Economics and complexity theory: “It’s like a swamp”

An article in New Scientist (issue 2679, 22 October 2008, page 8-9) provides what I think is very useful perspective on the current global economic crisis. At the New Scientist site, the full text is only available to subscribers, but I think it raises issues we all need to know about, so I’m going to quote it in full here with my humble apologies to the New Scientist and the author, who do hold the copyright. My own comments and additions are interjected.

[I urge those interested in the scientific issues of our time to subscribe to this magazine, or read it at the library; it presents current scientific research and problems across the board of scientific disciplines, with a strong bias toward social implications. While you may not agree with the sometimes rosy expectations for application of science and technology to problem-solving, the magazine is the best single source of new insights into problem analysis that I know of.

The article is entitled “Why the financial system is like an ecosystem”, by Debora Mackenzie.

AS GOVERNMENTS struggle to prevent the global financial crisis turning into a deep worldwide recession, attention is also turning to the longer-term problem: how to avoid a similar crisis happening again. When politicians meet in Washington DC in December they are likely to agree that the “loose touch” approach to financial regulation of the past two decades will have to give way to tighter controls. But the global financial system now operates at a level of complexity no one has ever tried to tame. How do we re-engineer it so breakdowns don’t happen again?

One place to start is the science of complexity itself. We now know that large interconnected systems, such as the weather, can behave in unexpected ways: for example, small changes can trigger fundamental shifts. New understanding of the principles governing such complex systems offers hope that the global financial system can be got under control. The snag is that politicians will have to accept that costs are likely to be involved.

Existing economic policies are based on the theory that the economic world is made up of a series of simple, largely separate transaction-based markets. This misses the fact that all these transactions affect each other, complexity researchers say. Instead, they see the global financial system as a network of complex interrelationships, like an electrical power grid or an ecosystem such as a pond or swamp. In a swamp, certain chemicals that normally keep pond life ticking over can, under the wrong circumstances, trigger an explosion in the numbers of one species – an alga, say – which then goes on to strangle all other life in the swamp.

Similarly, they say, apparently unimportant changes that have crept into the global financial system may have triggered the current crisis. “Slow changes have been accumulating for years, such as levels of indebtedness. None on their own seemed big enough to trigger a response,” says Johan Rockström of the Stockholm Environment Institute. “But then you get a trigger – one investment bank falls – and the whole system can then flip into an alternative stable state, with different rules, such as mistrust.” To prevent events like this, governments need somehow to restructure global finance to limit these kinds of instabilities.

So how exactly has the financial system come to be so vulnerable? One key factor is that money can now flow more easily from country to country. This has stimulated trade and prosperity throughout the world, but it also means that an upset in one place can have severe and unpredictable consequences elsewhere.

Days before winning the 2008 Nobel prize in economics last week, Paul Krugman of Princeton University published an analysis which concluded that the rapid increase in cross-border investments since 1995 is what allowed a local shock – the collapse in inflated US real estate values – to propagate globally, especially through highly indebted investment firms that can respond to a loss of money in one place by pulling back credit anywhere in the world. Krugman noted that “these channels are not yet part of the standard analysis”. This is exactly the kind of linkage that the complexity theorists say economists have been missing. “The source of the current problems is ignoring interdependence,” says Yaneer Bar-Yam, head of the New England Complex Systems Institute in Cambridge, Massachusetts.

I would add that, at least in the US system, deregulation allowed a blurring and overlap of functions between banks, insurance companies, savings and loans, and other financial businesses. The packaging and selling of home mortgages is an example: instead of loans being made and held by local institutions, they were made by various sorts of institutions and then resold to other sorts of institutions as investments.

It appears as though the same bundles of loans were being sold and resold repeatedly in some cases. This creates a fragile dependency: the soundness of the investment depends on actions by the original lender, and subsequent buyers have no reliable way to know whether those actions were wise or even legal. The bundled mortgages were supposed to minimize risk because each investment contained multiple mortgages––like diversifying a portfolio of stocks––but in this case each bundle represented not stock from a single company, but mortgages from various sources, too many to evaluate given the scale of the transactions. And many bundles must have contained mortgages from the same few big irresponsible lenders (like Countrywide), thus undermining the diversification of risk. (I’m no economist; I’m just reasoning from what I have read over the past weeks.)

For example, he [Paul Krugman] says, financial firms calculate the risk involved in taking on a debt for each transaction separately, and then simply add them up to arrive at the total risk. This made the whole system look more secure than it actually was, because failure in some transactions can in fact multiply the risks of others. “They totally failed to account for couplings between them, which can change things dramatically,” Bar-Yam told New Scientist.

Warnings go unheeded

The banking industry itself was not entirely oblivious to this. In 2007 the Federal Reserve Bank of New York published a study, based in part on testimony from ecologists and engineers specialising in complex systems, which concluded that while vast sums were spent assessing the risks of individual investments, almost nothing was being spent on systemic risk – which could be much more grave. “It is really frustrating to me and others that the warnings were not heeded,” says ecologist Simon Levin of Princeton University, who was one of those who testified – all the more, he points out, because increased connectivity doesn’t just propagate trouble, it makes the whole system less diverse and more vulnerable to dramatic shifts.

According to Rockström, one of the key ways in which diversity was lost arose from the uniformity of criteria that have been used to judge economic success. One example of this is value-at-risk (VaR), the measure used by banks to report their potential losses from trading financial instruments. Since the late 1990s, it has been standard practice for banks to publicly report VaR measurements. When use of this measure was proposed, critics argued that this would encourage herd behaviour, with banks rushing en masse to sell off assets that were depressing their VaR numbers, but their concerns were ignored.

To prevent this sort of thing, complexity experts say that “firebreaks” that cut back connectivity should be built into the financial system, and that it must become less uniform. “The heterogeneity of the system must be restored,” says Levin. In other words, don’t let everybody become part of the same pond, all following the same rules.

This is unlikely to be popular with the banking industry: it lost diversity and gained connectivity in the first place because this cut costs and boosted profits. But such diversity is what allows ecosystems to remain resilient as conditions change; the same principle should apply to financial systems.

Achieving this is likely to be difficult, not least because in a complex network like the financial system, no one is in charge. And if international coordination were to happen, it could end up imposing even greater rigidity and uniformity. “Governments will have to be very careful, and set rules and limits for the system without actually telling people what to do,” says Bar-Yam. It can be done, he says, citing Wikipedia as a good model for such coordination.

Among the factors not mentioned here is one that seems fundamental to me: the ideal of never-ending growth that underlies our economic system. Economic diversity is maintained not just by restoring the legal differences between types of institutions––differences removed by deregulation––but also by taking steps to preserve larger numbers of institutions in each category. Here in the US we have already heard that some banks want to use bailout money to acquire other banks, thus continuing the very trend toward mega-institutions which has intensified the crisis. If the banking industry, for example, functions in some ways like an ecosystem, say a swamp, then we want lots of swamps of various sizes, not three huge swamps. (I must admit that the swamp analogy is especially appealing, given the slimy behavior of so many of these financial companies and executives.) But all the structure and ideology of this country’s economic system is in favor of growth: a larger company is a better company, the big fish eat up little fish and get even bigger so they can eat up bigger little fish.

Another way that this growth madness contributes to a crash is when companies “diversify” their activities solely based on profit margins, without considering their core strengths. Last week, for example, I saw a television ad for the aggressive refinancing company Ditech, and noticed that Ditech is part of GMAC, the General Motors financing division originally set up to finance car purchases. It may seem that it is easier to make money by collecting interest on loans, than by building cars (which has so many more complications such as labor unions, cost of materials, cost of energy for manufacturing, changing desires of consumers, etc.). Maybe it is easier, but it means entering a whole new world of risks too.

General Electric is another company most of us think of as an industrial giant, which has “diversified” into the financial business in a big way: “over half of GE’s revenue is derived from financial services” according to Wikipedia. Before the September/October crisis, GE was even working on selling off its industrial divisions (rail cars, appliances, even the “entire GE Consumer & Industrial group”. Why? “This is really a reflection of the fact that these are not growth engines for the company,’’ said William Batcheller, who helps manage $85 million including GE shares with Butler Wick & Co. from Youngstown, Ohio. “This has been [GE Chief Executive Officer Jeffrey R.] Immelt’s mantra: “We’re a growth company and we’re going to invest in the businesses that are growing and we’re going to trim the businesses that aren’t.” Then came the crisis (the part of it that we’ve seen up to now, it hasn’t bottomed out yet), and Oops!––

US conglomerate General Electric (GE) experienced a massive fall in third-quarter earnings as a result of the ongoing financial crisis.

With the weak financial sector, which normally contributes to a large portion of consolidated earnings, GE’s net income fell by 22 percent to $4.31 billion.

Earnings per share fell by 10 percent to $0.45, GE said in Fairfield, Connecticut, on Friday.

Its financial services division earned $2 billion, 33 percent less than the third quarter last year. Earnings from other GE divisions such as energy, infrastructure or business media with the broadcaster NBC Universal, however, grew. (source)

The bloated delusionary financial services sector that led to this economic disaster has crashed, which leads to reduced purchasing by consumers and businesses, which will mean less demand for the products of GE’s manufacturing and research divisions. Another proud giant of American industry bites the dust, perhaps, as General Motors seems likely to do.

Bar-Yam says, however, that he sees little evidence of such thinking in government responses to the crisis so far. For example, early in the crisis, US regulators put limits on the “short sellers” who speculate that a company’s stock value will stop rising. Short sellers were supposed to weed out weak firms, but a loosening of rules last year meant that they also brought down healthy ones. Bar-Yam says the result was like a predator-prey system run amok. Yet when regulators acted, they only stopped them attacking certain types of company, leaving them free to pounce on others. “It shows they still aren’t thinking about this as a connected system,” he says.
Bar-Yam thinks models of complex relationships such as those between predators and prey can help prevent such systemic problems, and show regulators how they can modulate market behaviour in a more sophisticated way. “We haven’t had the scientific tools to do this for very long. But we can now model the global system and capture the key collective behaviour that causes collapse.”

“At its core the science of complex systems is about collective behaviour,” Bar-Yam points out. “The invisible hand of the market is collective behaviour.” The problem till now, he says, has been that economic policy has failed to take into account the complexity and consequent unpredictability of such behaviour. In the absence of testable models, people “try to believe what they know really isn’t true”, he says – for instance, that real estate values always increase.
The remedy Bar-Yam proposes is to subject economic policies to verification with the same sort of rigour that is normal in science. That has never been done. “But with recent scientific advances, I believe we can now truly inform policy.”

I am not convinced that the science of complexity theory is ready for the powers proposed to it here, but it does offer a new way of examining and evaluating economic issues. At the very least it would be another tool to use. The ones used by those (like Alan Greenspan) charged with overseeing our system, seem to have failed us quite badly. The complexity model challenges some of the assumptions that Greenspan admits to having made; that alone makes it valuable.

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