Booms & Busts Law of Diminishing Returns

The Law of Diminishing Returns

This article by Niall Ferguson a noted British economic histrian is an interesting read from the Sunday New York Times magazine. He places the global economic crisis in the historical context of the law of dinishing returns.  In not so many words, what he is saying in succinct context is that as the size, complexity and factors of the ‘boom & bust’ cycle of an economic system expands, then contracts over time that the expected rate of returns of the ‘boom’ diminishes each time, and the negative shock of the ‘bust’ gets greater each time.  By parallel, this also results in declining investor confidence in the global markets over time as the complexity and reasonsing for the explanation of ‘why it happend’ expands or becomes more creative (some — myself included — would say in denial) by bankers, traders and Wall Street insiders.  Interesting stuff. . .

If financial crises were distributed along a bell curve — like traffic accidents or people’s heights — really big ones wouldn’t happen very often. When the hedge fund Long-Term Capital Management lost 44 percent of its value in August 1998, its managers were flabbergasted. According to their value-at-risk models, a loss of this magnitude in a single month was so unlikely that it ought never to have happened in the entire life of the universe. Just over a decade later, many more of us now know what it’s like to lose 44 percent of our money. Even after the recent stock-market rally, that’s about how much the Standard & Poor’s 500 index is down compared with October 2007.

For reasons to do with human psychology and the failure of most educational institutions to teach financial history, we are always more amazed when such things happen than we should be. As a result, 9 times out of 10 we overreact. The usual response is to introduce a raft of new laws and regulations designed to prevent the crisis from repeating itself. In the months ahead, the world will reverberate to the sound of stable doors being shut long after the horses have bolted, and history suggests that many of the new measures will do more harm than good. The classic example is the legislation passed during the British South-Sea Bubble to restrict the formation of joint-stock companies. The so-called Bubble Act of 1720 remained a needless handicap on the British economy for more than a century.

Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Read more here.