This is a rehash and update on a little economic theory idea.
On Feb 8, 2008, at 11:37 AM, Horace Heffner wrote:
Within the context of the mortgage industry debacle precipitated
financial crisis it appears there is something even more sinister
making for the crazy markets:
http://tinyurl.com/3czmpr
Actual URL for above:
http://www.forbes.com/home/opinions/2008/02/06/croesus-chronicles-
darkpools-oped-cz_rl_0207croesus.html
The quants and their systems may be unintentionally setting up the
world markets and financial systems for a crash. Automated
arbitrage systems appear work fine until an underlying market
fundamental changes, like sudden changes in the the value of real
estate or some set of commodities.
The problem with modern portfolio theory is its fundamental
assumption, that the market activity is actually based on
stochastic processes. It is assumed that all fundamentals are
known by all the participants and very quickly "priced into the
market". All that is left is due to random fluctuations. I think a
large part of the variance in the random distributions is not
random at all, but rather merely due to variables and functions not
understand, but which test well for being random distributions. An
example of this might be the effects of a feedback loop between
publications (reporters) and politicians, and further, the changes
in cycle time, amount, quality, distribution, and lack of
information control brought about by the internet.
Of greater concern is the fact market transactions are increasingly
instant computer trades rather than trades by open and manual
bidding systems. This vastly increases the "velocity of money"
within the market place in times of a crises, and the velocity is
further increased when the buyers and sellers are mostly computers
too. We are moving toward the point where the ultimate crash
could take place in seconds.
The velocity of money is the average frequency with which a unit of
money is spent, the dollar turnover rate, the frequency of dollar
spending per unit of time. For a discussion of the velocity of
money see:
http://en.wikipedia.org/wiki/Quantity_theory_of_money
and also see:
http://en.wikipedia.org/wiki/Velocity_of_money
There you'll see Milton Friedman's famous equation:
M*V = P*Q
V = P*Q/M
where M is the money in circulation, and P*Q is the gross domestic
product, the sum of the values of all transactions in a given
period of time. The value of a transaction is the unit price time
quantity for the transaction. This is expressed in the equation of
exchange:
M*V = Sum[i=1,n] p_i*q_i
In a computer generated crash, a huge amount of the world's capital
can cycle around between multiple investors instantly, i.e the
velocity V -> inf. Let F represent the values of all non stock
market transactions:
F = Sum[i=1,x] p_i*q_i
and G represent the sum of the values of all stock market
transactions:
G = Sum[i=x+1,n] p_i*q_i
This means
V = (F+G)/M
and if G remains fixed, yet the market transaction values for some
period go toward infinity, then we have as:
as G -> inf, V -> (F+G)/M = (F+inf)/M = inf/M = inf
This means
V = P*Q/M -> inf
the velocity of money goes to infinity. Since the quantity of
goods Q would remain fixed in the seconds of collapse, given it
rigorously must be that, since P*Q/M -> inf, either (or both):
P -> inf, or M -> 0
and neither case is good. If I have this right (and I am
definitely not an economist!) either price goes toward infinity, or
money supply goes toward zero, or both. Since we are in a global
economy, this seems to me to apply to the global money supply.
This theory seems to be working out to some degree. It appears M has
been driven strongly toward zero. The most recent reactions to that
it appears could result in the other outlet, namely driving P toward
infinity, massive inflation. See:
http://tinyurl.com/6ylcjq
If this little bit of theory is correct then the main ingredient
needed for stabilization is still missing, namely international
action to significantly reduce the high velocity of money due to fast
international computer driven trading. Suppressing shorts on some
stocks helped achieve this to a degree, but more is needed if the
above deductions are correct.
Best regards,
Horace Heffner
http://www.mtaonline.net/~hheffner/
