A few weeks back I mentioned a well known resource minimization problem called the Traveling Salesman, and a far out “solution” to an analogous problem (scavenging) leveraging life. Graph theory is an area rich in algorithms which are designed to yield optimal, or more often good enough answers to problems which can’t be computed exhaustively¹. In this morning’s riff I’ll explore similarities between shortest paths, current flow and capitalism and hopefully learn a little in the process.

Ohm’s Law

Current flow through parallel networks (optional paths) is inversely proportional to the resistance along each path. Put another way, current automatically finds and flows along the most energy efficient path between potential differences. The shortest path for circuits can be thought of as the set of currents which optimize flow. An interesting result of parallel flow is that a single zero resistance path nullifies current through alternative routes (commoditize the complement²).

Ohm’s law states that the current through a conductor between two points is directly proportional to the potential difference across the two points, and inversely proportional to the resistance between them.
(source)

Pure Capitalism

Like current, liquid capital flows along the path of least resistance between potential differences defined by supply, demand, and available business resources. Government tax and business margins act as resistance to resource flow along economic paths. In capitalism competition is the result of alternatives, and consumers reinforce the paths of least resistance.

Asymmetries in liquidity, demand, and information are analogous to potential differences. This potential enables shrewd businesses to capitalize on economic forces and satisfy market needs. This motive force also leads to a continually evolving market as technology advances, and society’s tastes shift.

Economic systems: is a set of institutions for allocating resources and making choices to satisfy human wants.

Resource allocation is the assignment of resources to specific tasks to determine the basic economic choices, which are what to produce, how to produce, and for whom to produce for.

Pure Capitalism: is an economic system in which individuals own productive resources, and those individuals can use resources in whatever manner they choose, subject to common productive legal restrictions. In other words, it is the private ownership of productive resources including labor and the use of market mechanism and prices to coordinate economic activities. This system concerns the three Ps, prices, profits, and private property. This economic system is sometimes referred to as a laissez-fair system. Producing those goods and resources that people will buy at profitable prices will yield efficiency. In fact, advocates of this system argue that it encourages efficiency, stability of output and employment and economic growth. The government is limited to provide certain public goods such as national defense, basic education, and legal systems.
(source)

Notes:

1. O(n!) or O(nⁿ), for n=15, 15! is greater than a trillion operations
2. Commoditizing the complement in regards to current flow is the result of offering a free (no resistance) alternative to consumers, depriving competition of capital flow, and encouraging purchases of a business’ high margin product or service.

Related links:

• Variant Traveling Salesman Problem Solved by Sharks
• Ohm’s Law
• Pure Capitalism

What’s a Bubble?

Let’s start from a consensus definition of economic bubble (I spoke too soon, more links!):

An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, or a speculative mania) is “trade in high volumes at prices that are considerably at variance with intrinsic values”.[1][2] (Another way to describe it is: trade in products or assets with inflated values.)

The Interview

I recommend you read John Cassidy’s interview in it’s entirety, but here’s a good representation of Eugene Fama’s perception on the economy and bubbles. I had to reread it a couple of times to really understand Eugene’s point of view, my macroeconomics background is nil.

John Cassidy: I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.

Eugene Fama: That’s what I would think it is, but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

John Cassidy: Are you saying that bubbles can’t exist?

Eugene Fama: They have to be predictable phenomena. I don’t think any of this was particularly predictable.

John Cassidy: Is it not true that in the credit markets people were getting loans, especially home loans, which they shouldn’t have been getting?

Eugene Fama: That was government policy; that was not a failure of the market. The government decided that it wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower grade mortgages.

John Cassidy: But Fannie and Freddie’s purchases of subprime mortgages were pretty small compared to the market as a whole, perhaps twenty or thirty per cent.

Eugene Fama: (Laughs) Well, what does it take?

John Cassidy: Wasn’t the subprime mortgage bond business overwhelmingly a private sector phenomenon involving Wall Street firms, other U.S. financial firms, and European banks?

Eugene Fama: Well, (it’s easy) to say after the fact that things were wrong. But at the time those buying them didn’t think they were wrong. It isn’t as if they were naïve investors, or anything. They were all the big institutions—not just in the United States, but around the world. What they got wrong, and I don’t know how they could have got it right, was that there was a decline in house prices around the world, not just in the U.S. You can blame subprime mortgages, but if you want to explain the decline in real estate prices you have to explain why they declined in places that didn’t have subprime mortgages. It was a global phenomenon. Now, it took subprime down with it, but it took a lot of stuff down with it.

John Cassidy: So what is your explanation of what happened?

Eugene Fama: What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.

John Cassidy: But surely the start of the credit crisis predated the recession?

Eugene Fama: I don’t think so. How could it? People don’t walk away from their homes unless they can’t make the payments. That’s an indication that we are in a recession.

John Cassidy: So you are saying the recession predated August 2007, when the subprime bond market froze up?

Eugene Fama: Yeah. It had to, to be showing up among people who had mortgages. Nobody who’s doing mortgage research—we have lots of them here—disagrees with that.

John Cassidy: So what caused the recession if it wasn’t the financial crisis?

Eugene Fama: (Laughs) That’s where economics has always broken down. We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. (Laughs again.) We’ve never known. Debates go on to this day about what caused the Great Depression. Economics is not very good at explaining swings in economic activity.

John Cassidy: Let me get this straight, because I don’t want to misrepresent you. Your view is that in 2007 there was an economic recession coming on, for whatever reason, which was then reflected in the financial system in the form of lower asset prices?

Eugene Fama: Yeah. What was really unusual was the worldwide fall in real estate prices.

John Cassidy: So, you get a recession, for whatever reason, that leads to a worldwide fall in house prices, and that leads to a financial collapse…

Eugene Fama: Of the mortgage market…What’s the reality now? Everybody talks about a credit crisis. The variance of stock returns for the market as a whole went up to, like, sixty per cent a year—the Vix measure of volatility was running at about sixty per cent. What that implies is not a credit market crisis. It would be stupid for anybody to give credit in those circumstances, because the probability that any borrower is going to be gone within a year is pretty high. In an efficient market, you would expect that debt would shorten up. Any new debt would be very short-term until that volatility went down.

John Cassidy: But what is driving that volatility?

Eugene Fama: (Laughs) Again, its economic activity—the part we don’t understand. So the fact we don’t understand it means there’s a lot of uncertainty about how bad it really is. That creates all kinds of volatility in financial prices, and bonds are no longer a viable form of financing.

John Cassidy: And all that is consistent with market efficiency?

Eugene Fama: Yes. It is exactly how you would expect the market to work.

John Cassidy: Taking a somewhat broader view, the usual defense of financial markets is that they facilitate investment, facilitate growth, help to allocate resources to their most productive uses, and so on. In this instance, it appears that the market produced an enormous amount of investment in real estate, much of which wasn’t warranted…

Eugene Fama: After the fact…There was enormous investment across the board: it wasn’t just housing. Corporate investment was very high. All forms of investment were very high. What you are really saying is that somewhere in the world people were saving a lot—the Chinese, for example. They were providing capital to the rest of the world. The U.S. was consuming capital like it was going out of sight.

What Eugene was saying is that the market prices and expectations weren’t the root of the problem, but instead were a causality. External government influence (pushing mortgages) was part of the problem. But there was a recession in the works that preceeded all the inflated trading. When mass mortgage failure collided with the inflated subprime we experienced market gridlock. Assets (like property) around the world decreased in traded value, and Fama attributes the root cause to an unidentified “economic activity”.

If Bubbles exist how do we identify them before they pop?

There appears to be a form of “market momentum” which exists only as long as it takes prices to catch up to current intrinsic values. To free market purists, the traded value is the intrinsic value, ie you can’t estimate a better value. This model is defended by a common idea, if you know the intrinsic value, and it’s not the current market value, you should be very rich since the market has to catch up. The fallacy of that argument, knowing the intrinsic value, is not equivalent to knowing that there is a discrepancy between traded and intrinisic values.

My assumption is a simple one. The act of exchanging currency or any asset shouldn’t influence it’s intrinsic value. Equivalent trading doesn’t generate wealth, but takes wealth from multiple sources by providing liquidity. That’s Markro Economics in a nutshell.

But according to supply and demand I’m wrong. If I purchase all available oranges, I drive up demand by limiting supply. But I’d argue the intrinsic value of an orange hasn’t changed. I haven’t made it more satisfying, or nutritious. The inflated price is an illusion. The scarcity is an artifice of the market, unless I destroy the oranges, and I don’t know many folks who would do that with their own money. That alone is a good reason for investment companies (banks, funds, insurance, etc) to be required to own the majority of their investment capital (they can only invest a minority fraction of other people’s money). In contrast, if there were a real orange crop freeze, that would drive up the intrinsic value unless demand dropped proportionately (thank Trading Places for the example ).

The faster the market tracks the real value of any asset, the less impact any minor differences between traded and intrinsic value can have. The perfect market evaluator leaves no room for bubbles to grow.

Far Out Analogy and Why I could be totally wrong

The following analogy just occured to me. Let’s compare quantum physics to market trading for a moment.

• The act of observing in Quantum Mechanics affects the state of particles by collapsing the probabilistic wave form
• The act of buying and selling in free market exchange affects the value of assets by collapsing the probabilistic wave form of intrinsic value

So simply exchanging ownership could affect the intrinsic value. I’ll have to think more about this.