Wednesday, March 31, 2010

Economics Rigor

There is a rich intellectual discourse on economics in the recent years. My classes in college got stuck on the basics: Paul Samuelson, price elasticity, supply and demand, micro and macro economics. The good stuff where never covered like behavioral economics and financial investments. Basically the stuff about capital markets like the stock market, central bank functions and so on. I guess it’s because the country back then has not reached the level of sophistication as the west. The whole concept of the efficient market was bypassed in relation to the capital markets.

The only significant treatise I remember from college was the critique on the School of Economics on the Marcos regime. It was basically a challenge on the form of cronyism that affected the free functioning of the market. These days these problems seemed to be quaint and simplified. Other Asian countries like Malaysia and Indonesia have even exceeded the Philippine in terms of cronyism. Now, government intervention and control seem to be the accepted response in the wake of the financial turmoil. It seems government will always play an important role in the economy. This role is something that is already in full bloom in countries like China, Japan, Korea and Singapore.

I guess my college years were more a reaction to the Marcos regime where the old oligarch is reacting against the new cronies raised by Marcos. It seems that this is a normal development in third-world economies where everyone wants to keep the pie for himself. The underdevelopment of the capital markets resulted in not being updated with the latest theories on stuff like modern portfolio theory, diversification, Black-Scholes model and so on. The recent crisis has resulted in an explosion of books that tries to explain the current problems. At the heart of the critique is the failure of the efficient market theory. This efficient market theory is now being replaced with the so called behavioral economics where irrational people subject the market boom and bust cycles.

The destruction of wealth plus the fall of institutions like Lehman Brothers and Bear Sterns have shown that tools like risk management is inadequate. Risk was not understood the wrong pricing models made the situation unmanageable. So we are back to square one although people like Warren Buffet and George Soros as usual prove everybody wrong. I guess these people do not rely on exotic theories but on common sense although Soros tried to create a philosophical framework for investment, coming close to behavioral economics with his theory of reflexive phenomenon. So its important to jump into the books again to understand the present predicament.

Books by Gillian Tett, Justin Fox, George Soros and Benoit Madelbrott, Nassim Taleb all try to explain the present situation. It now clear the Alan Greenspan is likely wrong. and efficient market is a fallacy although some parts of the model still work. So one should cultivate the following skills: understand one’s cognitive bias in investing, the herd of crows and behavioral economics and assessing risk. It does not hurt to learn as well from Warren Buffet and read books like ‘Fool’s Gold,’ ‘The Last Man Standing’, ‘Lords of Finance; and so on to understand the new normal in the financial systems. It’s a good way to understand tomorrow’s world today.

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