Rational markets can be efficiently designed, most economists will concur. And by using complex algorithms and models, efficient markets can become ever more rational.
That was essentially the premise behind awarding this year’s Nobel Prize in Economics – the Sveriges Riksbank Prize – to two American luminaries of game theory, Alvin Roth and Lloyd Shapley. Designing systems to efficiently match students with schools, organs with recipients and husbands with wives, among other things, Roth and Shapley have independently advanced the science of cooperative game theory to improve markets and keep pushing out the ‘efficient frontier’.
Both recipients are undoubtedly well-deserving, having laboured for decades, publishing scores of papers between them and turning literally hundreds of students into avid game theory researchers themselves. Yet at a time of global economic turmoil, almost unprecedented in living memory, the choice is a curious one. Academic economics – a pinnacle of which is stochastic game theory – after all, can be as much to blame as any other cause of the GFC, whether that be global trade imbalances, income inequality, the failure of ratings agencies or mere regulatory incompetence. And, after awarding no less than eight previous Nobel Prizes to other game theorists before Roth and Shapley, surely Sweden’s Riksbank could have by now worked this out?
Alas however, within the cloistered halls of academic and central bank economics, it seems not. Economics here is seen as a science, something that can be accurately measured and rationally explained through mathematical models and theorems. Unlike the humanities, which use a different lens of understanding, economics as science is as predictable as the limits of probability allow.
But by treating economics in this way we face a prisoner’s dilemma. Not the prisoner’s dilemma of Cold War nuclear planning of course – a theoretical game interrogated by the RAND Corporation in the 1950s, where Shapley himself once worked – but the prisoner’s dilemma of Plato’s Allegory of the Caves, something you’d rarely see in a modern economics syllabus. Tied to the wall of a cave, the Greek philosopher postulated, and having only seen the world refracted into shadows, was the representation of a jar or an urn cast against the wall merely a symbolic vessel, or to these prisoners was it the real thing? Having seen no ‘real’ example, wouldn’t the shadow become the reality?
Expanded upon millennia later by French philosopher Jean Baudrillard, Plato’s cave wall shadows would to postmodern thinkers become ‘simulacra and simulation’, the title of Baudrillard’s 1985 text on the subject. And in a world of symbols and simulacra the representational would become the real. Indeed, to any reader of an online article on this subject, how could that not be so?
Yet returning to economics, herein lies the dilemma: how can a science that only deals in models and representations, that may or may not be true, be properly interrogated? How do we know – as Baudrillard asked, paraphrasing Argentine author Jorge Luis Borges – where the landscape of the map ends and the desert of the real begins?
If this all sounds a bit Matrix, it is – the film’s scriptwriters were big fans of Baudrillard – but it’s not mere fantasy. It’s indeed a question being asked by hedge fund manager Christopher Cole of Artemis Capital Management, who says that financial markets have become “a game of impossible objects.” And making a lot of money from trading volatility, Cole should know:
In a world where global central banks manipulate the cost of risk, the mechanics of price discovery have disengaged from reality,” Cole wrote in a recent letter to clients, “resulting in paradoxical expressions of value that should not exist according to efficient market theory.
He continues:
Fear and safety are now interchangeable in a speculative and high stakes game of perception. The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.
And the result of this, Cole says, is at the heart of our present crisis:
In the postmodern economy market expectations are more important to fundamental growth than the reality of supply and demand the market was designed to mimic. Our fiscal wellbeing is now prisoner to financial and monetary engineering of our own design. Central banking strategy does not hide this fact with the goal of creating the optional illusion of economic prosperity through artificially higher asset prices to stimulate the real economy. In doing so they are exposing us all to hyperreality or what Baudrillard called ‘the desert of real’.
To traders, not to mention economists who have puzzled over the increasing volatility of equity, debt and commodity markets in recent years, this much is obvious. Billionaire investor George Soros’s theory of financial reflexivity – essentially, that you make more money by predicting what other people will predict – has transmogrified into a Nyarlathotep of abstracted and semiotic markets.
It’s where the value of derivatives exceeds tenfold the value of real money and where bad economic news leads to good days on the share market, all in the vain hope that Ben Bernanke, or Mario Draghi, will print more money and save the day. It’s where, like Schrodinger’s cat, the Aussie dollar can be both a risk asset and a safe haven all at the same time. It’s where the Riksbank prize committee, in all their wisdom, can award money to the grand theorists of such a perverted system, and believe that they’re doing humanity a service.
But as we’ve written before in this column, the sacred idols of economics – infinite growth, logical actors, efficient markets, rational price discovery – are daily getting smashed on the rock of financial reality and by retreating into hermetic Gnosticism, academic practitioners of the dismal science are merely making themselves increasingly arcane, even irrelevant.
When we think of the world’s economic problems, what we need is not more efficient tools to game the broken model, but a new model, or preferably no model. When we consider the challenges humanity faces in the 21st century, when the first world pain of the GFC is long forgotten, what we need is a better philosophy and better institutions to underpin it, where the resources we have at our disposal can be distributed or put to work, in a fairer, more equitable and more humane manner than either socialism or capitalism can currently come up with.
Just as the first theorist of shadow games, Plato, was very much interested in good governance – he is perhaps best remembered today for his Republic – so too were the economists of the eighteenth and nineteenth centuries: Adam Smith, Jeremy Bentham, John Stuart Mill, Karl Marx and David Ricardo. And while it is not Nobel practice to posthumously award prizes to the centuries-long dead, perhaps future choices ought to be more focussed on those finding solutions for the common good, not the common denominator.
The nature of men and women who work in garrets, coming up with radical new philosophies, is that they’re generally unknown or unappreciated by their contemporaries – I can think of one Australian economics professor who fits this mould. But just as the Nobel Prize has experimented with radical selection in the Peace Prize – the European Union this year was a bold but enlightened choice – perhaps the economics division could seek such people out, leaving game theory to the Field Prize in mathematics.
It’ll stir up controversy for sure, but the alternative is just more of what we already have: shadow banking, shadow prices and shadow games. All representational and, ultimately, chimerical.
Michael Feller is an investment strategist at Macro Investor. If you take the red pill, Macro Investor is offering a free 21-day trial to new subscribers. If you take the blue pill, then you’ll awake in your bed, remember nothing, and believe whatever you want to believe.