Funny article, epistemic arrogance strikes yet again...

For those non financial gurus here is your background:
CDS are credit default swaps. They are over-the-counter (private) insurance policies. They are usually purchased to insure against defaults on bonds. So it you were a good portfolio manager you could buy bonds from France, and for a fee insure them against default (from AIG). The problem is disasters are systemic and are caused by other disasters and will create bigger ones. So even though AIG could aford to pay if Fench bonds defaulted, the road that led to that catastrophe (global depression, 100 other countries defaulting first) would mean that AIG could not pay and thus under-estimated the risk of such event. Catastrophes do not occur in a vacuum. Being able to price risk like this means you have to understand the most complex system on the planet... the global economy and only the most arrogant think they can.

http://www.zerohedge.com/article/fed-proposed-become-next-aig

I'm always frustrated when people try to understand systems, whether it be an ecosystem or a market, in anthropomorphic terms. Dramas make us feel at home in the universe, but they don't add any genuine understanding.

While earlier societies saw the gods behind all events, today we're very quick to conjure up boogeymen when events do not unfold to our liking. We like to imagine there are just a few Montgomery Burns-type characters pulling the strings for everything. Journalists love pouring gasoline on a fire, using wrong terms for an economic analysis -- just as realtor altruism doesn't explain why the housing prices are falling, it would be a mistake to claim greed is causing healthcare premiums to rise.

For example, I recently had a discussion with my ISTJ father and INFP brother about this stuff. They both hate corporations, believing they're agents of evil out to plunder and exploit everyone. Supposedly government is the only institution protecting us from corporate rapacity. Okay, I asked, how do you explain your incomes being well over the minimum wage? Of course, corporations would like to pay them a dime an hour, but that wasn't the point, because competitive considerations involving supply and demand determine prices, including wages and salaries, not greed and altruism. My Dad, of course, thinks supply and demand is "just a theory" (which is true but trivial-- evolution, electro-magnetism, and atoms are theoretical too), while my brother somehow believes the loss-motive is more noble than the profit-motive, without the imagination to see what misery the loss-motive creates when universally applied.

--Jason

My Dad, of course, thinks supply and demand is "just a theory"

I've only taken one economics class (the 100 level, most basic intro one at college, lol), but the teacher for it was quite, quite good (he's a legend on campus). One of the best things he could do was that he would run "experiments" in class to show economic theories in practice. The first one we did was on supply and demand. We split into groups of 3, and he handed out production costs the selling groups, at varying values. He then did the same thing with the sellers, except with monetary redemption values, supposed to indicate varying levels of enjoyment on the part of the person buying the good. He then turned the class into a free for all, and said "offer anything, to buy or sell, that you want, and if anyone else in the class accepts, then the trade is made." The buyers would make (transaction price) - (production cost) in profit, and the buyers would make (redemption value) - (transaction price) in profit, with the goal obviously being "make as much money as possible". There were also prizes for real money involved (over the course of the whole year, so they weren't all luck-dependent), so the students had some incentive to make as much as possible.

It was really pretty phenomenal to watch. As far as I can tell, the only thing that separated it from a real market was the fact that every group could hear every single price offered, and whether it was successful... which isn't really realistic, in the real world. We also did the experiment twice, so that the second round would include peoples' prior knowledge of the market, and how much goods usually cost. In this massive lecture hall, though, the supply and demand prediction got "how many items transacted" within about 3-4 (out of 45 or so), and "average price" within about 10 cents (on the scale of $1.50 or so) in the first round, and within 1 unit and right on the equilibrium price in the second round.


It's a great way to shut people up who are skeptical. I'm sure hundreds of other factors go into defining a price and quantity transacted in a real market, but it (and a later experiment, where they messed with the costs/redemption values a bit) illustrated the trends of how less supply raises the price, and less demand lowers it, and stuff like that, really well.