I have been thinking a lot about the important problem of establishing cause and effect, since Nigel Davies brought up the topic earlier in the week.

It seems like the more complicated systems become, the more difficult it is to establish cause and effect relationships between different phenomena. Physicists often say that two phenomena are "associated", when they don't dare establish a cause and effect relationship.

But the science that really has a problem with this is biology, which studies extremely complicated systems (remember that there are more cells in your body than there are stars in the Galaxy, and each cell is quite complex). Perhaps more biological thinking would do us good, rather than the physics-like thinking often used in market modeling.

In the germ theory of disease, for example, it is very difficult to establish the mechanism by which the germ actually causes the disease. And the mere presence of the germ in large numbers is not enough to establish cause and effect. The germ may be an opportunist, taking advantage of the diseased state to increase its numbers.

Anyway, around the turn of the last century an attempt was made to make criteria for establishing this kind of cause and effect. One scheme was called Koch's postulates. Here they are in their original form:

Koch's postulates are:

1. The microorganism must be found in all organisms suffering from the disease, but not in healthy organisms.

2. The microorganism must be isolated from a diseased organism and grown in pure culture.

3. The cultured microorganism should cause disease when introduced into a healthy organism.

4. The microorganism must be reisolated from the inoculated, diseased experimental host and identified as being identical to the original specific causative agent.

I'm sure my fellow Specs can find holes in this scheme. But can we establish our own postulates for cause and effect in markets? Of course we can't "introduce" and "culture" market phenomena (much as we would like to). But maybe some other kind of formal scheme would provide food for thought.

Nigel Davies adds: 

This seems like such a good analogy. For example there are recurrent conditions in which the sufferer has occasional outbreaks of the disease.

In considering outbreaks of a market disease there might need to be the presence of germs plus some trigger factor such as 'stress'. Even then there are no guarantees.

Bill Egan writes:

Tylenol (acetaminophen or paracetamol) is the #1 cause of fatal liver failure. It produces minor effects on the liver at the recommended dosage levels (4 grams per day in adults). Fatal liver damage (zone 3 necrosis) can happen with as little as 10 grams per day. The safety margin is a mere 2.5x between pain relief and death.

Most drugs are metabolized by enzymes in your liver, so that they can be excreted more easily. Acetaminophen is not an exception. Five percent of acetaminophen is converted to a reactive metabolite that will bind to liver cells and kill them. This is normally prevented by the body's anti-oxidant defense system, a molecule called glutathione, which binds to reactive molecules and thus prevents them from causing damage. Should your glutathione levels be low (not eating right, alcoholic, sick, etc.) you will be more susceptable to damage caused by the reactive metabolite of acetaminophen because your glutathion levels will be lower than normal. Should you ingest a bit too much acetaminophen, you rapidly exceed even the capacity of the normal levels of glutathione to prevent its damage. It is like a step function.

What market mechanisms act to prevent routine damage? What is the tolerance limit beyond which they are overwhelmed? (This is a violation of Koch's postulate #1 but it is chemical not biological.)


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