a risk free investment strategy with a guaranteed return. The second, a risk management strategy, takes advantage of the law of large numbers to focus risk around a known rate. The third, a simple open system model, guarantees improved economic conditions by improving productivity at the margins. All three seem foolproof, but two have shown us the how our hubris can lead us astray, and we raise the question, “Can we really restore our economy by attempting to restart the old system(s)?”
An example of the hubris of mathematics. The Black-Scholes equations, with only some simple assumptions, give us a mathematical way to make simultaneous bets on options and on the underlying product in a balance that guarantees a small, but risk free return on our investment. Unfortunately, one has to review ones assumptions and pay attention to the system. The assumption that failed in around 1997 was that no major component would fail catastrophically. When the Russian ruble collapsed, funds lost billions of dollars, all because the basic assumptions were not being tested and confirmed often enough to detect or predict the collapses in time to protect the investments.
An example of the hubris of statistics. Risk is a part of investment, we are often reminded that profit is the reward one gets for taking risks. One way we minimize the effects of risk is through insurance, where the pooling of risk results in a very predictable rate of loss. This is why insurance companies can survive, by carefully measuring and managing pooled risks. In the Collateralized Debt Obligation crisis documented in Micheal Lewis’s book, The Big Short, we learned that the housing crisis was also brought on in part by a failure of an underlying assumption. The assumption that failed in this case is one at the heart of risk pooling, which is that the losses are independent of each other. Just as houses burn independently of each other, so do mortgages fail independently (most of the time). But when a systemic change causes all or most of them to fail, the CDO risks are still low variance events, but instead of guaranteeing the “historical rate” of 5% failures, they will guarantee the new rate — 95% failures (or higher, in the collected instruments that CDOs represent). This failure of the critical assumption, that failures were independent, is still causing economic turmoil.
An example of the hubris of economic theories. Our third example is being tested now. In the Adam Smith model of economic growth (classical economic theory) we find that the churn in businesses and markets at the margins, enhanced by free markets, result in a more prosperous society (more goods produced for fewer inputs, whether labor or materials). This results from the conversion of poorly performing capital investments to producing new products in new markets as new competitors and products out-compete the old businesses in their own markets (this is an interesting example of the effect of evolutionary Darwinian selection in markets*). But one of the underlying assumptions is the idea that the appetite for consumption will grow, that the need for new housing will grow, and that the consumption will be fueled by a steady flow of capital through the society (trickle-down if you are supply-side, or Keynesian government spending if you are demand-side, in some ways the reason does not matter). But this assumption may not be a constant, and the transition of societies from growing pyramids to more sustainable steady-state models (reflected in part by the change in the demographics of our societies) may signal the end of both the supply-side and demand-side economist.
This third test is still underway, what assumptions are our political parties making when they promise to restore our economy and create jobs using either of these approaches? And what should we do when they make promises that we don’t think they can keep, because we fear they may be working toward a model that is no longer viable?
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Representative Kelby Woodard, HD 25B, will be hosting “The Right Discussion” this Friday, January 27, 2012, at 12:15 pm. His guest will be Representative Sarah Anderson (R-Plymouth) to discuss Congressional and Legislative re-districting. Rep. Anderson chaired the re-districting committee in the Minnesota House.