A Batesian Mimicry Explanation of Business Cycles

Eric Falkenstein’s Falkenblog is one of the smartest risk management/investing sources I’ve found. Eric’s essay on mimicry and the business cycle is a good example, and not too technical:

Historical Applications In the 1990’s tech firms in general and internet firms in specific were doing very well. The internet bubble was filled with a naïve lack of skepticism that allowed otherwise absurd business ventures to get funding. Using hindsight there were so many businesses with doomed business models, you wondered how they could have been taken seriously, but investors were looking primarily at a few key criteria—net presence, branding—and these did work well for several years until the March 2000 crash, especially using the criteria of their stock price. Consider that Enron was able to engage in negative cash flow activities for at least 5 years while their stock price kept climbing, highlighting that if you hit the key signals investors are naively prioritizing, they can be fooled, just not forever.

(…) This model explains why business cycles are not forecastable, it’s inherent in the mimic’s selection process. The recalculation Arnold Kling mentions relates to an investing error of a particular expansion, which is always unique. Mimicry explains why the biggest winners in a business cycle are also the biggest losers: their productivity was pervaded by fraudulent and incompetent mimics. It explains why the biggest losers of the prior business cycle often do above average in the next recession: investors are wary of mimics, so mimics only thrive where they are not expected. It explains why recessions are concentrated in certain sectors, and why these sectors are different each recession.

(…) Efforts to prevent the next recession face a large difficulty, in that the impetus for the next recession by necessity will be in the area that invites the least concern, because that is where mimics fester. Any risk analysis that can identify risky ventures necessarily identifies safe ones, and when these safe investment characteristics become known to the mimics, they will be exploited. Top down risk management, the focus of so much policy talk in Basel, Washington, and wonky journals is futile, because risk grows dangerously only where one does not suspect it (G-7 sovereign debt, anyone?).

This suggests focusing on robustness, as opposed to prediction, because the system works against rational expectations, especially those consensus ideas that come out of large bureaucracies. After all, what better sufficient statistic for a mimic to exploit than some well-known regulatory bullet point that supposedly ensures no risk? Recessions are not going away; they are endogenous because zero mimicry is not an equilibrium among insects, reptiles, or humans. Expect more unexpected recessions, just not real soon, and not in subprime housing.

Do remember the following the next time you see Joe Stiglitz quoted as an authority on markets:

Joe Stiglitz and Peter Orzag wrote a paper for Fannie Mae arguing the expected loss on its $2 trillion in mortgage guarantees of only $2 million dollars, 0.0001%.

Lastly, Eric’s published papers are another important resource.