New world order: biological science links patterns of economic behaviour
The summer heatwave in the US corn belt is going to hit grain production and has already raised food prices. So far, such price increases have not yet translated to global inflation, thanks to better food crop production in other parts of the world.
Commodity traders today use satellite maps to track global crop production and weather conditions in order to predict commodity prices. In 1878, British economist William Stanley Jevons even suggested that economic cycles are related to sunspots, because sunspots affected the weather, which in turn affected crop production and the economy.
The summer heat is also raising political tension in many countries, on top of the European debt crisis and the fear of the Chinese economy slowing, all adding to market volatility and uncertainty. What is the best economic framework to make sense of what is happening? All we can say with some certainty is that the economic and risk management models of the current efficient market hypothesis are not working well at all.
MIT Sloan School professor Andrew Lo, in a recent paper, 'Adaptive Markets and the New World Order', suggests that we should view financial markets and institutions from the perspective of evolutionary biology rather than physics. He suggests that today's efficient market hypothesis models are not so much wrong as incomplete. These models worked reasonably well from the 1930s to the mid-2000s in the US financial markets, but he suggests that the last decade is really the beginning of a 'new world order' of higher volatility, due to larger population and economic shifts caused by technology, competition for resources from population giants like China and India, and rising leverage and global imbalances.
His adaptive market hypothesis recognises that efficient and irrational markets are extremes, while most market conditions are somewhere in between. Market behaviour adapts to changes in the environment, such as policy changes. For example, the Peltzman study in 1975 found that seat belt requirements did not lead to much of a decline in highway deaths because people became more reckless, since they felt more safe.
The idea that the market knows best underpins current corporate governance theory, that share prices reflect the market assessment of how well a company is performing. However, the rule change to allow share buybacks meant that a company can use its own cash to keep its share price up, at least delaying the signalling effect of weak share prices on performance.
The adaptive market hypothesis suggests that rather than thinking that there is always 'the wisdom of crowds' - the logical extension that markets are always right - one should think about the creative tension between the wisdom of crowds and 'the madness of mobs'.