Monday, March 2, 2009

Economics: Mandelbrot & Ferguson

Of course, the topic of the year—and perhaps, in some way, every year—is economics. How did we get in this mess? Two books that I recently read address this issue, one analytical and one historical. The analytical book is Benoit Mandelbrot and Richard L. Hudson’s The (Mis)Behavior of Markets: A Fractal View of Financial Turbulence (352 p. 2004). In this book Mandelbrot and Hudson discuss Mandelbrot’s mathematical insights brought to markets, his fractal geometry. The math was beyond me (although they avoid technicalities for the most part), but what you do learn (and this is well before the current financial crisis arose) is that markets follow a fractal pattern, one that often mimics natural phenomena. Mandelbrot rejects the contention that markets will follow tame, Gaussian distributions (no wonder Nassim Taleb speaks so highly of him!), and the authors argue that markets are subject to the vagaries of human behavior. Mandelbrot developed his fractal theories looking at data for cotton prices and Nile river floods, among other items (huge data sources). He comes to some conclusions that all would do well to head:
A. Theory says that all economic decisions are rational. In reality, they’re not. Behavioral economics, as actual limited, fallible, human behavior is the norm (thereby reducing predictability of action and outcome).
B. Theory says all investors are alike. In reality, different investors have different time horizons, making for different decision parameters.
C. Theory says that prices change continually and on a continuum. In reality, prices jump; nay, at times they leap.
D. Theory says that prices follow Brownian motion. In fact, they don’t.
After making these points, Mandelbrot and Hudson posit 10 “heresies of finance”:
1. Markets are turbulent.
2. Markets are very, very risky, much more than standard theories imagine.
3. Market “timing” matters greatly, as great changes have occurred in small periods of time.
4. Prices often “leap” and do not “glide”, thereby increasing risk.
5. In markets, time is flexible.
6. Markets in all places and ages work alike.
7. Markets are inherently uncertain and bubbles inevitable.
8. Markets are deceptive.
9. Forecasting prices is perilous, but one can estimate odds of future volatility.
10. In financial markets, the idea of “value” has little value.
This book does a good job of describing Mandelbrot’s work and how his insights compare to Black-Scoles-Merton, and others like them. Not an easy or a quick book, but insightful and available for even a non-economist, modest math skills reader like me.

Right now, if someone asked me to recommend a book to explain our current financial and economic situation, I’d suggest Niall Ferguson’s The Ascent of Money: A Financial History of the World (358p. 2008). Ferguson is a first-rate historian (currently teaching at Harvard) with the knowledge and insight to write on economic and financial topics (he’s previously written a history of the Rothschilds and The Cash Nexus: Economics And Politics From The Age Of Warfare Through The Age Of Welfare, 1700-2000 (2002)). In the present work, he really does provide a history of how money and finances developed over time. Most of the significant developments come out of the Italian Renaissance (those wonderful Medici!) and run up to the date of writing (May 2008). In fact, a great deal of the book—written in a very easy and engaging style—deals with recent developments. From this book we learn a lesson that we should have learned long ago: the more things change, the more they stay the same. None of the bubbles, scams, debts, or the like is really new. Of course, numbers, names, countries will differ, but the patterns of human behavior remain stubbornly the same. Ferguson does an excellent job of creating just enough historical background on things like banks, joint stock companies, insurance, bonds, and other financial issues to really highlight and understand the present developments. Although Ferguson published too early to be able to discuss the collapse in the fall of 2008, when reading this book, one certainly better understand how and why such events occurred as they did. This is a superb book for anyone interested in the thing that makes the world go ’round: money. (By the way, he also had a special on PBS under the same title; very worthwhile: how the financial world went to hell in 120 minutes or so.)