Lower the nose, boys!

The US economy is showing signs of instability.

This is not surprising, given what a bad mental model we have of how things work, and given the wretched way the MBA genius crowd is trying to increase wealth production -- or at least their own wealth.

To figure out what to do about that, it would help to know what the "that" is we're looking at. Let me simply ignore economics ("the dismal science") and pick a new model.

Consider a small airplane. I happen to be a pilot, so I'm familiar with airplanes, and they are great visual examples of the conceptual problems student pilots face -- which I think may be the same conceptual problems "we" have with the economy.

First, as I believe Dave Barry pointed out, there are in fact no "red and blue arrows" holding the plane up. Why planes fly at all is indeed somewhat mysterious, even to a physics major like yours truly. The books all show diagrams where the air flows faster over the top of the wing than the bottom, which causes suction to pull the wing upwards --- it says. The only problem is illustrated by the Citabria acrobatic airplane - a nimble little plane that has a completely symmetric wing. The air flows above and below are identical. And, the plane flies as well upside-down as right-side-up. So much for theory.

What is very solid, however, is costs. You can't get around the cost of energy. If you want to go uphill, it's going to cost you energy, period. That's pretty solid. We can rely on that rule.

So, if you want a plane to climb, you have to supply energy. Period. There are no exceptions, at the scale of people.

More altitude will cost you more energy. Period. No exceptions.

So, if you are flying along happily at cruise speed, and you decide now you'd like to climb, you have two immediate choices that appear to work. Which one is best?

• a) Pull back on the control wheel, or
• b) Hit the gas and spend energy.

Clever test takers already will know that the correct answer is (b) -- hit the gas and spend more energy. And, in fact that's correct. The control to change in order to gain altitude in an airplane is the power setting. You hit the gas pedal, or in a plane, the throttle, in order to climb.

Whoa, this doesn't seem right to new pilots. Why not just pull back on the "stick" or the plane's steering wheel, pull the nose of the plane up, and climb that way?

The answer is that, in physics, there is no free lunch. Yes, if you pull the stick back, and pull the nose up, the plane will climb -- for a while. Where's the energy coming from to do that? It's coming out of your savings account - your speed. Yes, you can convert the kinetic energy of speed into the potential energy of height -- for a short time. The more you climb, the more it costs you, and the more your speed falls.

That, however, cannot go on forever, or even very long. As your speed falls, so does your "lift", that is, the mysterious thing that holds the plane in the sky in the first place.

If you persist in this foolish, newbie way of trying to climb for free, and think you have found a loophole in the laws of physics, you will be in for a rude awakening. At some point, as the speed falls, your plane will start to experience squishy controls, and seem to become unresponsive, then it will start shaking and a very loud buzzer alarm will go off telling you what is about to happen. And, if you persist past those warning signs, your "lift" will abruptly and catastrophically fail. The air flow over the wing will transition from smooth to turbulent and, you will transition from being a plane to being a rock with a pasenger. This is known in aviation as "stalling" the aircraft. (It has nothing to do with the gasoline-powered engine, but everything to do with the energy account "engine").

In other words, the plane will, basically, simply fall out of the sky. If you are very fast, you can shove the nose DOWN, point it at the ground, and reverse the process, pulling energy out of the altitude checking account and putting it back into your speed savings account -- and then, when the air flow is good again, you can pull the nose up back to level flight and recover and let your adrenaline settle down. Of course, you will have lost several thousand feet of altitude, or,
if you started too low, you are now dead. This is known as "stall recovery."

So, what are the lessons here? If you're going fast, you can cash in some of that speed and use it to pay for some altitude, but this is a very short-term solution. It's great for small corrections, or avoiding obstacles like trees. It's a loan, not a free ride.

The only way to climb and not fall out of the sky is to increase power, and pay the bills. Planes do not understand "deficit financing." You can't climb now and pay later, maybe.

Anyway, with that model in mind, look at the economy and the recent behavior of the stock market. One senses that the whiz-kid geniuses have discovered that, if you pull back the stick, you can get the market to climb! Wow! And they did that in a huge way, sucking the real energy out of the economy in an ecstatic ride upwards - possibly wondering on the way why no one else had ever thought of this clever solution before.

In point of fact, they had "discovered" that, with a credit card, they could buy all sorts of things, apparently unlimited, and not have to pay for them! Suddenly the country goes a few trillion dollars in debt, while the stock market soars, and they are just so happy that they have "created wealth."

Ahem.

Then comes the bill. Not only has all the loose capital been taken out of the market, but it's been sucked out of all the companies that need cash to operate, and sucked out of all the families that used to own houses that they now live in but, in fact, have already spent and are just waiting for the knock on the door telling them "You are now homeless. Get out."

Oopsie.

The question now, in that model, is whether the whiz kids will, as newbies always do, "pull the nose up even more", or push the nose down rapidly and pick up some speed again, at a major cost in altitude. The "climbing" it turns out wasn't really earned, it was just borrowed, from a lending agency that doesn't take "No" for an answer when the bill is due.

So, in looking at the stock market, the question is whether this model is applicable. Since 1995, have we created a huge amount of new wealth -- and PAID FOR IT by spending more energy, or have we created the appearance of wealth, the illusion of wealth, by cashing in the actual economy's health and momentum and converting it to "height" of the Dow Jones over the ground.

The one process - climbing by paying for it, can run until you "run out of gas".
The other process, climbing by cashing in health and momentum, runs out of steam and then is no more. All gone.

The recent efforts by airlines to push planes to 100% capacity, or 105% capacity, seems eerily like new student pilots desperately pulling back on the stick even more, as they notice that their speed is dropping, and even though the engine is running and the nose is pointed up, in fact the altitude is dropping.

I'm not sure about industrial health. My sense from the number of layoffs and watching the Big-3, now Big-2 auto companies fall to Toyota, is that things are not well there. I am sure about individual-level health of the US population, and that is plummeting, even before their mortgage payment jumped 40% in one month. Obesity, stress, diabetes, fatigue are all soaring.

It does have some signs that the economic whiz kids are trying to kick up the market and create wealth, and "climb", by sucking all the energy and momentum and health out of our normal operating "flying speed." It does appear that the process has reached an unstable point where there are lurches downward, like yesterday's 280 point drop in the Dow Jones average.

This is not good.

The hard part is recognizing the problem, and giving up a lot of that altitude to get back flying speed. The alternative, in that model, is crashing and giving up all the altitude and the flight.

The question is, how much of the stock market and economy's rise since 1995 is due to actual value added and new plant, equipment, training and other hard "capital", and how much is fluff due to exactly the opposite -- selling off everything of value, firing the older experienced workers, and pretending that cash flow was "income."

The GDP, Gross Domestic Product computation doesn't make the distinction between real income and pretend income. The fact that the GDP is growing tells us nothing about how sustainable that growth is, and whether a deal with the devil was made to obtain it.

Regardless, laws of physics win. If it's earned wealth, we can keep it. If it's borrowed wealth, like the nice 4000 square foot house in a nice suburb, we are going to have to let go of it, or it will let go of us.

If that model's right, that is. Like all models, the analogy gives us something to look for and think about, and doesn't "prove" anything. It's the looking and pondering that has the value.

Maybe we conclude "that model doesn't apply." Fine. Maybe we conclude "Hey, that model does apply." Either way we've learned something and have a better idea what we need to do next.

references:
Standard & Poor Price/Earning Ratio Historical Trend - 1943 to present.
http://www.lowrisk.com/sp500pe.htm


Shiller's data - just showing the P/E ratio history since 1880. (chart at the
start of this post).


Robert J. Schiller (author of "Irrational Exuberance")
http://www.econ.yale.edu/%7Eshiller/data/ie_data.htm

Bloomberg Data to 4/2006
(also at top of post)

2007 Data from bull and bear wise
S&Poor 500 chart (not P/E, just the index)
from Yahoo Finance.

Credit crunch reaches larger

More "unintended consequences" from the credit market leveraging everything against everything, trying to make infinite profit on zero assets. (a.k.a. "house of cards"):

Was this visible coming? (from the Washington Post discussion with columnist Steven Pearlstein 8/12/07):

Renfrew, Pa.: Steve, Good timing for a Q&A. One question, when you refer in your article to how "we are learning several painful truths about the new global financial system," would you say this is just another situation although the damage is done, there were plenty of sensible economists (like yourself) who knew exactly the danger and tried to alert a dumbed-down administration and its thoroughly braincell-challenged electorate about it? Kinda like Iraq, 9-11 and Hurricane Katrina?

Steven Pearlstein: I'm not an economist, by the way, but I have been warning about this for some time. The response of policy makers was, yes, that's a risk, but we don't see any sign of it. You have to wonder if they need to get their eyes checked.

Scope of the problem:

Tight Credit could stall some buyout booms:
Washington Post

he severe turmoil in the credit markets last week has raised serious questions about the future of the buyout craze that gave rise to the biggest deals in U.S. corporate history.

For the past few years, a group of elite Wall Street players have been buying up major American icons and taking them private. These massive acquisitions have depended on access to cheap credit, which is supplied by a complex relationship between investment banks and hedge funds.

But with credit markets tightening, the pace of these deals, at least in the short run, is expected to dramatically slow. Already-announced multibillion-dollar buyouts, like Tribune Co., Sallie Mae and Hilton Hotels, are likely to be far more complicated to close, analysts said.

If one or two of these big deals were to collapse, it might not send the economy into a downturn. But it would profoundly shake investors' confidence in a financial system already under siege from billions of dollars in losses from home mortgage defaults. That could make it even more difficult for companies and home buyers to get loans.

And, how exactly is this happening? What are the "system effects" where changes over "there" have an impact over "here"?

Steven Pearlstein again:

Steven Pearlstein: Not sure about the difference in the rating system. But the problem really is that when some supposedly sophisticated investors saw a AAA rating for mortgage-based securities, they assumed there was no risk. Indeed, there is very little credit risk, meaning the risk of not getting paid.

But there is liquidity risk which the rating does not deal with -- the risk that, at some times, the market for these securities may dry up and they cannot be sold or priced. If you hold the securities till maturity -- till all the loans are repaid at the end of their term -- then you don't care about liquidity risk.

But if you are a hedge fund or a pension fund or even a bank that has to estimate the market value of that asset every day, or week, or month, or quarter, then you do care.

And if that price temporarily falls below the amount of the loan you used to buy it, then your bank suddenly cares and demands its money back (the dreaded margin call). Then you either have to sell the mortage backed security, if you can, or if not, sell some "good" asset.

And it that sale of the "good" assets that is how this contagion has developed.

Finally, why exactly is it, how is it, that these changes were "unexpected" or "unseen" when so many people saw them coming?

That is the pivotal question that we need to slow down and investigate. Which of the "instruments" on our leaders "dashboards" is broken, and what else could leak through that hole? Apparently making billions of dollars in profit does not make people any smarter or improve their vision -- or, maybe, it makes it worse.

The linkage between things, "systems thinking", does seem to be the part where human intuition fails entirely to grasp the consequences of actions.

Furthermore, increased IQ or education, by itself, doesn't seem to be a protection against such thinking errors, or makes them worse with overconfidence.

Here's a few quotations from MIT Professor John Sterman's textbook "Business Dynamics".

Many advocate the development of systems thinking - the ability to see the world as a complex system, in which we understand that "you can't just do one thing" and that "everything is connected to everything else." (p4)

Such learning is difficult and rare because a variety of structural impediments thwart the feedback processes required for learning to be successful. (p5)

Quoting Lewis Thomas (1974):

When you are confronted by any complex social system, such as an urban center or a hamster, with things about it that you're dissatisfied with and anxious to fix, you cannot just step in and set about fixing things with much hope of helping. This realization is one of the sore discouragements of our century.... You cannot meddle with one part of a complex system from the outside without the almost certain risk of setting off disastrous events that you hadn't counted on in other, remote parts. If you want to fix something you are first obligated to understand ... the whole system ... Intervening is a way of causing trouble.

IN reality there are no side effects, there are just effects.

Unanticipated side effects arise because we too often act as if cause and effect were always closely linked in time and space. (p 11)

Most of us do not appreciate the ubiquity and invisibility of mental models, instead believing naively that our senses reveal the world as it is (p16).

The development of systems thinking is a double-loop learning process in which we replace a reductionist, narrow, short-run static view of the world with a holistic, broad, long-term dynamic view and then redesign our processes and institutions accordingly. (p18)

Quoting Nobel Prize winner Herbert Simon (p26) : The capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problem...

These studies led me to sugest that the observed dysfunction in dynamically complex settings arises from misperceptions of feedback. The mental models people use to guide their decisions are dynamically deficient. As discussed above, people generally adopt an event-based, open-loop view of causality, ignore feedback processes, fail to appreciate time delays between action and response in the reporting of information, ... (p27)

Further the experiments show the mis-perception of feedback are robust to experience, financial incentives, and the presence of market institutions... First our cognitive maps of the causal structure of systems are vastly simplified compared to the complexity of the systems themselves. Second, we are unable to infer correctly the dynamics of all but the simplest causal maps. (p27)

People tend to think in single-strand causal series and had difficulty in systems with side effects and multiple causal pathways (much less feedback loops.) (p28).

A fundamental principle of system dynamics states that the structure of the system gives rise to its behavior. However, people have a strong tendency to ... "blame the person rather than the system". We ... lose sight of how the structure of the system shaped our choices ... [which] diverts our attention from ... points where redesigning the system or governing policy can have a significant, sustained, beneficial effect on performance (Forrester 1969.). p29.

People cannot simulate mentally even the simplest possible feedback system, the first order linear positive feedback loop. (p29). Using more data points or graphing the data did not help, and mathematical training did not improve performance. ([p29). People suffer from overconfidence ... wishful thinking ... and the illusion of control... Memory is distorted by hindsight, the availability and salience of examples, and the desirability of outcomes.

The research convincingly shows that scientists and professionals, not only "ordinary" people, suffer from many of these judgmental biases. (p30). Experiments show the tendency to seek confirmation is robust in the face of training in logic, mathematics, and statistics. (p31).

We avoid publicly testing our hypotheses and beliefs and avoid threatening issues. Above all, defensive behavior involves covering up the defensiveness and making these issues undiscussable, even when all parties are aware they exist. (p32).

Defensive routines often yield group-think where members of a group mutually reinforce their current beliefs, suppress dissent, and seal themselves off from those with different views or possible disconfirming evidence. Defensive routines ensure that the mental models of team members remain ill formed, ambiguous, and hidden. Thus learning by groups can suffer even beyond the impediments to individual learning. (p33).

Virtual worlds are the only practical way to experience catastrophe in advance of the real thing. In an afternoon, one can gain years of simulated experience. (p35).

The use of virtual worlds in managerial tasks, where the simulation compresses into minutes or hours dynamics extending over years or decades, is more recent and less widely adopted. Yet these are precisely the settings where ... the stakes are highest. (p35).

Without the discipline and constraint imposed by the rigorous testing imposed by simulation, it becomes all too easy for mental models to be driven by ideology or unconscious bias. (p37).

System dynamics was designed specifically to overcome these limitations. ... As Wolstenholme (1990) argues, qualitative systems tools should be made widely available so that those with limited mathematical background can benefit from them. (p38).

Most important ... simulation becomes the main, and perhaps the only way you can discover for yourself how complex systems work. (38).

Thus endeth the reading for today.

As John Gall has pointed out so well, "Failure is our most important taboo."

I note that these thoughts of human limitations are what I call "volatile knowledge", in that, regardless how much sense these make to you right now, by next week they will have evaporated from your brain. Our minds do not like to be challenged, and killing the messenger is commonplace. If we look in history books, the largest event of 1918, the massive killer influenza, has almost entirely disappeared or been relegated to a single sentence, as if, oh yes, that year it rained a lot.

Like all beginning Instrument Pilots, most humans have a lot of trouble knowing how they should operate if it is true that their brains and eyes are routinely lying to them about what's going on and why. The resulting method used to resolve that conflict is to carefully erase and forget those inconvenient facts, and go back to trusting our senses.

In reality, both computer-aided simulation where available, and consultation with as wide and diverse a group as possible are the best protection we have against ourselves and our stubborn refusal to admit that we actually can't see very well ourselves, and what we do see is suspect, or should be.

Whether in religion or science, that core humility is the first step towards wisdom.