John Rutledge, Claremont Graduate University February 14, 2012

Dr. John Rutledge Claremont Graduate University February 14, 2012 Far From Equilibrium Economics: Network Failure, Credit Crisis, and Optimal Portfolios

Our Fragile Island Economy Capital $200 trillion GDP/Work $15 trillion

Earth’s Thin, Fragile Crust

Hayek Neural Networks
Price system as information network
Neural network (Sensory Order)
System of telecommunications
Price as a kind of symbol
Prices coordinate actions of different people
Solves division of knowledge problem
One of the great triumphs of the human mind
Division of knowledge
the really central problem of economics
Only the most essential information is passed on…only to those who need it
Perfect markets, equilibrium are tautologies
Change in knowledge disrupts equilibrium
Economic problem, rapid adaptation to change
Suggests 2 states (regimes), phase transition
Price clearing vs. Non-price clearing regimes
As in Edward Lorenz (1963) weather model
Lorenz Attractor Lorenz Equations Deterministic Non-periodic flows

Evolutionary Economics
Early work: Malthus-Darwin (1869), Marx (1867), Marshall, Veblen (1898 Why is Economics…? ), Schumpeter, Hayek, von Mises
Nelson, Winter (1982). Carrier of information, knowledge, rules as genes.
New models of agent behavior: behavioral, experimental, neuro
New models of interaction: complex adaptive systems, dissipative structures, directed graph theory, percolation theory, de Donder, Schrodinger, Prigogine, Haken, Mandelbrot, Lorenz, Barabasi, Arthur
Empirical work: Farmer, Lillo, Geanakoplos, Lo, Allen, Gale, Chen, Cont
Synthesizers: Schweitzer, Sornette, Foster, Witt, Dopfer, Metcalfe, Potts, Hodgson
Results: both agent behavior and interactions lead to cascading failures, power law signatures of far from equilibrium phase transitions between regimes
Applications:
Macroeconomics: financial crises, contagion, recession, depression
Finance: Portfolio Theory

Credit Crises: Cascading Network Failures
Network Architecture
Network Core
Core Shift
Cascading Failure
System Regression
Savonarolla Effect
Non-Price Clearing regime

Debt, Deflation Theory of Great Depressions Irving Fisher (1933)
Cycle theory creed --Booms and Depressions (1932)
“ Equilibrium…seldom reached and never long maintained.” p. 339
Disequilibrium…delicately poised…beyond certain limits instability ensues…breaking of many debtors constitutes a crash, after which no coming back to original equilibrium (sound familiar?)
Two dominant factors, over-indebtedness (debt disease) to start with and deflation (dollar disease) following soon after. (debt is a network property)
Debt starters…new opportunities…easy money cause of over-borrowing. Crises 1837, 1873, 1893 (2001?, 2007?)
Public psychology for going into debt…lure of future income…hope of immediate capital gain…reckless promotions…scandals, frauds…always real basis

Fisher’s Key Result: Liquidating Debt Defeats Itself
Debt liquidation leads to distress selling…All fluctuations come about through a fall of prices
Liquidation defeats itself…the more debtors pay the more they owe…the very effort of individuals to lessen the burden of their debts increases it because of the mass effect of the stampede to liquidate in swelling each dollar owed
1929 debt greatest known to that time…by 1933 liquidation reduced debt by 20% but increased the dollar 75%...real debt increased 40%
Vicious spiral many years…universal bankruptcy…natural way out of depression…needless cruel bankruptcy, unemployment starvation…political revolution…reflation
Controlling price level new importance…those in drivers’ seat will be held to a new accountability

Portfolio Theory
MPT, CAPM, APT
Return distribution
Fixed mean, variance, covariance
Efficient frontier, optimal portfolio
Risk free rate, market portfolio
Asset allocation industry, Pension Act of 2006
MPT Does an Adequate Job in Normal Market Conditions
MPT Fails During Credit Market Crises
Credit markets fail, banks call loans
Volatility jumps, clusters
Correlations converge on 1.0
Asset prices fall across the board
Optimal investors have little cash
Forced asset sales at deep discounts
Contagion between portfolio, businesses
Makes financial crises worse

Credit Crises: Correlations Break Ddown
Correlations are transitory by nature
Correlations are not fundamental parameters of nature
Secular increase in correlations
Correlations approach 1.0 in times of crisis
Diversifications benefits not realized
Optimal portfolios lead to forced selling

Evolutionary Economics and Portfolio Theory
Random distribution rules out big changes (exponentially small), mean, std dev
Actual time series frequent big changes
Power Law: N(x) = x –  
N(x) is number of movements of size x
DJIA data Log N(x) = -3.96x -3.3 R 2 =.97
Random OK small, hopeless for large changes
P(3%) = random 718 per century, actual 780.
P(6%) = random 1 per century, actual 57
P(8%) = random 1 per 10 6 centuries, actual 11
P(10%) = power law predicts 6, actual 8.
Fat tails, clustered volatility signatures
Implications: non-equilibrium, phase transition between two states (regimes)
Equilibrium regime
Non-equilibrium regime (cascading failure)

Credit Crisis – 2 Period Model
Credit Crisis
Non-price credit rationing
Reduction in Lending
Reported interest rate falls
Unreported shadow price (R cc ) rises
Opportunity cost of cash soars
Optimal portfolio - credit crisis
Opportunity cost of cash > r(E)
All cash corner solution
But 2 period model unsatisfying
Does not allow return to equilibrium state
View as statistical problem?
Opportunity cost of cash distribution
R(credit crunch) = 20%, r(equil) = 2%
P(credit crunch) = 0.3
Expected value = 7.4%
Standard deviation = 8.4% (no risk free asset)
Correlation with risk asset? (certainly < 0)
Conclusion: 2 period model unsatisfying

Credit Crisis - Optimal Investor 3 period model

Credit Crisis – Cash-Rich Investor 3 period model

Summary
Opportunity cost of cash
Higher than risk-free rate on average
Much higher than risk free rate during credit crises
There is no risk-free (zero variance) asset
Negatively correlated (-0.8%) with other risky asset returns
Casualties:
Cash-rich portfolios are optimal with credit crisis regimes
Corner solutions possible/likely
Tobin separation theorem no longer holds
There is no longer a unique market portfolio of risky assets
Extensions:
Forced liquidation of business operating assets
Collateral (Geanakoplos), credit channel, employment and output effects
Empirical tests using mezzanine data
Separate return distribution into equilibrium, non-equilibrium regimes
Hypothesis: Equilibrium regime distribution Gaussian; non-equilibrium regime power law, fat tails
Recognize that phase transition (network failure), not standard deviation, is key risk-return tradeoff
Incorporate phase transition risk into portfolio theory

Next Project: Value Investing Intrinsic Value, Intrinsic Risk Tradeoff

Dr. John Rutledge Claremont Graduate University February 14, 2012 Far From Equilibrium Economics: Network Failure, Credit Crisis, and Optimal Portfolios

John Rutledge, Claremont Graduate University February 14, 2012

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John Rutledge, Claremont Graduate University February 14, 2012 Presentation Transcript

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