Muse, Economics and Thermodynamics

There’s a song in Muse’s latest album that stands out in a big way. Not only is it their first song to feature dubstep, it incorporates an ambitious attempt at their own economic theory. You can listen to the song here but since the economics bit is so short, here it is in its poetic glory-

All natural and technological processes proceed in such a way that the availability of the remaining energy decreases. In all energy exchanges, if no energy enters or leaves an isolated system, the entropy of that system increases. The fundamental laws of thermodynamics will place fixed limits on technological innovation and human advancement. Energy continuously flows from being concentrated, to becoming dispersed, spread out, wasted and useless. New energy cannot be created and high-grade energy is being destroyed. An economy based on endless growth is unsustainable. *cue crazy dubstep*

 

Now I know it’s just a song so maybe it shouldn’t be taken too seriously, but it’s certainly an interesting idea- can we apply physics, particularly thermodynamics (the laws behind gases), to the economy?

The gut reaction would be no, of course not, the economy is based on inherently unpredictable human beings, how could this be governed by the laws behind gas expanding or ice melting? Human beings are not well-behaved atoms. But this is where thermodynamics is different to this atomist idea of science- thermodynamics accepts, embraces even, the idea that we can never really know what any one atom is up to. And yet it manages to produce extremely powerful laws that have been shown to be very accurate and are behind most of the inventions of the industrial revolution, such as the engine. So how do physicists get from calling atoms unpredictable to neat, predictive laws? Statistics, dear boy, statistics.

We may not know where an individual air molecule may be in 5 minutes time, but we can get an idea of the most probable places it will be. Scientists often call this the “random walk” model- if you flipped a coin to determine if you should step forwards or backwards, the chances are that after enough throws you’d get about as many heads as tails and end up somewhere close to where you started off. The modern equivalent of this is called the “Apple Maps walk”. Now imagine doing the random walk experiment with a thousand people, all starting quite near each other. Let’s go to the top of a tall building and look down on our coin-flippers after, say, a thousand tosses. What will we see? We should find that most people are pretty close to where they started off, even if only a few are exactly at that spot. We’ll also notice that there are people a bit further away but that there are fewer of them the further out we go in either direction. Then we might find one guy who made it all the way to the end of the street. He was the one guy who managed two hundred more heads than tails. Someone was bound to, after all.

The shape or formation of these random walkers is what mathematicians call a “normal distribution”. Now let’s throw in thousands more people and get them to spread out across a whole city, flipping coins as they go. From our aerial perch you might be struck by something- doesn’t this look an awful lot like a gas expanding in slow motion? It turns out that atoms can also be thought of as flipping coins and while some of them might end up in strange, unpredictable places, like the guy who threw a lot of heads, the overall formation is fairly predictable- a normal distribution, with things like pressure and temperature affecting probabilities.

And so with this model we manage to get the solid-as-a-rock- laws of thermodynamics, even if we can’t say much about what any particular molecule is up to. What the Muse song was suggesting is that we could apply this principle to the economy as well and with a bit of thermodynamics in our pocket, we can see why. Might humans also perform random walks with their economic decisions? There’s a chance some people will want to spend money on video games, others on holidays. Some people will want to be doctors, others teachers. We can’t predict what any individual will do but could we find an overall, reliable distribution that gave as a decent insight into the overall progress of the economy? Many physicists in recent decades have thought just that. Unfortunately for them and for the rest of us they were wrong. Massively wrong.

The logic of thermoeconomics (yes I made that up) seems pretty sensible but unlike thermodynamics, it simply doesn’t face up to the evidence. Thermoeconomics does actually provide a reasonable way to model the everyday fluctuations in the stock exchange but where it fails is exactly where it is needed most- it is helpless in the face of extreme events. Thinking back to thermodynamics, it is pretty clear that when released from an aerosol, the particles of a deodorant will spread out fairly evenly across the room. What we would never expect to happen would be for all particles to very abruptly gather in the corner of the room. That just doesn’t happen. Unfortunately this is exactly what happens in a stock market crash- people stop behaving randomly and start moving in herds. Where selling once balanced out buying, suddenly everyone wants to sell. Where lending balanced out need for capital, suddenly everyone’s too scared to lend.

Part of this is psychological. Fear can prevent people from making what might normally be seen as a rational decision. Lack of information can make people risk adverse. But more than this is a fundamental problem with the thermoeconomic model. Thermoeconomics assumes that all economic “particles” are independent of each other but in our economy people and institutions can get much more interconnected than was previously thought. Banks were way more exposed to the housing market than anyone had realized, for example, and as one bank faced failure, the complex web of banks lending to banks lending to banks left the whole system in danger. The aerosol gas was retreating to the corner of the room while neatly spelling out “SHIT”.

So where does this leave our philosophizing rock stars? The thermoeconomics they preached may be no good for accurate day-to-day prediction, but could it be applied to make comments about the economic system in general? My instinct is no, it can’t. Not only is thermodynamics a rubbish way to model human interactions, we are not an isolated system. The earth emits thermal radiation out into space in a more disordered form than it came from the sun, increasing the entropy (disorder) of the universe but not necessarily of the Earth. The only bit of their argument that really makes sense is that we should be cautious about using limited resources. But that much is pretty obvious, a posh way of saying that resources won’t last forever. We just need to use more renewable resources to avoid running out of fossil fuels, that’s all. There’s certainly no reason to believe thermodynamics put a limit on human progress.

Perhaps I shouldn’t have taken the song too seriously, but it’s been a fun ride. The next time you hear a rock star make some claim about the application of physics to economics, you’ll be well armed. Muse should stick to their music.

Freefall- a manifesto for economic change

As markets tumble in Europe, America and across the globe, the world is waking up to reality: the recession is back. Indeed it never really went away. How much of this can really be a surprise? We have more or less the same economic system today as that which brought the economy to its knees just three years ago. In 2008 policy makers could at least plead naivety. Who could have seen the sudden collapse of the world’s largest banks? And who could have known just how interconnect companies and countries had become?
But these rhetorical questions do in fact have answers: Joseph Stiglitz, professor of economics and Nobel laureate, was our Cassandra.  He was preaching long before the housing bubble and credit default swaps of the inherent dangers posed by lax legislation and misaligned incentives. His 2010 book Freefall, recently updated, is his victory lap. But more than “I told you so”, Stiglitz offers a way out of the mire. Politicians would do well to head his advice.
Market Failure

Stiglitz lays the blame for the crisis squarely, triangularly and circularly at the feet of free markets and their ideologue proponents. I’ve blogged before about my own flirtatious relationship with free markets and identified some of their key failings. One failing I didn’t mention was externalities, which was a failing central to the near collapse of the financial system and one which Stiglitz emphasises.  Externalities are by-products of business where there is no market mechanism to account for them- sometimes positive, sometimes negative. If I own a bee farm and an orchard sets up next door, the orchard benefits significantly from my bees’ polination without affecting me. But should the orchard owners not pay for this privilege? This is an externality– the market provides no way of paying me. A negative externality would be global warming- harm is caused by business but not in a way penalised by the markets. 
Stiglitz argues that banks, with their light touch regulations, posed huge negative externalities on the economy as a whole in a number of ways: the misunderstanding of risk, performance related pay and implicit government subsidy.
Risky business

Before making a loan, banks need to understand the risk associated with the borrower defaulting and adjust the interest rate accordingly. But to further decrease risk, banks started to package loans together with assumption that the more loans one had, the more the risk was spread out. This was fine, provided defaults weren’t correlated. But when house prices started to fall across the country, defaults became very correlated indeed. Because many of these loans had been packaged together in highly complex ways, banks suddenly realised that they couldn’t really tell which loans were safe and which weren’t. They also couldn’t trust the safety of other banks and so stopped lending to each other, resulting in the credit crunch. Stiglitz verdict is clear- commercial banks shouldn’t be allowed to create products they don’t fully understand. As US Treasury Secretary Henry Paulson quipped, “the only useful financial innovation in recent decades has been the cash machine”.
Performance related pay and other oxymorons

Performance related pay was abandoned by most professions when it became clear that it rewarded quantity, not quality and encouraged short term results. These are precisely the problems plaguing modern banking. Bonuses are paid for gains but not removed for losses, promoting excessive risk taking as bankers just couldn’t lose. Mortgage vendors were rewarded according to the number of mortgages issued, not their quality, leading to the phenomenon of “liar loans” for which borrowers required no proof of income. Even after the Crunch, the flow of bonuses continued, making a mockery of the claim that they were performance based.
Bankers on benefits

But perhaps the strongest externality was the implicit guarantee that the government would always save the biggest banks to protect the rest of the economy. This safety net enabled banks to take much greater risk at much lower interest rates- a subsidy of billions of dollars, greatly distorting the market. When the bailouts were received, very little was loaned on to small and medium sized business, the risks of speculation were still too tempting.
What’s to be done?

Stiglitz is no communist and recognises the importance of markets- the key is regulation. As the world sits on the brink of what may well be a double dip recession, here are his suggestions for policy changes to make a difference-
  1.    Separate commercial banks from investment banks- banks shouldn’t be taking huge risks with ordinary households’ money.
  2.      Require banks to keep some of the mortgages they sell on their books to ensure they have a vested interest on providing loans to those how can afford them.
  3.     Give share holders greater say over executive pay and stop payments in stock options- they encourage short-term thinking.
  4.     Require bailout funds to go to small and medium sized business. Much of it is their money, after all.

This is Stiglitz’s manifesto for change. Free markets have failed but markets can still work within sensible rules.  Failure to change in 2008 brought around the current difficulties. The world cannot afford to make the same mistake twice.

Trying to be Less Evil

I have a confession to make. Over the last year or so, I’ve been really quite evil. I really never meant to be, but there it is. Evil as a doorknob. Like many of my ilk, I can pin point the exact day the evil started, it was in November 2009 and I was in the Felix office, chatting to the business editor (you know who you are!). The chat went something like this,
Moi: The government should really pay for education/ health/ hash brownies for the poor.
Satan: Well, if it’s such a good thing, why don’t richer people just pay for it for them anyway? Can’t people just be charitable, or are you saying the government is more moral than everyone else?

And there the bastard had me. Wouldn’t it be a whole lot better if people just came together themselves and sorted out each other’s difficulties? What was it that made government intervention so much better than private action? This got around a WHOLE load of issues too. Want your child to learn evolution? Set up a school that does it. Want poor kids to learn about evolution? Set up a school for them too. Is it really that different from the government doing it? In fact, it should be better- being controlled from near, not Whitehall, means better efficiency and accountability. On top of that, surely the freedom to teach as you wish has a moral value to it? It’s not like current state schools are anything to write home about. Assuming you can write, that is.
I started to see the benefits of privatisation everywhere. I didn’t believe that cuddly services such as health and education should be run purely in pursuit of profit, rather that the freedom should be given to professionals, patients and parents to make their own decisions about services and this freedom comes from privatisation. Every time someone complained that the government should do more for such and such I’d think, “Why don’t you just go ahead and do it, or convince professionals to?” At every stage this was my outlook. How on earth could the government do something better than its citizens, I thought. Yes, most of us don’t have the expertise to set up a school, but neither do most politicians. They hire professionals with our money, why not cut out the middle man and hire them ourselves?
But I wasn’t an evil voice in the wilderness, I had my Gospel and I really did read it religiously; The Economist magazine. You really have to read the thing to understand its allure, but basically it kept me in market- loving, unions- hating rapture for hours on end every week. And when my sister got me a Kindle subscription for Christmas? In the Holy Name of Friedman, I just didn’t stand a chance.
It all reached its zenith when, one fateful May morning, I put an x beside the name of Sir Malcolm Rifkind, Conservative MP for Kensington, my constituency. Yes, that’s right. I’m Rory the Tory. Rory the Milk Snatcher. The Sheriff of Ror-ingham.
But things have since changed. Let me be clear, I really didn’t mean to be evil. I honestly believed the in freedom, efficiency and accountability that letting the market into public goods would bring. I now realise I was mistaken. The purpose of this blog is to explain just why I was mistaken: why markets really aren’t as wonderful as free marketers such as my younger self might hope. Perhaps in the process some other poor devils might realise the errors of their market orientated ways, too.
Market Failure

Even in theory, markets can’t always work properly. A year ago, I’d have said that if there were a more efficient way of doing something, the market will always find it and adopt it, as otherwise businesses wouldn’t survive. Unfortunately, this isn’t the case and market failures can appear in two fundamental ways.
The problem of Lemons. Firstly, I have no problem with fruit and neither do markets. We’re talking about Lemons with a capital ‘L’; crap cars. It’s a well known fact that the very second you drive a new car out of the car shop, it drops fabulously in price in a way that doesn’t make perfect sense. It’s true that everyone likes the idea of being the first owner of a car, but not so much that they would insist on paying many thousands of pounds less just because someone had ‘her’ for a week. Instead, there’s a classic market failure operating.
Imagine you see an ad for a car. It’s almost new and so going for a price not too far off what it would have been hot off the shelves (that’s how a car shop works, right? Shelves and massive industrial trolleys?). It seems like a good deal, but something’s bugging you. If the car’s really so good, why is the guy trying to sell it? Sure you can give it a test drive and check out the MOT, but all that already takes up time and time is money, already making the car more expensive. And even if the MOT etc checks out you’ll still be left wondering why this car’s on sale- unless it’s faulty? Because you don’t know everything there is to know about the car, there’ll always be that doubt. Coupled with the extra money and time it takes to check the car out, this means that inevitably you’re going to offer a lower price than the seller should really get for the car, to compensate for the uncertainty.
But now look at it from the car owner’s perspective; he realises that if he tries to sell the car, the above reasons will mean he gets a poor price. Which means that unless there is an emergency (a new baby, unemployment) he has little incentive to sell a perfectly good car. Unless, of course, it’s faulty. Then he still has every incentive to get rid of the thing.
And now we can see that both buyer and seller will create a spiral; the buyer is scared of Lemons so he offers a low price, the seller doesn’t like the low price so he only sells if he has a Lemon which means even more used cars are Lemons which means the buyer will offer even less to compensate for  the risk and so on. This isn’t so bad when it comes to cars and manufactures now offer guarantees on used cars to alleviate this but it’s still an issue. The big problem is the exact same market failure exists in healthcare- just as Lemons are more likely to be put up for sale, sick people are more likely to take out health insurance. People getting lower prices than they would like for their cars is ok, but sick people finding themselves priced out of insurance really isn’t. There is a clear case for government intervention here. This leads us to the next market failure;
The prisoners’ dilemma. Thisun’s a nice economics parable. There are two recently arrested prisoners being interrogated separately by police. Whatever evidence the police have, it’s not enough for a conviction. The prisoners are each given a choice; either own up to what you and your friend did, in which case you get 2 years in prison and the other guy 10, or you can keep quiet but if the other guy ‘fesses up things are reversed, he gets 2 years you get ten. If you both confess, you get 5 years each. A confusing state of affairs, but it’s clear that the best result for both is to keep quiet. The problem is, since neither of them can be sure the other won’t say anything, the most rational move for each is to confess, rather than run the risk of being the only silent one. All things being equal, keeping quiet gets you an average of 5 years locked, speaking out gets you just 3.5. Two rational prisoners will always tell on each other, leaving both unnecessarily in prison.
There are many real world examples of this, an obvious one being hygiene. Sandwich shops, for example, would have no incentive to spend a small sum on making clean sandwiches if it means making them slightly less competitive than rivals, despite the fact that sandwich shops making people ill is bad for the industry as a whole. Clearly businesses need educated workers and yet it makes no sense for any individual business to invest in schools if those guys are just going to work for someone else. Again, there’s a clear case for government intervention here.
Halfway to Damascus

I was gradually convinced that markets, however rational, could never fully create the optimal outcome for everyone and, sadly, it’s the poorest who would lose out the most. I’m no commie, mind, but these are sensible reasons for a well regulated market system with social welfare and public goods. I haven’t changed altogether. In an election tomorrow, I would still vote Tory (they’re hardly full on free marketers these days) and I don’t necessarily support every last penny spent in the name of welfare. So I’m a long way from skipping down a small country lane with pretty petals in my hair nursing an injured baby rabbit, but the evil has rescinded, somewhat.
A blog for another time, perhaps, but how come nothing happened about the free market ideology that lead to the current recession…? Thoughts on a postcard please.