Chaos Theory, or Why EJ Is My Favorite Meteorologist

[disconnect]

I had a couple thoughts recently about EJ’s work on this site that I thought I’d share for discussion. I think everyone would agree that he’s done a fantastic job in forecasting the economy and markets through the two giant bubbles that occurred in the last 12 years, as well as posting insightful commentary and analysis on the world monetary system as it stands. However, reading the articles over the last couple of years as an occasional subscriber, I can’t help but wonder if the world has just gotten to a place where it can’t be accurately forecasted – where the butterfly effect has taken over to the point that small changes on the periphery have major consequences to the outcome and the system is so chaotic that nothing can be forecasted sufficiently into the future.

What got me thinking about this today was EJ’s contention that a Euro breakup was unlikely due to the technical difficulty of implementing it as well as the strong negative effects it would have. I agree with that in theory, but in practice I don’t know if that will matter. If his forecasts have been based on this assumption and that assumption is incorrect, then regardless of the correctness of his model, the entire output could be invalidated. This is just one example of where assumptions have to be made and small changes in geopolitical events lead to important but unpredictable outcomes. I look at it like EJ has built the world’s best weather model capable of incredibly accurate forecasts, but if a few weather balloons feed back bad data into the model, its forecasts could be simply wrong. Living in Minneapolis, it’s like a huge snowstorm is forecasted for us, but if it ends up tracking 150 miles north, instead of two feet of snow we’ll just get a heavy, cold rain. Still bad weather to be sure, and the snow still happens, just north of us, but all the snow tires, shovels, and salt we’ve stockpiled goes to waste.

I hope this is received as constructive criticism and food for thought because I really would like to see this site continue to deliver the accurate forecasts it has in the past, and I still value the analysis Eric provides, I just wonder if the global economy has become too much of a chaotic system that is impossible to predict, where small, unknowable changes in inputs lead to radically different outcomes.

[DRumsfeld2000]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

You make some good points and in fact it is one of the main reasons why I have just become a subscriber. It is also why I wanted a site/information based on fundermental not technical analysis, as the world is just too complex for the simple rules of TA. I do not doubt that EJ will get some things ''wrong'', but I believe that he will throw light on areas in a way which will at least give some basic additional knowledge, from this you can broaden it from your own reading. Good luck, I think we will all need it very soon!

[jpatter666]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

Note that EJ has recently admitted his Euro-nobreakup theory may need to change.

[raja]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

Why are there so many differing perspectives of what's going on with the economy?
All these "smart" guys disagree. For example, Krugman, Mish and Hudson come to very different solutions and predictions when presented with the same facts. They have all spent many years immeshed in econonic analysis, yet they all disagree on the causes and the "solutions".

So I agree with you, disconnect, that the global economy is an entity that is entirely too complex to understand and predict with a high degree of accuracy. Anyone who is certain he or she is able to do so should be taken with a big grain of salt.

Even though I may be an relative economic neophyte, there is one aspect in which I believe I have the edge over many of these pundits . . . psychology. Complexity is not the only nemesis of economic predicting . . . another is personal bias.

When I weigh the various analyses and predictions of the "experts", I not only look at their track records, I also consider their psychology. Are they open-minded to others opinions vs. so sure they are right that they can't imagine anyone else could possibly be correct? Do they respond to criticism directly, or are their answers evasive or non-sequitors? Is there a consistent psychological bias to their predictions? The more the "expert" measures up to these criterion, the more I expect their predictions to be accurate. The more faults they exhibit, the less likely am I to give credence to their words, because they are viewing the world through psychological distortion.

The most dangerous trap is to let one's own hopes for the future color predictions. For example, someone who consistently paints an overly rosey picture of the economic future is doing so for a reason. Perhaps they are an entrapreneur, and to continue life as they know it, they need to have the economy recover so they can continue with their desired life. This is essentially "talking their book", but happens on an unconscious level . . . .

[jk]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

ej has said explicitly that the period from about '96 to '09 was much easier to predict than what is happening or about to happen now. he ascribed this difficulty to the large effect of varying political decisions going forward.

[jiimbergin]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

ej has said explicitly that the period from about '96 to '09 was much easier to predict than what is happening or about to happen now. he ascribed this difficulty to the large effect of varying political decisions going forward.

and I believe, if anyone can come close to figuring it out, it is EJ. I would rather put my money on him than any of the others.

[Raz]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

and I believe, if anyone can come close to figuring it out, it is EJ. I would rather put my money on him than any of the others.

+1.

[disconnect]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

ej has said explicitly that the period from about '96 to '09 was much easier to predict than what is happening or about to happen now. he ascribed this difficulty to the large effect of varying political decisions going forward.

I've seen this and agreed, but what I'm getting at here is that it may not just be harder, it may be impossible. This is kind of just expectation-setting for myself that I wanted to bounce off folks here as I think everyone recognizes that accurately forecasting the global economy down to the micro level is kind of tricky. :-) I just think there is a history here of impressively accurate specific forecasts that is implicitly expected to continue, even if it's an answer that's harder to get to than before. I'm proposing here that regardless of EJ's abilities or the amount of work that the iTulip team puts in, the conclusions reached and the actionable calls developed will be inherently riskier than say, shorting the stock market in 2001. Put another way, there is an uncertainty and margin of error around current forecasts much larger than before. From the subscriber's perspective, this is something to be very aware of and also tilts the value of this site away from actionable investing ideas and towards general macro research and education.

[doom&gloom]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

mish had the following link up today. it is quite interesting.

http://blogs.telegraph.co.uk/finance...r-meat-course/

If the Euro falls apart, the cost to Germany is in the high tens of billions, and add in France and it's around $155bn. However I think it gets even worse, as Germany is the China of the Eu zone -- the merchantilist exporter who, thru their efficiecny and work ethic, can crush their local brethren. But poorer countries that withdraw will not only NOt have the money to purchase from Germany (et al), nor the credit, but they will have the resentment to avoid purchases from Germany for some time, thus further impacting Germany's future GDP adversely.

A EU breakup is not really to anyone's benefit except the large debtors who give everyone the finger ala Argentina. And even in their case, they do not have the resources of an Argentina.

Personally, if Spain or Portugal leaves, I think I know where my retirement home will be however...

[shiny!]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

Personally, if Spain or Portugal leaves, I think I know where my retirement home will be however...

Interesting that you're thinking along those lines. I've been thinking a lot about Greece lately...it might be fairly affordable once the dust settles. Perhaps like Iceland, the first ones down the rabbit hole will be the first ones out.

[doom&gloom]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

Interesting that you're thinking along those lines. I've been thinking a lot about Greece lately...it might be fairly affordable once the dust settles. Perhaps like Iceland, the first ones down the rabbit hole will be the first ones out.

yeah, but who wants to learn Greek?!

Spanish is much easier, and so is Portuguese. And if you do Portuguese first, you already get like 60-70% of the spanish with it.

[shiny!]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

yeah, but who wants to learn Greek?!

Spanish is much easier, and so is Portuguese. And if you do Portuguese first, you already get like 60-70% of the spanish with it.

Yeah, but Greece is... Greece! I went there when I was young and fell in love with the islands. But OK, I'll check out Portugal, too. Portugese doubles for Brazil as well.

[c1ue]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

What got me thinking about this today was EJ’s contention that a Euro breakup was unlikely due to the technical difficulty of implementing it as well as the strong negative effects it would have. I agree with that in theory, but in practice I don’t know if that will matter.

My view is also that a Euro breakup is unlikely, but my reasoning is different.

The reason the EU exists is because Europe as a collection of individual nations is largely irrelevant. Couple this with 2 catastrophic inter-European wars in the past 2 generations, and there is a powerful incentive for union.

The problem is that the EU is not a federalized nation like Brazil, China, or the United States. As such it has all of the problems of a federalized nation, but very few of the strengths. This is entirely a result of trying to entice the various European nations into a union via carrot methods.

Thus while long term there is a lot of benefit for Europe to become one nation, in the short term the half baked equivalent that is the EU is simply not very stable when push comes to shove as it is doing so now.

I still do not see Germany remaining within the EU barring significant progress toward federalization, and I still don't see federalization as being very likely. Hollande's election was in no way a surprise to me, as I have long noted that France is much closer in economic policy to the PIIGS than it is to Germany.

Thus while Germany does stand to lose a great many euros of existing export markets, the reality is that these export markets aren't going to be the drivers of German economic growth as they were right after the introduction of the euro. Germany's future lies elsewhere: while the PIIGS might buy German submarines, tanks, cars, household appliances and what not, at the same time they supply little of the raw materials Germany also needs.

Be that as it may - I still don't see the EU returning to its per-WWI or pre-WWII balkanized state either. Whether Germany decides to go or is pushed off to its own way, the rest of Europe still has strong reasons to unify. Thus a 'breakup' of the EU must be defined as well: is Greece departing/being pushed from the EU considered a breakup? Germany?

Also to be fair, in the context of a likely remonetization worldwide, the barriers to change are lower. By remonetization I mean that the ongoing ZIRP/devaluation/inflation measures going on worldwide are eroding the base fabric of trust in all currencies at all levels - similar situations in the past saw collective sovereign action to remedy the situation. In this I believe EJ's view is going to be quite accurate.

[EJ]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

I had a couple thoughts recently about EJ’s work on this site that I thought I’d share for discussion. I think everyone would agree that he’s done a fantastic job in forecasting the economy and markets through the two giant bubbles that occurred in the last 12 years, as well as posting insightful commentary and analysis on the world monetary system as it stands. However, reading the articles over the last couple of years as an occasional subscriber, I can’t help but wonder if the world has just gotten to a place where it can’t be accurately forecasted – where the butterfly effect has taken over to the point that small changes on the periphery have major consequences to the outcome and the system is so chaotic that nothing can be forecasted sufficiently into the future.

What got me thinking about this today was EJ’s contention that a Euro breakup was unlikely due to the technical difficulty of implementing it as well as the strong negative effects it would have. I agree with that in theory, but in practice I don’t know if that will matter. If his forecasts have been based on this assumption and that assumption is incorrect, then regardless of the correctness of his model, the entire output could be invalidated. This is just one example of where assumptions have to be made and small changes in geopolitical events lead to important but unpredictable outcomes. I look at it like EJ has built the world’s best weather model capable of incredibly accurate forecasts, but if a few weather balloons feed back bad data into the model, its forecasts could be simply wrong. Living in Minneapolis, it’s like a huge snowstorm is forecasted for us, but if it ends up tracking 150 miles north, instead of two feet of snow we’ll just get a heavy, cold rain. Still bad weather to be sure, and the snow still happens, just north of us, but all the snow tires, shovels, and salt we’ve stockpiled goes to waste.

I hope this is received as constructive criticism and food for thought because I really would like to see this site continue to deliver the accurate forecasts it has in the past, and I still value the analysis Eric provides, I just wonder if the global economy has become too much of a chaotic system that is impossible to predict, where small, unknowable changes in inputs lead to radically different outcomes.

I appreciate the comment. As JK and others have noted, in mid 2009 I told subscribers that the models that allowed us to so accurately forecast the asset bubble growth, collapse, and reflation process were no longer useful going forward.

I wrote that the bubble era was over, that the private credit markets that fueled the bubbles were tapped out for the duration and that henceforth the engine and rudder of the economy are in the hands of public finance and central banking policy makers.

But way back in 1998 I warned that after the over-indebted US economy has its eventual financial crisis, it will teeter on the edge of a deflationary abyss. That brings us full circle back to circa 1999 Ka-Poom Theory.

The credit crisis will leave a persistent output gap that depresses wages and incomes, reducing the ability of the economy to pay down debt, accumulate savings, and invest for future growth. The private credit markets will not be able lend enough money into existence to prevent a decline in the overall price level, leaving government and the central bank to the job of lending sufficient quantities of new money into existence to keep the economy from sliding into the abyss.

Each time the economy begins to slip back toward the edge, the Fed will try this and try that to keep the economy out of the vortex.

But over time the government borrowing and lending creates its own problems, in particular the crowding out of private lending, and later political problems as one party or another latches on to budget deficits and foreign debt as a political tool. And each time the debt deflation elixir of QE and fiscal stimulus is applied, the effectiveness is reduced.

The economy now operates like a windsock. When the Fed via QE and the Congress via deficit spending, and the dollar falls due to both policies, the economy moves forward. When the stimulus runs out, it stalls.

Referring to the Fed, Congress, and the White House collectively as The Kremlin, the institutions dedicated to the proposition of keeping our over-leveraged economy from collapsing into a deflationary depression, I told readers we are all Kremlinologists now, all of us who try to forecast the direction of the economy.

So we set to work honing our Kremlinology skills. As you can't know what's going on in the Kremlin if you don't go inside, I began to attend frequent meetings at The Boston Fed and broadened my network of contacts. In a couple of weeks Janet Yellen will speak to us and I have questions for her along the lines of those I had for Larry Summers and others. We developed a whole new set of models. Until recently, I wasn’t sure we’d ever discover anything worth noting until we dusted off Ka-Poom Theory and determined that it is the model for the end game.

To help readers understand how we arrived at that conclusion, let’s briefly review a subset of iTulip positions and follow the chain of causation from one to another.

iTulip Position 1999: The stock market is a bubble. Capital gains tax revenue on windfall gains from inflated stock prices pushed the budget into surplus. When the bubble pops, the hit to public finances will be twofold. One, the capital gains will evaporate and with them the tax revenue that financed myriad public spending programs and created a budget surplus and made President Clinton and Alan Greenspan heroes. Two, the crash will cause a recession, forcing the Fed to cut interest rates and Congress to expand spending as tax receipts plummet, pushing the budget into a deep deficit.

We asked: How are these idiots going to get out of this one?
Answer: An even bigger and more ill advised bubble, this time debt rather than equity financed, involving the entire banking and financial system. Brilliant.

iTulip Position 2002: Holy crap! These idiots are creating a housing bubble to reflate the economy after the stock market bubble smashed the economy. They are letting their pals on Wall Street make fortunes financing this bubble. When it busts in three of four years it will take down the banking system and economy. After Congress implements emergency bailouts and spending programs, the budget deficit will explode.

iTulip Position 2006: Housing bubble top. Countdown to financial and banking crisis and massive global recession.

iTulip Position 2007: The massive recession started in Q4 2007. Stocks will fall 40% in 2008. The housing market will collapse and remain moribund for a decade or more. Unemployment will rise into double digits and stay that way for years. Incomes will fall. Oil will keep running out and the dollar will weaken. Inflation will rise. (By the way, our Jan. 2008 contest to award a gold sovereign to anyone who can locate as accurate a forecast as ours of the so-called Great Recession is still open.)

We asked: Sure, we know how these idiots believe they going to get out of this one. They think that by printing money (QE) and deficit spending and allowing the dollar to depreciate against other currencies that the economy will “catch” like a sputtering engine. The output gap and debt bubble hangover will go away. But what will they do when the figure out that it the anti-deflation policies are creating a windsock economy?
Answer: In iTulip parlance, Ka-Poom.

iTulip Position 2012: The US economy will go through one or two more Ka-Poom cycles before the final one that blows up the IMS or an outside event, such as the collapse of the euro block, triggers a final Ka-Poom cycle. The timeframe is 2013 to 2015. We are in a new Ka-Poom cycle now. Next week we publish the next installment of the theory update.

[raja]

Re: Chaos Theory, or Why EJ Is My Favorite Meteorologist

and I believe, if anyone can come close to figuring it out, it is EJ. I would rather put my money on him than any of the others.

I'm curious . . . how do EJ's predcitions influence your investment decisions?

I let my subscription lapse a couple of years ago because I didn't see any practical effect on my investment decisions. Maybe I should reconsider?