Economists Prove Einstein’s Theory About Repeating Behavior And Expecting Different Results.

Mainstream economic theory (MsET) has two fundamental tenets that most thoughtful people (even economists) realize are wrong and yet economic decisions and importantly even Fed policy is still based on this flawed model. We know what Einstein said this defines and it’s true.

Problem #1 is the Efficient Market Theory (EMT) or Theory of Rational Expectations says that economic information is widely distributed and that we as individuals and collectively as a market of decision makers and consumers consistently make our choices based on what will give us the most benefit. This has been scientifically proven to be not the case way more often than we like to think. For more on this see “Predictably Irrational” by Dan Ariely and “Thinking, Fast and Slow” by Kahneman in the ‘On Our eReaders Now’ box in the far right column of this page.

The second problem is that MsET is built on the idea that the economy tends to be stable and that dislocations are temporary and tend to correct themselves back to stability somewhat like a train running down the tracks that gets thrown off from time to time. History teaches us that is not the case either. Most often we are moving away from or back towards stability and occasionally pass through stability but typically overshoot. It doesn’t take much imagination to see how these two errors cause problems for economists (and us) and leads to a dismal reputation for them.

I’ve been reading a lot on economics lately searching for a new improved model and have just found a number of articles that tackle those issues. They are lengthy but well worth the reads. The first two were posted by John Mauldin in his ‘Outside The Box’ (OTB) series where others write about and discuss their sometimes opposing views from John’s. Mauldin will begin each piece with an intro about the author and where he might differ from that point of view. His guests are typically people who deal at the highest levels and their insights are not often available publicly or for free, which John’s newsletter is by the way. I highly recommend subscribing.

Outside The Box #1: American Gridlock, Part 2 with Dr. Horace ‘Woody’ Brock

Outside The Box #2: Face The Music, an interview with Dr. Stacy Hunt

The second set of articles are by Paul Brodsky. He is the Co-founder & Co-Managing Member of QB Asset Management.  QBAMCO manages private discretionary investment funds. So this is someone who takes his own advice every day with large amounts of money. Linking to their website wouldn’t be helpful as you can’t even get past the welcome screen without a code.

Definitely read the comments under part two as there is a lot of top talent commenting there and some of them disagree with Paul’s take vehemently.

Brodsky part 1: An Adult Approach – I (Investing in a Vulgar Age)

Brodsky part 2: An Adult Approach – II (Defining Relative Real Value)

If you’re still with me by now you’re probably wondering how do I get value from this post without having to read thousands of pages of esoteric economic theory? That’s a great question and one that I was going to devote a second, even longer post to until I read this gem of an interview with Swiss investor Felix Zulauf where he neatly sums up everything I was going to go on and on about in three paragraphs. Here’s the exec sum:

So, at the moment, you have two countervailing forces. On the one hand, you have a high level of debt, which is a highly deflationary force, which results in lower economic growth and a decline in prosperity for the masses. If you let this run unchecked, it leads to depression and the collapse of the system.

In order to counter these deflationary forces, governments and central banks adopt policies aimed at fiscal and monetary reflation. At the moment, we’re weaving between these two forces, and at any moment, it’s a question of which force is stronger…

Eventually there will be a conclusion, either a systemic collapse or a rise in inflation which will lead in some countries to hyper-inflation. And hyper-inflation itself always leads to systemic collapse.

There is much, much more in the interview and if you read nothing else today make it this: Felix Zulauf’s market global economic prognosis. In part two I will discuss what this means for the apartment market here in the States.

Thanks to Barry Ritholtz for posting Brodsky part 2 on his blog The Big Picture. Barry is a prolific reader and poster, typically in excess of two dozen a day including top 10 am and pm reads seven days a week. He is also a ‘quant’ someone who uses mathematical formulas to keep investing objective and not influenced by opinion which is good because he holds many and quite strongly too. Those opinions make him a great read (and a WaPo columnist) but this also makes him a very good ‘Investor Know Thyself’ guy too. His analysis system is available by subscription over at FusionIQ.

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2 thoughts on “Economists Prove Einstein’s Theory About Repeating Behavior And Expecting Different Results.”

  1. As a side note, while doing research on apartment market cycles I came across this gem in a report titled: “Real Estate Cycles and Their Strategic Implications for Investors and Portfolio Managers in the Global Economy” Pyhrr, Roulac and Born (1999).

    “As recent as the late 1980s, it was not uncommon to hear a finance professor dismiss the concept of real estate cycles as a research topic and decision variable…Support for these assertions is based on fundamental concepts embodied in the efficient market hypothesis.”

    The underlying assumption is that price fully reflects information at each point in time and that all information is freely available to everyone and, thus can be known by all market participants.

    Now since the existence of real estate market cycles has been scientifically established and are used by professionals as a crucial part of their decision making process then this is yet another hole punched in the EMT. The exact reason EMT was thought to disprove RE market cycles will require further study but I’m presently focused on a piece about apartment market cycles so that will have to wait.

  2. And here’s a third misconception about the economy that causes economists to go badly wrong: ‘The Output Gap’. Essentially that the if an economy can produce X widgets and there’s only Y widgets being consumed then demand has to be pumped up with cheap credit. The problem comes when production capacity was built on demand caused by a credit bubble that subsequently deflates (as our did) no amount of cheap credit will pump up demand until consumers pay off (or at least down) their loan balances from the previous round of consumption. Instead another credit bubble will be created which will eventually turn into an asset bubble; stocks, bonds. commodities, gold, oil…? Se here: http://bit.ly/ypS5Ma For even more check out the links at the end of the article.

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