One of the most overlooked aspects of the financial crisis…

March 7, 2012
London, England

[Editor’s note: Tim Price, a frequent Sovereign Man contributor and Director of Investment at PFP Wealth Management in London, is filling in for Simon today.]

An engineer, a biologist and an economist are washed ashore on a desert island. After a few days without food they are starving. Eventually, they stumble on a can of beans on the beach.

They spend a few minutes considering how they might feed themselves. The engineer is the first to speak: “We could hit the can with a rock until it opens.”

The biologist counters, “We could suspend the can in a seawater solution and wait for erosion to work its magic.” The economist is last to contribute: “Let’s just assume we have a can-opener.”

OK, so it’s not the funniest joke in the universe. But it has the ring of truth.

For example, one colossal presumption of mainstream economic theory holds that the economic mean reverts to some form of stable equilibrium; all that is required from our enlightened monetary leaders, we are told, is a gentle nudge of this policy lever or that, and the path back to stability is assured.

But what if the presumption is fundamentally wrong at its core? What if the economy is never destined to reach a stable equilibrium- a state in any case analogous in its cold sterility to the dynamism of air molecules in a perfect vacuum?

Judging by recent market action (on the part of equities and euro zone government bond yields), investors would appear to believe that the euro zone debt crisis has been largely resolved.

The market’s supposed saviour has been the European Central Bank, benignly tipping half a trillion euros of liquidity onto the continent’s banks. More pertinently, a crisis of overmuch credit provision seems to have been resolved through the medium of… more credit provision.

Computer scientists coined the phrase “garbage in, garbage out” to describe the vulnerability of computers to process meaningless input data and produce comparably meaningless output. One could drawn similar conclusions about the modern financial system and all the economic garbage going into it.

It was Nobel laureate William Sharpe, for example, who devised the capital asset pricing model in the 1970s in an attempt to establish the sort of risks that can be reduced by diversification.

But the CAPM (as it became known) also contains a number of assumptions about financial markets that can variously be described as either quaint or ridiculous, including:

* Financial markets are perfectly competitive
* Tax does not exist; nor do transaction costs
* All investors have the same time horizon
* All investors have the same expectations of returns and volatility
* All investors can borrow and lend at one risk-free rate
* Investors can go short any asset and hold any asset fractionally

Clearly the natural world we actually inhabit simply does not behave according to the sort of models that economists use.

In “The Origin of Wealth,” Eric Beinhocker makes a convincing case that the rot set in to field of economics when serial French loser Leon Walras, having failed as engineer, novelist, journalist and banker, set his mind to this exciting new discipline. Beinhocker writes:

“Prior to Walras, economics was not a mathematical field. Walras and his compatriots were convinced that if the equations of differential calculus could capture the motions of planets and atoms in the universe, these same mathematical techniques could also capture the motion of human minds in the economy.”

And so erroneous, inappropriate, and flawed models were lifted wholesale from the world of physics, and made to fit, somehow, jammed and crammed, no matter what pieces broke or flew off, into the unstable and probably unforecastably wild world of the economy.

This matters. And it may be one of the most overlooked aspects of the financial crisis: widely accepted economic wisdom may be fundamentally inappropriate in “the real economy”, and the scope for potential losses in “the real economy” driven by such fundamentally inappropriate economic wisdom is almost infinite.