The free market and regulation could be friends

In the aftermath of the financial crisis, voices have been raised to regulate the economy more tightly. Contrary to the current right/left political jargon, regulation per se is not the left wing enemy of free markets. Protectionism and barriers of entry are and often regulation is used as a stealthy vehicle to achieve these ends.

Any society needs rules and regulations both for social interaction and economy or we would see web sites for assassination services or similar, which would make economic sense but are not desireable. Good rules and regulations create an even playing field boosting innovation and competition. Regulations should preferrably be global to extend the playing field even further. Good regulation deal primarily with the "what" and not with the "how".

When some incumbent is crying for more regulation to prevent unknown, and in particular new (disrupting) ways of working, extreme caution should be exercised because this regulation is probably not good for the economy as a whole. Often this is disguised as "business friendly" from right wing sources too fool us economic liberalists into believing that the best interest of the economy is being served. Politicians, don't fall into this trap (unless that is what you are paid to do :()

A man's best friend - E-coli

According to Dr Sharon Moalem, in her book "Survival of the Sickest", every person is really a small ecosystem of thousands of species. Bacteria of all conceivable kind and other microorganisms evolve together with the host, competing and cooperating in a wild evolutionary dance.

The evolution in micro-organisms (and viruses for that matter) happen at a speed several orders of magnitude faster than in any mammal. How on earth is anybody still alive when these buggers can outrun (actually outbreed) any defences?

The answer must be that it is beneficial for most of these species that the host is alive providing the habitat. Those microorganisms that don't benefit from the host being alive and kicking and that actually would take the host down will not only have to immediately fight the immune system of the host but also have to face the other species of the habitat in a longer term evolutionary battle. So without E-coli and his friendly neighbors we would most likely already be extinct.

Precisely wrong

The Black Swan by Nicholas Taleb is an impressive book, indeed. It has totally convinced me of being wrong. The main premise of the book is that very few processes are normally distributed and most of the randomness in real life comes from totally other distributions we can only guess (and why we shouldn't believe any forecast or risk measures built on the normal distribution).

We use the normal distribution because we know how to calculate with it. Mea culpa, I'm one of them. I never realized what I did when I wrote the ill boding words "assuming that the variable is normally distributed" in my Master's thesis of economics. In fact it simply means that the whole thesis is plainly wrong about currency hedging.

This is how he convinced me of the rareness of the normal distribution. The normal distribution is built up from discrete events, like coin flips. This binominal distribution, when the number of flips approach infinity, will form the bell curve.

Well, there are two assumptions behind this, none of which hold true for currency rates, or really any other real life event for that matter. Firstly the coin flips should have no memory, that is, a previous flip does not influence the next. We know that currency rates tend to overshoot. Bang - the first hole in the edifice. Secondly all outcomes should be of the same size, meaning that when you flip tails, it counts as only one tails, not 20 or 100. Clearly the up or down movements in currency rates are not of the same size every time. Bang, bang - the whole thing comes crashing down.

It was either to assume normal distribution or not to write anything about optimal hedging, I just did not know that then.

The Memetic Swan

I'm reading the Black Swan by Nicholas Taleb. I haven't even finished it but feel compelled to comment on it right now.

The Black Swan event, according to Taleb, is a very improbable event with enormous implications, a far outlier in the Gaussian sense. One of my first posts in this blog was about links and nodes of networks and based on that my conjecture is that black Swan events can arise in nonlinear environments but not in linear. Linear events, where the output is proportinal to the input, pile up a Gaussian curve statistic but in a network the same trigger can either fade away or blow out of proportion through the many nonlinear feedback loops.

I conjecture that all memes are potential Black Swans. The memetic network is like a excited laser, feed in the wrong frequency and nothing will happen but with the right input the whole energy is released in one go.

The point

I got some comments about my previous post. It was pointed out that the capitalism of big corporations is a meritocracy. This is, of course, true and I realized that the main point implied in the artice was not spelled out clearly enough.

Any stable order is a meritocracy given the parameters of the system. My point was that the capitalism of big corporations will not bring about the meritocracy that the Enlightment thinkers and the Founding Fathers of USA had in mind. These thinkers envisioned a society with free individuals, all having an intrinsic human value and where their starting point in life would not be an impediment for the pursuit of happiness.

In a system where the incumbents can tweak the rules in their favor, this will not happen.

Capitalism and the American Dream

I saw a video clip about Milton Friedman defending capitalism against critics.

He is right that other systems have not been able to deliver the goods as well as this system and in this way is better for its citizens, but he is dead wrong when he lets us understand that capitalism equals free markets and free competition.

Capitalism, as commonly understood today, is the capitalism of corporations. Corporations loathe free competition - they do everything within the law (and sometimes beyond) to achieve a monopoly of sorts, because that can deliver the highest profits. Basically they like competition when it allows them to move in on somebody's turf but cry foul when it is done unto them.

As my pseudonym indicates, I'm no lover of monopolies. It does not matter do they come from corporations or trade unions. It is the same idea, to monopolize the market of a certain good and create barriers of entry.

Capitalism as of today left unchecked is not a good idea since it will not increase the chances for the challengers of the world, bringing in the full competition and innovation that humans can muster. However, the allocation mechanism of "the market" is unsurpassed in its efficiency and should be kept going at maximum speed but that does not mean that it can be left unchecked either, as we have learned in the near past. Its allocation efficiency will not be hampered even if it has strict rules and full transparency. Capitalism with not easily manipulated checks and balances is probably the optimal system that we can achieve.

Americans have been conned from birth into believing that today's capitalism equates to the "The American Dream" where Scrooge McDuck relying on himself only and his skill and his hard work, can work himself up during his lifetime from being the shoddy immigrant at Ellis Island into the richest duck in Ducksburg. With fewer barriers of entry driven by the incumbents and the helpful governments, we would have more Scrooges. The American Dream is much better served by full competition (even foreign) underwritten by the government. Regulation is actually needed to bring this about.

I see the main economic role of governments to make sure that the playing field is level, this will not emerge. Not that I believe it to happen any day soon, since political parties are organisations driving their own particular monopoly with no love lost for actual competition regardless of the color of the banner they fly.

A totally level playing field would actually equal to meritocracy. That is a scary thing since you can not be so sure you are the best, can you?

Heads - I win, tails - you lose

I read an interesting book, "The Return of Depression Economics" by Nobel laureate Paul Krugman. I found this book very readable offering a explanations to those events I really never understood when following the world news with investor eyes during the last 15 years.

I think he is right on by claiming that moral hazard is central stage to the bubbles that eventually bust with more or less devastating effects. As he says that anything that performs banking functions and is so crucial that it has to be bailed out in times of crisis, then such an entity also have to be regulated like banks. I think this is good advice for the future. Free markets are all good and true until somebody can play the game described in the header on a massive scale.

The catch is - it is not very easy to see which entities perform banking functions, that is entities borrowing from some and lending to others and trying to make a profit in between (by taking more risk) and at the same having to be able to satisfy the liquidity needs of the creditors for the market mood not to go haywire. These come in all shapes and forms and will, most likely, not be recognized in time until they pop.