Theories in Economic and Finance
Dog walking theory (by Andre Kostolany)
- First Steps to Trading.
- André Kostolany.
- The Dog Walking Theory in Federal Learning: [2404.11888] The Dog Walking Theory: Rethinking Convergence in Federated Learning.
… As famous economist Andre Kostolany once said, the relationship between the stock market and the economy is like a man walking his dog. The dog follows his master, and yet is always ahead of him—just like the stock market is always ahead of the economy, because it’s role is to anticipate the future.
Efficient-market hypothesis
The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information.
Reflexivity (in economics)
- Economic philosopher George Soros, influenced by ideas put forward by his tutor, Karl Popper (1957), has been an active promoter of the relevance of reflexivity to economics, first propounding it publicly in his 1987 book The alchemy of finance. He regards his insights into market behaviour from applying the principle as a major factor in the success of his financial career.
Reflexivity is inconsistent with general equilibrium theory, which stipulates that markets move towards equilibrium and that non-equilibrium fluctuations are merely random noise that will soon be corrected. In equilibrium theory, prices in the long run at equilibrium reflect the underlying economic fundamentals, which are unaffected by prices. Reflexivity asserts that prices do in fact influence the fundamentals and that these newly influenced sets of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles.
An example Soros cites is the procyclical nature of lending, that is, the willingness of banks to ease lending standards for real estate loans when prices are rising, then raising standards when real estate prices are falling, reinforcing the boom and bust cycle. He further suggests that property price inflation is essentially a reflexive phenomenon: house prices are influenced by the sums that banks are prepared to advance for their purchase, and these sums are determined by the banks’ estimation of the prices that the property would command.
Soros has often claimed that his grasp of the principle of reflexivity is what has given him his “edge” and that it is the major factor contributing to his successes as a trader. For several decades there was little sign of the principle being accepted in mainstream economic circles, but there has been an increase of interest following the crash of 2008, with academic journals, economists, and investors discussing his theories.
Economist and former columnist of the Financial Times, Anatole Kaletsky, argued that Soros’ concept of reflexivity is useful in understanding China’s economy and how the Chinese government manages it.
Gresham’s law (Good Money)
- The law was named in 1857 by economist Henry Dunning Macleod after Sir Thomas Gresham (1519–1579), an English financier during the Tudor dynasty. Gresham had urged Queen Elizabeth to restore confidence in then-debased English currency.
- The concept was thoroughly defined in Renaissance Europe by Nicolaus Copernicus and known centuries earlier in classical Antiquity, the Near East, and China.
In economics, Gresham’s law is a monetary principle stating that “bad money drives out good”. For example, if there are two forms of commodity money in circulation, which are accepted by law as having similar face value, the more valuable commodity will gradually disappear from circulation.
Impossible trinity
- The concept was developed independently by both John Marcus Fleming in 1962 and Robert Alexander Mundell in different articles between 1960 and 1963.
The impossible trinity (also known as the impossible trilemma, the monetary trilemma or the Unholy Trinity) is a concept in international economics and international political economy which states that it is impossible to have all three of the following at the same time:
- a fixed foreign exchange rate
- free capital movement (absence of capital controls)
- an independent monetary policy
It is both a hypothesis based on the uncovered interest rate parity condition, and a finding from empirical studies where governments that have tried to simultaneously pursue all three goals have failed.
Historically in advanced economies, the periods pre-1914 and 1970–2014 were characterized by stable foreign exchange rates and free capital movement, whereas monetary autonomy was limited. The periods 1914–1924 and 1950–1969 had restrictions on capital movement (e.g. capital controls), but exchange rate stability and monetary autonomy were present.
Kondratiev wave
In economics, Kondratiev waves (also called supercycles, great surges, long waves, K-waves or the long economic cycle) are hypothesized cycle-like phenomena in the modern world economy. The phenomenon is closely connected with the technology life cycle.
It is stated that the period of a wave ranges from forty to sixty years, the cycles consist of alternating intervals of high sectoral growth and intervals of relatively slow growth.
Long wave theory is not accepted by most academic economists. Among economists who accept it, there is a lack of agreement about both the cause of the waves and the start and end years of particular waves. Among critics of the theory, the consensus is that it involves recognizing patterns that may not exist (apophenia).
Lipstick effect
The lipstick effect is when consumers still spend money on small indulgences during recessions, economic downturns, or when they personally have little cash. They do not have enough to spend on big-ticket luxury items; however, many still find the cash for purchases of small luxury items, such as premium lipstick. For this reason, companies that benefit from the lipstick effect tend to be resilient even during economic downturns.
Malthusian trap
Malthusianism is a theory that population growth is potentially exponential, according to the Malthusian growth model, while the growth of the food supply or other resources is linear, which eventually reduces living standards to the point of triggering a population decline. This event, called a Malthusian catastrophe (also known as a Malthusian trap, population trap, Malthusian check, Malthusian crisis, Point of Crisis, or Malthusian crunch) has been predicted to occur if population growth outpaces agricultural production, thereby causing famine or war. According to this theory, poverty and inequality will increase as the price of assets and scarce commodities goes up due to fierce competition for these dwindling resources. This increased level of poverty eventually causes depopulation by decreasing birth rates. If asset prices keep increasing, social unrest would occur, which would likely cause a major war, revolution, or a famine. Societal collapse is an extreme but possible outcome from this process. The theory posits that such a catastrophe would force the population to “correct” back to a lower, more easily sustainable level (quite rapidly, due to the potential severity and unpredictable results of the mitigating factors involved, as compared to the relatively slow time scales and well-understood processes governing unchecked growth or growth affected by preventive checks). Malthusianism has been linked to a variety of political and social movements, but almost always refers to advocates of population control.
Matthew effect
- The term was coined by sociologists Robert K. Merton and Harriet Zuckerman in 1968 and takes its name from the Parable of the Talents in the biblical Gospel of Matthew.
The Matthew effect of accumulated advantage, sometimes called the Matthew principle, is the tendency of individuals to accrue social or economic success in proportion to their initial level of popularity, friends, and wealth. It is sometimes summarized by the adage or platitude “the rich get richer and the poor get poorer”.
The Matthew effect may largely be explained by preferential attachment, whereby wealth or credit is distributed among individuals according to how much they already have. This has the net effect of making it increasingly difficult for low ranked individuals to increase their totals because they have fewer resources to risk over time, and increasingly easy for high rank individuals to preserve a large total because they have a large amount to risk.
Early studies of Matthew effects were primarily concerned with the inequality in the way scientists were recognized for their work. However, Norman W. Storer, of Columbia University, led a new wave of research. He believed he discovered that the inequality that existed in the social sciences also existed in other institutions.
Minsky moment
A Minsky moment is a sudden, major collapse of asset values which marks the end of the growth phase of a cycle in credit markets or business activity.
A Minsky moment is the onset of a market collapse brought on by speculative activity that defines an unsustainable bullish period.
Minsky moments generally occur after a long period of growth, which ultimately leads to overleveraging once prices stop rising.
Pareto efficiency (Pareto improvement)
- The concept is named after Vilfredo Pareto (1848–1923), an Italian civil engineer and economist, who used the concept in his studies of economic efficiency and income distribution.
In welfare economics, a Pareto improvement formalizes the idea of an outcome being “better in every possible way”. A change is called a Pareto improvement if it leaves everyone in a society better-off (or at least as well-off as they were before). A situation is called Pareto efficient or Pareto optimal if all possible Pareto improvements have already been made; in other words, there are no longer any ways left to make one person better-off, without making some other person worse-off.
In social choice theory, the same concept is sometimes called the unanimity principle, which says that if everyone in a society (non-strictly) prefers A to B, society as a whole also non-strictly prefers A to B.
The Pareto front consists of all Pareto-efficient situations.
In addition to the context of efficiency in allocation, the concept of Pareto efficiency also arises in the context of efficiency in production vs. x-inefficiency: a set of outputs of goods is Pareto-efficient if there is no feasible re-allocation of productive inputs such that output of one product increases while the outputs of all other goods either increase or remain the same.
Besides economics, the notion of Pareto efficiency has also been applied to selecting alternatives in engineering and biology. Each option is first assessed, under multiple criteria, and then a subset of options is identified with the property that no other option can categorically outperform the specified option. It is a statement of impossibility of improving one variable without harming other variables in the subject of multi-objective optimization (also termed Pareto optimization).
Paradox of thrift (Paradox of saving)
- It had been stated as early as 1714 in The Fable of the Bees, and similar sentiments date to antiquity. It was popularized by John Maynard Keynes and is a central component of Keynesian economics.
The paradox of thrift (or paradox of saving) is a paradox of economics. The paradox states that an increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower total saving. The paradox is, narrowly speaking, that total saving may fall because of individuals’ attempts to increase their saving, and, broadly speaking, that increase in saving may be harmful to an economy. The paradox of thrift is an example of the fallacy of composition, the idea that what is true of the parts must always be true of the whole. The narrow claim transparently contradicts the fallacy, and the broad one does so by implication, because while individual thrift is generally averred to be good for the individual, the paradox of thrift holds that collective thrift may be bad for the economy.
Ratchet effect
The ratchet effect is an economic process that is difficult to reverse once it is underway or has already occurred. A ratchet is an analogy to a mechanical ratchet, which spins one way but not the other, in an economic process that tends to only work one way. The results or side effects of the process may reinforce the cause by creating or altering incentives and expectations among participants.
A ratchet effect is closely related to the idea of a positive feedback loop. In addition, like releasing a mechanical ratchet used to compress a spring, the reversal of an economic process that involves a ratchet effect may be rapid, forceful, and difficult to control.
Scarring effects
Economic scarring refers to the medium-long term damage done to the economies of one or more countries following a severe economic shock which then leads to a recession.
Spontaneous order
Spontaneous order, also named self-organization in the hard sciences, is the spontaneous emergence of order out of seeming chaos. The term “self-organization” is more often used for physical changes and biological processes, while “spontaneous order” is typically used to describe the emergence of various kinds of social orders in human social networks from the behavior of a combination of self-interested individuals who are not intentionally trying to create order through planning. Proposed examples of systems which evolved through spontaneous order or self-organization include the evolution of life on Earth, language, crystal structure, the Internet, Wikipedia, and free market economy.
In economics and the social sciences, spontaneous order has been defined by Hayek as “the result of human actions, not of human design”.
In economics, spontaneous order has been defined as an equilibrium behavior among self-interested individuals, which is most likely to evolve and survive, obeying the natural selection process “survival of the likeliest”.