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Wednesday, 03/30/2005 1:03:30 AM

Wednesday, March 30, 2005 1:03:30 AM

Post# of 187119
Beware of singularities
By Martin Hutchinson
UNITED PRESS INTERNATIONAL
March 28, 2005


Washington, DC, Mar. 28 (UPI) -- As the Fed raises interest rates quarter point by quarter point, the financial environment may seem to be changing little, but in reality it is becoming increasingly at risk of singularities, financial tornadoes that appear from a clear sky and produce economic devastation.

Conventional economics deals primarily with equations that are linear or exponential. Relationships between the different components of the economy are held to be linear, economic growth is held to be exponential, with the economy increasing in size each year by a constant or even an increasing rate, depending on productivity growth, which is supposed to be constant in the short run albeit possibly increasing in the long run. Linear and exponential equations have the great virtue of being relatively easy for economists to solve; they also tend to behave in smooth ways, so that if an economy behaves in one way in one year it will behave in a similar way in the following year; change is always gradual, and there are no point "singularities" at which sudden changes occur.

It's an attractive if somewhat sterile picture, no doubt useful when teaching economics to the less academically gifted students. It allows simple folk such as the George W. Bush economic team to make confident predictions of continued economic progress, halving of the Federal budget deficit within five years etc., without more than the usual barrage of politically motivated criticism. However, it doesn't bear a great deal of resemblance to reality, and nor should we expect it to.

The reality is more complex, and the complexities are not simply errors of detail in the standard economic model, but fundamental flaws in its underlying mathematics. You only have to read a standard economic textbook to realize that many of the relationships described in it, such as the demand curve, the interaction by which comparative advantage takes effect, and the interaction between marginal tax rates and economic output are neither linear nor exponential, but some quite different relationship -- the standard demand curve, for example, is fairly close to a hyperbola.

Equations were simplified to linear and exponential forms by the early econometricians, who were not particularly good mathematicians and wished to construct computer models of the economy using equations they thought they understood. Even then they got it wrong: the notorious MIT/Club of Rome model of the world economy constructed in 1971, which purported to prove that whatever policies were pursued, the world was due for an exploding ecological crisis within no more than a few decades, wasn't wrong because of its details, it was wrong through technical error. The model extrapolated exponential equations for 30 or 40 years into the future without taking account of the fact that if you extrapolate exponentials on a finite digital computer, the errors caused by rounding to a finite number of digits also increase exponentially, and after a few dozen iterations explode the graph off the screen in some random direction no matter what the underlying reality.

In reality, a significant number of economic equations appear to be determined not by linear or exponential equations, but by power series equations, mostly of the quadratic, cubic or quartic order. This fits economics in well with physics, chemistry and other "hard" sciences where such relationships are relatively common.

Although simple quadratic equations are easily solvable, complex systems with such equations intermingled are not. The principal difference between such systems and linear/exponential systems is the existence of singularities, where a small change in conditions or a small interval of time produces a large and discontinuous change in the output, a discontinuity in the "phase space."

Modern mathematics, in particular "catastrophe theory" and "chaos theory" have examined these types of systems in much more detail than was possible 30 years ago. Discontinuities in the system do not occur randomly; over large areas of the system there are no discontinuities, while in other areas where the equation set is "critical" there are many discontinuities or even an infinite number of them.

Turning with relief back to the real world, we can see that economic crises follow this pattern quite closely. During some lengthy periods, there are no crises, and obvious areas of unsoundness in the system have very little effect, continuing or even intensifying themselves for years, without causing the damage that is predicted for them. During other periods, crises occur with bewildering rapidity, while institutions that have appeared entirely stable and well managed suddenly spiral into bankruptcy with very little warning. Areas of unsoundness that have persisted for years or even decades, without apparently leading to any ill effects, suddenly cause a major financial collapse with large adverse economic consequences, and often further collapses in areas only distantly related to the first.

Late 2001 and early 2002 was one such period. The U.S. economy had undergone a period of very slow growth during 2000-2001. Then the attack on the World Trade Center caused a crisis in confidence that was not reflected in any great movement in financial markets, but was nevertheless pervasive through the U.S. population. While the stock market as a whole had declined only moderately from its peak, and in a manner far more orderly than during the "Crash of 1987," the tech sector had imploded much more severely, and the Nasdaq index was fully 70 percent below its peak level of March 2000.

The result was a series of financial collapses -- Enron, Global Crossing, WorldCom, Adelphia -- in business areas largely unrelated to each other, whose shared characteristic was only that well connected and previously much admired corporate managements turned out to have been running Ponzi schemes of one kind or another, at the expense primarily of their gullible shareholders and lenders.

The result was a tightening in corporate disclosure standards, by the Sarbanes-Oxley Act of 2002 and now by the much delayed regulation of stock option expensing, due to come into effect in June 2005, accompanied by a further loosening in monetary policy and in early 2003 a second tax cut. Much to the relief of the majority of U.S. politicians, this appears to have worked; the spate of unexpected bankruptcies ceased, the stock market began a robust recovery and the U.S. economy, fueled by record volumes of mortgage refinancing and negative savings rates, ended what proved to have been a remarkably mild recession.

For an example of how the world doesn't necessarily end "happily ever after" in this way, examine the three recessions of 1969-1982, which can increasingly be viewed as a malign "triple dip" linked by a period of high inflation, low economic growth and extremely low or even negative productivity growth. The creativity of the U.S. economy did not cease during this period; indeed it saw a flowering of innovation, with the computer chip, pocket calculators, digital watches and the personal computer all appearing within a relatively short timeframe and changing everybody's life and work habits forever. Yet each dip produced unexpected bankruptcies.

In 1969-70, apart from the collapse of numerous bull-market prodigies such as National Student Marketing, there was the Penn Central bankruptcy, the United States' largest railroad and one of its premier companies. In 1973-74, there was Franklin National Bank and Herstatt, which together rocked the international financial system and caused the premium on short term deposits to solid Japanese banks to escalate to an unheard of 2 percent. In 1980-81, there was First Pennsylvania Bank, which managed to become insolvent through investing in Treasury bonds (which declined in price as interest rates rose) International Harvester, the Hunt silver collapse and the de-capitalization of the U.S. savings and loan industry, which happened in this period even though lenient regulators and deposit insurance allowed the industry to stagger on to the end of the 80s. The economic malaise that accompanied these collapses was very severe, worse than anything in the United States since the Great Depression, far worse than the 2001-2 blip, and caused a stock market decline of 75 percent in real terms in 1966-82, second in U.S. history only to 1929-32, albeit masked by inflation.

The difference between the two periods arose from the level of interest rates and the growth in the money supply. When interest rates are low, and real money supply growth is high, crises are few and far between and generally do not lead to unpleasantness in the economy as a whole. The Mexican and derivatives crises of 1994, the Asian and Russian crises of 1997-98 and the collapse of Long Term Capital Management in 1998 were all expected to lead to economic difficulty, but in the event the U.S. economy and stock market sailed serenely on, rising to new highs year by year. In 2001-02 also, even though the decline in the stock market and the psychological shock of the World Trade Center attacks caused some unexpected bankruptcies, the flood of cheap money that was pumped into the system thereafter quickly ensured that their long term adverse effects would be minor.

The "landscape" of the economy thus correlates pretty closely with the cost and availability of capital. When capital is cheap, with a bubbly stock market and low interest rates, frauds almost certainly proliferate but they do little damage; individual bankruptcies and exposed frauds do not lead to adverse economic consequences and the economic ship continues to sail ahead without difficulty. When real interest rates are high, on the other hand, the stock market is low, and capital is expensive, frauds are much less likely, but unexpected bankruptcies caused by the high cost of capital happen quite often, and the adverse effect on investor confidence and the economy in general from such events is severe.

This is why investors today should beware of singularities. Short term interest rates are increasing steadily, and may have to increase faster because even at 2.75 percent the Federal Funds rate remains significantly below the steadily rising rate of inflation. Banks, which have covered up an almost infinite quantity of insane consumer and corporate lending by the profits from the "carry trade" of borrowing short term and lending long, are looking at a bleak future. Either short term rates will overtake long term rates, in which case the "carry trade" will go into reverse, wiping out a huge source of profits, or long term rates will increase enough to prevent this, in which case banks are looking at huge losses on their mostly unhedged bond portfolios, particularly corporate bonds (whose yields can be expected to rise more that Treasuries) second quality consumer debt (whose default rates will soar in a period of tighter money) and mortgage backed securities, whose refinancing rate will drop to zero, defaults rise and maturity extend to infinity, as homeowners can no longer refinance and get into financial difficulty.

In the corporate sector, General Motors' likely debt downgrading will add hugely to its cost of capital, any decline in the stock market will put its pension fund irretrievably under water, and consumer difficulties will affect both auto sales and auto financing. The same is doubtless true at Ford and at DaimlerChrysler (which will also be affected by management's lack of focus on its Mercedes crown jewel and by the eternally rising euro/dollar exchange rate). Porsche nearly went bust in the late 80s; a weak dollar is hell for luxury German auto manufacturers.

Hedge funds, with $1 trillion of capital, have invested altogether unwisely and covered their losses through profits on the "carry trade," which have distorted the government debt market beyond recognition. Expect huge losses of capital in this sector.

Fannie Mae and Freddie Mac can expect their debt ratings to decline as rates rise and mortgage defaults soar, while their mortgage backed securities portfolios become illiquid. Only Congress can save them now; as Democrat fiefdoms they'd better hope for a big swing to the left in 2006!

The tech sector will have to report sharply lower earnings after June, with expensing of stock options, which itself will affect their stock prices and ability to raise capital. Also, Moore's Law, by which semiconductor performance doubles every 18-24 months, is clearly approaching its limits at the molecular level, eliminating much of the sector's growth potential. Expect a repeat of the Nasdaq fall of 2000-2002; the sector's only consolation is that it will not be alone, this time.

As I said, singularities. Mathematically, it will be very interesting indeed!

http://www.washtimes.com/upi-breaking/20050325-031318-1921r.htm

**Happy Trading**

Your Economy #board- 1948

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