Thursday, January 28, 2010

Three Conclusions FLG Has Recently Come To As Well

Buttonwood writes:
1. The system cannot insure itself. People tried to hedge their portfolios against disaster but that hedge was only as good as the credit of the counterparty with whom the position was hedged. Here I confess that I was too inclined to believe the Greenspan argument that the new instruments had spread risk right round the system, and thus reduced the risk of a crash. This turned out to be wrong in practice, as well as theory; the risks were highly concentrated as AIG proved.

At the time, FLG really did believe this spread risk.

2. The three most important factors are leverage, leverage and leverage. At the macro level, rapid credit growth always precedes a crisis. At the micro level, Patterson quotes Ed Thorp** as saying that "Any good investment, sufficiently leveraged, can lead to ruin." And of course if credit growth is too fast at the macro level, investors will be piling money into the markets, slashing yields and trimming arbitrage opportunities and thus encouraging individual firms to use more leverage in order to earn the desired returns.

FLG thinks he's mentioned that leverage really is the culprit on multiple occasions. However, since real estate is where most people take the most leverage he also thinks we need to look at that secondarily as well.

3. Economics and markets are not like chemistry. One can discover "laws" or patterns in past data, but acting on those patterns will affect the future; whereas a chemical does not change its behaviour because we have discovered it.

This is one of those things that drives me nuts when people use the idea that economics didn't predict X or Y as evidence in an argument that economics is bullshit. Economics, and indeed all the social sciences, but especially economics involves human beings. Human beings change their behavior in response to other human beings and events. If I find a way to beat the market, then you can reverse engineer may way and beat the market too. Eventually, and by eventually I mean pretty quickly, the market incorporates my method and I can no longer beat it. Physical systems are different. Gravity doesn't change based on our actions. It always acts in the same, predictable manner.

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