Chaos Theory in Financial Markets

Chaos theory attempts to explain the fact that complex and unpredictable results can and will occur in systems that are

Chaos Theory (film)

sensitive to their initial conditions. A common example of this is known as the Butterfly Effect. It states that, in theory, the flutter of a butterfly’s wings in China could, in fact, actually effect weather patterns in New York City, thousands of miles away. In other words, it is possible that a very small occurrence can produce unpredictable and sometimes drastic results by triggering a series of increasingly significant events.

Lets try to figure it out with Capitalism at a Cross Roads :

Here is the Preface

The Fed’s Dual Mandate and the Birth of Crybaby Capitalism: finding the butterfly

1)  A state of whining and miserable self-centered avarice,

2) The antithesis of Masters of the Universe,

3) A psychotic state suffered by free market participants when overfed a steady diet of cheap money.

Jim Cramer, the original poster boy for crybaby capitalism. The fact that he feels empowered to scream and rant about the need for the Fed to cut rates and save his friends’ jobs would be comical if it weren’t so pathetic. Jim Cramer is a good showman and has a reasonably good research firm, directed at stock picking. He has an amazing knowledge and memory of individual companies and is an accomplished advisor to small investors. He is also, however, the archetype of a generation of Crybaby Capitalists fed an ever increasing diet of cheap money by the Fed – which has been desperately trying and miserably failing to answer multiple and contradictory mandates.

The Great Recession is a rolling disaster that the world economy seemingly stumbled into in the spring of 2008 and continues most colorfully today with the slow motion train wrecks of monetary policy in the United States and the collapsing Euro. This rolling economic Verdun was born many years before in a series of ill-conceived and poorly understood policy initiatives championed by consumer advocates and industry groups alike. These reforms – generally characterized as deregulation – were targeted at the seemingly laudable targets of risk mitigation and fairness, and categorically achieved just the opposite.

Each of these examples is a terrific case study of chaos theory at work. In chaos theory, a small action/change in a complex/dynamic system can have enormously disproportionate impact in the future. The classic example is posited by Lorenzo in his 1972 paper, Predictability: Does the Flap of a Butterfly’s Wings in Brazil set off a Tornado in Texas? What is most important to remember here is that chaos theory is very sensitive to initial conditions, and unpredictable beyond very short periods of time. For those making economic policy this requires a constant vigilance for the undesirable unintended consequences of policy changes – clearly the butterfly did not intend the tornado.

The Fed set out on its dual mandate in 1987, and has been futilely pumping excess liquidity into the economy ever since, hoping to promote economic nirvana, and got a bunch of crybaby capitalists instead. These guys need ever increasing injections of cheap money, much like a junkie needs his fix. As in Japan before and Europe now, we’ve reached the point where money can’t get cheaper, the babies are crying, and the economy is stuck in the mud. No amount of economic chicanery is going to pump this economy up through the chasing of the dual mandate. Can you hear the butterfly wings flapping yet?

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