The 3 Economies

When talking about the US Economy there is a set of problems that I see people running into again and again. It is almost as if people are not talking about the same economy which in turn leads to economic arguments where we can’t even agree on basic facts much less begin to work towards a solution.

Instead of viewing the US economy as a single entity, I believe there is value in viewing it and discussing it as 3 different economies that are imperfectly connected to each other. Each of these economics follow slightly different rules. The 3 economies are: the financial market, the goods and services market, and the labor market.

The Financial Markets

The financial markets are hyper reactive. Things change on a dime. A new market price can be reached in a fraction of a second. Pricing information is largely open and readily available. Due to public disclosure laws, it is as close to perfect information as you can get for a product. Don’t misunderstand me, a skilled and unethical accountant can fudge the numbers to make a company look better than it is, but only to a point. In terms of information, you know far more about the stock you are buying then your next toaster.

Note that although the NYSE is critical, it is only part of a larger international financial market place. Other stock exchanges, various public and private bonds, venture capital, and private investment are all competing for the same resource, capital. Ups and downs in a specific subset may reflect a fundamental change in the financial markets… or may just be a rebalance between subsets. The old joke in Economics is that the NYSE has correctly predicted 9 of the last 5 recessions.

It is also critical to remember that the financial market is what statisticians call “noisy”. There is a lot of ups and downs that just happen. Over the last decade, on average the Dow Jones Industrial Average changed about .75% per day on trading days. If you look for dramatic changes then a guideline of two standard deviations (to cover about 95% of the data) comes out to be about a shift of 1.8%. In other words, a shift of greater than 1.8% in a single day happens about once a month. If someone tells you that something massively important happens and that the markets reacted to it, then look at the shift. If it was less than 1.8% shift then it was not that dramatic. If it is less than .75% then there was actually a less than average about of change on the market that day. If you take a hard look at most financial reporting, expect to see a lot of false drama over sexy issues used to explain tiny shifts that frankly are just noisy markets being noisy.

The big, powerful, fancy theory in Economics to explain the financial market is something called “Modern Portfolio Theory” (MPT). It is taught in most graduate schools and is largely regarded by both practitioners of the market and scholars as dysfunctional. Specific critiques center on false assumptions built into the underlining theory and a mismatch between forecasts made using MPT and actual market prices. In fact more recent graduate level text books open with a discussion on MPT not as a tool that should be used but as a pedagogical exercise.

I genuinely believe that MPT can and will be replaced, and fairly swiftly, once a better theory with more consistent predicting power enters the field. Traders and Economists have been watching for that theory since the mid 1970’s and it has not yet emerged. This theoretical gap is critical since those who turn a profit in the market are those who can “get in front” of the market. It is this desire that has in many ways forced traders to be overly sensitive to changes and information. This adds to the lean, aggressive trader and the quick changes in prices that we see in modern financial markets.

…

Thank you for taking the time to read my blog. The entries for the next two weeks will be about twice as long. Next week I will be talking about the goods and services market as wells how it fundamentally differs from and interact with the financial market. In two weeks I will conclude this topic by using the same approach to discuss the labor market with a few final conclusions to wrap things up.