The Three-Body Problem: Chaos Theory in Investing and the Economy

During their recent episode, Taylor, Carlisle, and Doug Ott discussed The Three-Body Problem: Chaos Theory in Investing and the Economy. Here’s an excerpt from the episode:

Jake: Okay. Cool. Well, we’re not going to talk about that at all. [Tobias laughs] We’re talking about the real-world mind-bending physics problem that’s really been puzzling scientists for centuries. What exactly is the 3 body problem? Picture this. You get like three celestial bodies floating around, let’s say the earth, the moon and the sun. They’re all pulling on each other with gravity.

The next question is, can we predict their motion? Can we project out into the future? Now, if you tried to solve a two-body problem, let’s say, just the earth orbiting around the sun, it’s actually pretty straightforward. We can thank Sir Isaac Newton for a lot of that.

It really is a stop for a second to appreciate really how Newton was able to use math to then predict the future. Before that the future was like the entrails of chickens and whatever else. But he came up with mathematical reasoning to then tell you where something was going to be. You think of like Halley’s comet, for instance, and knowing when it’ll next arrive and then being right about it. Like, could you imagine how that must have blown people’s minds? The answer of when it’s coming back again, by the way, is 2061. So, hopefully, we’ll all be there. We’ll be old man together.

Tobias: I saw it last time. So, I’ll be seeing it again.

Jake: Beautiful.

Tobias: I was about five.

Doug: Nice.

Jake: Nice. Yeah, I remember. So, Newton was solving these two-body problems. But then, if you throw in a third body, it’s suddenly this cosmic juggling act goes wrong. You can’t just write down a nice, clean formula that predicts the paths of these things. Instead, these bodies influence each other in chaotic and unpredictable ways.

So, if I try to think of analogy of this, let’s say, you had a boardroom meeting, and maybe there’s three high powered CEOs who are negotiating a deal together amongst the three of them. If there are only two of them in the room, it’s fairly straightforward to figure out maybe where things are going to end up. Like, one will make a move, the other responds. Eventually, you find this balancing act.

But the moment you add a third person in, it’s like a whole new game. Like, alliances can shift, the strategies that you would go with all of a sudden are suboptimal and a single decision for one changes and negotiates for the other two. And so, this is the three-body problem in a nutshell. You get this really unpredictable, sensitive to initial conditions, starting conditions, and a total mess, most likely. So, scientists have been trying to solve this puzzle for centuries.

One of the most famous attempts came from Henri Poincaré, I think is how you say his name. Late 19th century mathematician, statistician. He discovered that the system was chaotic. It was like this is the early work on chaos theory. The tiniest tweaks to the initial conditions, like the position of one body being off by a hairbreadth totally changed the future path. And so, this is the early, early steppingstones for chaos theory came from this three-body problem.

So, let’s get back to our world of investing and finance that we always try to bring it back to. We are at home right now having some landscaping done in the backyard. I was having a friendly chat with the owner of this small business. I was asking him, what his margins typically look like, what kind of returns on capital does he see labor inflation, what’s it been like, usual stuff that you discuss with your landscaper.

We got onto the topic of the Federal reserve, and were they going to lower rates and by how much? It became very clear to me– He was waiting to buy some new equipment for rates to go down. It was really obvious that he was following along super closely with what Powell was up to. He probably knew what Janet Yellen had for breakfast that morning. [Tobias laughs] It struck me as fairly preposterous. Here we are, me, a citizen, and him, a small businessperson, we’re trying to affect a commercial transaction here. We have this third body who’s playing us with its own gravity. [chuckles]

So, the original mandate of any central bank is really to be the lender of last resort, just in case. If they should provide liquidity, ample liquidity, but at punitive terms, you shouldn’t want the money from them. It should be very expensive. And now, we end up with this fed that wants to steer the economy, unemployment, interest repayments on federal debt, consumer protections, I think all this stuff is way beyond the initial bounds of the starting mandate that they had.

My argument is that the fed is supposed to be this stabilizing mechanism in the system, but due to the three body problem dynamics that you find in physics, it’s actually a source of chaos, because now, there’s two parties who want to transact, and you have this third body who is changing all the outcomes potentially. It becomes impossible to predict. So, these small changes, a little tweak in the interest rate, they have these massive, unpredictable effects that no one can really model out, because physics says that you can’t model it. This is how you end up with chaos theory. So, investors, they might get spooked, and maybe they cause a sell off or maybe they cram in due to FOMO. Who knows?

But meanwhile, these companies are also reacting to it. They’re cutting back on their investments or maybe they’re ramping up expansion, like my landscaper was considering. Just like the celestial version of the three-body problem, these interactions, they’re nonlinear and they’re unpredictable. At the end of the day, it’s just a man behind the green curtain in the Marriner Eccles building.

So, I think sometimes our trust and our faith should be examined a little bit in some of our monetary mandarins, as Jim Grant would call them. So, there’s a three-body problem, and what the problem results in economically.

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