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The Equilibrium Accounting Identity

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The FCO blog discusses how the system approach allows one to develop diagnostic methods and predictions of crises.

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Why the crisis is going to continue as long as we expect financial investments to replace hard work to pay for our pensions and for better living standards.

Comment by Didier Sornette (16 April, 2010)

In a nice essay entitled "Why Active Investing Is a Negative Sum Game", Eugene F. Fama and Kenneth R. French in their forum (http://www.dimensional.com/famafrench/essays/why-active-investing-is-a-negative-sum-game.aspx) point out the "equilibrium accounting" identity: active investors who choose not to hold the market portfolio are necessarily underperforming as a group compared with the market portfolio. This is not open to discussion. This conclusion results from the definition of what is called the market portfolio, that is, the totality of all traded firms, weighed by their capitalization.

I would like to elaborate on an important consequence of this equilibrium accounting identity to understand the root cause of the crisis and how this bears on its resolution. There are so many discussions, works, brain-storming and efforts to find better ways to regulate, to manage, perhaps to diagnose and to control the financial system in order to get out of the problems, have the economy recover and prevent future crises.

I think that they are collectively and fundamentally misleading and misled. As a corollary of the analysis [1], it dawns on me that the core of the problem is us, in a collective sense. The core problem is our belief that active investments provided by pension funds, banks, mutual funds, hedge-funds and all the financial industry have the potential to out-perform naive static boring investments. But if GDP grows at, say, 2% per year after inflation, how can financial investments as a whole provide more return?  Believing that financial investment can give more than the growth of the global portfolio is a gross illusion, which I believe is shared by most of us, either consciously or unconsciously.  This is the illusion of over-optimism. This is the illusion of control. But it violates the fundamental equilibrium accounting identity and the fact that our collective wealth does not grow faster than (good measures of) GDP. As long as we, the people and the future retirees, hope for more return, we will provide the manure for the development of the species of parasites, called the banking and financial industry, that feed on our illusion and never ending hopes of easy gains.

A disclaimer: Having said the above, my team and I are actively engaged in developing methods to diagnose financial markets, and identify pockets of predictability. We thus participate in this race for beating the global market portfolio. This is so fun, such an extraordinary intellectual and practical challenge.  But we forget in doing so that this challenge is created by us, for us, and against us.

The consequences of this diagnostic are clear. Rather than focusing on the banking industry, which should be utterly de-fanged and dispossessed of its exorbitant privilege and rents, we should strive to increase productivity, human capital and knowledge in those sectors of the economy that produce real value.  There are so many challenges in the first half of the 21st century that this is an opportunity. I fear that calamities will be needed before we face and address the reality.


[1] Didier Sornette and Ryan Woodard, Financial Bubbles, Real Estate bubbles, Derivative Bubbles, and the Financial and Economic Crisis (2009), (http://arxiv.org/abs/0905.0220), to appear in the Proceedings of APFA7 (Applications of Physics in Financial Analysis). This conference series, organized by Misako Takayasu and Tsutomu Watanabe, focuses on the analysis of large-scale Economic data, (http://www.thic-apfa7.com/en/htm/index.html)

The Discount Rate Mismatch

http://baselinescenario.com/2010/04/19/discount-rate-mismatch/

 

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