The Economist this week had an interesting discussion about the epidemiology of financial contagion. It is interesting to observe the use of language. The article starts out with a correct observation about how economists choose a particular type of language used to lend their observations credibility:
“Economists, who like to borrow medical terms to lend themselves an air of scientific rigour, call this “contagion” (see also: Dutch disease, liquidity injection, etc). Economic troubles in one country can infect others. Can economic epidemiology predict which countries might fall sick following a Greek exit?”
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The hint of irony here suggests a sensible scepticism about the use of models from other disciplines in economic discourse. But then another metaphor is adopted: water and ripples, in its place:
“It has long been known that shocks in large countries or markets send out ripples. In a 1989 paper Robert Shiller of Yale University showed that between 1919 and 1987 American and British stockmarkets had moved in tandem, but that this correlation could not be explained by parallel changes in dividend payments.”
The metaphors are extremely revealing. Irrespective of whether one sees financial contagion as a disease — viruses or microbes some other unnamed horror running around the world mucking things up — or as some kind of fluid similar to water but not quite water, there is a fundamental logical error. Capital markets are made up of transactions. Each transaction is both an artifice and a set of rules made by self aware people. In neither case is it a natural “thing” that “flows” about a bit, or “infects other things”. No matter how attractive it is to try to observe in it quasi-scientific fashion, either as a form of biology or physics, it has zero chance of working effectively. If, by some rare chance, it did happen to work as an analysis a few times, it would immediately be adopted by traders and cease to work.
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So where should we look instead for models that might be a bit more effective? We can safely disregard neo-classical economics — that is, quasi physics — as nonsense, but what other models might be useful? I can think of quite a few, but here I will briefly glance at one. Semiotics, or the study of signs. Charles Peirce, the pragmatist philosopher and father of semiotics described a sign as this:
“I define a sign as anything which is so determined by something else, called its Object, and so determines an effect upon a person, which effect I call its interpretant, that the latter is thereby mediately determined by the former.”
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That is not a bad description of how finance operates. The object of money is something else — what money buys — and money determines an effect on a person (usually fear, greed, buying an expensive Mercedes or declaring oneself bankrupt). Money, according to this approach, is a sign. Not a tangible, physical thing, or water, or some kind of strange disease. And those three elements: the sign, what the sign points to, and the person interpreting it are not a bad way of characterising what finance is: money, what money buys and the traders who interpret the whole game. It matches what Peirce framed:
“a sign signifies only in being interpreted. This makes the interpretant central to the content of the sign, in that, the meaning of a sign is manifest in the interpretation that it generates in sign users.”
That is what happens in financial markets. The meaning of money (the sign) only becomes evident from traders’ behaviour. So, if we approach financial markets as semiotic systems, then we should focus on how traders derive meaning from the signs they are watching (in their pursuit of Mercedes, lap dancers or strange white substances).
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Now of course, there is far more to Peirce than this, much of which I do not understand. But analysing financial markets in terms of his ten classes of signs might get a lot closer to what is really happening in the global financial markets. The weird worlds of meta money that we have created. It surely has to be a lot better than water or viruses, the interchangeable metaphors preferred by The Economist:
“Ripples from the Mexican and Asian shocks spread further than expected. The contagion puzzle was still unsolved. Kristin Forbes and Roberto Rigobon, “No contagion, only interdependence: measuring stock market co-movements” both of the Sloan School of Management at the Massachusetts Institute of Technology, were among the first to give an explanation. They showed that in good times spillovers between countries don’t matter much—so markets can appear not to be related. But during a crisis, when volatility rises, pre-existing links between economies suddenly have huge effects. This finding was striking: a dormant interdependence of economies was spreading disease like a shipful of flea-covered rats. This suggests that economies are far more linked in bad times than their ties in good times suggest.”
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If you ask me, it is this way of describing things that is the ship of flea covered rats.