from Maudlin Economics,
8/13/21:
“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
―Ernest Hemingway, The Sun Also Rises
Change happens quickly and, often, unpredictably. And as we will see, the unpredictable part is actually a mathematical principle. As in the Hemingway quote above, not just bankruptcy but change also happens slowly and then, seemingly, all at once.
I have updated an letter I wrote in 2006 a little bit, but the principles are timeless.
I’ll be quoting from a very important book by Mark Buchanan called Ubiquity, Why Catastrophes Happen. I HIGHLY recommend it if you, like me, are trying to understand the complexity of the markets. The book isn’t directly about investing—although he touches on it—it’s about chaos theory, complexity theory, and critical states. It is written so any layman can understand—no equations, just easy-to-grasp, well-written stories and analogies.
As kids, we all had the fun of going to the beach and playing in the sand. Remember taking your plastic bucket and making sandpiles? Slowly pouring the sand into ever bigger piles until one side of the pile starts to collapse?
Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time, it’s a small one. But sometimes, it builds up, and it seems like one whole side of the pile slides down to the bottom.
First, economist Dr. Hyman Minsky showed how stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist, and then the more dramatic the correction when the trend fails.
A second related concept is from game theory, the Nash equilibrium.
When I originally wrote that letter, it was 2006, and the fingers of instability hadn’t yet created the Great Recession. You could certainly see red dots in the sandpile, most notably subprime debt, but there were literally hundreds of dots scattered throughout the world economy, most of them innocuous until they weren’t.
There is a surprising but critically powerful thought in that computer model from 35 years ago: We cannot accurately predict when the avalanche will happen. You can miss out on all sorts of opportunities because you see lots of fingers of instability and ignore the base of stability. And then you can lose it all at once because you ignored the fingers of instability.
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