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Crash 2012: The Sunspots Are Coming ...

Tuesday, September 20, 2011 11:53

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Spurious Predictions

Next year will, scientists predict, be the peak of the current sunspot cycle, when the Earth will be blasted by electromagnetic waves emanating from the Sun, disrupting communications networks, destabilising power grids and causing an almighty market crash as panicked investors head for the hills. Although presumably they’ll leave their battery powered cars at home.

Of course, if that turns out to be true I’ll claim I’m prescient and if it doesn’t, well, then it’s a deft attempt at irony. The effects of sunspots, however, are very real indeed and, for reasons we shall now analyse, the worst affected people appear to be economists.

Extrinsic Uncertainty

As we probably all know the Sun, our guiding light, is afflicted by a condition known as sunspots, strange blemishes on its otherwise pristine surface. These marks, though, have come to stand not just for an astronomical observation but for an economic condition referred to as “extrinsic uncertainty”, essentially an event external to markets which causes a financial crisis.

An extrinsic variable is any deemed to be outside of the scope of the markets: anything which does not directly impact the fundamentals of the market, and the shorthand of “sunspot” is used as the example of an event which, by definition, is not just outside of the markets but also outside of our planetary orbit and about which, therefore, the markets should be neutral assuming that they’re rational. The only problem is that actually this is a really good example of why economists shouldn’t use terms they don’t understand to describe behaviour that think they ought to.

Galileo and the Comfy Chairs

In modern times it’s Galileo who is most associated with the discovery of sunspots, although they seem to have been independently identified by three or four astronomers at around the same time. This sudden flurry of solar discovery was not unconnected with the invention of the telescope, another invention not unrelated to the interests of the markets, being seized upon by traders anxious to be the first to spot returning merchant ships. The medieval equivalent of high-frequency traders, so to speak.

It was definitely Galileo, however, who figured out that sunspots were actually blemishes on the sun’s surface rather than, say, shadows being cast upon it by planetary objects, and that they were rotating along with that surface: a discovery he seized upon as evidence that Copernicus’s heliocentric system was correct. Through a combination of scientific exactitude and pig-headed stubbornness this led inexorably to the Pope’s minions placing him under house arrest after what appears to have been the equivalent of being threatened with Monty Python’s comfy chairs – there’s certainly no evidence he was ever really in any danger of being tortured, as the legends have it.

Eventually the Catholic Church admitted that, ahem, it had possibly got this particular call wrong, and reversed the sentence. Sadly this was fairly moot, as far as Galileo was concerned, because it didn’t happen until 1991, a mere 400 hundred years or so after his death. And, although the Church was going to make up for the mistake by erecting a really nice statue of him in the Vatican, they’ve now decided this was rather rushing his rehabiliation and have quietly shelved the idea.

Economic Consequences of Sunspots

Investigations into sunspots then rather meandered about for a few hundred years, although a few observers noted that they seemed to follow some kind of periodic behaviour, flaring up and then dying down again, without actually being able to formulate a theory to explain this. As ever, though, the absence of proof of an idea has never stopped economists from latching onto a good metaphor and back at the end of the nineteenth century Stanley Jevons, who we’ve met before in Economics and Psychology: The Divorce, when economists started to build their theories based on an inadequate understanding of thermodynamics, decided that the lack of evidence of a connection between sunspots and the Earth’s climate wasn’t enough to stop him proposing an economic theory based on that very idea. You might note a bit of a theme emerging there.

Anyway, in The Periodicity of Commercial Crises, and its Physical Explanation, Jevons managed to find a period of 10.44 years between financial crises, and identified a cause:

“Merchants and bankers are continually influenced in their dealings by accounts of harvests, the comparative abundance or scarcity of goods; and when we know there is a cause, the variation of the solar activity, which is just of the nature to affect the produce of agriculture, and which does vary in the same period, it becomes almost certain that the two series of phenomena – credit cycles and solar variations – are connected as effect and cause”.

Jevons henceforth manages to blame sunspots on everything from the South Sea Bubble to variations in the price of Cornish tin. Of course, it’s easy to laugh at such ideas now, but the trouble is that there’s a tiny bit of truth in them …

The Maunder Minimum

In 1976, at just about the same time the Church was beginning to have second thoughts about whether Galileo might possibly have been right after all, John Eddy published a paper on the relationship between sunspots and the Earth’s climate. In particular he was able to validate the ideas of Edward Maunder, who believed that a falloff in sunspot activity was correlated with a drop in the Earth’s temperature. The Maunder Minimum is the term now used to describe the period between 1645 and 1715, otherwise known as the Little Ice Age. Eddy’s research has had confirmation from a variety of sources, not least Hans Neuberger’s innovative study of weather in paintings.

Of course, just as scientists were beginning to give some credence to the idea of sunspot activity correlating with the Earth’s climatic conditions, and hence offering a path for direct economic impacts, economists started using the term “sunspot” as a derisive reference to events external to the market that were supposed to have an economic effect, but didn’t. The reason for this was that they’d become intoxicated with the rational expectation theory of markets, aka the efficient markets hypothesis: so that the idea that events external to the markets could impact prices was “obviously” wrong.

The Crash of 2012

This is, of course, genius. Firstly Jevons decides that sunspots predict economic activity on no evidence at all and then when science finally does come up with some evidence that he might have been accidentally correct the economists ignore it and decide he wasn’t.

In fact we now know definitively that sunspots do have an impact on the Earth, and flare ups in sunspot activity can knock out communications systems, while periodic decreases in their magnitude can lead to prolonged changes in planetary temperatures and climates. The next maximum is due next year, in 2012, and is predicted to be a whopper. Previous surges in activity have seen communications networks and electricity grids fail, so the idea that a sunspot maximum can have a significant short-term economic impact is not at all far-fetched.

Fundamentals and Sunspots

Over time, the economic understanding of sunspots has also advanced, and it’s now accepted that extrinsic uncertainty – events external to the markets – can have pricing consequences regardless of fundamentals. As John Duffy and Eric Fisher state:

“We are the first to provide direct evidence that extrinsic uncertainty can be an important source of volatility in real markets. Furthermore, we have shown that the efficacy of sunspot variables in coordinating expectations depends on the flow of information, and this finding has obviously important theoretical implications.”

In essence, “animal spirits” do cause volatility and this volatility means that market prediction is just about impossible. As the researchers explain, a completely ridiculous idea like the Super Bowl Effect, where the conference of the winners of the trophy can predict the subsequent direction of markets, can be explainied as an economic sunspot – if enough people know about it and believe it to be true it becomes a self-fulfilling prophesy.

Back in the real world, the economic consequences of real sunspot maxima are unlikely to be long-lived, although temporary insanity amongst investors is always a possibility. No change there, then. A more serious issue might be a collapse in sunspot activity as during the Little Ice Age – that might put a whole new spin on the problems of global warming. Nonetheless, we should continue to take a sceptical view of the premise that Galileo’s sunspots are going to seriously damage our economic prospects, and an even more cynical one of economists who start theorising without first mastering their data.

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