Posted by: ryanmccoskey | May 20, 2009

A Timely Book Review

There are, most certainly, at least three reasons to maintain a blog. The most common application of it, insofar as I can tell, is as a social addendum – that is, an extension of one’s regular conversation with friends and acquaintances. Although it may be a lazy form of conversing, it is a form nonetheless.

Secondly, it can be utilized as personal entertainment; this is my usual application. I can’t speak to the enjoyment of the readers, but I can confirm that of the writer’s!

A blog can also be employed to relate significant (but not necessarily useful) information. I’d like to think that all things significant are equally useful; but, just like beauty, the benefit of knowledge is in the eye of the beholder (unless, of course, we are talking about Jesus and/or Copeland. In both of these cases, devotees are not required to confirm inherent worth – especially Jesus)

As for this post, it is my intention to apply the latter use. Are you ready for some significant, but not necessarily useful information? Of course you are! So let’s get to it.

In the wake of the recent sub-prime mortgage meltdown, several experts representing various worldviews have offered up their opinions and diagnoses of the situation. Some of these proposals deserve focused attention; however, with others, I use the word “expert” very loosely.

One of these in particular won my undivided attention.

A highly capable (not to mention delightfully witty) economist by the name of George Cooper had something very interesting to say. In his first published book, “The Origin of Financial Crises,” Cooper lays out an incredible argument against the widely accepted “Market Efficiency Hypothesis” (MEH). According to the MEH, financial markets naturally seek an equilibrium, and thus, only external “shocks,” as we call them, can effectively throw them out of kilter.

If markets truly do seek a natural equilibrium, then asset prices are always accurately reflective of the actual worth of said asset. If this is true, then each movement of the market must be entirely random (Brownian motion), and disconnected from each previous movement. And as truth would have it, this is exactly how a vast majority of notorious economists view the markets – each movement, whether up or down, only as predictable as the flip of a coin.

However, Cooper has something to say about that. In his lucid consideration of historical economic realities, such as bank runs and the implosion of many debt-soaked societies, Cooper establishes a strong argument for a form of “memory” in the markets (Mandelbrot’s fractal geometry). In other words, an economy in a state of growth, according to Cooper, is predisposed to continue towards growth until debt levels exhaust the credit-creation process, sending the economy towards contraction. Likewise, an economy in a state of declension will continue to contract until all unsecured debt is eliminated, allowing for the credit-creation process to jumpstart the economy, so to speak.

The implications of Cooper’s findings could possibly mean that an economy that relies on leverage through credit (i.e. every major economy) has a natural tendency to swing from one extreme to another, far from the equilibrium described by the MEH camp. And as history shows, Cooper’s understanding of the markets is more supported by the historical data as compared to the Market Efficiency Hypothesis.

So what is the use in this knowledge? There are at least three takeaways. First, if markets have a natural tendency to move in one direction and then to suddenly and unpredictably swing to the other, then “timing” the market is incredibly risky (by timing, I mean the process by which investors use data in an attempt to “buy low” and “sell high” in order to gain the most profit). Secondly, if markets are naturally unstable, then the FED’s assymetric policy of encouraging huge “booms” of asset growth, while also discouraging huge “busts” of asset loss is totally counterproductive and only produces mass inflation; if Cooper is correct, then the only way to avoid huge busts (like the sub-prime mortgage meltdown) is to “prick” asset bubbles that get too big, too fast.

Finally, and perhaps most relevant, the third takeaway is a simple caution. When everyone clamors to the market because of a huge upswing, perhaps you should be prepared for the possibility of a major correction. Likewise, when everyone is lamenting “woe is me” and withdrawing all of their funds during a contraction, perhaps you should be prepared for the possibility of a major jump.


Responses

  1. I thoroughly enjoy blogging as a form of communication as well. I would disagree, however, that is is a lazy form.

    As with most things, it definitely could be used in that fashion–a passive, read-at-your-leisure type of friendly update on one’s life/thoughts.

    But I actively communicate with people outside of blog world as well.

    I have no comment about the book review. I read the blog until I got to the title of the book, then skipped down to comment 🙂 I hope that’s not offensive, in some way. I just don’t understand ‘the market’ and financial terms that go along with it. I’m fairly ignorant when it comes to such things. So, in essence…it’s me, not you. (i’ve had that line used on me more times than countable).

    By the way, could you msg me your address sometime? My e-mail is still the same.

    It’s for non-creepy purposes, I promise 🙂


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