The market - conducting 'experiments' with real money

April 1, 2009 8:31 PM

A philosophy professor takes on the financial system. Or perhaps that should read - a philosophy professor's take on the financial system. Daniel Cloud, teacher of philosophy at Princeton University and a founding partner in two hedge funds, makes the case in a recent opinion piece that "... complicated explanations about derivatives, regulatory failure, and so on are beside the point. ... The truth is that ... models are most useful when they are little known or not universally believed. They progressively lose their predictive value as we all accept and begin to bet on them."
posted by woodblock100 (28 comments total)

Hubris, again!
posted by turgid dahlia at 8:46 PM on April 1, 2009

That was one of the more lucid deconstructions of market ideology that I've read.
posted by gsteff at 8:53 PM on April 1, 2009

Hubris, again!

I really wish he hadn't emphasized that word; it's not really what the core of his argument is about.
posted by woodblock100 at 8:58 PM on April 1, 2009

Of course he doesn't explain how to distinguish between models that break down when everyone believes them and models that don't, and that, in fact, become true precisely because everyone believes them. For example, everyone believes money is worth something. That's why it is. There, belief in the model builds its validity. In other cases, maybe the opposite is true.
posted by shivohum at 9:21 PM on April 1, 2009 [4 favorites]

Why are people trying to predict markets anyway, like they're cloud formations? Markets are just places where people buy and sell goods and services. How could our models predict them anymore than they can predict the behaviors of children playing on a school yard?

We always over-complicate simple things until their comprehensibility is lost.

The stock market began as a place where people buy pieces of companies whose services or products they considered to have value and the potential for growth, and then they got to share in those companies' profits in return for their investment. Now what the hell is it? It definitely isn't that anymore. Most investors don't even know what companies they're invested in, much less whether or not the company's CEO is an asshole, and the company is headed for disaster in the long-term as a result.

Why can't we ever just keep things simple?

BTW, the analysis in the FPP actually seems pretty weak to me. It's not really any more substantive than the meaningless fluff I wrote above: just empty platitudes and broad generalizations. I'd expect better from a Princeton educated philosopher (though in fairness, he is writing for a general interest audience).

On the contrary, the financial crisis isn't about hubris, moral hazard, or "the final science of man" (whatever that is)--it's about very specific, present-day market mechanics: specific actions that institutions in the markets and their regulators did and didn't take.

I don't know about Danial Cloud in particular, but in general, I wouldn't uncritically trust any hedge fund manager for objective information or analysis on the financial crisis right now--especially when it comes to raising doubts about the judgment of the current leadership in Washington--since the treasury is, at this very moment, seeking broadly expanded authority to regulate the heretofore untouchable hedge funds.

And I don't buy all that crap implying that asymmetry of information is a requisite for healthy market functioning either (as in his unsupported assertions that markets may have once actually been efficient before efficient market theory emerged). It's basically just economist argot for the patently insulting idea that only certain people can be allowed to understand how the more complex markets work well enough to figure out how to profit from them or else the markets will collapse. Well, sure, if your concept of a functioning market is one in which only a handful of investors really profit, and most investors end up being fleeced.

Those kinds of markets do, for good reason, have a tendency to collapse once most people figure out how they really work.
posted by saulgoodman at 9:31 PM on April 1, 2009 [5 favorites]

I don't know about Danial Cloud in particular, but in general, I wouldn't uncritically trust any hedge fund manager for objective information or analysis on the financial crisis right now--especially when it comes to raising doubts about the judgment of the current leadership in Washington--since the treasury is, at this very moment, seeking broadly expanded authority to regulate the heretofore untouchable hedge funds.

There's another reason to look askance at these guys' opinion pieces: they want to move the market towards their positions.
posted by grobstein at 9:40 PM on April 1, 2009 [1 favorite]

This guy needs to read more Marx.
posted by ornate insect at 10:16 PM on April 1, 2009 [1 favorite]

We could easily be "stimulating" and "rescuing" the economy for a rather long time, in ways that only delay the needed adjustment, before we are finally forced to allow the required creative destruction to occur. But that is not the real problem. The real problem is the pseudoscientific ideology behind today's crisis. A final science of man has no room for the unplanned and unpredictable recovery that is the only kind a capitalist economy can have after a crisis of this size.

So... we just wait for capitalism to recover, however messy that is, instead of actively making radically creative changes?
posted by anarcation at 10:27 PM on April 1, 2009

My first boss on a trading desk had an expression that agrees precisely with this guy's argument: "If everyone is thinking the same then no one is thinking".

Almost every time I've applied it I've made money. An article to think about - many thanks for taking the time to post woodblock100, as I probably wouldn't have seen it otherwise.
posted by Mutant at 1:00 AM on April 2, 2009 [1 favorite]

Careful anarcation, you're beginning to sound like those anarchist types the BBC keeps warning me are gathering in London...
posted by Dysk at 1:38 AM on April 2, 2009

Cloud's argument seems to consist of a lot of great big words that might be boiled down to a simple statement: there is no such thing as a free lunch. Too bad that, as a hedge fund manager, he apparently didn't understand that himself.
posted by tommyD at 3:34 AM on April 2, 2009

saulgoodman, Cloud's not talking about asymmetry of information as a feature of healthy markets, he's talking about asymmetry as being a feature of all interpersonal competition.

Capitalism is, among other things, a struggle between individual people over the control of scarce resources. Like boxing and poker, it is a soft, restrained, private form of warfare. Military strategists have known for centuries that there is, and can be, no final science of war. In a real struggle over things that actually matter, we must assume that we are up against thinking opponents, who may understand some things about us that we don't know about ourselves...The truth is that such models are most useful when they are little known or not universally believed. They progressively lose their predictive value as we all accept and begin to bet on them.

When looking for a theory as a guide which will help me win a competition, the very definition of what it means for my theory to be good is that it helps me take advantage of the other guy. "The key is to obscure your intentions and make them unpredictable to your opponent while you simultaneously clarify his intentions." Once I know what economic theories are being used by other players in the game, I can look for bugs in their theories to exploit. (e.g. Icelandic banking, an excellent argument against unrestricted competition)

It is unusual (but not unheard of) for archaeologists to keep secrets from each other, but we have good reason to think that a lot of cutting edge economics is underground. That is part of what caused the current crisis (e.g. experts who expected the market to crash having a good incentive to keep quiet while selling short).

I take Cloud's main point to be that many traders mistook the models of the economy which had been to their short term strategic advantage in the past (housing prices always rise!) for universal truths. We need to educate against that. One way of doing that would be to draw a line between the social sciences proper (e.g. sociology, anthropology) and strategic studies (e.g. war studies, economics).
posted by justsomebodythatyouusedtoknow at 3:36 AM on April 2, 2009 [3 favorites]

Wow. A quick google search on this guy turns up some amazing facts: he's a post-doc fellow, not a professor, and his work is mostly in philosophy of biology.

Anyway, I rather suspect that Cloud's central claim about the 'social science' of economics is right on the money, but only in terms of micro-economic efficiency theories, not really at the level of macro-economics. Every finance person I've ever met had stamped 'historical performance is no guarantee of future earnings' on their foreheads. On most of the big issues there's still enough controversy that even Cloud would have to acknowledge that there's no clear winner. Traders may get the whiff of a theory and follow the herd for a while, but trading consensus isn't the same as ideological consensus. They don't all believe in Keynes or Friedman, they're just trying to figure out what everybody else believes so they can take advantage.

His connection to hedge funds suggests that he's probably had lots of experience at a particular task: persuading investors and banks to think counter-cyclically. This little essay is like they guy's stump speech or an elevator pitch.
posted by anotherpanacea at 4:15 AM on April 2, 2009

This is similar to the sociologist Robert Merton's concept of self-fulfilling vs. self-negating prophecies. The value of money would be something like a self-fulfilling prophecy. The money has value, because people believe it has value. By contrast, the failure of quantitative models of the stock market would be a self-negating prophecy. The models fail precisely because too many people know about the models to make them a safe bet.

Ironically, Robert Merton's namesake and son was responsible for the Merton-Scholes equation that was linked to the Long-Term Capital Management hedge fund fiasco.
posted by jonp72 at 6:25 AM on April 2, 2009

I don't quite buy the thesis that the market acted out of "belief" in their economic models. I suspect it was more a case of "holy shit, this is working for us" - making hay while the sun shines, so to speak - getting those bonuses, and hoping (or not) that somebody somewhere had a handle on this. And their companies had no desire to kill the cash cow. So, the people at ground zero had a massive disincentive to raise flags or moderate their actions.

I do believe that the market would be more capable of self-correction if no corporation was "too big to fail". Fail is the market's best mechanism for correction.
posted by Artful Codger at 7:01 AM on April 2, 2009

slight derail - this Slate article by Eliot Spitzer asserts that: Washington had the power to regulate misbehaving banks. It just refused to use it.
posted by Artful Codger at 7:08 AM on April 2, 2009

On the contrary, the financial crisis isn't about hubris, moral hazard, or "the final science of man" (whatever that is)--it's about very specific, present-day market mechanics: specific actions that institutions in the markets and their regulators did and didn't take.

I don't know, this argument seems blunderingly reductionist, or at the very least overly simplistic. The author is trying to paint a narrative about how we got here, informed by his worldview and the facts at hand. While it's true that "specific actions that institutions in the markets and their regulators did and didn't take" may have lead to the financial crisis happening when it did, the roots go much farther back and piecing together a specific chain of events that lead us to where we are now is a lot harder than what either you or the author have done.

It seems you're asserting that the chain of events originated on it's own, apart from the economics of the culture it originated in. The author of the piece asserts that chain of events which is playing out now is the result of something wrong with the culture that it originated in, a claim I support mainly because of historical precedence: the holocaust, globalization, the ongoing destruction of the environment, wage slavery, etc. etc. I don't know if I agree that much with his particular narrative, but I think the key to understanding this mess lies in trying to reconcile an existing narrative with facts or coming up with a new narrative based on those facts (or something in between). Without that narrative, a cohesive understanding is pretty much impossible.

Here are three attempts at narratives that helped my understanding of the financial crisis a lot:

The Investment Delusion by John Michael Greer
Debt: The First Five Thousand Years by David Graeber
Money and the Crisis of Civilization by Charles Eisenstein
posted by symbollocks at 8:11 AM on April 2, 2009 [2 favorites]

"The truth is that such models are most useful when they are little known or not universally believed. They progressively lose their predictive value as we all accept and begin to bet on them. But there can be no real predictive science for a system that may change its behavior if we publish a model of it."

I stumbled onto Goodhart's Law last night, and that led me to the Lucas Critique, which I think is similar to what he's getting at here.

It's the idea that when some measurement becomes a policy goal, especially within economics, it ceases to be an accurate measurement because of the underlying distortion of priorities that must happen.

But I do agree that the piece was a bit thin—it's "HUBRIS!" plus a little padding. And as someone who enjoys a bit of Classics lit, you can't have hubris without at least one Greek.
posted by klangklangston at 8:24 AM on April 2, 2009

My first boss on a trading desk had an expression that agrees precisely with this guy's argument: "If everyone is thinking the same then no one is thinking".
Almost every time I've applied it I've made money.
Your boss was probably thinking of this quote from H.B. Neill's The Art of Contrary Thinking: "When everybody is thinking alike, Everyone is likely to be wrong." Neill's basic argument, though simple-minded and absurd, does provide a nice parallel to this thread. I think the point that Cloud is struggling to make is a really simple one: when it comes to social phenomena, such as the stock market, to be truly objective means to take into account many things that are usually considered "merely" subjective. You can see how Neill is relevant here, even if his theory is ultimately wrongheaded. I am always amazed/amused/flabbergasted when one of these American business-types realizes, way behind the curve, a basic truth that any reasonable person could grasp with a moment's reflection. What? People are not atoms? Their beliefs affect their actions? Publishing theories about the market can change the way that market operates? Oh well...back to the drawing board, fellas.
posted by cnjnctvsynth at 8:44 AM on April 2, 2009

I stumbled onto Goodhart's Law last night, and that led me to the Lucas Critique, which I think is similar to what he's getting at here.

It's the idea that when some measurement becomes a policy goal, especially within economics, it ceases to be an accurate measurement because of the underlying distortion of priorities that must happen.

This is a good point. But the Lucas critique is not at all mainstream in macro policy (it would toss out the Keynesian consensus, which is based on manipulating "expectations" that move predictably). In the economics profession it's very common to look for macro models with "micro foundations" (which therefore don't depend on mass behavioral trends), but I think those guys are losing the war for real-world influence. (Crises hurt the stock of ex ante thinking.)
posted by grobstein at 8:48 AM on April 2, 2009

"When everybody is thinking alike, Everyone is likely to be wrong." Neill's basic argument, though simple-minded and absurd, does provide a nice parallel to this thread.

There are restricted domains for which this argument is true. The classic example is beliefs about the valuation of stocks. If everyone thinks a stock is undervalued, then prices will reflect that belief such that it's not undervalued. The thesis applied to this restricted domain is called the efficient capital markets hypothesis, and is a somewhat embattled but still important part of financial economics.
posted by grobstein at 8:54 AM on April 2, 2009

I don't know, this argument seems blunderingly reductionist, or at the very least overly simplistic.
...
The author of the piece asserts that chain of events which is playing out now is the result of something wrong with the culture that it originated in, a claim I support mainly because of historical precedence: the holocaust, globalization, the ongoing destruction of the environment, wage slavery, etc. etc.

Well, I do also have an argument that goes a little deeper than just market mechanics, but in this particular case, I think it would be pointless to search for any kind of totalizing theoretical explanation for the mess we're in, because so much of the mess was created by people who either literally didn't know what they were doing, or who certainly didn't ever bother to be guided by any coherent philosophical theory of how markets work. The current financial sector crowd play the markets like a game, thinking only enough moves ahead to maintain their advantage. As taxpayers, we lost the game and now we need to think about all the moves made in the game. We need to study the board and figure out what our blunders were. Then we can worry about the deeper philosophical roots of our mistakes (although I talk a little more about what I think those are below).

When looking for a theory as a guide which will help me win a competition, the very definition of what it means for my theory to be good is that it helps me take advantage of the other guy.
...
I take Cloud's main point to be that many traders mistook the models of the economy which had been to their short term strategic advantage in the past (housing prices always rise!) for universal truths.

And now we get to the real heart of it. The fallacy that's ultimately responsible for the mess we're in, IMO, is the misguided notion that competition should be the be-all-end-all, guiding hand of the markets (or even that it yields positive outcomes as a general rule). This, to my view, is not economic science at all but a cultural legacy of certain widely-held misconceptions about Darwinian natural selection that came to prominence in the early part of the 20th century, particularly among the upper-classes (who, after all, were and still are the chief drivers of the markets)--a kind of economic Darwinism, which overemphasizes the importance of competition in determining adaptive fitness. As Stephen J. Gould does an excellent job of explaining in his essays on Darwin, competition is actually a relatively small component of what goes into determining adaptive fitness in Darwinian theory--and even then, it really only becomes a determining factor when there is real scarcity of resources. The problem, I think, is that people have misread "survival of the fittest" to mean something like "survival of the strongest" or "survival of the most competitive," but in its original sense, it actually meant something more like "survival of the best-fitted" or "survival of that which is best suited to its environment."

One need only consider how little energy most plant life expends in competing with its peers and with other species in order to realize that there are many highly-effective long-term survival strategies that don't require a species to engage in any particularly ruthless competitive behavior to thrive. Most plants that reproduce sexually don't even have to compete for mates: they just shoot their DNA into the air and hope it finds its mark, and guess what? That works for them!

And in fact, the most profligate and successful species tend to be species that are more socially cooperative and/or scavengers--mice, cockroaches, etc.--not those that compete aggressively with each other or with other species. Aggressive territorial competitors tend not to thrive, being much more susceptible to population collapse due to changing environmental factors and resource scarcity.

Remember, stock markets really weren't originally meant to be a playing field for hyper-competitive traders. Stock markets came into existence as mechanisms for letting competitive enterprises (businesses) secure needed capital in exchange for opening themselves up to some share of public ownership. The only real competition in play should be competition in the marketplace among the public companies themselves, with traders playing a role only to the extent that they share in the successes and failures of the companies they invest in, as those companies compete with one another on the basis of the goods and services provided and the profitability and soundness of their underlying business models. We need to get back to the basics of stocks and bonds as investments in real enterprises, and to stop using the markets as a playground for fulfilling our pseudo-Darwinist fantasies. Then and only then could we expect to see markets remain relatively stable over time and an end to the boom and bust cycles of previous decades. But this would also require us, generally speaking, to settle for relatively modest rates of return on our investments.
posted by saulgoodman at 9:34 AM on April 2, 2009 [4 favorites]

So psychohistory will fail us because we actually recognize this as a Seldon Crisis?

Can't believe I'm the only one who immediately thought "Foundation".
posted by JaredSeth at 9:54 AM on April 2, 2009

Aren't we also talking about belief and the influence that has on both markets and models? Isn't there a touch of a religious-like quality at work here? Perhaps faith, misplaced or otherwise, is also partially responsible?

It reminds me of this book by one of the authors we publish called Economics as Religion. We're working on a similar book by the same author that considers the religion-like qualities in environmentalism and how the two "religions", economic and environmental, are currently engaged in a "holy war".
posted by Toekneesan at 10:39 AM on April 2, 2009 [1 favorite]

Toekneesan: The article you linked makes some interesting points on the topic of Marxism as religion, but I'd add/emphasize that the underlying religious character of modern economic thought goes even deeper than any one economic theory or theoretician. IMO, it goes down to the very bones of modern economic science as a discipline.

Adam Smith's famous "Invisible Hand," for example, was explicitly understood to be the equivalent of the Stoic religious concept of "Providence", or the idea that the divine origins of the world ensured that, ultimately, without human interference, events work naturally toward the best outcomes. "Providence" was the unseen hand of God, patiently arranging the world into its optimal and most orderly configuration. Smith's ideas essentially boiled down to, "Stay out of the way of markets, with a few reasonable exceptions, and God will take care of the rest."

We still generally assume this to be true of markets, though we no longer openly argue for divine providence as the basis for our beliefs. And every time some large-scale market collapse or systemic breakdown seems to contradict such fundamental assumptions of market theory, we devise a new model and blame the collapse on our previous reliance on the wrong model. But one thing never changes: We still always assume that free markets are, in effect, guided by the invisible hand of providence.

Although more scientific developments in economic theory have accumulated to supplement the earliest economic theories over the years, the fundamental axioms of economic theory that underlie even these more sophisticated ideas--Marxist or otherwise--are essentially still religious, not scientific, in character. That's why economic theory continues to be, at best, a pseudo-science: Not because, as Cloud seems to argue, our economic models put too much faith in science, but because the fundamental axioms on which all such models are based are not scientific but quasi-religious in origin.
posted by saulgoodman at 11:52 AM on April 2, 2009

errm... most profligate prolific and successful species (didn't mean to impugn mice.)
posted by saulgoodman at 12:27 PM on April 2, 2009

The link I used is actually a chapter from the book. The thrust of the book goes well beyond Marx and develops the argument more specifically through comparing the Chicago school of economics with the early Christians. It's not about a specific religion but instead compares a need for faith. New movements in both religious and economic thought really require a certain amount of faith for them to influence. In economics this was true of Marxism, the Chicago school, and it was true of models that these novel financial instruments relied on. Not unlike Roosevelt's admonition that all we have to fear is fear itself, the factor in economics that seems to be frequently overlooked is how there needs to be both faith and belief. When we stop believing, it stops working. The crisis may be caused not only by troubling facts, but also by a loss of faith in the power and stability of markets.
posted by Toekneesan at 2:28 PM on April 2, 2009

I see. Thanks for the link, Toekneesan. My own personal take, though, is that this "need for faith in the power and stability of markets," which indisputably does exist, only exists because market theory and finance are informed by so many unexamined superstitions and beliefs.
posted by saulgoodman at 2:46 PM on April 2, 2009