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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Rising commodity prices cause a perception of scarcity, which leads to more buying and still higher pricesNONLINEAR THERMODYNAMICS AND ECONOMICS Nonlinear thermodynamics was developed by Ilya Prigogine, for which he was awarded the Nobel Prize in chemistry in 1974. This theory, an extension of classical thermodynamics beyond its traditional limits, has important ramifications for physics, chemistry and biology — and, perhaps, economics. The subject matter of classical thermodynamics is the quiescent behavior of systems near thermodynamic equilibrium. Thermodynamic equilibrium is characterized by homogeneity: uniform temperature, pressure and chemical potentials. Near-equilibrium states are characterized by small differences in these parameters. For many thermodynamic and chemical systems, it is possible to calculate the conditions for equilibrium and their behavior near equilibrium. The equations describing such systems are a standard part of physics curricula. But some of the most interesting thermodynamic behavior occurs in open systems far from equilibrium. This cannot be understood in terms of classical thermodynamics. Turbulence and convection are common examples of far-fromequilibrium behavior that lie beyond classical thermodynamics. To be alive an organism, an organ, or even a cell, must be far from internal equilibrium, from homogeneity. Common processes in chemistry and biology that are characterized by stable cycles take place in open systems far from equilibrium. These systems and the behaviors peculiar to them are the subject matter of nonlinear thermodynamics. They are characterized by a principle of selforganization. As they evolve they generate new and stable internal orders that can sustain themselves even in the face of changes in their environments. The simplest and purely thermodynamic example is Bénard instability, in which neighboring molecules “cooperate,” moving in the same direction at the same time over considerable distances to dissipate heat in macroscopic hexagonal convection cells. At a greater level of complexity nonlinear thermodynamics explains oxidation and reduction cycles in chemistry. At still greater levels of complexity, large molecules form templates for their own reproduction. Manfred Eigen and Peter Schuster incorporated this into an explanation of the evolution of life, an explanation far more plausible than small molecules coming together in random interactions to form macro-molecules. In Eigen and Schuster’s view, there is a positive feedback reaction in which molecules form templates for the production of other molecules. Nucleotides produce proteins, which in turn produce more nucleotides. (Naturwissenschaften, 1978, p. 341f.) A system will generate nonlinear behavior only if: (i) It is open, able to exchange matter and/or energy with its environment. (ii) Its evolution can be described by non-linear differential equations. (iii) The equations describing its evolution allow for positive feedback. (iv) It is sufficiently far from internal equilibrium. Under these conditions microscopic fluctuations within the system may not be suppressed, but may be amplified to the point that they bring a new macroscopic order to the system, an order that is typically cyclic. Economies satisfy these conditions: (i) They are open and exchange matter and energy with their environment (e.g. trade). (ii) Their evolution can be described by nonlinear differential equations. (iii) They commonly exhibit positive feedback. Higher inflation ? higher inflation expectations ? a propensity to spend faster, before prices rise further ? a higher velocity of money ? still higher inflation… (iv) They are often removed from internal equilibrium. With respect to the distribution of wealth, the more wealth concentrates in fewer hands, the further removed is the economy from internal equilibrium. The same sorts of equations that describe the evolution of chemical and biological systems can also describe the evolution of economic systems. But the nonlinear characteristics of economies do not stop there. Even though economies are vastly different entities from chemical systems or biological organisms, their behaviors draw attention to similarities between economics and chemistry or biology. These behaviors cannot be explained in classical economics, but they correspond to common patterns of nonlinear thermodynamics. One characteristic of these patterns is their cyclicality. As early as 1947, Dewey and Dakin (Cycles: The Science of Prediction) called attention to the predictive value of the regularity of business and financial cycles. (Also see W. Mitchell, Business Cycles [1927.]) Several prestigious groups and journals study these cycles, whose periods range from the controversial 60-year Kondratieff cycle to Kitchin cycles of 3-4 years. The outstanding technical work of Ian Notley (Yelton Fiscal) is based on the superposition of price-generated cycles of different periods, ranging from more than 30 years to approximately two months. Ravi Batra (The Great Depression of 1990) has applied the historical cycle theory of Prabhat Sarkar to economics and has argued for coincident 30-year cycles in inflation, money supply and government regulation. Cycles figure prominently in the work of Joseph Schumpeter. (Unfortunately, it appears that few economists, even among disciples of Schumpeter, are familiar with nonlinear mechanisms that generate cyclic behavior or with the thermodynamic, chemical or biological counterparts to economic cycles.) There are also longer-term cycles. European history has been characterized by an inflation cycle of between two and three centuries (Fischer, The Great Wave). In addition to cyclicality, the occasional extreme sensitivity of nonlinear systems to minute changes in their environment, overreacting by orders of magnitude to insignificant stimuli, is characteristic of financial markets, despite conflicting with classical economic theory. There are many examples of sharp price moves in response to minor events, or to no apparent event at all. Through most of 1985 and 1986, inventories of non-ferrous metals were declining. Even as they fell to historic lows, prices remained low, suggesting to industry that there was no need to add to in-house inventory. When prices finally began to rise, even in the absence of significant news, managers who had been sedated by stable prices to the point of letting internal inventories run down desperately tried to rebuild stocks. Prices soared, nickel up five-fold in less than a year and other non-ferrous metals more than doubling in that same period. The stock market crash of 1987, in which broad averages lost one third of their value in hours, despite the absence of significant news, is another example in which a large change, rather than being self-limiting, fed on itself. This sensitivity is an effect of a positive feedback loop between prices and perception. Rising commodity prices cause a perception of scarcity, which leads to more buying and still higher prices. Falling stock prices cause a perception that something must be wrong, scaring away buyers and prompting the cautious to sell. Concentrated buying leads to more buying. Concentrated selling leads to panic. Just as the crossing of a critical threshold leads to qualitatively different behavior on the part of thermodynamic, chemical or biological systems, it can lead to qualitatively different financial or economic behavior. Contrast the nonlinear approach to that of classical economics. On the standard equilibrium account such sensitivity is impossible. Any price change must be self-limiting. In the absence of new information any rise in prices must bring in at least as much selling (those who would sell at the higher price but not the lower one) and no additional buying (as people who refuse to buy at a lower price surely won’t buy at a higher price). This can exert a downward, but not an upward, force on prices. A decline in price must produce just the opposite effect. Natural economic forces tend to restore any equilibrium. According to most texts, this is a necessary truth. The necessarily nonnegative slope and continuity of the supply curve and the necessarily nonpositive slope and continuity of the demand curve entail prices must be stable around their equilibrium. Wrong! Classical equilibrium theory is not true by necessity. It is not true at all. The problem lies with the seemingly innocuous extension of local stability to global stability. Given that IBM closed at $100, an investor, liking the company’s prospects, might be willing to buy the stock at $99. He might or might not be willing to buy the stock below $99. If IBM opens the next day at $98, he may buy it. If, however, it opens at $50, he may be spooked into reconsidering his “buy” decision. He may believe something must be seriously wrong, even though he has no idea what it is. If everything were all right, he may reason, there wouldn’t have been so much selling and so little buying from other investors to drive the price so low. Thus, that this investor may have been willing to buy at $99 does not entail he would be willing to buy below $99. (This is the rationale for “buy-stop” and “sell-stop” orders, to buy a stock once it advances beyond a given price or to sell a stock once it declines below a given price.) This is what happened in the oil price crash of 1985 and the stock market crash of 1987. Potential buyers disappeared when — and because — prices plunged. These may seem to be isolated occurrences. In fact, this type of behavior is more common than many suppose, and it plays an important role in financial markets. The rapidity of the rise in stock prices can cause investor mania and become a primary motivation for new buying. These new investors, previously afraid to buy at lower prices, are now afraid of being left behind, of missing easy and automatic appreciation. (How many individuals who would not touch a stock or mutual fund in the early 1980s invested heavily in the late 1990s, after stocks, mutual funds, and market averages had appreciated more than ten-fold?) In market panics, the severity of the price decline scares investors — who would not sell earlier at higher prices — into dumping their positions. Margin debt introduces a feedback mechanism that amplifies the decline: the lower stock prices go, the more margin calls go out, the more margin debt must be liquidated, the more stock must be sold, the lower stock prices go. The same feedback mechanisms that cause euphoria and crashes contribute to normal market cyclicality. Momentum investing is common even in normal times, and from investors who are unaware that they are momentum investors. The longer a stock performs well, the greater is the confidence of investors that it will continue to perform well. The price advance itself generates new buying as investors, concerned about risk at a lower price, become increasingly comfortable as, and because, the price moves up. Momentum buying, feeding on itself, carries the price beyond a reasonable level and sets up the next decline. The decline is a mirror image of the previous advance, in which momentum investors sell the stock primarily because it is declining. In their haste to get out, they sell it at a price below a reasonable level, setting up the next advance. There is also long-term positive feedback between financial markets and the economy. In a secular bull market, investors’ wealth increases as their stocks appreciate. Their additional wealth increases their comfort in spending more. The wealth effect stimulates the economy and leads to higher corporate profits. Higher profits support higher stock valuations, which further increase investors’ wealth, leading to even more spending. In a secular bear market just the opposite occurs. This feedback increases the amplitude of long-term economic and financial cycles. So much for a self-correcting market! There are similar feedback mechanisms within industry. The ethical drug sector has consistently provided an above-average return on equity and aboveaverage growth combined with below-average risk. According to classical economics, such an industry should attract sufficient capital to foster enough competition to reduce its return on equity to the average. Yet these superior returns have persisted for more than half a century, the result of another positive feedback cycle. Researchers, marketers, etc. are attracted to the top industry, which can choose the best of them. Their contributions allow this industry to continue to outpace others. These examples illustrate a major difference between a nonlinear worldview and that of classical economics. In nonlinear systems cycles and nonuniformities are natural, requiring no special explanation. By contrast, classical economics regards a uniform unchanging steady state as natural. Cycles and non-uniformities are deviant and require special explanation. It is a weakness of the classical view that even ingenious attempts to explain standard nonlinear behavior appear forced. Traditional economic theory has been handicapped by the need for assumptions that are mathematically tractable within its paradigm. The nonlinear paradigm has an important advantage in this respect. The conditions necessary to nonlinearity — open systems, far from internal equilibrium, whose evolution can be described by nonlinear differential equations in which there is positive feedback — are more realistic than those necessary to classical economics. What are the ramifications of an economic theory based on nonlinear thermodynamics, as opposed to one based on laissez faire? An immediate effect is to free us from the laissez faire conception of people as interested only in their own immediate economic welfare. This conception conflicts not only with our own experience, but also with traditional views. Aristotle regarded people as by nature political animals who understand that they do not live in a vacuum, but that their own well-being and security depend on the well-being of their community. In contrast to laissez faire, in a world characterized by nonlinearity independent action will be natural under certain conditions while mutual cooperation will be natural under other conditions. This lies closer to the view of the classical Greeks, and also to common sense. At a more practical level, laissez faire sees natural economic forces as purely benign, leading to and maintaining a stable wealth-maximizing equilibrium. Any interference with those forces can only diminish total wealth. By contrast, nonlinear steady states may be unstable and natural forces may lead systems away from equilibrium. There is no assurance that this process is benign. To the contrary, there is historical evidence that it can lead to disaster. It may be appropriate to intervene to mitigate the effects of these forces. This is not intended to imply that a nonlinear approach is incompatible with free markets. It is incompatible with theological laissez faire, with the doctrine that any interference whatsoever with the free market must diminish economic performance. But it fits with the unfettered operation of the market within a broad range. (It may be reasonable to extend a nonlinear approach beyond economics. The flow of history resembles nonlinear systems in its cyclicality. Historians from Arthur Schlesinger to Jose Ortega y Gassett, from Arnold Toynbee to George Modelski, have argued for the importance of cycles in history. William Strauss and Neil Howe (Generations, The Fourth Turning) claim that generations at similar phases of different historical cycles have the same worldviews and the same collective personalities. Independently, there are times that the direction of history can be highly sensitive to minor events, a typical feature of nonlinear systems. How would the world be different if the field of battle at Waterloo had been dry? What if Marx had had the money to leave England for the U.S.? Perhaps there are similar sensitivities in individual lives. “There is a tide in the lives of men, which, taken at the flood, leads on to fortune; omitted, all the voyage of their life is bound in shallows…” (Shakespeare, Julius Caesar). While history cannot be described in terms of differential equations, nonlinear thermodynamics at least suggests analogous mechanisms for historical patterns of structure and change.) The most important implications of nonlinearity for the present U.S. economy are based on the feature that once a nonlinear system crosses a critical level, called a bifurcation point, there are new solutions to the differential equations describing its evolution. These solutions entail new and different behavior. Rules that had previously predicted behavior no longer apply. Forces that had previously been applied with success to change the behavior of the system no longer work. A system that had been controlled by these forces may spiral out of control. Presently, evidence supports the conjecture that in our record stock market valuation and our record debt, both surpassing the previous records made in 1929, we have crossed important bifurcation points. The positive feedback loops characterizing the unwinding of this state express themselves in vicious circles leading to a downward economic spiral: This sort of cycle is not just a twentieth-century phenomenon. The bursting of speculative bubbles in 1837, 1857, 1873, and 1893, bubbles incubated by the new technology of railroads, led to stock market declines of 50% or more. All of these declines touched off economic contractions. There is no reason to think things are different today. The annual rate of change in the S&P Composite is the single most accurate of the Commerce Department’s leading indicators. This suggests that the wealth effect may have a consistent effect on spending and GNP. If the bursting of our technology-financial bubble were to cause similar behavior, how severe could this downward spiral be? At its high in 1929, stock market capitalization reached 80% of GNP. From 1929 to 1932 the stock market lost nearly 90% of its value. The capital loss was 70% of GNP. The contraction in real GNP was 30%. At its 2000 peak, stock market capitalization was 180% of GNP. A 60% decline in market value would correspond to a capital loss of 108% of GNP, almost 50% higher than the loss following the 1929 peak. If the ratios remain the same, this would suggest a nearly 50% decline in our real GNP. Is a 60% stock market decline likely? Unfortunately, it could easily be greater. The only historical parallel with a stock market as overvalued as our current market was 1929, which resulted in a 90% decline. Even our 1973 bear market, in which stocks were not so overvalued and in which the financial bubble was far smaller, saw a decline of 60%. Independently, a drop in the average price-to-sales ratio or the price-to-dividend ratio to their average values over the past 50 years would result in at least a 60% market decline. Is it likely that we will have the same ratio between the loss of financial wealth and the loss of GNP? Some measures suggest the ratio could be larger. In 1929, only the wealthiest owned stocks. Many of these individuals did not change their spending habits as a result of the stock losses. Now, half of us own stocks. It is plausible that a sharp market decline would affect more people and result in a more widespread curtailment of spending. In addition, our personal financial leverage is greater than it was in 1929, suggesting that a financial loss would have a greater impact. There are some positives as well; though it is not likely that they could save the day. The Federal Reserve has the ability to increase money supply and lower short-term interest rates, which should stimulate the economy. In 2001, the Federal Reserve eased aggressively, lowering short-term interest rates 11 times, to a multi-decade low. Ominously, that is the first time since the Great Depression that repeatedly lowering the discount rate did not give the economy an immediate boost, and also the first time that such action left the stock market lower than it was when the Fed began easing. This suggests that something is different now. If, in fact, we have crossed a bifurcation point as we had in 1929, if the economy is sufficiently out of balance, then one might expect Federal Reserve actions to be ineffective. And with the discount rate below 2%, the Fed is dangerously low on ammunition. (In addition, excessive monetary stimulus could endanger our currency. Worries about a collapse of the dollar could restrain monetary stimulus.) A factor more likely to cushion our economy may be that in an economic contraction we would import less. Our balance of trade would improve, slowing our economic decline, albeit at the expense of our trading partners. But this would be a relatively small effect. All in all, it would be foolish to assume that some ineffable and infallible invisible hand will protect our economy from a severe contraction. It would be imprudent to neglect the very real possibility of economic catastrophe. Unfortunately, the effects of such a catastrophe could extend beyond the economy. It is possible that we have crossed yet another bifurcation point, a transition that could make matters even worse. For we now have a record economic inequality between the rich and the rest. Historically, extreme levels of economic inequality have uniformly led to an unraveling of the social fabric. For the first time in history we may be aware of this pattern. Hopefully, we will act wisely on the basis of such awareness. If we fail to do so, I fear it is likely that we shall experience yet another round of increasing violence, widespread decline in the quality of life for all, and a potential breakdown of our political and social systems. |
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