economic theory

     We have in the US energy policy regarding ethanol an illustration of the classic problem in economics which I like to call "too many balls in the air".  When it comes to economic thinking and analysis, individuals or groups with "skin in the game" tend to focus tightly on the single variable they want to improve (like the corn price in the case of ethanol) and fail to understand that markets are complex interactions of sometimes hundreds of linked transactions and markets all of which can and usually are affected by extra-market interventions to move the target variable.  There are economic models that can and do attempt to account for all of these impacts simulataneously and track the movement to a new equilibrium in all affected markets but they can be large and clumsy and not very good at tracking the short term movements to new long term equilibria.

With the news that the EU is officially in recession and all of the signs point to the same thing for the U.S., the swine industry in the United States is facing a critical challenge related to demand.  After more than a decade of continuous growth in demand for U.S. pork, the industry is likely to face the inevitable leveling off or much more likely, a decline in demand for 2009.  Some are forecasting up to 10% less exports for 2009.  As the EU and the US enter recession, demand for consumer goods has already begun to fall, in some cases at record month over month rates. 

As we watch the markets throughout the world plunge trying to find a trading range, we are witnessing the global market reset to economic fundamentals.  Before you think this is unambiguously bad (the reset) consider that this entire event spanning the last two to three years was set in motion by government policy actions and the flood of liquidity beginning after the September 11th attacks.  The market is simply correcting now what government policy actions have caused, a massive destruction of the mirage of paper wealth they created.

Economists often make the distinction between risk and uncertainty. When they do, most people think they are splitting hairs just for their own personal amusement. This kind of thing gives rise to my favorite definition of economics: "Common sense made difficult".

However, what we are seeing on display in the equity markets is a classic example of the distinction. Risk is normally defined as the likelihood of a negative outcome upon which a probability can be assigned. Uncertainty on the other hand exists when outcomes are out there to which no probability can be reasonably assigned.