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The paradox of Economics: a non-linear world run by linear methods

It is true, the idea that Economics must be a science plagues the minds of mankind. Many professionals and academics around the globe, among others, are trying to prove the validity and importance of existing economic models, theories or predictions. They also try to come up with other models, new ways of explaining “economic reality”, which besides their increased difficulty (because no one is interested in reading trivial representations of ideas that they have already heard of or are already “knowledgeable” in) do not bring much to the table.

Thus, if there is nothing spectacular for others to see, why even bother? That is, if you do not come up with a new complicated model (that is probably minor in terms of relevance), you’d better stay home.

However, Nassim Thaleb showed in one of his books, The Black Swan, that complicated macroeconomic models, for instance, are no better at predicting the future than are taxi drivers! In yet another attempt to illustrate this idea, investment advisers were asked to select a number of stocks that they think will perform well throughout the year. They also asked an orangutan to do the same. It turned out that the latter outperformed the much-praised experts.

However, above all else, economists attempt to convince themselves and, most importantly, other earthlings that what they are doing HAS to be a science. As for now, it appears they have been successful.

But why exactly is this harsh controversy such a hotly debated topic? Why is it so important to justify that Economics is a science, rather than a special type of art, for instance? Probably for much the same reason that you cannot allow a blindfolded driver to transport people in a car along a snowy mountain winding road. That is, masses cannot stand the idea of randomness. They can’t imagine their lives as mostly random sequences of events that occur because of factors that are outside their knowledge or power. Thus, there has to be an authority to “guide” them along the way. It is in human nature to seek connections and come up with coherent explanations that explain from human behaviour to…wars!

Nowadays, the beginning of WW2 is described by most historians as a normal, natural consequence, given the “escalating crises” and “unstable situation” of that period, among others. However, Niall Ferguson has shown that in reality, the situation was quite different. He did this by emphasizing the steady price of the imperial bonds, which should have changed in anticipation of the “obvious” imminence of war. (During wartime, governments will run large budget deficits in order to fund their expenses which in turn will increase the chance that they default on their payment obligations. Since investors expect this, they start selling their bonds, hence the decrease in price).

Yet there were no changes in the prices of bonds, which means that the war took a big part of the world by surprise, unlike what the backward-looking historians were led to believe.

To continue with the previous idea about our general blindness, the passengers would not even think about setting foot in the vehicle, had they known the state of the driver and the incredibly high chance of a disaster.

But what if they do not know? What if they are also blindfolded? Well, then, they are probably going to be in a lot of trouble. It might be possible that the driver is somehow able to keep the car from crashing on a straight, empty boulevard with no stop lights, but as soon as she encounters the difficult mountain road, the catastrophe is imminent.

Now think about our economy. On the “straight boulevards” everything goes more or less as planned, blindfolded people drive quite well, models work (almost) perfectly, and no one really cares about the “little” imperfections that occur or about the errors in the different types of predictions. After all, we can’t have everything!

Had the world been similar to what Nassim Thaleb called Mediocristan, where roads are usually straight and large deviations rarely occur (and also have a small impact), such inaccuracies would not have mattered a great deal. However, things differ in reality, or Extremistan, as Thaleb addressed it. The roads are winding, snowy and dangerous; wild fluctuations with high impacts DO occur and usually the impact of rare events is high.

Unfortunately, because the world is mostly run with methods from Mediocristan, when a rare, high impactful event actually happens, that is, when one of the variables from our non-linear “equation” changes with an amount that existing models cannot possibly sustain or predict, the outcome will be disastrous.

There is yet another important problem that occurs. Because we have only driven on a certain path and we have only seen a particular pattern for a large enough number of times, we start thinking that this is all there is to it, sunny, straight boulevards! The more time we spend under ideal or even normal conditions, the more our minds perceive the probability of something bad happening in the future as unreasonably low, since we expect that particular sequence of events to always happen.

We will all be quite surprised when we get to the unstable, snowy road where we cannot control our car anymore.

In the good times, however, a number of economists and others working in similar fields are praised for their sound models, win countless awards, and some even earn gigantic bonuses. Suddenly, a crisis occurs. After a short-lasting shock, most economists come back to their senses. The denouement was crystal clear, it was inevitable.

They then go on ranting about how obvious the crisis was and then proceed with the much-needed explanations. They find a lot of causal relations: too many subprime loans, financial derivatives that nobody understood, high leverage or AAA bonds that were actually junk. All too obvious. How could you have not foreseen the crash? Finding causes apparently works much like a potion healing the economists’ wounds. Even so, these scattered rationalizations are but a drop in the ocean.

In some cases (the world economy, for example) it is quite tedious, if not impossible to fully analyse and assign precise causes to certain outcomes, since a major event could virtually be determined by an infinity of causes. This is called The Butterfly Effect, and in essence it emphasizes how minor, linear elements can affect complex systems in a non-linear way.

In such an instance, there has to be an entity that pretends it is on the case and that the situation is under control (such as a central bank) in order to confer masses a psychological feeling of ease. A sizeable problem here is that more often than not, they do not acknowledge that one simply cannot predict and explain certain facts (and so is not in control). Despite that, they still act as if they really were in control, which usually leads to more harm than good.

What is also bothering is that a lot of forecasts concern the long term. Unfortunately, the further that particular point in time that is targeted by a particular prediction is or the longer the timeframe, the higher the probability of monstrous deviations from the initial estimate, given that we are part of a non-linear complex system, and even very small changes in the many variables of the “equation” can heavily influence the outcome.

Humans are, however, blinded by predictions and probabilities. Allow me to illustrate one variation of Hume’s induction problem: the pig is bought and fed every day for a long period of time before being cut for his meat. While, throughout this period, the butcher feeds the pig very well in anticipation of obtaining the greatest value out of him, the pig begins to think that having such a life is a privilege.

The more days passing, the stronger, happier and fulfilled the pig feels. He “considers” that the probability of being cut is lower with every passing day, since the custom of being fed has already inhabited his oblivious mind, when in fact it is the complete opposite.

The pig is blinded by probabilities too. The judgement day comes and he is slaughtered by the butcher, at the particular point in the pig’s life where he was the most solid he has ever been and when it was regarded (from the pig’s point of view) that the probability of being executed was the lowest.

There was absolutely no indication that the pig would be cut, if you were to ask him, according to past behaviour of the butcher. Yet, it happened.

Not to mention, this anecdote has plenty of applications in real-life.

This story has an important implication: while some (most) of us are pigs, completely blinded by our own ignorance and insensitivity, there are some butchers who profit from the pigs’ misinterpretation of reality.

Now, this does not mean that being a butcher is always acceptable and moral. For instance, right before the financial collapse of 2008, “butchers” were selling financial derivatives to their clients, while describing them as intrinsically valuable and good investments. In fact, they were betting on the price of those products going down, behind their client’s backs of course.

I feel like morality is quite an important attribute in the world of Economics and should not cross certain lines. Although corporations officially admit its importance, this still remains nothing but a utopic expectation.

Thus, do not be a butcher at all costs!


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