## Time

8 Jul, 2019 at 10:49 | Posted in Economics | 2 Comments

Time is what prevents everything from happening at once. To simply assume that economic processes are ergodic and concentrate on ensemble averages — and hence* *in any relevant sense timeless — is not a sensible way for dealing with the kind of genuine uncertainty that permeates real-world economies.

Ergodicity and the all-important difference between time averages and ensemble averages are difficult concepts — so let me try to explain the meaning of these concepts by means of a couple of simple examples.

Let’s say you’re offered a gamble where on a roll of a fair die you will get €10 billion if you roll a six, and pay me €1 billion if you roll any other number.

Would you accept the gamble?

If you’re an economics student you probably would because that’s what you’re taught to be the only thing consistent with being **rational**. You would arrest the arrow of time by imagining six different “parallel universes” where the independent outcomes are the numbers from one to six, and then weight them using their stochastic probability distribution. Calculating the expected value of the gamble – **the ensemble average** – by averaging on all these weighted outcomes you would actually be a moron if you didn’t take the gamble (the expected value of the gamble being 5/6*€0 + 1/6*€10 billion = €1.67 billion)

If you’re not an economist you would probably trust your common sense and decline the offer, knowing that a large risk of bankrupting one’s economy is not a very rosy perspective for the future. Since you can’t really arrest or reverse the arrow of time, you know that once you have lost the €1 billion, it’s all over. The large likelihood that you go bust weights heavier than the 17% chance of you becoming enormously rich. By computing **the time average** – imagining one real universe where the six different but dependent outcomes occur consecutively – we would soon be aware of our assets disappearing, and *a fortiori* that it would be **irrational** to accept the gamble.

Why is the difference between ensemble and time averages of such importance in economics? Well, basically, because when assuming the processes to be ergodic, ensemble and time averages are identical.

Assume we have a market with an asset priced at €100. Then imagine the price first goes up by 50% and then later falls by 50%. The* ensemble average *for this asset would be €100 – because we here envision two parallel universes (markets) where the asset price falls in one universe (market) with 50% to €50, and in another universe (market) it goes up with 50% to €150, giving an average of 100 € ((150+50)/2). The time average for this asset would be 75 € – because we here envision one universe (market) where the asset price first rises by 50% to €150 and then falls by 50% to €75 (0.5*150).

From the ensemble perspective nothing really, on average, happens. From the time perspective lots of things really, on average, happen. Assuming ergodicity there would have been no difference at all.

On a more economic-theoretical level, the difference between ensemble and time averages also highlights the problems concerning the neoclassical theory of expected utility.

When applied to the neoclassical theory of expected utility, one thinks in terms of “parallel universe” and asks what is the expected return of an investment, calculated as an average over the “parallel universe”? In our coin tossing example, it is as if one supposes that various “I” are tossing a coin and that the loss of many of them will be offset by the huge profits one of these “I” does. But this ensemble average does not work for an individual, for whom a time average better reflects the experience made in the “non-parallel universe” in which we live.

Time averages give a more realistic answer, where one thinks in terms of the only universe we actually live in and ask what is the expected return of an investment, calculated as an average over time.

Since we cannot go back in time – entropy and the arrow of time make this impossible – and the bankruptcy option is always at hand (extreme events and “black swans” are always possible) we have nothing to gain from thinking in terms of ensembles.

Actual events follow a fixed pattern of time, where events are often linked in a multiplicative process (as e. g. investment returns with “compound interest”) which is basically non-ergodic.

Instead of arbitrarily assuming that people have a certain type of utility function – as in the neoclassical theory – time average considerations show that we can obtain a less arbitrary and more accurate picture of real people’s decisions and actions by basically assuming that time is irreversible. When your assets are gone, they are gone. The fact that in a parallel universe it could conceivably have been refilled, is of little comfort to those who live in the one and only possible world that we call the real world.

Our coin toss example can be applied to more traditional economic issues. If we think of an investor, we can basically describe his situation in terms of our coin toss. What fraction of his assets should an investor – who is about to make a large number of repeated investments – bet on his feeling that he can better evaluate an investment (p = 0.6) than the market (p = 0.5)? The greater the fraction, the greater is the leverage. But also – the greater is the risk. Letting p be the probability that his investment valuation is correct and (1 – p) is the probability that the market’s valuation is correct, it means that he optimizes the rate of growth on his investments by investing a fraction of his assets that is equal to the difference in the probability that he will “win” or “lose”. This means that he at each investment opportunity (according to the so-called Kelly criterion) is to invest the fraction of 0.6 – (1 – 0.6), i.e. about 20% of his assets (and the optimal average growth rate of investment can be shown to be about 2% (0.6 log (1.2) + 0.4 log (0.8))).

Time average considerations show that because we cannot go back in time, we should not take excessive risks. High leverage increases the risk of bankruptcy. This should also be a warning for the financial world, where the constant quest for greater and greater leverage – and risks – creates extensive and recurrent systemic crises. A more appropriate level of risk-taking is a necessary ingredient in policy to come to curb excessive risk-taking.

To understand real-world “non-routine” decisions and unforeseeable changes in behaviour, ergodic probability distributions are of no avail. In a world full of genuine uncertainty — where real historical time rules the roost — the probabilities that ruled the past are not necessarily those that will rule the future.

Irreversibility can no longer be identified with a mere appearance that would disappear if we had perfect knowledge … Figuratively speaking, matter at equilibrium, with no arrow of time, is ‘blind,’ but with the arrow of time, it begins to ‘see’ … The claim that the arrow of time is ‘only phenomenological,’ or subjective, is therefore absurd. We are actually the children of the arrow of time, of evolution, not its progenitors.

Ilya Prigogine

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“Assume we have a market with an asset priced at €100. Then imagine the price first goes up by 50% and then later falls by 50%.”

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A trader would put a side-bet on volatility. He would win because the volatility payout would be large.

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Conventional economic analysis that ignores derivatives such as volatility and other advanced financial instruments (butterflies, skew, etc.) mistakenly assumes that uncertainty cannot be hedged. Traders always have hedging options (they may choose to take a naked position and speculate but they are not forced to).

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In the bet example, you borrow and take out insurance against default. If you lose you pay the insurance at a slower rate and can thus cover it with other income without having to make a big payment that would bankrupt you immediately. Banking is about putting off final settlement for another day.

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“This should also be a warning for the financial world, where the constant quest for greater and greater leverage – and risks – creates extensive and recurrent systemic crises.”

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The systemic issue is economists’ ignorance of derivatives. Mortgage-backed securities were insured and thus the only uncertainty in 2008 was whether the Fed would honor the insurance contacts that would have worked but for a panic. The Fed could end such uncertainty by selling panic insurance upfront.

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“In a world full of genuine uncertainty — where real historical time rules the roost — the probabilities that ruled the past are not necessarily those that will rule the future.”

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Options in various combinations essentially allow you to go back in time and change bets. You buy an option to make a $1 billion bet on a roll of the dice but you sell the option before the roll and profit; or you insure against default using more options. Maybe you borrow $1 billion and make more from arbitraging long vs. short rates (doesn’t matter which way yield curves slope, you take advantage of spreads) than you have to pay in case you lose.

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“What fraction of his assets should an investor – who is about to make a large number of repeated investments – bet on his feeling that he can better evaluate an investment (p = 0.6) than the market (p = 0.5)?”

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Again, you must include derivatives such as volatility. The price of an asset may go down suddenly and precipitously but if you have a volatility hedge, you can easily come out ahead.

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Economists must study the wide variety of volatility products and bring them up when discussing traditional bets, because finance has evolved way beyond the simple analysis presented here.

Comment by Robert S Mitchell— 8 Jul, 2019 #

To be able to estimate the degree of risk in any international transaction, you have to have information if war and/or sanctions or blockades will be started, by whom, when, and of course who/what the target is. Finance has evolved far beyond any simplistic monetary games theory. I think that became evident in the early 1970-ies? As it was before WW2.

Comment by fredtorssander— 8 Jul, 2019 #