Economics–the infantile science

by on January 5th, 2009

At the start of the 21st Century, it shouldn’t take a Nobel-Prize-winning mind to understand that all dynamic systems need regulation in order to function and last.

The first steam engines ran away with themselves and blew up. Engineers came up with a simple, elegant, and totally non-controversial solution. They added a governor, a device that throttled back the flow of steam into the engine when it revved up too much.

To my knowledge, no 18th Century Ronald Reagan emerged to argue that steam engines were being over-regulated, and that the world could power more trains and ships by deregulating their engines and pouring on more coal.

Biologists and physicians have learned that the human body is an intricate network of dynamic systems, every one of which is held closely in check by one or more “governors”–negative feedback loops.

Flexing your biceps stretches your triceps. That sends a nerve signal back to your biceps that keeps them from contracting too much. If that feedback fails, your muscles can break your bones.

Down a sugar-laden dessert and your blood sugar level surges. In response, your pancreatic islet cells pour insulin into your bloodstream. The insulin drives your blood sugar back into a healthy range. If that feedback fails, you develop diabetes.

Cells in your skin, your gut, your liver and your bones are constantly dying and being replaced. Those billions of reproducing cells are held in check and in place by multiple inhibitory feedback loops. If enough of those feedbacks fail, you develop cancer.

Have you ever wondered how it is that your body temperature stays so close to 98.6 degrees? Or how all those variables that show up on your blood test results manage to stay in their normal range?

None of it happens by accident, nor from the intervention of some “invisible hand.” It happens because every system in your body is regulated, kept within its functional range, by negative feedback loops.

Do doctors wish away these intricate regulatory pathways? Do they yearn for the days when they didn’t have to think about how the body regulates itself? Do they urge you to eat all the sugar you want, spend unprotected hours in the sun, or dose yourself with carcinogens?

Of course not. They devote themselves to understanding and working with those vital regulatory loops. If a system is just out-of-whack, they try to tweak it back into range, for example with diet or exercise. If a system is broken, they try to replicate its function through carefully regulated doses of medication.

Is any of this news to anyone?

It was news when the steam engine governor was invented–in 1783–or when the dynamics of diabetes were first understood– in 1901.

It should not be news now.

Actually, you don’t need to know anything about engineering, biology or medicine to understand the need for regulation.

Think about any game, from marbles to NFL football. Every game has its rules and regulations, and–beyond the elementary school playground–its referees and commissioners.

Without rules, and rules that are enforced, games stop being fun or even playable. They degenerate into chaos, and the players walk away in disgust.

So how is it that the brilliant men that have been in charge of our markets–arguably the biggest and most important game around–convinced themselves over the past 30 years that markets not only could function without regulation and regulators, but would automatically create more and more wealth and prosperity as more and more regulatory loops were disabled?

Many pundits have offered explanations for the failures of the experts who have just run the global financial system into the iceberg of reality.

–Greed, for one, and short-sightedness for another. By report, the entire system was rigged to grossly reward people for any scheme they could float that would produce impressive short-term gains while disguising the risk, apparently in instruments so complex that nobody understood them.

–Others have noted a self-reinforcing coterie of economists all pursuing the same agenda and lauding each other’s brilliance, up to and including the experts who awarded a series of Nobel Prizes to the authors of a set of abstruse theories about how markets function and how risk can be calculated, all of which were based on the assumption that market moves follow a normal distribution, like height or IQ.

Unfortunately, that assumption is blatantly wrong.

As we have just seen for ourselves, market moves can frequently be enormous–the equivalent of running into a person who is a mile tall, or who has an IQ of 10,000.

The result, it seems, was a self-reinforcing system of theories and the financial instruments that flowed from them, all based on a grossly flawed assumption.

These theoreticians and traders turned out to be very, very wrong, but they were, and continue to be more than amply rewarded.

–And we still need to mention that even the tattered regulations that survived thirty years of regulatory clear-cutting were not enforced for the biggest players. For example, Bernard Maddoff and his $50 billion Ponzi scheme.

Although greed, short-sightedness, and institutionalized arrogance all played their role, I think that a more accurate assessment of how our economic and financial experts got this so very wrong is that economics remains an infantile science, a science that has yet to accept the existence of limits.

Infants live in a world of magical thinking. They imagine that they have unlimited power to shape reality to their will; that every wish will be fulfilled.

If they were infant philosophers, they might even invent an “invisible hand” that feeds them when they are hungry, soothes them when they are upset, and will continue to do o forever.

Growing up means leaving magical thinking behind, accepting that people can’t fly (at least not without building airplanes equipped with thousands of carefully designed feedback loops); that buildings can’t be built infinitely tall; that there’s no Santa Claus; no free lunch.

Growing up means living within the limits of nature and accepting the need for rules.

For economics, at a minimum growing up means recognizing something that’s been known since the first coins were minted and promptly counterfeited–markets need regulation.

That’s pretty much what the great deregulator, Alan Greenspan, admitted when he told Congress on October 23, 2008, “I made a mistake.”

That mistake, by this very brilliant yet remarkably wrong-headed man, and his colleagues, cost U.S. investors about $7 trillion, and investors worldwide perhaps $30 trillion, so far.

That’s almost $23,000 for each man, woman and child in the U.S., or $4,450 for every inhabitant of the world.

During the last few weeks of 2008, the S&P 500 index jittered aroud a 40% loss for the year.

That means that 40% of the value that just about everyone believed those stocks represented on January 1, 2008, was smoke and mirrors.

If we view the stock market as a gleaming, 100-story tower on January 1, 2008, with more floors fully expected, on December 31 it was a smoldering wreck, with the top 40 stories pancaked into dust and shards.

And, as we saw on September 11, 2001, it will be something of a miracle if the whole tower doesn’t come crashing down.

If the current financial collapse teaches us anything, it’s that it is time for economy and economists, theoretical and applied, to grow up, and fast.

Want a watch that keeps good time? Buy one with good feedback loops.

Want a car whose engine doesn’t explode? Buy one with good feedback loops.

Want your computer to keep working? Buy a good voltage regulator.

Want traffic to keep flowing? Keep paying for those pesky traffic lights and peskier cops.

Want the world’s financial markets to work long term?

First, we investors and voters need to grow up and not buy castles in the air, even if they are certified sound by the experts.

And, to make sure that the world’s markets and the people who run them act like grownups–regulate them, regulate them well, and enforce the damn rules, especially for the biggest players.

Robert Adler

Robert Adler