Posthypercapitalism
The Great Financial Crisis of 2008 makes clear that in a networked world, we need new, networked ways of thinking about the world.
This is an old article, restored from a previous blog.
Rorschach effect
The crisis on Wall Street is like a Rorschach test: it seduces people into making statements that primarily reflect their own state of mind. Everybody finds something to his liking that he latches onto.
Germans, with characteristic bombast, are talking about an economic 9/11 self-inflicted on Wall Street by investment bankers turned suicide attackers.
The French, in typical sweeping language, are proclaiming the need to re-invent capitalism. Sarko will unveil proposals for a new world order on a summit later this year.
Chinese media, without apparent sense of irony, point to excess creation of US liquidity and debt. Which are hugely financed by Chinese government dollar holdings.
American conservatives decry massive government intervention as ‘socialist’ and ‘un-American’. In other news, 25 billion dollars of taxpayer money has just been awarded to the US car industry for failing to anticipate fuel-efficiency demand.
Closet socialists, populists and just about everybody is tumbling over each other to condemn Wall Street greed and fat cat bonuses.
Economists, meanwhile, are furiously debating what the heck is going on. Is this a liquidity crisis, or a solvency crisis? Isn’t it insane to throw a trillion dollars at a problem we don’t understand? Isn’t it irresponsible not to?
The problem is: everybody is right – well, except maybe the Germans :-). The causes of this crisis are myriad: greed and corruption, faulty decisions, faulty technical models, excess liquidity, liquidity contraction, insolvency, intransparancy, lack of oversight and regulation, absurd levels of leverage, you name it.
If everybody is right, that probably means nobody really understands what is going on. There’s a different perspective that doesn’t get wrapped up in the inner workings of the financial system.
nonlinear complexity
Surprisingly effective explanations for the current financial meltdown emerge from the natural sciences. A growing body of work translates insights from biology, physics and mathematics into powerful models for economic interactions.
The key element that binds these narratives together is: emergent complexity. These models skimp on explaining individual behavior. They lack a ’theory of the firm’ and ‘bounded rationality’ concepts. Indeed, such models feature the coarsest imaginable agents, with only very rude binary (positive/negative) relationships to other agents and very rude binary (alive/dead) state.
Stringing such simplex agents together in networks that obey equally simple rules, modeling outcomes are achieved that show an uncanny resemblance to actual, historical, economic data time series. The implications are profound: individual decisions don’t matter very much, the actual outcomes are determined by structural properties, i.e. by the network of interactions.
Even more mind-boggling is the cross-disciplinary reach of these effects: a stock market crash very much resembles a traffic jam very much resembles species extinction events: the mathematics is much the same in each of these very different problem domains.
This points to an underlying regularity in the laws governing complex systems, of which the economic system is but a specific manifestation. To paraphrase McLuhan: the network is the effect. It is the structure of a network, rather than the actions of network participants, that determines the eventual outcome.
fractal markets
Benoit Mandelbrot, the mathematician of fractal fame, performed a technical (mathematical) analysis of market behavior in general, and the 1998 collapse of the Long Term Capital Management hedge fund in particular. The Misbehavior of Markets: A Fractal View of Risk, Ruin and Reward was published in 2004. (Mandelbrot and Hudson 2004) His conclusion? Markets don’t behave “normally”. In statistical terms, market volatility does not conform to a “normal” Bell curve. Extreme market events occur much more frequently. The under-estimation of the likelihood of extreme market events was a fatal modeling flaw that broke LTCM in 1998. And, we might add, is breaking banks all over the place right now.
creative extinction
Paul Ormerod, an economist, turns to biology to explain Why Most Things Fail. (Ormerod 2006) He describes patterns of failure and the similarities between biological failures (species extinctions) and economic failures (bankruptcies). Like Mandelbrot, he is keenly aware that extinction events are not governed by a “normal” distribution but by a “power law” distribution, which results in much higher probabilities for high-impact disruptions (mass extinctions, economic crashes).
A key insight to emerge from his analysis, is the extremely limited amount of information agents really have about their environments. The mathematical model fits observed reality only if agents have near zero “cognitive ability”. Translation: the sorry state of the world can only really be explained by our stupidity :-).
In short, despite the ability of humans and human institutions to act with intent, in reality it is as if they operate close to the paradigm of the agent with zero cognitive ability.
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The clear implication of this abstract theoretical model is that agents, firms, individuals, governments have very limited capacities to acquire knowledge about the true impact either of their strategies on others or of others on them.
Doesn’t that sound awfully much like an adequate description of the mess the CDO and CDS trades have created? Banks have stumbled into a situation in which they’re unable to adequately judge their own or their peers’ risk exposure.
flocks of black swans
Scores of other books in the non-fiction section of your local bookstore elaborate the same meme: complexity gives rise to catastrophe. A world of “normal accidents” is much more unsafe than we’d all like it to be.
There’s a bit of hope, however, in the realization that stock market crashes and Katrina-category extreme weather events are manifestations of similar patterns of interdependencies and feedback loops.
Wall Street crashes and must be rescued by huge public policy interventions. This powerfully underscores the limits of pure market-driven coordination, even in coordinating the sanity of markets themselves. Maybe this forceful demolishing of entrenched ideological doctrines creates an opportunity for some fresh insights to emerge, and to be applied to the wide range of problems, economical and ecological, that we’re facing this century.