Thursday, June 25, 2009

Financial complexities... 2

The point here is that the output from the systems that Watts is discussing is comparatively, deceptively, simple. It is intended to be so that users – the people who invest money in the system – can understand the levels of risk impinging their investment and the value their investments have earned. It is the Persian carpet that is hung on the wall. It is an agglomeration of pretty colours and an apparently organised pattern. Understanding the detail that lies behind it, the seed values, the process, is beyond the understanding of any person.

The output is prepared from the accumulation of detail into increasingly generalised categories,

- by people who “understand” what they are calculating,

- but can not necessarily grasp the enormity of the detail and risk that they are given as inputs

- by people who individually work to prepare summarised number descriptions of the detailed data for which they are responsible. (Whew!!)

No one can describe the output from these systems as “wrong”. They are not. They are a logical and systematic accumulation of the financial data of the business. They do not “fail” as a result of the incorrect process or interpretation of individual transactions, or even an individual category of transaction.

The difficulty, and Watts has touched this, is placing that output into the world-view of the larger system of many similar reports and how they might interact.

The delusion is, therefore, that an objective investor has little chance of accurately assessing either the “value” of his return, nor the level of risk that he is investing against.

Again, simplicity can be surprisingly complex.

The intent here is to introduce the principle of feedback. In the system proposed by Watt, there are innumerable feedback points. Again that is a point on which he has touched, primarily from the aspect of governmental review and control of the system.

If feedback is introduced to the system at the wrong point, or in the wrong fashion, then the resulting consequences will not be as planned or intended. That, in Watt’s example, is just what is happening.

That is the major line of criticism aimed at virtually every governmental attempt to minimise the (national, economic, political, individual, business... take your pick)impacts of the collapse of the global financial system.

The third factor that I want to introduce here is that of “self-referential” systems. Now this is something that is very easy to illustrate. It happens at least once to anyone who uses complex or extensive spreadsheets. (My favourite at work has over 65,000 formulas, some of them nested to three or four levels). All of a sudden things come to a grinding halt with the succinct little message that you have created a “circular reference”; the current formula is dependant apon a formula that depends upon… the answer of the formula it is trying to calculate. Now spreadsheets can not continue as long as that circular reference exists. It can not work round it. It stays stopped until the circle is broken.

But the truly complex system, such as the financial systems that Watts is discussing, can depend upon such circular, self-referential, relationships. Note, please, this differs from feedback. It includes the system itself changing and modifying as its complexity increases.

Those changes might internally created (evolved) to cope with or provide new opportunities. The development of the whole derivatives market was impossible 100 years ago except in very small markets. It is the increasing speed and complexity of global communication (another factor that Watts refers to but does not develop) that has allowed the derivative products market to reach the importance and the instability that has led to the current crisis.

They might also be imposed from without - environmental pressures requiring adaptations. The biggest and most obvious are government controls. The difficulty here is that if the control, the environmental influence is against the direction the systems is wanting to adapt then the result is a series of work-arounds, further evolutions which accept and ameliorate the impact of the changed environment.

So, that is how close Watts got himself to third, to a three base hit. He was within a fingernail of success.

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