RBA Rates Decision & Roy Morgan Unemployment

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The RBA's decision not to reduce rates this month caught most pundits by surprise—including me. Given the international and local data, I thought they'd err on the side of caution and cut rates.

As I always note when asked to call what the RBA will do next, this is a call on how another body will respond to what they perceive as the economic data and the direction their model of the economy predicts the actual economy will move in. That's closer to picking which cockroach is going to walk out of a circle first in a Changi prison gambling den than it is to economic forecasting per se (which is dubious enough activity in itself). So making a wrong guess about what the RBA will do is not the same as making a wrong economic forecast; you're just making a different forecast of the future than is the RBA.

The RBA's explanation for its decision shows that it is making a rosy call of both the current data and the direction in which the Australian economy is headed.

Information on the Australian economy continues to suggest growth close to trend… the unemployment rate increased slightly in mid year, though it has been steady over recent months… In underlying terms, inflation is around 2½ per cent… the Bank expects inflation to be in the 2–3 per cent range.

Credit growth remains modest, though there has been a slight increase in demand for credit by businesses. Housing prices showed some sign of stabilising at the end of 2011, after having declined for most of the year. The exchange rate has risen further, even though the terms of trade have started to decline … With growth expected to be close to trend and inflation close to target, the Board judged that the setting of monetary policy was appropriate for the moment.

As the Sydney Morning Herald editorialised, the RBA message was that the future looks good:

MOVE right along folks. Nothing to see here. By keeping interest rates on hold this week, the Reserve Bank is sending a subconscious message to borrowers: the economy is doing reasonably well. There is no need to panic…

Although we in NSW seem bogged Eeyore-like in our sad and dank little corner of the forest, glumly chewing our thistles day after day, perhaps we really ought to cheer up. Gloom is not just miserable in itself. When it comes to the economy, it's dangerous.

This is not the take that the majority of economic pundits have on the data—and for once, I'm with the majority. Normally the majority is bullish (because they have a Neoclassical perspective on the economy that largely ignores credit, and thinks the economy always returns to equilibrium) and I'm bearish (because I have a "Post Keynesian" perspective that sees credit as the key motive economic force, and believes the economy is always in disequilibrium).

The majority of economic pundits lined up with me for a change because there was a range of data that implied the economy was stalling. Firstly, unemployment has been trending up, and the "steady over recent months" phenomenon that the RBA referred to above was entirely due to a fall in the participation rate. Had this remained at the November level, the ABS unemployment rate would have jumped to 5.6% last month.

Figure 1

And that's the good news: as was widely reported, employment fell by almost 30,000 last month, so that net job growth in 2011 was zero—the worst outcome in 20 years.

Secondly, a broader measure of unemployment maintained by Roy Morgan Research hit 10.3 percent—5 percent above the ABS figure. The ABS treats someone who has worked for one hour in the previous two weeks as employed, a definition that Roy Morgan rightly rejects:

"Surely if someone is not working, is looking for work and considers themselves to be unemployed, then they should be considered unemployed regardless of whether they happen to have done a couple of hours work here and there during the month?"

The ludicrous official definition of unemployment is a classic case of bureaucracies (including the United Nations International Labor Organization in this case) eliminating a problem by redefining it rather than solving it. Many people have criticised this definition (including Peter Brain from the National Institute for Economic and Industry Research, who found that over a dozen official redefinitions of unemployment had all reduced the recorded level); since the late 1990s, Roy Morgan has gone one better and conducted a monthly survey using a definition of unemployment that actually makes sense:

" According to the ABS definition, a person who has worked for one hour or more for payment or someone who has worked without pay in a family business, is considered employed regardless of whether they consider themselves employed or not.

The ABS def­i­n­i­tion also details that if a respon­dent is not actively look­ing for work (ie: apply­ing for work, answer­ing job adver­tise­ments, being reg­is­tered with Centre-link or ten­der­ing for work), they are not con­sid­ered to be unemployed.

The Roy Mor­gan sur­vey, in con­trast, defines any respon­dent who is not employed full or part-time and who is look­ing for paid employ­ment as being unem­ployed. ” (Roy Mor­gan, Sep­tem­ber 2011)

Roy Morgan’s def­i­n­i­tion there­fore nec­es­sar­ily records a higher level of unem­ploy­ment than the ABS—and they are also a more legit­i­mate mea­sure of real unem­ploy­ment. How­ever their results are also more volatile, since their sam­ple is smaller than the ABS’s, and the results are not sea­son­ally adjusted.

Fig­ure 2

Over­all how­ever, Roy Morgan’s fig­ures are a more accu­rate indi­ca­tor of the level of unem­ploy­ment than the ABS’s, and also as a har­bin­ger of where the ABS data may move in the future. The cur­rent gap between the two mea­sures is the high­est it has ever been—over 5 per­cent, when the aver­age gap has been about 2.5 percent—and this implies that the next move in the ABS fig­ures could be sub­stan­tially upwards. Gary Mor­gan warned that the econ­omy is a lot weaker than the RBA seems to think:

Today’s Roy Mor­gan unem­ploy­ment esti­mates strongly sup­port anec­do­tal evi­dence of con­tin­u­ing job losses through­out Aus­tralia. Just in the past week we have been told that West­pac has announced 550 jobs to go; ANZ is axing 130 jobs; Holden will cut 200 jobs at its Ade­laide plant; Toy­ota will cut 350 jobs in Mel­bourne; Reckitt Benckiser (maker of Mortein & Det­tol) is to retrench 200 jobs at its Syd­ney oper­a­tions; defence firm Thales shed­ding 50 jobs in Bendigo — these are just the most promi­nent exam­ples of job losses occur­ring in the Aus­tralian economy!

Econ­o­mists and politi­cians are wrong to talk about a ‘tight’ labour mar­ket in Aus­tralia dri­ving wage pres­sures. Wage demands (infla­tion) at the moment are being dri­ven by unions — a small minor­ity of the Aus­tralian work­force — not by a tight labour mar­ket with work­ers chang­ing jobs to secure bet­ter wages and con­di­tions. Today’s Roy Mor­gan employ­ment esti­mates show why infla­tion in Aus­tralia is con­tained, and will remain con­tained — at its meet­ing next Tues­day the RBA must drop inter­est rates by at least 0.5% and prob­a­bly more.”

Fig­ure 3

 

If Gary Mor­gan is right, the RBA’s rosy fore­cast for the future will be shown to be in error. The pri­mary source of that error will be not merely mis­placed opti­mism, but reliance upon neo­clas­si­cal eco­nomic mod­els about the econ­omy that ignore the role of credit just at the moment that decel­er­at­ing credit is finally set­ting in in earnest in Aus­tralia, after being delayed by the First Home Ven­dors Boost.

Fig­ure 4

The First Home Ven­dors Boost was the sole cause of the rever­sal of delever­ag­ing in Aus­tralia after the cri­sis began, with the growth in mort­gages more than off­set­ting the reduc­tion in debt by the busi­ness sector.

Fig­ure 5

With that arti­fi­cial stim­u­lus to credit growth over, credit growth is now decel­er­at­ing in Aus­tralia, and caus­ing unem­ploy­ment to rise despite the off­set­ting impact of the resources boom.

Fig­ure 6

Mort­gage debt is now decel­er­at­ing strongly, and tak­ing house prices down with it.

Fig­ure 7

From its com­ment that “Hous­ing prices showed some sign of sta­bil­is­ing at the end of 2011″, the RBA appears to be buy­ing the RPData spin that a one month upwards blip in their data series after 11 months of decline sig­nals a bot­tom to the hous­ing mar­ket. How­ever a sim­ple com­par­i­son of house prices here to those in Japan and the USA after their bub­ble economies burst makes it hard to argue that “Aus­tralia is different”.

Fig­ure 8

Of course, at this stage it is too early to tell whether we’ll fol­low the long slow decline of Japan­ese prices, or the sud­den fall that marked the USA. But by the end of 2012, Australia’s house price decline pro­file should be apparent.

Fig­ure 9

About Steve Keen

I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
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74 Responses to RBA Rates Decision & Roy Morgan Unemployment

  1. Lyonwiss says:

    @ RJ Feb­ru­ary 11, 2012 at 10:33 pm

    I think you are an idiot just like me.

  2. Philip says:

    From what I gather about national account­ing iden­ti­ties, the pri­vate sec­tor will run a sur­plus equal to the gov­ern­ment deficit + cur­rent account surplus.

    The graph by Scott Full­wiler pro­vides a good illus­tra­tion of this.

    http://mmtwiki.org/wiki/National_accounting_identities_and_the_sectoral_balance_approach

    My ques­tion is this: does the account­ing iden­ti­ties take into con­sid­er­a­tion gov­ern­ment debt held by other sec­tors of the gov­ern­ment e.g. cen­tral bank, state and local governments?

  3. Steve Hummel says:

    Lyon­wiss,

    I would believe in some­thing only because I have NO choice but to believe in it.”

    But this is many times a false or delu­sional choice. For instance, today no mat­ter whether you believe in Amer­i­can cap­i­tal­ism or Euro­pean social­ist democ­racy you must believe in wage slav­ery. The false­hood is the ortho­doxy that you have cho­sen the most humane or in some way best sys­tem. The real­ity is that you’re sim­ply enslaved either way.

    Believ­ing in some­thing just because you feel that you are com­pelled to choose between avail­able alter­na­tives is surely a path to human mis­ery. This applies to eco­nom­ics as much as it applies to life in gen­eral: one wrong idea against another wrong idea.”

    Quite agree. The above exam­ple illus­trates this accurately.

    My point in the prior post how­ever, was that Man chooses. He’s a choos­ing being. If he doesn’t choose to base his ortho­doxy on uni­ver­sal human val­ues and ideas he will choose to base his ortho­doxy on eco­nom­ics and finance or some other lesser values.

    If he chooses in fact to say “I don’t know.” He’s cul­ti­vat­ing an open mind which is cer­tainly some­thing we need in today’s world which is fraught with false dualisms and ortho­dox­ies. But choice and choos­ing is ulti­mately not the prob­lem. It is inevitable. Sus­pend­ing belief until REAL choices are actu­ally considered.…that is a dis­ci­pline and a goal severely needed.

  4. Lyonwiss says:

    @ Philip Feb­ru­ary 11, 2012 at 10:49 pm

    For the national account­ing iden­ti­ties to hold empir­i­cally, all sources of gov­ern­ment debt would have to be included.

    In the last equa­tion (your link), the first two terms apply to a closed econ­omy, which is what fiat cur­rency fiends focus on, whereas the last term is the impor­tant one, in the real world of open economies.

    Sure, USD for­eign debt accu­mu­lated from cur­rent account deficits can be paid for by print­ing USD. But it is con­ceiv­able that one day, the US will be required to set­tle its cur­rent accounts in gold or some­thing, not USD. For exam­ple, Iran would want the US to pay for its oil imports in gold. That may explain why the US has been exer­cis­ing its “fiat” by wag­ing wars in the region.

    There is a par­al­lel in the 19th cen­tury, when China wanted sil­ver to set­tle trade bal­ances with Britain. Britain was run­ning out of sil­ver when it sent in the gun­boats to force China to accept opium imports, which were exported by the British from India. Clearly, the British cur­rency was irrel­e­vant to the Chi­nese then.

    The gold price is a mea­sure of the abuse of fiat cur­ren­cies. Every attempt has been made by author­i­ties to cap it in order to hide the fact. Much of the world of shadow econ­omy, money laun­der­ing, arms smug­gling, drugs, wars etc. lies out­side eco­nomic the­ory. War may be an inevitable con­se­quence of fiat money.

  5. RJ says:

    My ques­tion is this: does the account­ing iden­ti­ties take into con­sid­er­a­tion gov­ern­ment debt held by other sec­tors of the gov­ern­ment e.g. cen­tral bank, state and local governments?”

    No to cen­tral bank debt

    No I think to local Govt debt UNLESS (maybe) they raise the money direct from a bank rather than from the market.

    So if banks loan more this flows into profit for companies

    So if I loan 1 mil­lion from a bank to buy a house and the house seller buys local Govt bonds with this money. The key event is the increased bank lend­ing not the local Govt debt.

  6. RJ says:

    For exam­ple, Iran would want the US to pay for its oil imports in gold.”

    This will never hap­pen. Importers to the US will be paid in US dol­lars. If they then want gold (or any other asset) they will use the US dol­lars to buy gold or the appro­pri­ate asset. Very sim­ple. And some do this and other pre­fer to hold inter­est bear­ing bonds or maybe shares or prop­erty etc

  7. David Andrews says:

    Steve,
    Can you tell me where the data for the Aus­tralian real house price index comes from?

  8. Lyonwiss says:

    @ Steve Hum­mel Feb­ru­ary 12, 2012 at 6:11am

    I cer­tainly wouldn’t believe any­one with cock­sure opin­ions, as the truth is never as sim­ple as the text­book or the gov­ern­ment or the media presents. Here is some­thing (right or wrong) which sim­ple mon­e­tary the­ory does not even consider:

    http://www.financialsense.com/contributors/marin-katusa/petrodollar-iran-gold-what-you-need-to-know

  9. Philip says:

    Lyon­wiss,

    War seems to be an inevitable con­se­quence of the exis­tence of the nation state sys­tem regard­less of the type of finan­cial system.

  10. Lyonwiss says:

    @ Philip Feb­ru­ary 12, 2012 at 12:12 pm

    True, there are many rea­sons for war. But as my pre­vi­ous link sug­gests the recent wars waged by the US may be caused by the per­ceived need to defend the fiat-money, petrodol­lar system.

  11. Steve Hummel says:

    Lyon­wiss,

    I cer­tainly wouldn’t believe any­one with cock­sure opin­ions, as the truth is never as sim­ple as the text­book or the gov­ern­ment or the media presents.”

    Nei­ther would I, and thats not what I am say­ing or point­ing at.

    I’m say­ing that the philo­soph­i­cal roots of what­ever one believes in regard to eco­nomic, finan­cial or mon­e­tary the­ory must be aligned with one’s PERSONAL values.…..or there is illogic and result­ing cog­ni­tive dis­so­nance. The prob­lem with the world today is that we have gone on too long with the pri­mary pur­poses and val­ues of profit and/or work for its own sake. These are inad­e­quate ideas and val­ues to base a fully humane and Good soci­ety upon. For that you have to ACTUALLY and CONSCIOUSLY decide to base ALL of your sys­tems PRIMARILY (profit and work can be sec­ondary pur­poses in such a sys­tem) on uni­ver­sal ideas and val­ues like faith as in con­fi­dence, hope, love, grace and the inten­tion that the indi­vid­ual be free and empowered…not just the the sys­tems and their var­i­ous busi­ness, bank­ing or gov­ern­men­tal entities.

    We need to com­mitt to the re-assessment and align­ment of our sys­tems with these uni­ver­sal val­ues. Phi­los­o­phy is the proper begin­ning of every seri­ous endeavor. And that is also how you not only begin to actu­ally change soci­ety, but to change the entire par­a­digm of the eco­nomic, finan­cial and mon­e­tary systems.…economically from cyn­i­cism to con­fi­dence, from hope­less­ness to hope, socially from fear, lack of trust and reluc­tance to com­mitt, to love and all of its fruits, mon­e­tar­ily and eco­nom­i­cally from scarcity to recog­ni­tion of true and poten­tial abun­dance, finan­cially from once removed and deny­ing any con­cept of grace to direct con­sumer finan­cial dis­tri­b­u­tion based on a div­i­dend derived from one’s cul­tural her­itage of pro­duc­tive potential.

    The self actu­al­iza­tion of these val­ues, ideas and expe­ri­ences are restricted and even pre­vented by the par­a­digms of our cur­rent sys­tems. If we are want to con­tinue to evolve it is NECESSARY to make these changes.

  12. clive says:

    Phillip, “War seems to be an inevitable con­se­quence of the exis­tence of the nation state sys­tem regard­less of the type of finan­cial system”

    To retain their posi­tion of power most of them will stop at noth­ing. Look how suc­cess­ful Eng­land was for 100’s of years.
    Wars are usu­ally the last resort these days. So called free trade agree­ments WTO and copy write laws work well at the start, for any­one who might chal­lenge ‘author­ity’.
    Ter­rorisms a great con­trol mech­a­nism as well. Fear works won­ders to gal­vanise your pop­u­la­tion against the ‘Bad Guy’.
    These days I think it may have even gone beyond sov­er­eigns, multi nation­als only need to keep their oper­a­tions near the cur­rent power base, from there that can use lever­age to ensure the sov­er­eign will use any means at their dis­posal to ensure the cor­po­ra­tions sur­vival. Per­fect sym­bi­otic relationship

  13. mahaish says:

    cen­tral bank debt is the wrong ter­mi­nol­ogy me thinks

    the cen­tral bank deals in trea­sury debt .

    the cen­tral bank is the dealer and account holder that man­ages trea­sury account oper­a­tions both within and out­side the money supply

    it could con­ceiv­ably issue its own secu­ri­ties depend­ing on the reg­u­la­tory environment

    but

    cen­tral bank lia­bil­i­ties are bank and non bank assetts

  14. RJ says:

    Mahaish

    Agree. And this is the key

    cen­tral bank lia­bil­i­ties are bank and non bank assetts”

    Although by non bank I assume you mean Govts.

    The cen­tral bank is the banks and mon­e­tary sov­er­eign Govts bank. I know at times other com­pa­nies can have a cen­tral bank reserve bal­ance (not bonds) but this rarely hap­pens I believe

    But cen­tral banks do not issue our money

    So if a cen­tral bank (say from QE)

    DEBITS Com­mer­cial bank loan (or Govt bond account)
    CREDIT Com­mer­cial bank reserve account

    It makes no dif­fer­ence to our money in cir­cu­la­tion. Only Govt debt and bank debt increases or decreases does this.

  15. RJ says:

    http://www.financialsense.com/contributors/marin-katusa/petrodollar-iran-gold-what-you-need-to-know

    This arti­cle seems plau­si­ble but is total garbage

    The rea­son peo­ple hold US dol­lars is due to high US Govt deficits

    High deficits = lots of US bonds = an asset for peo­ple to invest in and also = money for US cit­i­zens to pay for imports.

    The prob­lems at present is far too lit­tle money. Or more cor­rectly far too lit­tle Govt debt (from deficits) worldwide.

    Peo­ple need money and then assets to invest in to save for their retire­ment. This can only come from Govt deficits and then Govt debt (as non Govt debt can­cels out).

    The US is one of only a few coun­tries prov­ing Govt debt. Over­all though Govt debt is grossly inad­e­quate hence our cur­rent problems

  16. RJ says:

    cor­rec­tion

    few mon­e­tary sov­er­eign coun­tries pro­vid­ing large safe quan­ti­ties of Govt bonds (from Govt deficits and debt) for the worlds savers to invest in.

  17. alainton says:

    Excel­lent article

    The math­e­mat­i­cal equa­tion that caused the banks to crash

    http://www.guardian.co.uk/science/2012/feb/12/black-scholes-equation-credit-crunch

    By Ian Stew­art a pro­fes­sor of Math­e­mat­ics — not overly dumbed down and makes the right con­clu­sion about volatil­ity and the need for a new eco­nom­ics based on com­plex­ity science.

  18. clive says:

    Alain­ton, That’s an inter­est­ing article

    At the fore­front of these efforts is com­plex­ity sci­ence, a new branch of math­e­mat­ics that mod­els the mar­ket as a col­lec­tion of indi­vid­u­als inter­act­ing accord­ing to spec­i­fied rules

    Note, ‘spec­i­fied rules’ and that’s where the prob­lems start,

    we:

    Change the rules
    Break the rules
    Ignore the rules
    Intro­duce new rules (only in some juris­dic­tions and not oth­ers)
    In some areas there are no rules because we are invent­ing and intro­duc­ing new prod­ucts before the reg­u­la­tors can make them.
    To fix the last point we then for­get the rules and intro­duce self reg­u­la­tion, which in effect brings us back to no rules.

    Finally to pacify those few who feel things might be get­ting out of hand the reg­u­la­tor informs us that things are fine, this is the great mod­er­a­tion it’s all in equilibrium.

  19. mahaish says:

    inter­est­ing arti­cle re iran,

    heres a prediction ,

    i think the ira­ni­ans will have their hands full sort­ing out their own squables to worry about any­thing else.

    the same forces that bought gadafi undone and now threaten to undo asad and just about everyother feu­dal ves­tige in the mid­dle east will cast its shadow over the ayoto­lahs of iran.

    theoc­ra­cies are just as much under threat as dic­ta­tor­ships and monar­chies in the mid­dle east.

    but the bal­ance of power between mod­ernist and tra­di­tion­al­ists in iran will be poised on a knife edge as this decade passes into the next. the power of money verses the power of reli­gious zenophobia.

    within the next 20 years, rev­o­lu­tion , counter rev­o­lu­tion, fol­lowed by zeno­pho­bic nation­al­ism. iran may well get its own napolean or hitler. and then the mid east will go to hell in a handbasket.

    we only need to study the french rev­o­lu­tion and the chain reac­tiuon it caused in the col­lapse of the euro­pean power stuc­ture in the fol­low­ing 150 years to under­stand this.

    the amer­i­cans will obvi­ously see the demise of the aya­tol­lahs as good thing, and they will do all they­can to assist in the demise. but they should be care­full for what they wish for.

    replac­ing tired old men who rat­tle their sabres with young angry true believ­ers who see the per­sians as the right­full mas­ters of the mid east may not be a good idea

    any­way i dont think we have a choice in the mat­ter, because i dont think a peac­full solu­tion in iran can be found

  20. mahaish says:

    the petro dol­lar sys­tem is only part of the rea­son as to what under­pins the value of the US dollar.

    despite the machi­na­tions of forex mar­kets, they usu­ally get dragged back to fun­da­men­tals eventually,

    and that is,

    the exter­nal value of the cur­rency is depen­dent on the inter­nal value of the currency.

    domes­tic demand and the domes­tic employ­ment and wage rates dri­ves the value of the cur­rency and drive cap­i­tal flows

    so as long as amer­i­can spend­ing power is main­tained in its sov­er­eign cur­rency and it is will­ing to run an exter­nal deficit with the rest of the world, for­eign­ers have no choice but to accumi­late dol­lar assetts thus main­tain­ing the demand for the dollar

    the amer­i­cans still have the largest econ­omy in the world and
    amer­i­cans have to pay their taxes in green­backs, and if for­eign­ers want to do busi­ness with amer­i­cans they have to do busi­ness in greenbacks.

    petro dol­lar or no petro dollar

    right now the amer­i­can con­gress seem hell bent on sab­o­tag­ing their sys­tem through var­i­ous arbi­trary con­straints to the trea­sury and debt ceil­ing, but this does not deny the fun­da­men­tal power they have with their sov­er­eign currency,

    which can be used to drive invest­ment and sav­ing, and hence exter­nal cap­i­tal flows

  21. Alan Gresley says:

    I won’t make a full com­ment yet. Just a cor­rec­tion. The link for unem­ploy­ment with the text “Roy Mor­gan, Sep­tem­ber 2011″ is to a Roy Mor­gan poll from Sep­tem­ber 2001.

    There is one in 2011,

    http://www.roymorgan.com/news/polls/2012/4742/

    and two in 2012.

    http://www.roymorgan.com/news/polls/2012/4730

    http://www.roymorgan.com/news/polls/2012/4742

  22. Lyonwiss says:

    @ Alain­ton Feb­ru­ary 12, 2012 at 9:10 pm

    I admire Ian Stewart’s books on cas­tro­phe the­ory and chaos, which helped my early edu­ca­tion a cou­ple of decades ago. But he is totally out of his depth here on the role of Black-Scholes in the cause of the bank­ing crisis.

    Black-Scholes is only a part of the efficient-market, uni­ver­sal equi­lib­rium, neo­clas­si­cal eco­nomic par­a­digm. Samuel­son had an option pric­ing for­mula, also based on Bache­lier random-walk, which had two para­me­ters, instead of one, as in Black-Scholes. Only one para­me­ter is needed, if you assume no-arbitrage equi­l­brium. This was thought to be a “break­through” in Black-Scholes, but I beg to dif­fer. Sim­plic­ity was pre­ferred over accuracy.

    The key point here is Black-Scholes was NOT pre­ferred because it was deemed to be the most accu­rate. There­fore, being “wrong” or inac­cu­rate in cal­cu­la­tion is not the issue in the cause of the cri­sis. In fact, most traders use their own mod­i­fied ver­sions of option pric­ing and the Black-Scholes is used as a bench­mark, rel­a­tive to which over-pricing and under-pricing is esti­mated. Hence to say the world trades on Black-Scholes is sim­ply not factual.

    Black-Scholes is based on a par­tial dif­fer­en­tial equa­tion, which is a multi-variate ver­sion of ordi­nary dif­fer­en­tial equa­tions, for which most finance and eco­nomic grad­u­ates are ill-prepared, as Steve has pointed out before. Math­e­mat­i­cally, it is straight-forward, but beyond the abil­ity of most peo­ple in the finan­cial mar­kets. So sell­ing finan­cial engi­neered prod­ucts is treated no dif­fer­ently to sell­ing elec­tronic engi­neered pprod­ucts, like your flat-screen TV: you don’t have to know how they work.

    But there is one impor­tant dif­fer­ence: if you TV doesn’t work, you soon know about it, whereas if your OTC deriv­a­tive doesn’t work, you will know about it only when it “blows up”. In a some­what over-simplified expla­na­tion, this is how deriv­a­tives are cre­ated and sold in the mar­kets for mort­gage back secu­ri­ties, CDOs, CDS etc. which led to mar­ket fail­ure when unex­pected losses were realized.

    It is ulti­mately human greed, cor­rup­tion and incom­pe­tence, not some mis­un­der­stood math­e­mat­i­cal equa­tion which caused the bank­ing cri­sis. As usual, the cause is that cor­rupt or incom­pe­tent peo­ple were in charge.

  23. alainton says:

    @lyonwiss

    I think you miss why Black-Scholes was ini­tially so widely taken up — it was tractable on a pro­gram­ma­ble cal­cu­la­tor — unlike its predecessors.

  24. alainton says:

    One for the Tea Shirts

    Econ­o­mist Jus­ton Wolfers gained some noto­ri­ety last week my shout­ing out at Greg Mankiw ‘Thats bol­locks Greg’ in class — but what was the issue?

  25. Lyonwiss says:

    @ Alain­ton Feb­ru­ary 12, 2012 at 11:10 pm

    No, bench­mark­ing is the main rea­son, because most traders used printed tables any­way even with Black-Scholes in the 70s. Pro­gram­ma­ble calu­cla­tors came later in the 80s.

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