Alice’s Adventures in Equilibrium

I daresay you haven’t had much practice. Why, sometimes I’ve believed as many as six impossible things before breakfast.

– The Queen, Alice’s Adventures in Wonderland, Lewis Carroll

Coherent thinking is interested in how things are related; where they come from, where they go, and the mechanisms by which they affect each other. Incoherent thinking is a world of magic, loose theory, and superstition; where things pop into existence, vanish without a trace, and are somehow related without any need to carefully describe cause and effect.

Much of what passes for economic and financial analysis is incoherent. I’ve chosen that word carefully. The problem is not that the beliefs of investors are “less true” than they think. It’s that many of the most commonly repeated phrases don’t mean anything close to what investors think they mean. It’s that many of these belief systems are inconsistent, confused, or rooted in false premises. They are incoherent in the same way that it’s incoherent to debate how many pine trees are planted at the edge of the earth, how many aardvarks you need to start a thunderstorm, or how the gold coins in the pot at the end of the rainbow are invested.

That’s not to say that incoherent beliefs have no impact on the markets. But it does mean that the speculative market impact is entirely the product of what Buddhists might call “mental formations” that may not, and need not, have anything to do with reality, and leave investors vulnerable because of it.

Equilibrium is like conservation of mass

The most frequent way that investors come to believe in impossible things is that they fail to impose “equilibrium.” They neglect to examine how output and securities come into existence, the arithmetic that dictates how they have to add up, and who ends up with what after each exchange. They imagine that what might be true for an individual investor or sector must also be true for the financial markets or the economy as a whole.