Jevons paradox and AI

Jevons’ paradox was developed in the 1800’s to explain dynamics in the coal market. Jevons found that technological improvements can increase resource efficiency, but that will often lead to an increase in total resource consumption. The increase in efficiency leads to lower effective cost, and with costs lower, demand will increase. 

We see this effect across many industries undergoing technological improvements, but it may be best exemplified by the AI market, where efficiency keeps improving while demand still grows. The electricity demand will increase. The demand for chips will increase. The demand for data will increase. Yes, there is efficiency, yet consumption of the core product and associated supplies will also increase. 

There is nothing special about the AI industry. It is following the same behavior we have seen countless times over centuries. 

Gun violence - the solution is following the research

Finished reading Unforgiving Places: The Unexpected Origins of America's Gun Violence by Jes Ludwig of the University of Chicago and I am once again awed by the power of good economic research. I may have had some biases before starting the book, but I had an open mind to learn about one of the worst problems in America. 

Ludwig also presents his case and evidence without any political bias. He wants to get to the heart of the issue, and, as with many economic problems, the obvious is not always right. Most of our views on many topics are, at best, only partially correct and do not serve as the only answer. Ludwig presents all sides of the argument about why there is gun violence and what possible solutions there are, but the main driver is behavioral economics. Gun violence is not about rationality but often irrational or, as Kahneman says, system 1 reactionary thinking. You put guns in the hands of people that have different reactions to situations not based on rational but on react, fight or flight thinking, and there will be a problem with tragic results. He makes a strong argument that many current models cannot explain why two neighborhoods that are adjacent and have similar demographics can have very different gun violence statistics. The only explanation is behavioral and social interaction between individuals. The poverty argument cannot explain gun violence - there are too many contradictory facts, and the idea of "bad people" does not explain the majority of violence, nor can using jails be the solution. 

For something inherently political, this book is well-written, thoughtful, and shows the power of good research that is able to separate common opinions from real facts. 

Edmund Phelps - more than a macroeconomist

Edmund Phelps died this week. Unfortunately, many may not remember his path-breaking work in macroeconomics, which opened the door to neo-Keynesian models. His most important macro work examined the inflation-growth trade-off through the lens of inflation expectations and addressed the natural rate of employment. First, if inflation expectations rose, there would be a corresponding impact on wages, leading to a wage-price spiral. Second, if central banks attempt to maintian emeplyent above the natural rate (the equilibrium rate) there will be a surge in inflaiton. 

While he was viewed early on as an important macroeconomist, he provided significant insights into innovation and creativity as drivers of economic dynamism. Few economists have had many important pieces of research across fields. 

He could not be placed in any school of thinking and should be viewed as one of the few truly independent thinkers on a range of topics. 

Neoliberals and the fight between dominium and imperium

 Quin Slobodian’s book Globalists: The End of Empire and the Birth of Neoliberalism was written before the pandemic and before the uproar about Davos and the World Economic Forum. Yet it is truly relevant to anyone considering the current world order, with its tension between some form of global government and nationalism. Globalist does a good job of describing the origins and rise of neoliberalism and helps readers understand how it differs from national movements or a national focus. 

What I found most interesting was the focus on differences between dominium and imperium capitalism. Dominium refers to owners’ rights to control their property, a key feature of capitalist private property. The imperium, or public power, refers to the sovereign power of the state to rule, tax, and regulate. The intersection between these two forms of capitalism is the crux of how neoliberalism bears on the issue.  

For Slobodian, neoliberalism is not a simple version of laissez-faire capitalism, but a project to, as he terms it, “encase” the market within legal and institutional frameworks to ensure that dominium is protected over imperium. Global capital is protected from democratic pressures, nationalism, and social redistribution that seek to take property away from owners. Thus, dominium is given a higher priority over imperium, and the right to rule by nations is constrained by international institutions. Capitalism is not left to self-regulate but needs oversight and active management to protect the dominium. Neoliberals believe there is a need to constrain democracy in a pure form that will subvert property rights in an effort to redistribute wealth. Neoliberals want an active legal framework to protect property rights and allow capital to move freely and be controlled by owners.  

Sorkin's 1929 - A tale of personality

 

I finally got around to reading Andrew Ross Sorkin’s 1929: Inside the Greatest Crash in Wall Street History - and How it Shattered a Nation. His narrative style is compelling for those who do not want to read dry financial history. The characters come alive with his writing, but I did not come away with any new insights into the stock market crash. There were signs before the October crash, so it was not a total surprise. Excess leverage, margins that were too low, excess greed, and herd mentality, but we already knew that. While I liked reading about the characters, I kept asking why we didn’t hear more about the central bankers. What about some of the surviving brokers? How about some of the businessmen outside of Wall Street? 

Do I better understand the psychology of bubbles and the 1929 crash? I don't think so. Perhaps I am jaded by all my reading on the topic, but did I learn anything new beyond the fact that the same tropes of greed and leverage are always with us?

What does 1929 tell us about markets today? Not much. There is significant leverage, crowd behavior, misinformation on policy choices, and fear of taking action. Perhaps that is the message. Things don't change.

Back to basics with bubbles - the fire analogy

The fire analogy, or triangle, was developed by Quin and Turner in their book Boom and Bust to describe what is necessary for a bubble and thus also identifies the conditions under which a bubble may burst. The triangle states that an asset needs Oxygen, Fuel, and Heat. Oxygen is the marketability or ease of trading. Fuel is the money and credit availability. Heat is the speculation or momentum associated with an asset. 

Assets have to be easy to trade by a large set of investors. Bubbles need credit or money to borrow and leverage into larger positions. Heat is the speculation or momentum of assets, which creates a sense of FOMO and provides positive feedback on market views.

We have all three conditions in the tech AI space, and until there is a change in conditions, we will continue to see prices move higher. Rates are coming down. These assets remain marketable, and momentum remains favorable. 

Boom and Bust - A great book on bubbles, which is useful today

Are the great minds leading to innovation?

 “the great minds of the Industrial Enlightenment had shown how the useful knowledge they were accumulating could be used to improve, to rationalise, and to innovate. The rest is commentary” - 2025 Nobel Prize winner in economics Joel Mokyr 

The burden on government and higher education is to better mankind, and that is best done through innovation that increases economic productivity. This raises living standards for all. It is not a matter of regulation but nudging greater minds to improve living standards. This is what is needed for the EU and for emerging markets. It is necessary for the US and China. Technology, not behavioral restrictions, improves lives. We need to focus more on how to use knowledge to benefit humankind. 

Nobel prize in economics - innovation and growth critical

 

We too often focus on the macroeconomic cycle. Of course, it is immediate, yet if you want to change the lives of many and a society, you need to focus on innovation, which leads to growth and productivity. The Nobel Prize winners in economics are three economists who concentrate on this critical issue. Moyr is an economic historian who closely studies the environment for innovation. Why did innovation occur at a particular time and place? The other two economists focused on endogenous growth through a Schumpeterian view of creative destruction.

Moyr is considered part of the idealist school of thinking on innovation. The culture matters when it comes to innovation. Aghion and Howitt are viewed as part of the materialist school, which focuses on modeling growth to explain how innovation drives it. 

Innovation drives growth, and we need to always think about how to foster it to increase growth and productivity.

Economics and the need for history

"Forty years of investment in mathematizing economics has made it less acceptable among economists to admit ignorance of mathematics than to admit ignorance of history" - Deirdre McCloskey

You cannot be an economist today without knowing your math. To complete any PhD program, you will need to possess a strong understanding of mathematics, statistics, and econometrics. You will also likely have strong programming skills. Finance is being dominated by quants. 

You will not need to know history in this environment; yet, as I get older, understanding history becomes a critical skill. All policy analysis needs context for what has worked in the past. You need history to describe "experiments" in the past. The past determines the path for the current and future. 

In finance at the local level, you need to know the history of companies; their evolution is relevant. At the macro level, we need to know the specifics to appreciate our generalizations. It seems that one semester of economic history is not too much to ask for our experts.

This has been a common theme on how we think.

Finance needs more history to help with the future

Financial amnesia and the need for financial history

Don't just follow history, act on it

The value of history for economics from Charles Kindleberger

History in five crashes - Finance in the last century

Counterfactuals, history, and market analysis

History, linear thinking, and addressing market noise

The Richard Stone Diagram of models, policies and plans

 

I came across the Model, Policies, and Plans diagram from the 1984 Nobel Prize winner Richard Stone. It attempts to explain the production process for economic knowledge. It is a helpful picture of how economists first blend facts and theory to form a model. A model is mixed with objectives to form policy. Controls on the policy will create a plan, and events will impact the plan, leading to our set of experiences. We then go back to the beginning and repeat. This is an iterative process. As we get new facts, we will adjust theories and models. In the case of monetary policy, we should ask how the Stone diagram works inside the Fed.

The current problem with government statistics

In contrast to physics, there is no estimate of statistical error within economics in spite of Oskar Morgenstern’s book, On the Accuracy of Economic Observation. The problem of error in economic observations is still a widely neglected problem. The various sources of error that come into play in the social sciences suggest that the error in economic observations is substantial. As the error might be substantial, this paper argues that the usefulness of econometrics becomes questionable. - Philipp Bagus Rey Juan Carlos University

The multiple news stories about the change in leadership and the BLS miss the key point that we are facing with macroeconomic analysis. We are only as good as the data that we use. If there are significant errors with the underlying data used to make macro decisions, there will be greater market inefficiency. Major revisions will reduce he trust in the numbers. Minor modifications will help investors refocus their attention on this data. The market reaction to any announcement will decline. It is not that the market will make wrong judgments based on the data, but that no judgment will be made at all. There will be less market reaction on any announcement date, yet there is likely to be greater misallocation of resources. 

Stan Fischer - A great influencer on macroeconomics

 

Stan Fischer is one of the great macroeconomist of the last 50 years, and as shown by the figure above he influenced many of the other leading economists of this time. He was one of the key pillars of MIT macroeconomics and was clearly one of the strong influencers of monetary policy choices around the globe. You cannot talk about macroeconomics or international macrofinance without looking at some of his papers. I cannot say that I always agree with his research work, but that does not change his substantial impact on macro thinking. 

He will be missed, yet we must ask what would have happened to macroeconomic thinking if Fischer had not existed. Would we be better or worse off with our thinking?  Would someone else have filled the void? More so than any one piece of research, Fischer was a teacher, whether at MIT, the IMF, the World Bank, or the Fed, who set the agenda for many other researchers. In this case, he could not be replicated.

Making sense of chaos - A readable explanation

 

J Doyne Farmer, a leader in complexity and chaos theory, has written a very readable book on complexity theory for the average reader. Making Sense of Chaos: A better economics for a better world takes the reader through the basics for why complexity modeling is necessary and different from classic economic theory. Farmer then walks through how complexity theory can be used to explain different economic phenomena. 

Complexity theory and simulations can be used to explain the financial crashes we have seen. It can help explain the housing bubble, and it has applications for providing deeper understanding of market efficiency. It has also been useful for explaining the issues of credit crises associated with leverage. 

Farmer provides good explanations for how complexity theory can be employed to predict weather and climate change as well as technical progress. He does a great job of taking a difficult topic and make it approachable by others, but the modeling of a complex system is not easy and requires a lot of simulation work where the results are not always expected. Simple changes in assumptions will give very different results. Nevertheless, it is important to think about many economic problems as complex systems that do not have the same features as an equilibrium model.

The changes in industrial organization

 

There has been a changing focus of industrial organization and the theory of the firm over my career that also may tell us something about the hedge fund industry. The hedge fund and money management industries have evolved with changes in the demand for their product and through competitive threats from other firms.

The study of industrial organization has evolved, and that evolution will help provide a framework for explaining hedge funds. I will start with my undergraduate course in industrial organization that used the textbook by Frederic Scherer. This was the dominant thinking on the topic and used the SCP framework for the empirical analysis on industries. Scherer was a discipline of Schumpeter and focused on competition, change, and innovation. 

The SCP framework, which was foundational for most business schools, looked at Structure-Conduct-Performance as the three drivers for understanding a firm and industry. The market structure, the number of firms and barriers to entry will determine the conduct of the firm based such as pricing and products which then lead to performance as measured by profitability. The Harvard Business School advanced Scherer to new generations through the five forces of Porter as the dominant view for thinking about firm, industry, and strategy. 

The SCP framework focused on the external behavior of the firm, but there was a growing interest in the internal structure of the firm that was explored through the work of Oliver Wiliamson, Ronald Coase, and Alan Alchian. There was a focus on how firms are structured based on minimizing transactions costs and information flows. The transaction cost view looked at market versus hierarchical structures to solve transaction costs problem. Along with the contracting of the firm, Jensen and Meckling applied the idea of the corporation as a set of contracts. The contracting view solved problems of asymmetric information and moral hazard. There was an explosion of research on principal-agent problems. While this work on the internal structure of the firm solved problems with how firms and contracts were formed, there was another school or direction of thinking about how firms interacted in a competitive environment. 

The work of Meyer, Milgrom and Roberts (MMR) applied a game-theoretic approach to the competition across firms and strategic behavior. This approach focused on information and incentives issues between firms. The work on information asymmetries helped explain strategic decisions. Like the work in finance to explain incentives for shareholders and managers, MMR applied this asymmetric information thinking for explaining the actions of firms. Firms will make strategic decisions to influence the behavior of their competitors. There also was work focused on competitive threats and whether industries were contestable as a means of determining whether there was a monopoly. 

The work on information, game theory, and contracting was linked to the more classic work in industrial organization through Jean Tirole who developed a more comprehensive framework for industrial organization to explain oligopolies, monopolies, monopsonies, and competition. This unified framework also provided a framework for price discrimination, the vertical integration of the firm, and tackled the reason for government intervention and regulation.

So, what does this have to do with hedge funds? The hedge fund industry is not special. It is subject to the same issues and problems of any other industry. Firms attempt to solve information and transaction costs problem to increase profitability or provide alpha for clients. Hedge funds compete for funds, so they have to focus on strategic decisions to improve their position relative to other firms. The hedge fund industry may have started out as a group of artisans, skilled managers, but are now vertically integrated and structured to gain an information edge and will become more horizontally integrated to improve their diversification and stabilize cash flows. We can learn from other industries to explain hedge fund and money manager behavior.

Douglas North - we need to think more deeply about institutions

 

I have been focused on the older work of Douglas North, the Nobel prize winner, as part of a longer piece of work on economic growth and competitiveness in the EU. There can only be a significant increase in growth if there is a change in the institutional structures within Europe. The rules of the game matter, so the study of these rules and how they form an economy are critical. The rules both formal and informal place constraints on behavior and what can be achieved. You cannot generate growth if the institutions and organization is not in place. 

North was part of a school of thinking that institutions and organization are developed to cope with the problem of transaction costs through information gathering, monitoring, and behavioral constraints. How do we form institutions that can improve market efficiency through reducing transaction costs and enhancing production? How will firms and agents organize in response to these institutions? 

Given that institutions and organization change slowly, growth will be path dependent. Our growth is impacted by the choices made decades ago, so we have to be careful on changing the rules of the game and we cannot expect an immediate response to new rules and institutions.

While I have been thinking about macro growth, institutions and organization impacts quant investing. There is the belief that knowing the institutions does not matter; however, we need know how trading occurs and how transaction costs impact performance and behavior. The institutional context for price behavior does impact trend and momentum and the response to new information.

Labor, Capital and Technical Change - where are we going to get innovation outside of AI

"If God had meant there to be more than two factors of production, He would have made it easier for us to draw three-dimensional diagrams." - Robert Solow c. 1950.

We always think in the two-dimensional space of labor and capital, yet if we want to truly grow an economy we have think about technical change and innovation. This is the third dimension. We have learned a lot about innovation and technical change since the early days of the Solow growth model and the Cobb-Douglas production model, yet innovation is still the great challenge for economist because it is the link to productivity. 

We have seen different Asian models of growth and observed that it is often cheap labor or capital that is doing the heavy lifting. Once the cheap factor is exhausted, we must worry about innovation and the institutional systems that will driver technical change. Innovation is either driven by a black box that we cannot control or is fully understood, or it the observation that the status quo institutions will have to change.

Commentary on economics - Need to closely observe

"Catch a parrot and teach him to say, 'supply and demand', and you have an excellent economist." Irving Fisher, 1907. 

If economists wished to study the horse, they wouldn't go and look at a horse. They'd sit in their studies and say to themselves, "what would I do if I were a horse?" -  attributed to Ely Devons by Ronald Coase. 

These are two phrases that throw shade on economists. Yes, if you can get an economist to focus on supply and demand he will get most of any problem right. Of course, the problem is that defining supply and demand is harder than you think. It is more than words.

Ronald Coase is still under appreciated by most economists and those in business. He is not easy to understand but answering problems of contracting, institutional arrangements, and transaction costs are critical to understanding why and how financial markets work. The only way to understand the economy is to go out and observe what consumers and businesses do. You can start with theory, but better to first just look and see.

Skidelsky provides a readable book on money and government

Money and Government: The Past and Futures of Economics by Robert Skidelsky is a very readable review and critique of monetary economics and Keynesian policy that can be enjoyed by a non-technical reader. Skidelsky is famous for his biography of Keynes, but this book shows his skill and confidence at explaining monetary economics and what have been the policy mistakes over the last 100 years. Even if you think you know macroeconomics well, there are plenty of useful insights that will improve your understanding in historical context. While Skidelsky is a Keynesian, his presentation is even-handed, and he describes both what Keynes got right as well as what could be improved. We need to place more emphasis on radical uncertainty and the difficulties with implementing policies.

Skidelsky shows that a gifted writer with a strong grasp of theory can provide insightful narrative on many of the vexing macro problems of the past and future. 

Ages of American Capitalism - A great economic history

 

I just finished the long but comprehensive economic history of the United States by Jonathan Levy, Ages of American Capitalism. If you want a review of economic history in the Unites States, this is the one book that should be on your reading list. I may have some issues with the interpretation of events by Levy especially since the 1920's where I have spent more time reviewing the history, but the depth of this work cannot be denied. The work breaks US economic history into four parts or ages. It stops with the 2008 Great Financial Crisis, but we can say that the Age of Chaos continues as we feel our way through deciding what is the proper level of regulation, innovation and change for the current era. The four ages are:

The Age of Commerce spans the colonial era through the outbreak of the Civil War and describes how the US moved from a colony to growing emerging country.

The Age of Capital traces the impact of the industrial revolution as it shapes the US economy. The volatility of the Age of Capital with labor strife, recessions and the growth of big business ultimately led to the Great Depression.

The Age of Control as a response to the Great Depression during which the government took on a more active role in the economy to solve the Depression and respond to WWII. 

The Age of Chaos came upon the US as deregulation and the growth of the finance industry created a booming economy for those in finance but also significant inequalities and a lack of oversight that created the environment for the crash of 2008.

This book provides a good a good framework for thinking about US economic development and should serve as a background for thinking about business history.

What makes a good economist?

 

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must before seen. Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.” 

- Bastiat 

I love this explanation of the difference between a good and bad economist. You have to think about the longer-term or second order effects form some policy action. This is especially true when being a macro economist in finance. The Fed lowers rate which may have an immediate effect on short rates, but you have to think about how this changes expectations and impacts other markets. It is not the immediate effect bur rather the impact on expectations that matters.