The Independent ran a photo of George W. Bush and Tony Blair on its front cover earlier this week. “Are these the only two people in the world who don’t think the war in Iraq is a disaster?” asked the headline.
Researchers recently tried to guess how much of a debacle the war really was. They focused on the number of people who had died since the government of Saddam Hussein was run out of Baghdad. Various estimates came in – between a low of 300,000 or so on the one side…and nearly a million on the other.
Estimates of the costs are similarly wide…from a couple hundred billion…to more than $1 trillion.
But it is a strange, strange world we live in. Can you really measure success or failure in terms of lives and treasure? The Bush team aims for “full spectrum dominance.” Who’s to say the occupation of Iraq didn’t help them get it? And who’s to say or know what fate has in store…or what purpose the heavens themselves may have for us…for the war…for the world?
An empire, being a rather grand and important public spectacle, makes many headlines. But all of them follow the same hiker’s trail – up the mountain on one side and down it on the other. The great historical achievement of the Bush team was to find a trail that got them over the hump quickly, and onto the path of self-destruction.
In politics or in markets, every fad and fashion follows a predictable pattern – from Dow 900 to Dow 12,000…from the beer hall putsch to the fall of Berlin. Like life itself, each one is destined not for eternal glory, but for the grave.
The housing bubble, like many other things, remains unfinished business. We have seen the headlines announcing its coming; we wait to see the headlines announcing its going. Its grave has been dug…but is still empty.
So too, in the 20th century, did we see extraordinary things. The human population began the century at just 1.6 billion. It ended it with the numbers reversed, at 6.1 billion.
The world’s output grew too, from $2 trillion to $39 trillion. Will we ever see the downsides of those trends, we wonder?
No one gets to read tomorrow’s newspaper headlines today. Still, after six centuries of moveable type – and countless centuries before that of longhand and oral traditions – you’d think the basic template for public spectacles would at least be vaguely understood.
Seeing one set of headlines…Germany Invades Poland…Union of Soviet Socialist Republics Declared…Dow Surges to All-time High…China is the New ‘Miracle Economy’…a reader might expect to see another, later, headed in the other direction. Looking ahead to long retreat…you’d think people would be tempted to stay home. ‘Why bother?’ they might ask themselves. The troops might stay in their barracks. Investors might put their money in the bank. Voters might avoid the polling stations. It is as if they could already know how the film ends; funny that they don’t get up and leave.
But they don’t. History continues. The old Sturm und Drang rattles and rumbles along. But why? We turn to logic – not for an answer, but for a culprit.
Any man who has had teenage children must be suspicious of logic. As soon as a teenager gets the hang of it, his sense of reason seems to leave him…and doesn’t return for at least five or six years. Or, if he takes up politics, law or economics, it may never return.
“If there really were a God,” says the teenager triumphantly, “he wouldn’t let people starve…he wouldn’t allow Bush to make war and kill people…and he wouldn’t make me do homework on Friday night.”
We don’t know whether God exists or not. But we’ve been around long enough to believe that God can do any damned thing he wants…even if it makes no sense to a 15-year-old.
Likewise, we’ve been around the investment markets long enough to know that they can do what they want too – even if it seems to defy our best thought-out theories and logic.
The logical mind wants to take the pieces apart…examine them…and figure out how they work. This is, of course, what separates man from the beasts. The poor creatures that walk on four legs can’t pick up a screwdriver, so they can’t take a clock apart to look at how the pieces go together.
Man, on the other hand, can’t seem to stop doing it. And so his knowledge of the material world advances, by fits and starts, and he’s gradually able to enjoy a kind of full spectrum dominance over the natural world. Except for tiny viruses, no living thing seriously challenges him.
Now, out in the penumbras and umbras on the spectrum of life…where the public spectacles occur…the light is either so white you are blinded by it…or so black you cannot see a thing. But the logical mind looks at politics, social order, economics, and finance as though it were a rudimentary cuckoo clock. He imagines that here, too, he can take the pieces apart and study them. Standing on two legs, with the entire natural world at his feet, he cannot help but think he can master this social world too…
It is here that he runs into trouble. He picks up the pieces, but he immediately sees that they are unlike the sprockets, wheels and gears of a clock. Instead, they are full of body fluids, bile, and air…hearts and guts…and “facts” as vague as a cloud and elusive as a bead of mercury.
For illustration, we turn to the investment world, but we might just as well turn to politics, war and other realms of collective imbecility.
The “naive scientist” looks at the stock market and he figures it must follow some patterns. Prices go up…and then they go down. When? How? Why? He studies the situation and comes to his conclusions. He proposes a trading hypothesis: ‘I will only buy stocks that have gone up for the last 3 months.’ Or, ‘I will follow the them stochastically.’ Or “I will buy in the morning and sell in the evening.’ And so, he sets out…investing rationally…until his money is gone.
Experts say that 90% of traders eventually lose their money. We are amazed; we thought the number was closer to 100%. Why such losses in such a rational world? Aren’t markets fundamentally logical? Isn’t it all a matter of numbers?
Where have you been, dear reader?
As far as anyone knows, markets are unpredictable. And if anyone knows anything to the contrary, he is keeping quiet about it – because as soon as other investors caught on, the secret would be rendered useless. He might just as well give out the address of a bar that serves free drinks; the place would soon be mobbed and useless to him.
Unlike a cuckoo clock, markets are infinitely complex systems without discreet or even knowable components. The pieces of a clock…or a television…or a hamburger…are identifiable and limited. But how many different factors influence the stock market? An infinite number. Each stock has its own universe of influences…the cosmic dust surrounding even a single, small company is mind-boggling. That’s why even the insiders – top management and main shareholders – are often wrong about how well the company will do in any given period of time. Which is why a strategy of merely following the insiders is not likely to work much better than simply buying the index.
Markets are “chaotic systems,” say the mathematicians. As such, they are subject to feedback loops from their constituent parts. Imagine a cuckoo clock that ran slower because the cuckoo was feeling tired! Well, that’s what markets do…a subject of constant amusement at the Daily Reckoning. Investors drive markets in perverse ways and at inopportune moments. After prices have been pushed up by too much investor interest – leave it to investors to drive them up even further!
Chaotic systems are also subject to inputs that are largely invisible and whose impact is wholly unforeseeable. This is what is known as the “butterfly effect.” Something as remote and insignificant as a butterfly flapping its wings in China could set off a chain reaction that would lead to a hurricane in the Gulf of Mexico.
Henri Poincare described the effect in 1908:
“A very small cause which escapes our notice determines a considerable effect that we cannot fail to see, and then we say that the effect is due to chance…it may happen that small differences in the initial conditions produce very great ones in the final phenomena. A small error in the former will produce an enormous error in the latter. Prediction becomes impossible.”
So, even if you were somehow able to see the parts of the market system clearly…and even if your logic about how they interact were impeccable…you still wouldn’t know what was going to happen next, because you could never foresee the impact of every little winged insect in the financial world. It was the collapse of an unknown and unimportant Viennese bank – CreditAnstalt – that triggered the Great Depression in America. Right at this very moment, there is surely some butterfly of a hedge-fund manager sweating some multi-billion dollar trade, and praying it doesn’t go against him. Who knows what the consequences for the whole system would be if it does?
Likewise, in the world of politics, small things can have huge, unforeseeable consequences. When Americans pressured Chiang Kai-shek to let Mao’s army escape to Manchuria…or when the Germans put Lenin and sent him to Russia…or when Ho Chi Minh decided not to become a pastry chef…the results were enormous.
Our naive scientists, of course, have no idea of all the various inputs, influences, and social forces that affect the flow of history. Examining the mechanism, they find the parts impossible to grasp…or even confine. Their only recourse is to simplify. Who knows how the Muslim world will react to American forces in Iraq? Who can say what would happen if Saddam were booted out of office? Who has any idea what a de-stabilized Iraq will mean for the future of the Middle East…or the world?
Out on the far edge of the spectrum, it is all darkness. Nobody knows anything. At least, a reasonable man would know what to do. He would go to a part of life where he could see what he was doing; he would focus on his work, his family and his private interests.
But we are talking about public spectacles. And in public spectacles, a man draws not on his powers of reason, but on the clunkiest kind of logic. He reduces complex ideas and contradictory information to simpler forms – childish and moronic political slogans – that the masses can understand as “reasons.” Then, he strings the reasons together with the artful finesse of a rail yard worker, putting together boxcars. One rusty simplification connected to the next…until they get him where he wants to go.
He becomes thoroughly logical…and completely unreasonable.
“The terrorists are out to get us,” he says, as if it were a fact. After that, his next fact sounds almost sensible. “We have to defend ourselves,” he says. “Better to do so in the streets of Baghdad than the streets of Baltimore,” comes the next heavy hulk. Does Baghdad have anything to do with terrorism? No, but it’s close enough for government work, as they say. And so, he eventually reaches Baghdad and gets himself into such a mess that the English papers are laughing at him.
Meanwhile, back in the financial markets, so great is the uncertainly and unpredictability of markets that professors of finance have come up with a short-hand simplification called the Efficient Market Hypothesis (EMH) to make sense of it. According to EMH, prices set by the market are so “perfect” you’re wasting your time trying to outsmart them. The market always has more information than an individual investor. Thus does the price reflect all known information and the collective judgment of all market participants. You’re better off buying an index fund, say the EMH experts.
The hypothesis is nonsense. Prices are not perfect at all…but wrong most of the time…and in shifting directions, from being too expensive to being too cheap. But EMH is a useful fraud; reminding investors how hard it is to beat the broad market and how unlikely it is that they will ever understand it.
Something similar should be developed for politics, in our opinion. The world is not perfect. But it is the reflection of the judgment of the world’s people – developed, elaborated, and evolved over thousands of years of experience. If a country like Iraq has a dictator of whom we do not approve, it may make sense to refer to the Perfect World Hypothesis, just to remind ourselves that “What Is” is for a reason…one we cannot necessarily know. We might what to replace What Is with What-Should-Be-In-Our-Opinion…but we ought to at least think twice about it.
for The Daily Reckoning