Why Markets Crash

John Cassidy has a great review of George Soros’ new book, ‘The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means‘.

Cassidy describes how Soros re-iterates his empirically derived theory of economics which explains why boom bust cycles necessarily happen in unregulated markets. The concept of inevitable instability is something rejected by the extreme free market view, based upon the monetarist economics of the Chicago School: Milton Friedman; Eugene Fama; Robert Lucas. They believed that free markets would always reach a stable equilibrium.

Nothing has defined the period of American hegemony from Reagan until now more than monetarism, which has transcended economics and morphed into the broader political ideology of libertarianism. The current financial crisis, with its massive-scale, state intervention, shows nothing other than the complete failure of monetarism and with it, libertarianism.

Soros has an economic theory that is an alternative to monetarism and explains why crashes happen, it is derived from experience and is not mathematically formalized. I know almost nothing about economics, but I know a bit about information theory, and it seems clear that Soros’ theory while possibly true is not needed, since the monetarist view surely contradicts some very basic laws of physics.

First, the background. Cassidy recaps how the Chicago school “had invented a new way of doing macroeconomics, known as the rational expectations approach, which enshrined in higher mathematics the stabilizing properties of unfettered markets… If in one period the economy gets out of sync, in the next period it jumps back to the “equilibrium” defined by the model.”

Cassidy goes on to show that “Soros had neither the inclination nor the technical ability to challenge the Chicago school’s formal arguments…What he does possess, however, is voluminous amounts of firsthand knowledge gained in the financial markets, together with a keen interest in formulating a theory on the basis of his observations.”

Soros developed the idea of Reflexivity, a “two-way feedback loop, between the participants’ views and the actual state of affairs.” He clarified reflexivity to critics who “claimed that I was belaboring the obvious, namely that the participants’ biased perceptions influence market prices. But the crux of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals they are supposed to reflect.”

In other words, the instability in markets is due to the feedback loop founded on us seeing things slightly wrong and acting on these perceptions which in turn actually changes the reality, allows it to be perceived with different uncertainty again, and so on.

The Soros view requires human perception to create chaotic fluctuations, but there are many things that behave chaotically, from eco-systems to the weather. Over time, all these things exhibit both cyclical and unpredictable behavior regardless of perception.

There are systems which self regulate to stability like the temperature of a hot bowl of soup in a closed room, or anything which runs down. This is called the second law of thermodynamics – over time entropy never decreases.

There is, however, a massive difference between systems that are inherently stable or will run down and ones that are chaotic. The former are always closed systems and the latter are open systems.

The economy is not a closed, running down system. Energy (or more specifically negentropy) is poured into it from high energy sunlight, past (oil and coal) or present (meat and veg). It is converted by industrious, growing populations of humans into local pockets of order, like buildings and machines and a much larger amount of waste. The eco-systems that connect these pockets of order are always chaotic and unpredictable in an open system, from the turbulent flow comprising cascading arrays of whirlpools as a river flows over rocks, to the flow of promises, in the form of money, through corporations.

Soros’ ideas may or may not be true, but they are not necessary, there is no need for an observer, just like there is no needs for a designer in nature. The monetarist view is surely wrong, period, and on a fundamental level, since it seems to be based on the assumption that the economy is a closed system.

Efficient markets aren’t smooth just like the weather isn’t, and thunder storms are not caused by psychology, but by the natural effects of open systems. Similarly, market crashes are caused by the chaotic nature of open systems, and the maximum efficiency is the production of waste.

Monetarism is wrong a pseudo science driven by an American ideological form of capitalism best described by the Libertarian label. From Ayn Rand to Reaganomics the economic ideas supporting them are based on the same ideological wishful thinking as Lysenko’s Larmarckian genetics, an idea which starved Communist Russia.