Complexity in Financial Systems
Courtesy of Tim at The Psy-Fi Blog
What’s Complexity?
We can probably all agree that modern day financial systems are complex, but what that actually means isn’t something that everyone agrees on. Typically, though, a system characterised by complexity isn’t something that anyone’s designed – it emerges, it adapts spontaneously and it produces stunningly unexpected outcomes when no one’s expecting them.
Which, let’s face it, sounds a lot like modern finance. The problem is that many economists are focusing on how they manage this system when, in reality, it’s impossible to do so. It’s like trying to contain swine flu using a butterfly net.
Complexity Is Not Engineering
When many people, including economists, discuss complex systems they often use analogies with complicated engineered systems like aircraft or nuclear power systems. Now these are definitely complicated, with many, many interacting parts, the failure of any of which may compromise their integrity. However, complicated human engineered systems are not truly complex. For the most part the designers of these systems go out of their way to make sure that they don’t exhibit the trademark unpredictability and non-linear outcomes of complexity.
Indeed, the very fact that these systems have a designer is a sure sign that they’re not truly complex. This was the problem that Charles Darwin solved – how do complex things like human beings come into existence if not through the guidance of a designer? The answer, of course, is that complexity can arise through interaction with the environment as long as there’s some means of adaptation. These are the trademarks of complex adaptive systems. Darwin was concerned with biological evolution, but the global financial system is of the same type.
Complex Means Adaptive
There are two noteworthy things about complex adaptive systems. The first is that they’re complex. The second is that they’re adaptive.
And while that may be a statement of the bloody obvious it’s one that seems to escape many financiers studying the subject. The ability of the system to adapt, often in completely unpredictable ways, means that you can’t model it and you can’t foresee the outcomes of any strategy of intervention. It’s all completely unknowable in advance.
Once you accept this it becomes suddenly apparent that a huge swathe of modern finance is complete rubbish. For example, in a complex system you expect to see “tipping points” or phase transitions when the system suddenly and unpredictably switches from one stable state to another. As Caballero and Krishnamurthy have documented this appears to be exactly what happens during the episodes of liquidity hoarding and flights to quality associated with financial crises. People suddenly switch from a belief that they’re in a state where risk is measurable based on probability to one characterised by fear in the face of absolute uncertainty, so called Knightian uncertainty.
So, in the depths of the panic of 2008 we saw investors selling Collateralised Debt Obligations at almost any price largely because they didn’t know how to analyse them. What it looks like is that they bought these sub-prime backed securities because they’d been given the highest rating possible by the credit rating agencies. When some of these went bad the investors – many of them supposedly high powered institutions – belatedly recognised that they hadn’t got a clue about what they’d bought and sold, virtually at any price. One day they had nice risk models giving default probabilities, the next day they had junk.
The Theory of Rational Ignorance
In fact the problem is slightly worse than this. Many of these institutions had rationally decided not to invest in understanding the products they were investing in because they figured out that it was too expensive to employ the people capable of analysing the issues, an example of The Theory of Rational Ignorance. As Steven L. Schwarcz has remarked in Regulating Complexity in Financial Markets:
“The complexities of modern investment securities can lead to a failure of investing standards and financial-market practices for several reasons: these complexities impair disclosure; they obscure the ability of market participants to see and judge consequences; and they make financial markets more susceptible to financial contagion and also more susceptible to fraud.”
Our problem is that most of the time we’re not prepared to invest as though everything’s about to go wrong. We’re habitually biased to look at the upside, not the downside so we build portfolios without hedges, because they’ll restrict our short-term profits and we’ll always take the view we can get out before it all goes wrong. This is where an understanding of the instability of the global financial system can help investors: it spends its life permanently tip-toeing across a shaky wire over a gorge populated with extremely hungry crocodiles.
And it’s got vertigo.
The Next Cause Will Be Different
There’s quite a lot of work now going into figuring out how we prevent the next crisis, much of it looking at how the financial system is re-engineered to prevent these types of failures. It’s a pointless exercise, because as fast as one set of rules is created the system will mutate to find ways around it. In so doing it’ll create all manner of unexpected connections, invisible to the overseers. Who, for instance could have predicted that badly designed mortgage schemes in middle America could have led to the collapse of the Icelandic government? Hidden links and invisible chains of consequence are everywhere in global finance.
Because the global financial system isn’t engineered and doesn’t have a designer there’s no way of controlling it. Those industrious academics trying to figure out how to use engineering concepts used to manage risk on complicated systems like aircraft are wasting their time. The failure of the global financial system isn’t like a single airplane unexpectedly crashing, it’s more like every single aircraft crashing simultaneously. It’s not the problems we can see, like the design of the avionics computer, that are the issue, it’s the fact that air-traffic control systems are dependent on a small number of global positioning satellites each of which happen to use the same specialised microprocessor, which has an unknown bug which is triggered by a combination of a certain date and freak sunspot activity.
Or something else, equally unpredictable.
Punks
Taken together the complexity of the global financial system, and the way that it’s often linked by tight but unappreciated couplings such that a small perturbation in one area can lead to devastating consequences elsewhere, makes it fundamentally unstable. Worse, however, is that even if you can get a handle on the risks today by tomorrow they’ll have changed. In such circumstances believing any prediction is an act of faith, rather than an intelligent assumption.
Equally any set of economic theories or financial models or loudmouthed gurus that claim to be able to foresee the future are hopelessly lost in their own rhetoric. There is no designer, there is no plan, there is no predictability. There’s just stuff, which happens. The best we can do either is plan with a margin of safety or just get lucky.
So, do you feel lucky, punks?
Related Articles: Ambiguity Aversion: Investing Under Conditions Of Uncertainty, Panic!, Don’t Overpay For Growth
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Here’s my comment on Tim’s blog, and his response:
Tim, it seems to me there are some things that can be done to limit the damage of the next disaster, as another commenter mentioned, restricting leverage, stopping bailouts, also regulation/limits on derivatives, enforcing laws that may already exist, but are not well enforced. Your conclusion seems like it’s saying nothing can be done, but it seems to me that most people with the ability to do something don’t want to. Which isn’t the same as can’t.
timarr said…
I’m definitely fatalistic about the trajectory of markets: they’re adaptive and the nature of adaptive systems is to change abruptly, often in the ways that aren’t to the advantage of the participants.
So I do believe that markets will one day fail again and that there’s nothing we can do to prevent this. However, I also believe that a lot more can be done to limit the damage caused by such failures: I wrote about this in Basel, Faulty? Currently we try to train the tightrope walker not to fall off, whilst at the same time incentivising them to get to the other side faster. This is wrong, we’d be better off constructing some safety nets under the tightrope and accepting a little less danger in our lives.
In response to c0mplexity’s questions on whether it’s inevitable that complexity will increase – well, the evidence from biology suggests not; complexity can decrease under the right environmental pressures. Much complexity in financial markets arises in order to confuse – as we saw in Finance: Where the Law of One Price Doesn’t Apply a few basic financial products are continually repackaged to avoid the profit erosion caused by allowing consumers to make pricing comparisons. Reducing complexity there would be a good start in creating a safer world.
