Tuesday, December 30, 2008

Notes from the Dismal Science

Over the Christmas break, I have been reading "The Return Of Depression Economics" by Paul Krugman. There are good reasons why they call Economics the Dismal Science. The worse the financial situation becomes, the more there is to analyze, discuss and comment on. These are exciting times to be an Economist. I will report more on the book later, in the mean time here are some thoughts on the Dismal Science.

To my delight, the current Wikipedia entry on the Dismal Science calls it a derogatory alternative name for Economics and tries to contrast it with the "The Gay Science", the title of a book by the philosopher Nietzsche. The "Gay Science" of the books title is apparently the technique of poetry writing. It also claims that the first reference to Dismal Science is in a pamphlet published by Thomas Carlyle. The problem with all this is that the dates do not match up. The best known dismal economist is Malthus who published the first version of his pamphlet on the impending doom of population explosion in 1798. The Carlyle pamphlet was published in 1849 and Nietzsche's The Gay Science was published in 1882.

One interesting thing about Malthus is his use of mathematical models to explain his thesis. His argument was that population growth is exponential while the growth in food supply is linear, leading future generations to have more and more people fighting for proportionally less food. Nowadays economists still use mathematical models to explain their positions, although they have now graduated to sometimes using differential equations to make their point. In my time, I have known several applied mathematicians. Their models are always second order differential equations and they always oscillate, just like our financial fortunes.

Another branch of mathematics with relevance is Game Theory. Derivative trading is a zero sum game. That is, one persons gain is another persons loss. I believe that bond trading is also a zero sum game as well. In a properly open market with good information, trading in bonds and derivatives should be a straightforward and relatively low profit enterprise. For at least 20 years, as depicted first in Bonfire of the Vanities and Liar's Poker, it has been exactly the opposite. The market players have conspired to hide information and keep the market inefficient so that they can reward themselves with enormous profits from trading.

Note that derivative and bond trading is only a zero sum game when they do not default. Adding defaults makes bond trading a manly game where the best can win. Thus, are defaults necessary to justify the the profits and bonuses that Wall Street firms have been paying? Is it a matter of: "It is not enough to succeed, others must fail"? Could it be that these ridiculous collateralize debt obligation bonds were deliberately created so that some of them would fail?

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