Sandpile model of earthquakes and economic instability

Dr. Steve Keen discusses this here and gives a clear description of a power law distribution:

"The pattern of movements you get from such a process can look superficially like a Normal distribution–the famous Bell Curve–but it differs from it in two fundamental ways. Firstly, there are many more movements near the average; secondly, there are also many more movements way, way away from the average–so many more that, in what is known as a pure “Power Law” distribution, the standard deviation is infinite: any scale event can occur, and will occur given enough time."

The standard deviation is infinite...here's a picture of what this looks like from Wikipedia:
The main point is that if you are using a normal distribution to model something that is actually is a power law distribution, your model is going to give incorrect results. Key to the normal distribution is the idea that factors contributing to the frequency of results are independent. The dice rolling example is commonly used because it's obvious that each roll of the dice doesn't have any influence on the next roll of the dice. The financial results of companies listed on the NYSE are definitely not independent of each other; for example most are dependent on a relatively small number of banks for routine financing.

Also, generally 68% of values drawn from a normal distribution are within one standard deviation σ > 0 away from the mean μ; about 95% of the values are within two standard deviations and about 99.7% lie within three standard deviations. This is called the "68-95-99.7 rule" or the "empirical rule." That's clearly different from the power law distribution.

Modern finance and pensions

"The real crime is claiming 7.75% return is achievable over the long term. "
I Heart CRbot | Tue, 03 Mar 09 18:03:25 -0600 | #

Unfortunately, finance textbooks have been saying that that's the equity premium over the risk-free rate of return for at least 20 years. I can see how people might get confused. Two problems; I don't think there has been statistically meaningful validation of the equity premium:), and at some point market timing comes into play, when the pension has to start paying out.

Generational personal finance and the current bust

Mish has an excellent post Wealth Does Not Pass Three Generations which describes what is sometimes referred to as "tired-blood" syndrome referring to the tendency of heirs of wealth to squander it.

"This is how I see it:

Few alive remember the great depression. Most boomers headed into retirement have seen rising asset prices all their lives. Those boomers thought they could live off their houses and/or investments in the stock market, expecting prices to rise forever, even though it was mathematically impossible for that to happen. Now, headed into retirement, boomers are realizing they are actually savings poor given that asset prices have crashed.

Moreover, children who have seen their parents wiped out in bankruptcy or foreclosed on are going to have a completely different attitude towards debt than their reckless parents did. Expect to see more frugality from parents and their children alike.

Three generations from now the lessons of today will have again been forgotten and the cycle will repeat."

Economic fallout

Excerpted from Setser:

-"Moving from a budget that balances at $70 oil to a budget based on $41 a barrel isn’t fun even if Russia uses its fiscal reserve to adjust gradually. Eastern European economies that relied on large capital inflows rather than high commodity prices to support their growth aren’t doing any better."

-" $40 a barrel oil requires the Gulf to dip into its foreign assets, but most countries still have plenty of spare cash (though not as much as before). Still, all of the Gulf is slowing. And the most exuberant bits of the Gulf – Dubai in particular – are in real trouble."

-"China is really slowing. Stephen Green of Standard Chartered has constructed an indicator of Chinese economic activity that isn’t based on the government’s reported GDP data. It suggests a far bigger fall in Chinese output than in 1998."

-"The fall in Korea’s output in the fourth quarter was quite large. Even larger than the fall in output in UK, or Japan."

-"Singapore and Taiwan are also contracting sharply. Singapore’s economy contracted an annualized rate of 12.5% in q4, and the huge fall in Taiwan’s exports cannot be good for its economic performance. Japan isn’t an emerging economy, but it too saw a sharp fall in output. It isn’t a stretch to think that Asian output could fall more in 2009 than in the 1997-98 Asian crisis."

Mercantilism works, until the consuming country runs out of the ability or desire to keep consuming. Every country listed above targeted the US as their primary export market.

Schumpeter and entrepreneurship

"Schumpeter criticized John Maynard Keynes and David Ricardo for the "Ricardian vice." According to Schumpeter, Ricardo and Keynes reasoned in terms of abstract models, where they would freeze all but a few variables. Then they could argue that one caused the other in a simple monotonic fashion. This led to the belief that one could easily deduce policy conclusions directly from a highly abstract theoretical model."

"Schumpeter's theory is that the success of capitalism will lead to a form of corporatism and a fostering of values hostile to capitalism, especially among intellectuals. The intellectual and social climate needed to allow entrepreneurship to thrive will not exist in advanced capitalism... He argued that capitalism's collapse from within will come about as democratic majorities vote for the creation of a welfare state and place restrictions upon entrepreneurship that will burden and destroy the capitalist structure."

ac(a Calculated Risk commenter) on Schumpeter:

"The Wikipedia article doesn't really make it clear whether Schumpeter is advocating socialism or capitalism. The way it's written sounds like he's trying to promote capitalism by hiding it behind a socialistic message.

Of course the problem with the socialist outcome still remains - we haven't figured out how to motivate people to work in a socialist environment. That leads me to believe that a transition from capitalism to socialism with the operating overhead and debt created by a capitalism economy will fail because the socialist economy will not be able to generate the activity to sustain these costs of operation (because people are less motivated to produce). To me this suggests that in order to sustain itself the government will attempt to compensate by yet another transition, this time to a more coercive authoritarian fascist type state."

Intriguing ideas...

The credit crunch has gotten through to consumers

Interesting tidbit from Across the Curve:

"No interest in homes

...though consumers painted a relatively sunny picture about the outlook, they don’t seem inclined to pull the trigger on big ticket items any time soon. Home buying intentions collapsed to just 2.1% of those surveyed, the largest one-month decline since August 1990. Given the tightening in credit conditions in this space it is little wonder to us that pool of prospective buyers is getting thin, not to mention that home prices have sagged by 20% according to the latest Case Shiller numbers out earlier today. Moreover, folks are still not seeing real estate as a great place to sock their investments. According to the University of Michigan survey, only 2% of respondents think home prices are going higher.

Even more disturbing was that new car purchase intentions dropped to just 1.5% of all respondents – an all-time low. This is an ominous sign for those auto sales numbers due out tomorrow – consensus is expecting an almost unchanged print to 13.5 million units while we see sales coming in about 1 million below that mark and we would not be surprised to see sales dip below 12 million in the months ahead."

Those are low numbers, but make sense when very few have down payments ready to put down on these kinds of big purchases. One of the major automakers will have to shut down if those sales numbers pan out. There is far too much production capacity out there.

The existence of an "Anglosphere"

An individual named James C. Bennett has apparently written a book titled The Anglosphere Challenge, the thesis of which has been described as follows:

"the peculiar island history of England produced a set of institutions that other advanced nations in Europe and Asia lacked--the common law, respect for private property, continuous representative government, a culture that nurtures civil society and entrepreneurial enterprise. It is thus no accident that the Anglosphere has excelled in innovation and economic growth and, Bennett believes, will continue to do so."

I haven't read the book yet, but I agree with the thesis based on what I know about the subject.

Black Tuesday?

General Motors has dropped a $39 billion bomb described here: by my calculations that puts the company's stockholder equity in the range of -$43 billion. We'll see what the actual number is tomorrow. It must have taken a long time for GM's executives to swallow making this move; usually it is the accountants that push for writedowns like this and they typically don't have much sway. Maybe GM's accounting firm was threatening to quit.

This link points to a Bloomberg story posted at 2 PM Eastern today that "Japan's Leading Economic Index Drops to Decade-Low 0". The explanation in the story states that "A reading of below 50 indicates the economy may slow in three to six months"..now the actual reading was ZERO! So Japan's economy is literally going nowhere. I had assumed on seeing the news item about this index that the result of zero was due to an equal number of positive versus negative components. That is not the case...if you follow the link in this post you will see that every single available component was negative. So the headline number is a bit misleading if you are not familiar with the details of how the index is calculated. It's hard to see how Japan can avoid a recessionary 4th quarter.

Meanwhile, " The U.S. doesn't have enough information to predict the outcome of events in Pakistan or whether President Pervez Musharraf can hold on to power, according to a Bush administration official." So the US's primary partner in restraining Islamic militants in south Asia is teetering on the brink of political collapse. It's hard to say whether this crisis will lead to increased insurgency in Afghanistan as Pakistan's military is focused on events in its own capital; or whether the insurgents focus on Pakistan themselves to try and help topple Musharraf. I think it's safe to say that there are more than a few people in Washington not getting a lot of sleep at the moment.

The Panic of 2007

seems an appropriate phrase to describe the market volatility that has hit global markets late this summer. Calculated Risk compares today's issues with the "Panic of 1907", and M. Shedlock has a post up today titled If You're Going To Panic, Do So Before Everyone Else...also see my earlier post A Genuine Financial Crisis for some examples of panic that have occurred in the last few weeks...

German growth potential

Misplaced scepticism about Germany’s growth potential; a piece at Eurozone Watch by Sebastian Dullien hypothesizes "that Germany is just on a good path to increase its medium term growth performance." Writing from a US perspective, I have to say that I think that Dullein's piece has completely misinterpreted the US productivity story in the 1990's. While welfare reforms did in fact reduce the number of individuals on welfare, I am positive that the number of persons who moved from long-term unemployment to employment was not "in the millions". This link to a study by the US Bureau of Labor Statistics on long-term unemployment directly contradicts Dullein's assertion that "The U.S. recovery after the 1990/1991 recession started out with very strong job growth". The study states that

"The most obvious reason for the slow improvement in longterm unemployment following the two most recent contractions was the relatively slower pace of job growth. Following each of the recessions of the mid-1970s and early 1980s, employment rose by 1.5 percent within a year. In contrast, employment was virtually unchanged in the year following the 1990–91 and 2001 recessions. As shown in the accompanying table, even by the time long-term unemployment had started to decline, employment had risen by 1.0 percent or less. Also, in contrast to the recessions of the mid-1970s and early 1980s, the employment-to-population ratio continued to decline far longer following the recessions of 1990–91 and 2001."

Further, rapid growth in US productivity later in the 1990's was largely attributable to heavy investment in information technology which was driven by rapidly increasing capabilities of information technology and the massive increase in Internet-related business and consumer activity. I don't foresee any kind of major technological shift occurring in the next few years that would be centered in Germany, particularly considering that German firms have been scrimping on research and development, as Dullein noted. With respect to housing booms in the countries where the median age is under 40, the booms were created by reduced interest rates and easier credit conditions that allowed younger households to purchase homes. Now, it is clear that housing markets have oversupply in these countries, but domestic growth was aided by the booms. In the aged countries, there is little chance that GDP growth will be aided by housing construction, as the number of households in these countries will remain flat or begin to shrink soon.

Chicago Fed National Activity Index

Thanks to William Trent for introducing me to this particular economic indicator:



The indicator is now in negative territory, but just an eyeballing of the entire chart seems to indicate that the indicator has spent more time below zero than above during the time frame being charted. That doesn't seem right, given that the expansion after 1991 didn't end until the dot-com bust, a period of about 10 years. A deeper exploration of the underlying data would seem worthwhile.

Expectations for capital spending in the US

naked capitalism says:

"One of the hopes, or more accurately, fantasies of a few months ago was that increased business investment would offset slowing consumer spending. This forecast defied basic logic. Why would businesses take on more risk if consumer buying, the big driver of the economy, was sluggish? One would expect lower rather than higher capex.

And that's precisely what we are seeing. A Financial Times story says that business analysts forecast a significant decline in capital spending in the US and Europe. Some experts argue that the projections are too dire and that companies are lowballing their requirements. Others say that the figures are misleading, since large corporations are increasingly investing in operations in emerging markets."

Given that consumer spending is slowing, then a slowing of business investment would seem to radically increase the chances of recession in the US sometime soon.

Rising mortgage rates mean home prices MUST go down

According to the AP,

"Rates on 30-year mortgages rose for a fifth straight week, hitting the highest level in 11 months as prospects dimmed further for possible rate cuts from the Federal Reserve.

Mortgage giant Freddie Mac reported Thursday that 30-year, fixed-rate mortgages averaged 6.74 percent this week. That was up from 6.53 percent last week and marked the biggest one-week rise in 30-year rates in more than three years. The five consecutive increases have pushed 30-year mortgages to their highest level since they were at 6.80 percent for the week ending July 20, 2006.

"Mortgage rates moved sharply upward this week," said Frank Nothaft, Freddie Mac's chief economist. "These moves parallel rising yields on Treasury securities as concerns about inflation pressures and continuing strength of consumer and business spending have dimmed hopes for an interest rate cut."

The monthly payment required for a mortgage depends on the purchase price and the mortgage rate...if rates go up, the portion of the monthly payment going to interest increases. Whatever a buyer's maximum that they can devote to the mortgage payment, if the interest portion increases, the purchase price portion must decrease. Decreasing rates drove home prices up the last 7 years; increasing rates will force home prices down regardless of supply factors.

When I bought a home 6 years ago, I was happy to get a 7.00% fixed and thought rates would never go lower. Silly me...

Economics of the Great Depression: worth rethinking

Over at Econbrowser, the poster mentions a new book Economics of the Great Depression...and posts some discussion of the issues in the context of an interview that was a source for the book. The post quotes Fed Chair Bernanke regarding understanding the Great Depression:

We are only beginning to get a sense of what we would need to understand and see why these effects were as large as they were quantitatively in an economy that was presumably more flexible than the one we have today. With respect to the recovery, the gold standard had a lot to say about that.

It is interesting that Bernanke would say that the economy was more flexible back then; that seems to run counter to the conventional wisdom that today's markets are the most flexible. It seems that there is room for worthwhile research to be done...