Chaos Theory in the Financial World: A New Trend in Central Banks’ Monetary Policies (Part I)

By Cheryl Grey, on October 21st, 2008

On the surface it seems simple enough. The Federal Open Market Committee (FOMC) of the Federal Reserve adjusts interest rates to manage both inflation and the economy. When inflation rises, the FOMC raises rates, which limits the money supply, raises the cost of credit and slows economic expansion to a manageable level. When inflation falls, the FOMC lowers interest rates, which (in theory, at least) floods the markets with money, lowers the cost of credit and encourages economic expansion beyond its current level. Central banks from Sweden to Australia follow this model, which has been standard practice for the past decade and more.

So if it’s that simple, why can’t central bankers agree amongst themselves? Why was it that, as recently as August, when the Bank of England’s Monetary Policy Committee held its scheduled meeting, seven members voted for no rate change, one voted for a hike and one voted for a cut?

The Taylor Model

The model generally used to determine the Federal funds rate was first proposed by John Taylor in 1992. This model utilizes a mathematical formula to balance inflation against the optimal rate of economic growth for each nation, with the sum of that equation indicating the proper interest rate necessary to achieve that balance. Because the rates of inflation and growth change over time, the interest rate must change in harmony to accomplish its goals.

However, according to a new school of thought, the Taylor model might be causing the very problems it’s attempting to correct.

One variable the Taylor model seems to miss is outside or unexpected shocks to the economy. Granted that any model flies out the window when the entire financial framework is rocking—you just grab whatever’s closest and hang on. But surely we can do better than ignore the pressures leaning on the markets and causing those shocks?

Of Fractals and Finance

Dr. Charles Ivie, a retired NASA analyst with a keen interest in the mathematics of chaos theory, verbally rubbed his chin when asked that question.

“The trajectory of a rocket is determined by Newton’s laws and by celestial mechanics and is completely deterministic,” he wrote in an email exchange. “Market behavior is more like that of an infinitely branching tree. …The actions of the individual players are multidimensionally recursive. By this I mean that individual investors react to a multitude of events and data elements to make their decisions. And these decisions are not always based on objective reality.”

He’s a rocket scientist; he should know.

Perhaps it’s no coincidence that, since the concepts of fractals and chaos theory have gone mainstream, central bankers have started to wonder if the Heisenberg uncertainty principle might not apply to national-level interest rates. If the very act of observing a phenomenon alters it, do we really know enough to jump in?

“In the case of economics,” Dr. Ivie wrote, “investors don’t just observe, they participate so the alteration of the process is compounded. It is this fact that suggests that economic behavior is mathematically chaotic.”

The new school of thought among central bankers, as suggested by an analyst at Danske Bank, could be called the non-activist school. More concerned with structural-level determinants, such as the switch from hydrocarbons to wind or solar energy and the effect that change will have on their nation’s financial foundation, this non-activist school has less time for short-term variables such as the rate of inflation or economic growth. (Of course, it’s also true that much of the financial distress of the Great Depression was caused by the Federal Reserve’s inaction, meaning they’re damned if they do and damned if they don’t.)

According to this school of thought, the current trembling in our global financial system has its roots in loose monetary policy during and after the 2001 recession. It can be argued that lowering interest rates now not only may not help the situation, it also carries the potential to make it much worse. If the global marketplace is not understood well enough to be quantified—if such an action is even possible—then the more the system is tampered with, the more likely it is that an unknown variable will kick in, resulting in unintended and unwanted complications or an even bigger shock to the system. And the biggest variable of all, human nature and the power of emotions, is harder to calculate than the path of the rockets we sent to the moon.



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Thoughts on Game Theory: Why Do Restaurants Serve My Food to Everyone?

By Bhagwad Jal Park, on October 21st, 2008

As an impartial observer, I’ve often wondered why, when I go to a restaurant in a group and order a dish, do they bring my order along with everyone else’s, and then serve my food that I ordered to everyone on the table! For example, if I order six dumplings, and there are six people in the group, the waiter will casually give each person a dumpling, and I get only one. Whereas I ordered six thinking that I would eat all of them. As a result, my hunger is not satiated.

Also, if I want to eat well, I must have the dishes that others have ordered which I may not like. My wife says that this is good etiquette, and that my not understanding this simple fact highlights my lack of social graces. As a person with a suspicious mind however (and a game theory one at that!), I have a different take on the issue.

When a group goes to a restaurant, either they all share the bill equally or each pays for themselves. It is considered less awkward and simpler if the group (all things being equal), split the bill equally. This means that as an individual, when I want to order something on the menu, the price of whatever I order drops proportionately to the number of people on the table. For example, if an item I want (say king prawns) costs $50, then I will only have to pay $10 if my group has five people.

Now I have no control whatsoever on what other people order. By not ordering anything expensive, I can’t guarantee that others will do the same. Therefore, it is in my best interests to order everything I want without looking at the price since I will never again get an 80% discount! True, others may share my meal, but in an expensive restaurant, you’re usually not paying for the raw materials of the food itself but for the ambiance, the nicely dressed waiters, etc.Expensive Restaurant

Image Credit: Matt and Kim Rudge

Since we assume that each person in the group is rational and is thinking just like me, they will order expensive things too, and so the total bill turns out to be extremely high. A variation of the prisoner’s dilemma actually.

Of course, if it was decided beforehand that each person will pay for what they order, then I will be much more circumspect about what I decide to eat. I can’t afford to pay $50 for 5 shrimps!

Knowing this, it is in the restaurant’s best interests to ensure that everyone shares the bill equally, since only then will each person go berserk with their orders. Therefore, they must operate in such a way that it becomes very difficult to gauge who has eaten what.

One of the ways to do this is to serve everyone’s dish to everyone under the cloak of “etiquette”. In fact, I won’t be surprised if they invented the practice in the first place since and started calling it Good Manners. Good Manners it may be, but it’s also good business sense.

Of course, if you’re a greedy person and want to sample expensive food that you would never normally eat, you must get into a group of people you don’t know very well and who are not very well off. You must then convince them to go to an expensive restaurant so that you will be the only one to order expensive food and make them share the bill. I would assume you can only do this a couple of times before your group started to feel the pinch.

Sometimes however, a person’s personality can be so captivating and charming that others forgive them. Or say you’re a beautiful woman in the company of four men, they will not only forgive you, but fall all over themselves in fighting over your bill. You can then show how independent you are by paying “your share,” when actually you’ve shifted over all the expensive food’s cost to your lackeys!



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Consumerism in the U.S. Healthcare System: Why We All End Up Paying for the Most Expensive Treatments

By J.C., on October 21st, 2008

The theme of my last several posts has been the profit motive inherent in the medical system. Many parties appear to be responsible for this including industry and the physician’s lobby. I submit that the most responsible party is the consumer. The consumer is the one who demands the most advanced procedure, the best medicine, and the “best” doctor. The consumer is the one who demands the best prognosis and a return to the highest function possible.

One example of this is the cyberchondriac who comes in demanding the latest medicine or implant that they have seen on television. You explain to the patient that you feel that the generic medicine is just as good and is cheaper and that you are most comfortable with prescribing it because you are familiar with its side effects. However, they have seen the commercials and they have heard of the snazzy brand name. Additionally, they do not mind paying the exorbitant price of the brand name.

It is not unusual to also have the healthy young asymptomatic patient who would like a routine work up of all of his labs. My feeling is that if you are young and have no symptoms you should have the most inexpensive tests done, if any tests at all. If they are normal then you shouldn’t have anything done for a while. These patients are the kind of patients that want to stay on top of their healthcare and come in for unnecessary tests.

Sometimes there is a patient with knee pain without a history of trauma. The patient wants an MRI when there is ample evidence that the majority of knee pain resolves within six to eight weeks of conservative therapy including icing, NSAIDS, and activity modification. The MRI costs about a thousand dollars, but the patient doesn’t care because his insurance pays for it. Thus he insists to have one and if one is ordered there is a reasonable chance that it might show an equivocal signal in the mensicus. Then an expensive Orthopedic referral is made. If the surgeon is unscrupulous or if the patient insists on having surgery, an arthroscopic procedure is done. And the chain of expensive events goes on and on in this manner, costing the health system a lot of money for an issue that probably would have resolved on its own.

The underlying theme driving the demand of healthcare by the patient is a sense of entitlement. We in the United States don’t understand that if you travel halfway across the globe there are thousands of people dying everyday of disease caused from lack of basic sanitation. But when we have an annoying pimple or wrinkle on our forehead we want to pay several hundred dollars to have it zapped. When we have pain we want and expect our healthcare system to fix us. If we are not fixed then we blame the doctor and the system.

In the end, the most expensive thing is human resources. If we as patients make people work to improve our health it is going to cost money. That cost is worth it when the situation is dire. When it isn’t, the cost is wasteful. As a patient and consumer it is important to understand this concept–making the healthcare system work for you costs everybody a lot of money and makes the system more expensive. We are all intertwined in this manner, whether we want to believe it or not.



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