Re: Fw: Epistemology & Economics

["ÁÎ×Ó¹â Henry C.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

Gunnar,

There are similarities between economics and astro-physics.  Both branches of
science try to deal with comprehensive systems and their externalities on which
the reserchers has pitifully inadequate data.  Even the basic overview or
conceptual framework of the systems under study are unknown and possibly
unknowable.  Both the basic driving forces and the rules governing these forces
are haphazardly identified and poorly understood, with available knowledge on
them valid only if the asummptions and defintions are not challenged. Validity
of governing laws are geneally achieved by narrowing the definition of the
boudaries.

Yet it does not mean that scientific approaches and mathematical logic are not
useful in advancing human undrstanding in these fields. As you know, there is
now a whole science and a vast field of mathematics to deal precisely with the
problem of uncertainties and boudaryless problem.  Knowing the unknowable is in
fact very serious business.

For example. the proliferation of quant shops on Wall Street is no passing fad.
Not only are their approaches fine-tuning the market performance of
sophisticated investors, the widespread use of such techiques in fact alters the
rules and formuli of technical analysis, forcing a new common sense among
market-savy professionals.

Long-Term Capital Management and its Nobel laureates in economics, Robert H.
Merton and Myron S. Scholes got wiped out more by excessive leverage than too
much science. Some evn think the suffered from too little science.   Still, more
than 20% of hedge funds, which control some $300 billion of capital and
trillions in notional value, are quantitatively oriented even today.

Nearly every major investment house and bank in the U.S. and abroad has a group
of highly paid mathematicians and physicists in its proprietary trading
department trying to beat the market with complex, computer-aided trading
strategies.  Most have been resructuresd after the LTCM debacle, but the sector
has not disappeared.

Wall Street warmed to quantitative mehtods not because it was impressed with
PhDs in physics or Nobel prize winners in economics. The Street, ever so
practical, was impressed by the money these quants were making.
The beauty of quantitative science application to finance was that though the
gambles were huge, the risks were minimal.  Risk management is a cosmic issue.

At the heart of the LTCM breakdown was an irrational global ''flight to
quality'' that had snowballing effect. The mathematical models had been
forecasting that differences in the interest rates of safe securities and risky
ones, which had widened, would return to their normal range within a short time,
driven by arbitrage profit, as they always had historically. But as Russia
unraveled and parts of Asia fell deeper into crisis, investors around the world
switched their money into the safest securities they could find, such as U.S.
Treasury bonds.  It Washington had rescued Russian bonds, as geo-political logic
dictated, LTCM would have won big.  So a question could be asked who, Rubins or
Merriweather, had acted irrationally.  The answer could have been Rubins.  Many
of the quant firms were betting on riskier, less liquid securities such as junk
bonds, and they got crushed also.  Instead of narrowing, the spreads between
safe and risky securities widened drastically in virtually every market around
the world.  The main lesson of LTCM is that size is a disadvantage unles you can
control the market by virtualof your size.

To work, the quant models need liquid markets on all sides of the trade. But
markets in August 1998 were thin, as Meriwether noted in his letter to
fundholders.  Volatility and the flight to liquidity were magnified. The trouble
with liquidity is that it is never around when you really need it, like bank
loans.

The global liquidity drought in 1998 was basically a panic in slow motion.
In this age of globalized finance, geographic diversification offers little
protection. The herd instinct always leads to widespread carnage, destroying
long-term or fundamental value.
There is much wisdom in the Wall Street maxim: ''Never meet a margin call.'' It
is only throwing good money after bad.

A case can be made that the LTCM disaster was attributable not to science but to
too little science, as I said earlier.  LTCM's worst-case scenario was only
about 60% as bad as the one that actually occurred.  It was underestimating the
escalting effect of bad news, the phenomenon of reverse leverage.

Some other quant firms, unlike LTCM which played universal markets, are niche
players, and their models concentrate on specific markets, did quite well. It is
the advantage of narrowing the boundaries, thus make the problem more solvable.
There is a axiom that the increase of one dimension of any problem will require
an exponential increase of resources to cope with it.

Henry C.K. Liu

Gunnar Tomasson wrote:

> Henry:
>
> You may be interested in the following.
>
> Gunnar
>
> ----- Original Message -----
> From: Gunnar Tomasson <tomasson@xxxxxxxx>
> To: David Gleicher <104201.2301@xxxxxxxxxxxxxx>
> Sent: Tuesday, April 11, 2000 12:13 PM
> Subject: Fw: Epistemology & Economics
>
> > David:
> >
> > For some reason, my answer to your message on 'Epistemology & Economics'
> > does not seem to have been forwarded through the PKT Forum.
> >
> > Do they exercise censorship with respect to the intellectual contents of
> > posts?
> >
> > In any case, here is my response.
> >
> > Gunnar
> >
> > ----- Original Message -----
> > From: Gunnar Tomasson <tomasson@xxxxxxxx>
> > To: <pkt@xxxxxxxxxxxxxxxx>
> > Sent: Monday, April 10, 2000 10:36 AM
> > Subject: Re: Epistemology & Economics
> >
> >
> > > David:
> > >
> > > Thanks for your comments.
> > >
> > > I read Feyerabend's book in the late 1970s.  My copy is now in storage,
> > but
> > > as best I recall he was right on the ball with respect to the central
> > point
> > > at issue - that talk of "method" is ex post facto "pretty-story"
> > > rationalization.
> > >
> > > Indeed, IF anyone wishes to contend otherwise, THEN they better be
> > prepared
> > > to take on and refute the view of the relationship between observation
> and
> > > theory held by (a) David Hume, (b) Albert Einstein, and - formally, at
> > > least, (c) Stephen Hawking.
> > >
> > > This is how Einstein put it in 1918:
> > >
> > > "The supreme task of the physicist is to arrive at those universal
> > > elementary laws from which the cosmos can be built up by pure deduction.
> > > THERE IS NO LOGICAL PATH TO THESE LAWS; only intuition, resting on
> > > sympathetic understanding of experience, can reach them."
> > >
> > > Absent "logical path" between empirical observations and our
> > > conceptualization thereof, and talk of "method" - except, given the role
> > of
> > > "intuition" in all this, possibly that of transcendental meditation! -
> is
> > > nonsense pure and simple.
> > >
> > > If all this be so, then here is a question for PKT econometricians, who
> > may
> > > agree with Paul Samuelson's claim in his Econometrica (July 1946)
> memorial
> > > piece on Keynes that the newly departed did not have the "technical
> > > knowledge" or words to that effect to know what he was criticizing when
> he
> > > dumped on Tinbergen's 1930s econometric studies for the League Of
> Nations:
> > >
> > > Absent "logical path" between the empirical observations that
> > > econometricians feed into their models and any would-be
> conceptualization
> > of
> > > associated theoretical aspects, in what sense, if any, can econometrics
> > rate
> > > as part of economic SCIENCE?
> > >
> > > In 'The Metaphysical Foundations of Modern Physical Science', Cornell
> > > philosopher E. A. Burtt summarized his conclusions with respect to
> > spurious
> > > claims to knowledge advanced by theoretical physicists as follows:
> > >
> > > "It has, no doubt, been worth the metaphysical barbarism of a few
> > centuries
> > > to possess modern science."
> > >
> > > In this respect, epistemological clarity is NOT of the essence in
> > physics -
> > > the essential stability of Nature's basic forms and their mode of
> > > interaction permits great operational advances to be achieved on the
> basis
> > > of the trial-and-error "method".
> > >
> > > Following Samuelson and Friedman, mainstream and monetarist orthodoxy
> and
> > > ALL econometrics are predicated on the MAKE-BELIEF that the like
> essential
> > > stability is an attribute of Man-made Economic Systems - including those
> > of
> > > Asia and Russia and the post-Bretton Woods international financial
> system.
> > >
> > > Hence my conclusion that the principles of modern economic analysis MUST
> > be
> > > rethought from the ground up or else, when the post-Bretton Woods
> > > international financial system hits the skids -as hit it will - economic
> > > scholars will (a) not know what hit them, and (b) be clueless on how to
> > > reconstruct a stable system.
> > >
> > > Gunnar
> > >
> > >
> > > ----- Original Message -----
> > > From: David Gleicher <104201.2301@xxxxxxxxxxxxxx>
> > > To: POST-KEYNESIAN THOUGHT <pkt@xxxxxxxxxxxxxxxx>
> > > Cc: David Gleicher <104201.2301@xxxxxxxxxxxxxx>
> > > Sent: Saturday, April 08, 2000 3:24 PM
> > > Subject: Epistemology & Economics
> > >
> > >
> > > > Gunnar,
> > > >
> > > > You might want to read, if you haven't already, Feyerabend's Against
> > > > Method.  To summarize:  his thesis is that, indeed, science is
> > "primitive
> > > > and muddled".  Scientists historically have used all sorts of tricks
> > > > (methods) to make their arguments (prove their theories), and the
> pretty
> > > > story that scientists avail themselves of a privileged method for
> > deriving
> > > > truth directly from facts (observations) is just that:  a pretty
> story.
> > > >
> > > > DG
> > > >
> > > >
> > > >
> > > > DG
> > > >
> > > >
> > >
> >