Biology, not Physics

I've mentioned the Odd Lots podcast before. It is very smart, and a lot of fun. The hosts are Bloomberg's Joe Wiesenthal and Tracy Alloway.

A recent episode is one of their best. In it, Andrew Lo, of MIT, describes financial markets as a mix of  both the neat efficiency described by neoclassical economics, and the messy emotion and misjudgment described by behavioral economics. Most of the time, market are fairly efficient, but on occasion, emotion takes over and fear or greed become dominant. That may seem like common sense, but I have not heard these two opposing views squared so well before.

One particular point Lo makes is that biology or ecology makes a better model for markets than physics. In ecology, there are things to count and measure, like the number of animals in a species and their weight, but there are also facts that are soft, and not readily modeled in equations. What does a species of animal feed on? What preys on it?

Switching back to investing, the advent of ETFs has increased the popularity of index investing, and this needs to be thought of ecologically. The growth in ETFs will hit its limit, as a proportion of the total, at some point. If you look only at price/earnings ratios, for example, it is hard to understand why the stock market has moved as it has. You have to look at the institutional structure of a market, too, which changes over time. Who are the players, at any given point? What are their constraints?

In other words, financial markets are complex adaptive systems, Lo says. They cannot be modeled fully, and are prone to breaking down. William White has said the same.

Anyway, I recommend this episode. I get it on my phone's podcast app, but you can also listen on the web via the first two links above. If you get into it, you will also like the recent Odd Lots episode with Citigroup's Matt King. King describes quantitative easing in a way that is entirely consistent with how Lo sees things.

Analyses of the Senate and House Tax Bills

Two very useful sources for keeping up with pending changes in tax law are the Tax Foundation and the Tax Policy Center.

Those who believe that nothing is literally dead-center could put the first just to the right side of the line, and the second just to the left. However, both are are serious and non-partisan.

Here are the links from each that describe the latest on the tax bill that the Senate passed this weekend: one post from the Tax Foundation, and one from the Tax Policy Center.

Hard to Keep Both Populist Voters and the Equity Markets Happy

This well-written, short leader, from the current issue of The Economist, gives an un-bubbly view of the stock market in the U.S.

Shiller Interview

This is a good interview, from last week, with the economist Robert Shiller. Topics include the current state of markets, the economy, and animal spirits, post-election. It is in the English version of Finanz und Wirtschaft.

While I'm at it, there was second good piece at the same site last week. This interview, on the hole central banks may be in, is with William White, former chief economist of the BIS.