Can faith solve our economic problems or do we need to challenge economic theology?

Can our economic problems be solved with belief and faith?  If yes we should all increase our attendance at church or mosque or temple.  If no we may need to challenge some basic economic theology and those whose interests are supported by current economic beliefs.

I figure the basic economic problem is with energy and mineral resources.  We have used up the most easily accessible.  While there may be lots left in the earth’s crust their extraction is difficult and requires lots of energy.  This means there is less energy available for all the other things we are used to having and standards of living are falling, at least for some people.

Many of us find it difficult to accept that this is a problem.  We want to believe that economic growth can continue forever.  We have been indoctrinated with the work ethic and believe that our happiness depends upon having a job and earning our keep.  Unemployment causes a great deal of hardship

If the above theory is correct, then the problem is not one of returning to economic growth but one of adapting to a different situation.  This means questioning a lot of what we believe about economics.

At this point I should distinguish between what I would like to see happen and what I expect to happen.

I believe we should have a collective responsibility to ensure everyone has the opportunity for the same standard of living as most other people.  Some ideas about how to accomplish this are outlined in the essay “LETS go to market: Dealing with the economic crisis” on this weblog.

What I expect to see is a return to the type of social order which existed before the industrial revolution where most people lived at a subsistence level and worked to support a very few in obscene luxury.

In the meantime the debate  of austerity as opposed to stimulus continues.  Austerity is probably necessary but the way it is being carried out is taking us to a feudal type of society.  Stimulus will use up even more of the available resources and bring us even quicker to a feudal society.  Hyperinflation is also a possibility.

When I read various reasons for the economic crisis and the few suggestions for dealing with it I think of people drowning in the middle of the ocean and thrashing about hopelessly.

The random walk and fractals

Long-Term Capital Management,  the theory of fractals and the Hurst Exponent lead me to question that markets are random and rational in the debate recently given a nudge by the awarding of the Nobel Prize in economics to economists on either side of this question.

For me the timing of the award was good because I have just finished reading When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein.

Long-Term Capital Management was an attempt to make money  out of a belief that markets are rational.  The company employed academics in economics/mathematics to trade according to models run on computers.  It worked for a while and this company became one of the most successful hedge funds and two of its board members were awarded the Nobel prize in economics.  But one of the reasons it failed was because the markets did not always behave as they had been modelled.  They behaved like fractals.

Another reason the company failed is that its employees were not really geniuses.  I have a theory that genius is 90 percent plagiarism.  Thus anyone can be 90 percent genius so long as they listen.  Those who don’t listen are stuck down below 10 percent. This would suggest that to be a genius you have to listen.    It is clear from the book that these guys were not listeners.   They were caught with the idea that you can prove how smart you are by how much money you can make.

The author of this book figures the way to make sure there isn’t another LTCM is with greater regulation.  Rather than regulation governments should require financial institutions to publish detailed information about their operations.  These guys were extremely secretive and refused to provide their associates with information which would have revealed their operations as being much riskier than anyone believed.  Their customers should have refused to work with them but the company was making so much money no one wanted to be left out.

I didn’t learn about fractals until sometime after I had studied economics. Now I think they provide a good model for a lot of human activity including markets and economics.

The classic example of a fractal is the sea-shore with its ins and outs and more ins and outs within the major ones.  Think of the song about a wheel within a wheel within a wheel.  The Elliott wave theory is a fractal, just remove the fives.  Markets and the economy can be seen as a series of trends with trends within trends.  They also have major turning points rather than following the straight line of regression analysis.

So the problem for somebody trying to forecast markets or the economy is to identify turning points, especially the major ones.

There is a concept of fractal dimension which indicates the extent of the trends and it can be calculated with the formula 2 – H where H is the Hurst Exponent.  Changes in fractal dimension indicate turning points.

Edwin Hurst was a hydraulic engineer working on the Nile River in the first half of the twentieth century.  He wanted to prove the different annual river flows were random and developed a way of testing a series of numbers to determine whether or not they were random.  To his surprise they were not.

The same test can be applied to any time series including market and economic data.  The Hurst exponent can now be calculated with as few as 32 data points and it varies considerably with each calculation, most indicating the numbers are not random.  This by itself is a strong indication that there are problems with the random walk theory.

I suspect a lot of the “quants”  who are currently using “black boxes” to play the markets, apparently with some success, are using the Hurst Exponent.

The importance of the debate about random walk may depend upon how much we want to understand about how markets and the economy actually work.  It may be that some people don’t want to understand how things actually work.  For those of us who do I think fractals are more promising.  And one should never place one’s savings with fund managers who don’t listen.

Government debt default and the money supply

A United States debt default will hit the economy as a reduction of government spending and it could also  hurt by forcing changes in the money supply.

The first thing to say about debt is that there is so much of it around the world that there is a high probability most of it will be written off either by defaults of inflation.  This debt is not so much borrowing from children as a transfer of purchasing power within this generation, some/most of which will never be returned. And those with the most are likely to lose the most but will still probably be more comfortable than the rest of us.

The second thing to say is that the probable root  cause of the economic crisis is in the real side of the economy as well as the financial sector.  We have used up most of the easily accessible energy and mineral resources and those that are left take a lot more work to extract.

If the United States defaults  some of its debt the government will have less money to spend.  As government spending is a component of gross domestic product there will be a reduction in economic activity.  Government spending currently makes up about 20 percent of GDP but only a small part of this will likely be cut immediately.

The effect of a debt default on the money supply is more complex and uncertain.  A drastic reduction in the money supply would bring a lot of economic activity to a halt.

Money is based on loans issued by the banks, involves fractional reserves (they are required to keep a percentage of deposits as reserves)  and dependant upon what is called high powered money which is subject to a multiplier because of the fractional reserves. (for and explanation of how money is created see these links, one, two.)  In a default one issue would be how much the losses fall upon institutions subject to fractional reserves because losses would reduce their reserves.  A reduction in their reserves would bring down the quantity of loans they could make – by a multiplier.  Thus the money supply in the economy would be reduced and without money the exchange of goods and services becomes difficult.

Under normal circumstances a reduction in the money supply would mean a reduction in the real economy.  But the real economy is already in trouble as noted above.

At this point I need to remind you of the formula MV=PQ.  The money supply times its velocity or the rate at which it changes hands is equal to prices or a price index times the quantity of goods and services.

In an attempt to stimulate the economy central banks have been using “quantitative easing” to inject more high powered money into the financial system so the banks will have more money to lend.   If the above formula is correct then there should have been a reduction in velocity or an increase in prices (inflation) or economic activity.  It may be that velocity has fallen but there is little evidence that inflation or GDP has increased.

If the formula is correct then something has to have happened to one of the other variables.   One possibility is that at least some of this extra money has gone into the financial markets and inflation has hit stocks.  If this is correct, then a reduction in money supply could hit the financial sector.

So there you have it a U.S. default would probably lead to a reduction in economic activity and it could also cause problems in the financial markets.  I just had a horrible thought.  What would happen if a lot of the major countries were to default at the same time?

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