Tuesday, March 21, 2006

The “uber-modern” economist*

The case for adaptive economics in an evolving world.

Like in Information Technology where a short while is long enough for a graduate/professional to become out of touch with the "real" world, financial markets and the world in general have evolved so much that old-school economists can and have been known to be out of touch with the "real" world. And with the new phenomenon of globalisation, coming hot on the heals of, and made possible by, the computer-age and Internet revolution, adaptive economics is now synonymous with adaptive knowledge of I.T, vis-à-vis its relevance in the "real" world today. Because of these above-described advances, and the current global behaviour of consumers and investors, the uber-modern economist thinks outside the box of the home market and he/she looks at the global consumer/investor under one hat.

Q: What happened to the fantastic trader?
A: He went to university and got an economics degree

The above joke holds true for old-school economists who, coincidentally, appear similarly endowed with risk aversion and constantly rational expectations. A view of a rational world and subsequent rational expectations made old school economists too practical, such that, when presented with an investor’s scenario of a falling asset price, the old school economist would have held on and taken the losses if he/she believed that in the long-run, the asset in question would exhibit a reversion of some sort; that fundamentals would restore things. But what about the birth of a new equilibrium? This differs from an investor or trader who would close-out the position as a kind of minimax strategy.

There was a time when economists were known to be rigid in their perception of the market and the world, just like there was a time when the world was thought to be flat. Sometimes schools of thought will be polar opposites and still have a large following, such as the proponents of the efficient markets hypothesis (financial economics) on the one hand, and those of behavioural economics (more recent of the two) on the other. An example of an area where traditional economic theory has failed to impress is that of development. Some outmoded principles in development studies are still taught in universities today, but it is the most adaptive economics – that which incorporates context – that is the most useful for countries that don’t fit the framework, i.e.: most poor countries. To quote Frédéric Bastiat,

"...economic truths should be arrived at by observing not only the immediate consequences of an economic decision, but also by examining the long-term consequences. Additionally, one must examine the decision's effect not only on a single group of people, or a single industry, but on all people and all industries in the society as a whole."

The new age economist and adaptive markets hypothesis.
What makes the uber-modern economist different? It is his/her appreciation for psychological factors and responses from within a market, taking into account the behavioural biases of consumers or investors, i.e.: the irrationality. The uber-modern economist accepts that it is rational to be irrational, and with this understanding, can better anticipate consumer and investor behaviour. Consumers and investors don’t always want more to less at any given time and it has been proven in many studies, such as this titled: brain battles itself to delay gratification. Increasingly, the consumer and investor psyche has become the new focus of analysis in a world where fundamentals are being blown out of the water, such as in the following scenarios: the UK housing market, the long US consumer boom, the US twin deficits, the conundrum that wasn’t a conundrum a.k.a the inverted US bond yield curve, the recent and sustained US dollar strength, etc.

Chris Dillow of Investors chronicle has suggested that economists often make bad investors because they often fail to see that processes last longer than expected, don’t fully anticipate turnarounds in macroeconomic data, overestimate speeds of adjustments and the market’s discounting ability. To me, the above are characteristics of old-school economists, the kind that still look at the Deutschmark-Sterling cross rate to estimate whether Sterling (£) is overvalued or undervalued against the Euro (€). He suggests that perhaps good investing consists not in being rational but by making the right mistakes. I add to this that if all investors behaved in a rational way, risk preferences would not matter and the market would be extremely predictable and boring. It is the uber-modern economist who champions this new understanding of irrational rationality and spearheads this new chapter of economics.
PS: It is encouraging to see that National Statistics have included items such as ipods into the basket of goods used to measure CPI inflation.

Reference: Economic schools of thought
* "uber-modern" economists can be young or old in age. It is the mind-frame that qualifies an "uber-modern" economist.


Blogger Ken said...

Terribly insightful post. You can be sure I will be back.
Have you any interest in the NSE or the East African economy ? I would love to see your thoughts on the same.

Thursday, June 29, 2006 7:41:00 am  

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