Theory vs Reality

"All things are for the best in this best of all possible worlds." -- Dr. Pangloss, in "Candide," by Voltaire.

The business cycle theory is flawed.

   People tend to have faith in what they want to believe in, regardless of history or reality.
   Here's an example, based on this assumption: Market volatility is inevitable, and therefore it is a good thing, because if it exists it must be good. The secret to success is in taking advantage in this volatility, and the more you can manipulate this volatility, the more wealthy you become. Therefore, more volatility is better.
   But here's the flaw: It's questionable whether more is better, especially when it conflicts with ethics. When people get hurt, volatility may not be a good thing.

   Theory is seductive. We can want to believe in something strongly enough so that we select facts and information, and bend them, if need be, to conform to the theory -- what we want to believe. And this is as true of finance as it is of many other fields.
   For years, finance wizards made use of the famous Bell-Shaped Curve of statistics to define outliers out of existence, and therefor their products could not possibly fail.

   Background: The Bell-Shaped Curve maps the average of averages, and shows that nearly all of the example in a population come with three "standard deviations" from the mean, or the average. (A standard deviation is an average of the amount an individual deviates from the mean, or the overall average.)
   The conclusion, then, is that if 97 percent of all individuals come within that acceptable range, any that do not are "outliers," and not really worth considering. From there, it's a very short step to saying that these outlying factors don't really exist, and cannot possibly affect the rest of the population.
   The flaw in that reasoning is ignoring the fact that they do exist. Granted, the chances of them affecting the rest of the population is minuscule. But it is there, and therefore there can be no guarantees.

   To act as if something can never happen is to ignore the reality that it can happen. And in the financial world, it did, leading to the collapse in the last decade. The finance wizards dismissed the outlying events as "impossible outcomes" that could never happen. In fact, not just one of these "impossible outcomes" happened, but several did indeed come in at the same time. The "irrational exuberance" that led to such complexicated financial packages being sold by overconfident brokers to underinformed investors caused the financial market to collapse like the house of cards it was.

   Volatility can be useful, because in enables observant investors to take advantage of changes, and therefore values, in markets. But it remains speculation -- another word for gamble.
   Wild volatility, however, can only hurt those who can least afford to participate, or who cannot participate at all. When a market collapses, these are the ones who are severely hurt.
   One answer, then, is to smooth out the cycle. And this is one function of government, because in doing so it helps ensure the health and safety of all.