Applying Methodological Individualism to the Financial Markets

I recently received a suggestion for me ‘quantify’ the probabilities of my risk scenarios.

While this may represent the conventional practise by the mainstream, I see this as a foolish undertaking.

Putting numbers assumes that I KNOW the nitty gritty or the minutest details of the risk events that I have been investigating. It also means that I KNOW how people think and their corresponding responses to the changes in the economy, the environment or the financial marketplace. Otherwise, I would be making irresponsible assumptions that may be out of touch with reality.

Besides, I don’t see the need to ‘signal’ or project my expertise just to get plaudits from any institutions. All I aim to do is to excel at my current undertakings in order to survive.

Anyway the prediction markets such as Intrade.com exhibits the probabilities of specific events based on actual risk money or bets and not merely from mathematical models.

For instance, the odds of a US recession in 2012[1] has been quite volatile.

The odds of a recession began to recede since the last quarter of 2010 and began to bottom out in the first quarter of 2011. But this trend reversed to the upside and currently stands at the highest level since the last quarter of 2009.

As of this writing, the odds of a recession by the betting public is at 43.6% and constantly changes depending on the risk perception of the betting public.

The above simply shows that there is NO constancy in people’s actions or that the only thing constant in the real world is change.

Therefore to apply probabilities based on math or econometric constructed ‘models’ from faulty and flawed assumptions would not be only ridiculous but dangerous, especially to our management of portfolio.

Class and Case Probabilities

A better option would be to apply what the Austrian School of economics calls as Class and Case Probabilities.

Class probability, as the great professor Ludwig von Mises defined is[2]

We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.

We know, for instance, that there are ninety tickets in a lottery and that five of them will be drawn. Thus we know all about the behavior of the whole class of tickets. But with regard to the singular tickets we do not know anything but that they are elements of this class of tickets.

On the other hand, Case probability according again to Professor Mises means:

We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.

Case probability has nothing in common with class probability but the incompleteness of our knowledge. In every other regard the two are entirely different.

Let me apply these probabilities to the recent typhoon that hit Metro Manila. [As a caveat I don’t know exactly the details of the typhoon but am comparing the major hits from a typhoon in the metropolis.]

Class probability means that we know some generalized information of the risk event.

-Typhoons can result to loss of lives, injuries or damage to properties as a result of flooding, strong winds and other related or ancilliary consequences (landslide, health hazards as leptospirosis, snake bites, E. coli and etc..).

-We can predict the path of typhoons using satellites.

-We know for instance that around 19 cyclones or tropical storms enter the Philippine area of responsibility every year[3].

From the above, we can even parallel class probabilities or “the behavior of a whole class of events or phenomena” to former US secretary of defense Donald Rumsfeld theory of uncertainty called ‘known knowns’[4]

Yet if there are ‘known knowns’ then the antipode would be the ‘unknown unknowns’.

This would represent as the Case probabilities or fragmented, dispersed and localized information on specific risk events.

Back to typhoons, we don’t know the exactitude and the variability of the typhoon’s strength (only estimates) and or its impact to particular affected localities.

While the Typhoon Nesat[5] [code name: Pedring] recently hit Northern Luzon’s Aurora and Isabela provinces the hardest, in Metro Manila, the famous Manila district of Roxas Boulevard got slammed by a barrage of extremely high storm surges that caused flooding at a public hospital, a five-star hotel and the US embassy.

This is in contrast to Typhoon Ketsana[6] [code name: Ondoy] in 2009 where strong continuous rains basically submerged Metro Manila’s Marikina City that led to many fatalities.

Think of it, about 19 typhoons hit the Philippines every year, yet we hardly know much about the prospective destruction or the scale of calamity these typhoons would bring about and where they will hit for us to apply precautionary measures.

But if you listen to the self-righteous blarneys of prominent media broadcasters, who base their comments on ex post analysis of ‘case’ events, you’d bear the impression that if the government only does as they propose the next typhoon won’t have an impact to the nation at all. Duh!

Yet fallacies from such presumptive omniscient gibberish can be applied to the most recent triple whammy calamity of Japan: the 2011 Tohoku earthquake, tsunami and the nuclear reactor meltdown[7].

Japan’s geographical location[8] makes her exceedingly vulnerable or prone to earthquakes. Thus Japan has lavished in putting up scientific prediction models, which only has proven to be a massive failure in predicting the latest catastrophe[9].

The moral: While it would seem as intellectually comforting to be guided by math based models in predicting the probabilities of the markets or the economy or of any people based risk events, unfortunately, they almost always fail to achieve their goals. The problem is that the social science isn’t physics or natural sciences that are quantifiable and work on some constants.

As Professor Mises wrote[10],

People would like to find in an economics book knowledge that perfectly fits into their preconceived image of what economics ought to be, viz., a discipline shaped according to the logical structure of physics or of biology. They are bewildered and desist from seriously grappling with problems the analysis of which requires an unwonted mental exertion.

Another notable example would be how the 2008 crisis exposed the travesty of quant[11] models[12]. UK’s Queen Elizabeth even questioned the economic profession[13] on why they haven’t seen the crisis coming.

To insist on applying something that doesn’t work is an exercise of self-deception or delusion.

Using Methodological Individualism on Uncertainty

The best methodology will always be to apply the understanding of human action or methodological individualism on social problems

Again from Professor Ludwig von Mises, (bold highlights mine)

Praxeological knowledge makes it possible to predict with apodictic certainty the outcome of various modes of action. But, of course, such prediction can never imply anything regarding quantitative matters. Quantitative problems are in the field of human action open to no other elucidation than that by understanding.

We can predict, as will be shown later, that — other things being equal — a fall in the demand for a will result in a drop in the price of a. But we cannot predict the extent of this drop. This question can be answered only by understanding.

The fundamental deficiency implied in every quantitative approach to economic problems consists in the neglect of the fact that there are no constant relations between what are called economic dimensions. There is neither constancy nor continuity in the valuations and in the formation of exchange ratios between various commodities. Every new datum brings about a reshuffling of the whole price structure. Understanding, by trying to grasp what is going on in the minds of the men concerned, can approach the problem of forecasting future conditions. We may call its methods unsatisfactory and the positivists may arrogantly scorn it. But such arbitrary judgments must not and cannot obscure the fact that understanding is the only appropriate method of dealing with the uncertainty of future conditions.

Understanding of how individuals interact with one another and with the environment should give us a better insight than sloppy thinking based on hypothetical numerical aggregates which attempts to substitute for people’s choices.

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[1] Intrade.com The US Economy will go into Recession during 2012

[2] Mises Ludwig von Uncertainty Mises.org

[3] Wikipedia.org Typhoons in the Philippines

[4] Wikipedia.org There are known knowns

[5] Wikipedia.org Typhoon Nesat (2011), Philippines

[6] Wikipedia.org Typhoon Ketsana

[7] Wikipedia.org 2011 Tōhoku earthquake and tsunami

[8] Wikipedia.org Seismicity in Japan

[9] See Science Models Fail To Predict Japan’s Earthquake, March 12, 2011

[10] Mises Ludwig von Blue-Collar Anticapitalism, Mises.org

[11] See How Math Models Can Lead To Disaster, February 25, 2009

[12] See Beware Of Economists Bearing Predictions From Models, May 27 2009

[13] The Telegraph The Queen asks why no one saw the credit crunch coming, November 5, 2008

No To Price Controls! No To Despotism!

Here’s a letter I sent to the editor in chief of the Inquirer7.net.

It’s a modified version of my earlier blog post: Price Freeze Policies Will Hurt Consumers

While I don’t expect to have my longish letter published, my intent is to nudge mainstream media of government’s creeping attempt to utilize today’s calamity via the declaration of the State of Calamity as an opportunity to expand despotism.

Mainstream media's fear appears misdirected, it is less likely about having to "raise funds for next year’s general election". But the worst possible risk is to use today's calamity as an opportunity to extend their political tenure.

Ergo, the right question that needs to be asked is: could the Presidential 2010 elections be in jeopardy?

Permit me to express my disenchantment over our government’s thrust to resolve today’s crisis in the face of Typhoon Ondoy’s calamity via the repeatedly failed age-old political tool of price controls. As an old saw goes, ``the road to hell is paved with good intentions.”

In mainstream media, entrepreneurs or business entities have been predominantly depicted as generally "greedy" while government portrayed as “equitable”.

This isn’t generally true; some indiscreetness by capitalists doesn’t apply to all. Beside, consumers are inherently empowered to render discipline to errant entrepreneurs via competition.

In contrast our government had been ranked as one of the worst in corruption in Asia, which would make our government relatively “greedier”.

Yet the important difference largely unappreciated by the public is that given the police power derived monopolistic function of governments, greedy entrepreneurs would have less of an impact to undermine society than a greedy official…unless the entrepreneur have been mandated by government privileges via state capitalism.

Next, officials try to make the public believe that they can subvert the natural laws of economics and allocate resources better than the marketplace.

They refuse to admit that governments are the least effective way to direct resources for its optimal use. They should learn from the recent lessons of Cuba's failed collective agricultural policies or from forty centuries history on price controls.

Price controls or "anti price gouging regulations" in contrast to popular wisdom worsens, and does not enhance, society's predicament.

How?

One, these regulations are likely to serve as disincentive for producers or providers of goods and services to sell. Probably, they would rather hoard their stuff instead.

Two, it prevents pricing signals to spur production or supply side responses to changes in demand. This would lead to more shortages.

Three, when prices of goods or services are legally constrained to sell below market levels, the tendency is to induce significant increases in demand.

As Henry Hazlitt explains in Economics in One Lesson,

``Now we cannot hold the price of any commodity below its market level without in time bringing about two consequences. The first is to increase the demand for that commodity. Because the commodity is cheaper, people are both tempted to buy, and can afford to buy, more of it. The second consequence is to reduce the supply of that commodity. Because people buy more, the accumulated supply is more quickly taken from the shelves of merchants. But in addition to this, production of that commodity is discouraged. Profit margins are reduced or wiped out. The marginal producers are driven out of business. Even the most efficient producers may be called upon to turn out their product at a loss.

``If we did nothing else, therefore, the consequence of fixing a maximum price for a particular commodity would be to bring about a shortage of that commodity. But this is precisely the opposite of what the government regulators originally wanted to do. For it is the very commodities selected for maximum price-fixing that the regulators most want to keep in abundant supply."

Fourth, since demand and supply balance can’t respond through pricing signals, black markets are likely to emerge out of the shortages.

Fifth, more regulations will breed more corruption. Some officials will probably keep a blind eye on entities selling at "high" prices but with a "take", or by themselves undertake such actions, directly or indirectly.

Lastly, restrictions in the marketplace will even lead to further restrictions, distortions and shortages in the economy.

This means that a feedback loop mechanism will arise from existing price controls as the shortages exacerbates.

And this would lead to expanding more government controls over production, via rationing, subsidies, cost-controls and or universal price fixing, all at the expense of entrepreneurs and capitalists, the latter of which understands how resources should be better allocated from their “local knowledge” through the marketplace.

Importantly, all these economic distortions will compound to translate to inflation, a concealed tax to the population.

Now when governments own and control the factors of production this is known as socialism.

It is unfortunate that while we would like to believe that our society operates under the political process known as “democracy”, we seem to deceive ourselves into believing that economic freedom function disparately from our political “democratic” process.

Worst, the raft of economic controls signifies our incremental retrogression into the morass of despotism, placing our fragile democracy at heightened risk. What’s next, martial law?

Lastly, such knee jerk regulatory responses may not even be targeted at attaining the enhancement of our economic weal, but as political advertisement for the coming elections.

In analyzing government policies, noble motives must always be matched with economic reality, failing to do so, we should go for reality.

I say NO to Price controls.

Benson J. Te

Update: Email address to the editor I sent has expired.

Typhoon Ketsana (Ondoy) In Pictures

Boston.com's The Big Picture captures the wrath of Typhoon Ketsana (Ondoy) in a deck card of pictures.

Here are two samples:

See the rest here