We can't predict anything in financial markets, let's stop fooling ourselves and the public

Throw some sand in the wheels of speculation
Sand in the Gears. Image by JFabra [de nuevo en América Latina

The illusion that unregulated markets produce largely stable economies has been burst by the current set of overlapping national economic and macroeconomic crises. The expectation that trading financial assets (like bonds, stocks, and exotic investment products) was worth more to an individual than actually making something in the real world has been temporarily dashed, and that's a good thing.

Writing about the current US recession in the Houston Chronicle, Prof. Joe McCauley, a physicist, explains why the US economy is in the doldrums and why a simple injection of credit to markets won't be enough to solve the problem:

"But merely making credit available via bailouts is not  the answer, and would only return us to the same path we’ve followed for decades. One cannot live well from borrowed  money over the long haul, production and exports are necessary for prosperity. Unregulated markets have led us into the trade deficit and recession. "

Unregulated markets, such as those for derivatives, allowed the expansion of financial products with no basis in the real economy. Take a mortgage. That's a piece of debt (what you, the punter, owe the bank), and that debt can be sold on. If something goes wrong with the future stream of payments you the punter are supposed to hand over over the next 30 years, then at least there is a house to sell to recoup some of the money. So the debt is 'secured', in some sense, to the real world.

The new financial products developed since the high mathematisation of finance (we're talking about a product pricing the probability of the probability of a default, and so on) are unsecured, in the sense that they are not anchored in any sense to the real world. This produces dramatic wealth, but it's a mathematical fiction, as the real world needs real goods and services rather than abstruse mathematical concepts.

Prof. McCauley speculates that

"The mathematization of finance has played a very strong role  in the crash because banks and trading houses completely  failed to worry about liquidity. It was a typical bubble atmosphere inside the boardrooms and trading rooms. "

Where can we go from here? First, we need a return to job creation policies which restore real world wealth creating industries. Second, taxes must rise to allow government spending to enact these policies without undue borrowing. Third, the regulation of financial markets must take place on a grand and international scale, to put, as James Tobin once suggested "sand in the cogs" of the global financial order. Simple percentage taxes on financial transactions would be sufficient, but if the regulation is not enacted globally, then the resultant flight of capital to less regulated  markets will perforce bankrupt the nation.

The stakes are so high, predictions and models of financial behaviour in this situation would be most useful. But they're useless.

In a new paper, published in the International Review of Financial Analysis, McCauley et al produce an analysis of the predictability of simple derivative markets. They find, surprisingly, that markets which are more or less in equilibrium (statistical equilibrium) are generally very hard to beat, which replicates the celebrate findings of Fama and French, but not in the manner Fama and French would approve of.

Statistical analysis of past recessions cannot be used as a guide to what we should now do

Read the paper here to find out how.