Cloudy, with a Chance of Default

by John on January 2, 2013

 Timely forecasts can be essential to safety

Global finance has more in common with weather prediction than many economists might admit. If they studied the history of weather forecasting, they might be a little humbler in their statements about business cycles and equilibrium.

After all, until the ’60s, weather forecasters thought that more data, more computational power and better models would improve long-range forecasting so that a thankful public could plan weddings and picnics far in advance, free from meteorological harm.

Then MIT mathematician and meteorologist Edward Lorenz ruined everything when he noted that his models, run from the same starting point, would produce widely divergent results. Probing the underlying mathematics, Lorenz discovered Chaos Theory, one of the most important scientific developments of our time.

Until then, meteorology had progressed rapidly, based on understanding physical systems. Descartes founded modern meteorology with his 1637 publication of ‘Les Meteores’ but lacked the basic data to develop his theory. As measurements and understanding evolved—Galileo and his thermometer, his student Toricelli with the barometer—and the realization that temperature and pressure varied with altitude, more attempts were made at forecasting, with little success.

Modern meteorology awaited early-20th century developments and the fundamental observation by Norwegian mathematician Vilhelm Bjerkness, who defined the properties of air masses, weather fronts and atmospheric waves. He stated that all future weather patterns stem from their initial form, acted upon by physics via known mechanical and thermal laws. If only the financial ‘weather’ parameters were so well defined.

Meteorologists then felt that they simply needed to feed sufficient data into the correct models. They could not do so until, in April 1950, John von Neumann, of physics and game-theory fame, worked with meteorologist Jules Charney, created the first successful computerized weather prediction. Soon the computerized models were more accurate than their human counterparts.

Despite these advantages, the ability to predict the weather precisely more than a week or so ahead has not happened. Meteorology has made great strides in understanding the weather, such as storm tracks for hurricanes, and overall understanding of drought, extreme weather and climate-change patterns. But, as Lorenz’ discovery shows, the ability to predict weather at a specific location more than a week or so ahead is barred by the chaos intrinsic to global weather. Why should the even more complex, dynamic and non-linear world financial system, mainly governed by human perceptions rather than physical laws, be any less chaotic?

Comparing the development of meteorology and climate science with economics, weather researchers began to recognize that, as the American Institute of Physics put it: “Before they could understand how climates change, scientists would have to understand the basic principles for how any complicated system can change. Early studies, using highly simplified models, could see nothing but simple and predictable behavior, either stable or cyclical. But in the 1950s, work with slightly more complex physical and computer models hinted that even quite simple systems could lurch in unexpected ways. During the 1960s, computer experts working on weather prediction realized that such surprises were common in systems with realistic feedbacks.”

Attempts to reduce climate physics to a couple of hundred lines of equations were set aside in the development of ever more sophisticated simulations, analyzed and modified against their ability to reproduce historic weather conditions, such as ice ages and aerosols from volcanoes such as the 1991 Mt. Pinatubo eruption. Only after decades of modeling of global warming, international cooperation across a wide variety of disciplines including oceanographers and paleobiologists, and numerous model changes to incorporate an increasing range of factors such as aerosols and ocean temperatures, could the editor of Science Magazine announce, in 2001: “Consensus as strong as the one that has developed around this topic is rare in the history of science.”

AWH Phillips, of Phillips Curve and Moniac hydromechanical simulator fame, proposed that a similar effort might be made in the study of economics. Realize that he had done much pioneering work on analog simulators and economic stability in the 50’s when the results were shown on an oscilloscope!

Phillips proposed that future developments might enable the construction of an electronic analog machine that “using a combination of econometric and trial-and-error methods, the system of relationships, the form of time lags and values of parameters of the analog might be adjusted to produce as good a ‘fit’ as possible to historical time series, and the resulting system used in making economic forecasts and formulating policies.  This would be a very ambitious project. Apart from the engineering problems involved, requiring close coordination of statistical, theoretical and historical studies in economics…” The engineering problems have been overcome with the development of massive computational capability, and the history of climate modeling provides a direct parallel in the study of global warming, an even larger problem than economic stability. 

In 2008, Queen Elizabeth, visiting the London School of Economics, asked: “Why didn’t economists forecast the crash?” Consider global finance as a separate entity, assigning resources worldwide; the ‘weather system’ in which economies operate, a chaotic global flow of cash with series of highs and lows, rapidly shifting storms and calm areas.

To borrow from Lorenz’ analogy as to the flapping of a butterfly wing setting off a tornado in Texas, the waving of financial paper by a London or Singapore trader can trigger the loss of billions of dollars in New York. Recall the ‘London Whale’ and JP Morgan, and the collapse of Baring’s Bank (1762-1995) by rogue trader Nick Leeson. He hoped to cover his errors by betting on a major rise of the Japanese Nikkei stock index, only to see it sent crashing by the 1995 Kobe earthquake. The delusion of human expectations met the realities of real-world events.

Back in the ’30s, John Maynard Keynes spoke eloquently on the unpredictability of such events and their financial impact: “About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” More recently, Nassim Talib used the analogy of the Black Swan to explain the unpredictability of events in his eponymous book.

Consider Talib’s Mediocristan/Extremistan country analogy, replacing geography with an economic weather map where financial markets’ ‘ extreme weather’ can radically affect real-world economics. Visualize the ‘real’ economy as an aircraft flying through the ‘atmosphere’ of the financial markets. We want a smooth ride through the stable areas on our financial weather map. But the risk of encountering extreme turbulence, such as an embedded thunderstorm, is greatly increased when flying in unstable weather.

Airlines operate in all sorts of weather but avoid extremes by using weather radar and other short-term measurements to assess the risk of continuing the flight and divert around those extremes. If the weather is too severe en route, they don’t fly. Even today, their judgment may be flawed, evidenced by the 2009 Airbus crash in the South Atlantic, but airline flying has become extraordinarily safe.

The Federal Aviation Pilots Handbook guidelines on extreme weather could easily be changed into a policymakers ‘flight’ manual to insure safety. In extreme weather, the most important task is to maintain a stable attitude, rather than altitude and maximum velocity, and operate at a speed that prevents overstressing the aircraft’s structure, thus avoiding situations that could exceed its safe loads and stability envelope. Flying at maximum speed and altitude into potential extreme turbulence is the economic equivalent of turning control over to an autopilot programmed by the financial community, oblivious to the risk of flying directly into financial turbulence capable of ripping the wings off the economy.

Dr. David Leinweber of the Advanced Computational Group at Lawrence Berkeley National Laboratory has proposed just such a solution to the problems of instability in flash trading: upon  detection of instability, slow the rate of automated trading until markets enter a more stable regime, as discussed in his OECD article ‘What can NASCAR teach NASDAQ about avoiding crashes?’.  He proposes real-time monitoring of trading conditions, much as weather forecasters monitor physical data, and rapidly identifying conditions that will lead to instability, then slowing the markets to prevent these conditions from getting out of hand, as in the famous ‘Flash Crash’ and more recent high-speed trading debacles.

It’s tempting to make analogies to Hurricane Sandy, where it was impossible to predict the exact birth of the storm. Once it developed, short-term predictions of its path and impact became possible. The phenomenon of ‘gravity waves’ is perhaps a far better analogy for the interactions of financial markets with the real world economy.  They can rapidly induce severe weather events, such as 4.5-inch-diameter hail in Texas, as illustrated in this NOAA article, (be sure to watch the animation).

Weatherwise, a highly readable meteorological journal  carried a fine explanatory article describing snowfalls, where weather/ocean interactions over the Pacific and Arctic can trigger fast-moving conditions on the East Coast that shut down virtually everything. These snowstorms incur real and immediate economic impact, including the costs of snow removal. Similarly, a financial ‘gravity wave’ such as the sub-prime debacle can cause a storm that dumps enough on the real- world economy to bring it to a near halt.

Perhaps economists should revisit William Phillips’ work on cybernetics and stability as a basis for studying the interactions of financial turbulence with the real-world economy. We could then give government agencies the computational and data-gathering tools they need to monitor Wall Street and the financial community in real time, so that they straighten up and fly right.

Till then, the forecast will be cloudy, with a chance of default.

 

3 comments

Our Children Know

by John on December 18, 2012

 2011 Advertisement for the Bushmaster ACR taken from the web.

 (Click for larger image)

The ad heading, “Forces of Opposition, Bow Down” is designed to evoke strong emotions and convey the power to control.  Considering the unspeakable events in Connecticut, it gives perspective to look at the ad above vs. websites about the Bushmaster ACR that was involved in the tragedy, and how we deal with complex issues that stir passions. The same type of gun was used by the DC Sniper.

The first is a youtube clip of a young male proudly displaying his Bushmaster ACR at: http://www.youtube.com/watch?v=ZCUjYe7SpJE  Notice the second magazine on the table.

The second reviews a ‘virtual’ Bushmaster, used in a violent shooter video game. http://www.youtube.com/watch?v=fx4AvVV6cHY  (Not advised if gore bothers you)

And here is an ad for a large gun shop legally selling Bushmasters, except they seem to be sold out.  http://www.budsgunshop.com/catalog/index.php/cPath/36_60/sort/6a/page/1

Depressed young people read these ads and it is shamefull that we grownups seem unable to discuss important issues in a way that reassures our children that we are indeed behaving as rational adults. We’re not reticent about either side in an argument scaring the heck out of our kids to drive home their points. Imagine what a child feels when they look at the following advertisement. Having behaved in a way that has made our children feel helpless, powerless and  depressed about their future, we then show them websites laced with guns and violence.  Why does the outcome surprise us?

 Consider: violence, political extremism on any issue, heated rhetoric, assault rifles, extended ammo clips and threatened and murdered children. In situations as terrible as the Arizona tragedy, now Connecticut, it is almost impossible to look beyond our immediate perceptions. This makes it doubly important to try to understand and respond rationally. I found just such understanding in the work of Lewis Richardson, a British scientist born in 1881 of a Quaker family, educated in math and physics at Cambridge. He volunteered as an ambulance driver in World War One. Seeking to understand the nature of conflict as a way to prevent it, he listed all deaths from war and murders from 1820 to 1950, which he published as “The Statistics of Deadly Quarrels.”  When I read his conclusions, it gave me quite a visceral reaction. In any given year, murder and war account for approximately one percent of all deaths, and thus are statistically insignificant. My first thought was that this simply could not be correct, but Richardson is right. The subject of deadly quarrels has emotional power out of all proportion to its demographic and statistical meaning. It triggers only the pathos, or empathic element of Aristotle’s three aspects of meaningful debate: logos, ethos and pathos.

The pathos is so strong that appeals to logos, or logic and ethos, or ethics have little or no impact. Richardson understood the ethos and pathos of his work, as well as the logos of statistical analysis. He lumped murder and combat together. To those who held that “murder is an abominable selfish crime, but war is a heroic and patriotic adventure” he replied: “One can find cases of homicide which one large group of people condemned as murder, while another large group condoned or praised them as legitimate war. Such things went on in Ireland in 1921, and are going on now in Palestine.”  The fact that his two examples are equally relevant today speaks to the power of emotion to obstruct logical and ethical solutions.  While our actions may be driven by pathos, we must turn to logic and understanding to prevent the destruction of the ethical structure of our society.

Consider the Connecticut tragedy evaluated in light of the political power structure.  Start with the major U.S. commercial interests in the gun market, owned by Cerberus corporation, a private equity firm. Fueled by cheap takeover money, they started in 2006 to build the Freedom Group, which now owns 13 brands of guns and ammunition manufacturers, including many iconographic gunsmiths, such as Remington, Marlin, and the Bushmaster.

The Oct 19, 2009 Wall Street Journal Dossier on the group cites this 2007 statement by a gun industry source:  “One positive aspect to Cerberus’ involvement in the gun industry is that the huge political clout Cerberus commands as the ‘rescuer’ of Chrysler Corp. (which Cerberus also acquired) should undermine efforts to ban AR-platform rifles if the Democrats score big in the 2008 elections. Cerberus is big enough to make waves in Washington. Money talks in politics and Cerberus has lots of it.”  Cerberus filed with the SEC in  October 2009 to take the  Freedom Group public, but the bubble in ammo and gun profits, caused by propaganda feeding the fear that Obama would take away peoples’ weapons, collapsed.

First quarter 2010 profits were halved. Bloomberg/Businessweek ran a 28 October 2010 article entitled, “Misfires Aplenty at Cerberus Gun Unit’. Their premier new product, the Bushmaster ACR,  has been recalled because of a dangerous, accidental tendency to go on full-automatic fire. This type of misfire should be no surprise from the company that mismanaged Chrysler and GMAC severely, was bailed out with several billion taxpayer dollars, then triggered a robo-signing mortgage crisis. Adding insult to injury, one of their board members and major investors was involved in the Madoff scandal and was a board member of GMAC under Cerberus ownership. He resigned shortly after the Federal Reserve gave bank-holding status tp GMAC, giving them access to $5 billion in taxpayer money via TARP. Former Vice President Dan Quayle and former Bush Treasury Secretary John W. Snow remain as senior management of Cerberus.

Not surprisingly, Cerberus Capital Management was the biggest contributor to the Ben Quayle (son of Dan Quayle) 2010 congressional campaign.  Ben Quayle introduced pro-gun legislation during his one-term tenure in Congress, including the Second Amendment Sovereignty Act to block regulation under the United Nation’s Arms Trade Treaty, removing funding to negotiate or implement this treaty–shades of Congress recent killing the ratification of the international treaty on rights of the disabled, negotiated by George H.W. Bush and ratified by 126 countries. The illegal small-arms trade addressed by the Arms Trade treaty is worth $60 billion annually. Maybe money really is the root of all evil.

It is an extreme position to say that military weapons should be available to the general public, and it is equally extreme to say that all guns should be banned.  We owe our children a meaningful debate, seeking a sensible middle ground between these extremes.  To solve all these crucial issues, from gun control to the financial cliff to climate change, we need responsible politicians, who will take the risks of meaningful legislation, not piecemeal political grandstanding driven by the calculus of their own political advantage. We need a media who will report fully on not only the legislation, but the gun industry itself, and if (or perhaps inevitably when) our political and business leaders act with contemptible, self-serving stupidity, reveal the facts that expose them for the fools they are.

Otherwise, we will have no future, and go on trying to fool our children, lying to them until the very end.

The children know.

 

(Shortly after this article was posted to the Web, Cerberus announced that they would sell Freedom Works, which manufactures the Bushmaster.  For an earlier article on the idiocy of some politicians, please see an earlier post, Politicians, Perspicacity and Paintball.  However, it’s not funny any more)

 

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The eleventh hour of the eleventh day of the eleventh month.

November 13, 2012

I was born in England after WWII, and I still remember the paper red poppies, sold as the remembrance of Armistice Day, celebrated by Veterans Day in the U.S.   I wrote this piece several years ago, and somehow, on this most recent Veterans Day, the realities of war seemed lost in the force of [...]

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Is the Financial Sector Worth What We Pay It?

October 19, 2012

Plenty more where that came from! (This article is cross posted from my article for OECD Insights where they provide discussion of a wide range of subjects that influence world development) A basic capitalist tenet is that the market represents the most efficient way to allocate capital. How well is it working? We are rapidly evolving a fast-moving, [...]

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Downton Abbey Economics

October 14, 2012

Celebrating the Height of Empire as Queen Victoria Opens the Great Exhibition of 1851 How much do Public Broadcast Service viewers understand about the economy that led to the lifestyle of the wealthy Edwardian-era family in the hit series Downton Abbey? If one watched only PBS historical dramas, the British history leading up to the [...]

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Napoleon III, Butter and West Marin

September 14, 2012

Large cheese waiting for shipment on the platform at Fallon, West Marin in the late 1800′s Napoleon III had a huge effect on agriculture, product branding, lobbying and indeed, on the health of West Marin’s dairies. In 1869 he offered a prize for developing a butter substitute for his army, while appeasing the lower classes [...]

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Polluted, Political, Pregnant or Profitable

August 22, 2012

Male Chastity Belt, US Patent No.995600 by Jonas E. Heyser, 1911.  Ideal for preventing platform self-abuse and hypocritical behavior in the more risque quarters of Miami during the upcoming Republican Convention Occasionally scientific fact, polemical positions and public policy collide where none of the principal parties look good. Recall the lack of self-awareness of Jonathan Swift’s [...]

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Republicans are Planning to Cook Your Grandchildren

June 11, 2012

“How much can the economy really heat up?” NASA Virtual Solar Observatory Image Yet another part of the long-term Republican plan has emerged with North Carolina banning excessive sea level rise . Wondered about the proliferation of super yachts? Obviously the mega-rich who prefer coastal living have made their coasts personal and portable.  No more unseemly [...]

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Hedging the Apocalypse

May 24, 2012

When some latter-day Aristophanes distills the tragicomic story from the mash of the current Greek econodrama, I’ll wager that it will have much in common with the original story of the Acharnians.  The London Review of Books synopsized the story in a review of a fairly recent translation, which as they note, had come just [...]

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Economics: Repeating Rhymes

February 13, 2012

 Harpers Weekly,  1871 As Mark Twain famously didn’t say: “History may not repeat itself, but it certainly rhymes.”  There is something unfortunately close to doggerel here, when considering the nostrum that tax cuts and bailing out the wealthy improves the economy. Reviewing the Bush tax cuts and the current Republican candidate’s positions, recall Treasury Secretary Andrew Mellon’s [...]

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