Monday, June 29, 2009

Financial complexities... 3

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 to anyone who uses complex or extensive spreadsheets. All of a sudden things come to a grinding halt with the succinct little message that you have created a “circular reference”; a 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 system that Watts is discussing, can depend upon such circular, self-referential, relationships. Note, please, this differs from feedback. It is the system itself changing and modifying as its complexity increases. 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.

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

The homer in this is in a quite different direction. It comes from a tv programme, a news excerpt I think that led to a “re-enacted instance” involving the purchase of a car.

Essentially, when you are choosing between two or more alternatives there is a limit to the amount of relevant information the brain can use to make the decision. There are any number of systems and research ideas into how that limit can be overcome; ranging from processes to determine the most important factors in the choice to ranking each alternative between chosen factors.

That limit, given that no “artificial aids” are used, cuts in at four factors and removes any reasoned decision at six factors. So, in the car example a person provided with the full technical specs of two cars will revert to “four door wagon manual and I like the look” or “I prefer Toyota” rather than a reasoned analysis of make and model, engine capacity, safety, fuel consumption, drivetrain, wheel/tire size, acceleration, and all of the other information provided.

So, in making an investment decision it is far more likely that the investor will look at a small range of data, will close the paper, and run with what his brain tells him “feels right”. Even given full information, it is likely that the decision will not be fully rational.

This is being borne out time after time in the past two years by people who have invested in Finance Houses at the sharp (high-risk) end of the market with the same confidence as they might invest their money in a bank at less than half the offered return. “Safe as houses!”

And they were wrong. And so were their Financial Advisers. And so were the salesmen of the products being offered. And it goes on down the line as has been proven by so many in the past two years including Watt.

But no one has asked the question “Why were they wrong?” There are many who were looking no further forward than the next commission check, to be sure! There were many who just believed, without question, what they had been told. A large number would have been taken in by (what I know as) “The Brightest Men in the Room Syndrome” (TBMRS).

Even TBMR would have been operating close to the “six level” – choosing out of those six the factors that best suited their sale and which (they thought) were the strongest reasons.

It is important to note here that this leaves out intentional dishonesty. We are talking of the mythical “reasonable man” here and not the snake-oil charlatan (of which, incidentally there seems to have been far too many). But that is how TBMRS works as Enron proved.

To return to the point, Watts is correct in that the complex system is at fault. For any of the reasons he has given, and for the few others I have run through here. As he concludes –
Government regulators telling firms they can't grow or innovate sounds like dangerous meddling in free markets. But there are at least three reasons to think that it is reasonable.

First, there is already a precedent for precisely this kind of government intervention - namely anti-trust law, which effectively guards against firms growing so large that they stifle competition. Perhaps what we need is an "anti-systemic risk" law that would aim to avert systemic risk before it is too late. No doubt firms that are denied the right to grow under this law would complain; but firms complain about anti-trust rules as well, and somehow our free market system has survived, in part because the beneficiaries of anti-trust rulings are often smaller and more innovative.

Second, the current crisis has demonstrated that markets do not automatically regulate systemic risk any more than they automatically guarantee competition. Pragmatically speaking, therefore, government intervention is required to prevent markets from destroying themselves, and the relevant question is what kind of intervention is effective: preventive management, or after-the-fact rescue.

Third, and most fundamentally, there is something badly wrong with the kind of free market that ends up at the mercy of a single firm. Failing to deal with systemic risk, in other words, creates a world that is not only uncertain, but also unjust, in that individual firms can generate immense profits by taking risks that everyone else ends up bearing as well. Taking free-market principles seriously, therefore, requires us to acknowledge that firms that are "too big to fail" are really too big to be permitted to exist.

And, I regret, that is a silly gism based upon at least two delusions. (Don’t you just LOVE Dodgson?).

Watts’ first conclusion is right, there is precedent for governmental intervention in markets.

His second is really the question he set out to answer, though I suspect that he and many others will have forgotten that. Further, it is in the nature of markets to develop in a manner that makes choice and determination more rather than less difficult. I give credit that he speaks of the markets “destroying themselves”.
The third is just wrong. Until the point is reached where one firm has total control of a market, there has to be equilibrium. That point of stability requires the composition of the market to act as individuals. Lehman was not in that position. Not one of the players within the international market was “too big to fail”. The system would have continued without Lehman had they (or any other individual component) been left to die.

To blame the downfall of the global financial system on one firm, such as Lehman, as he and so many others have done is nothing short of simplistic nonsense. Watts had the right line – the complexity of the system – and failed to follow it through. It was not one firm, nor was it one product such as loan derivatives or short selling.

The “culprit” is a system that has become so large and so complex that nobody can say that they “understand” or can “predict” its total operation and outcomes. The internal relationships are such that even small changes in one factor can lead to large swings in seeming totally unrelated outputs.

Because of that complexity, fault-finding and remedies are reduced to the same level as mediaeval medicine, “Take this and if it doesn’t kill you it might cure you. At best it will have no effect”.

Essentially, what Watts (what? Only three wots? That’s not very bright!) should be arguing is that the global financial system got to the point where:
• It is self-sustaining and self-replicating.
• Self-referential and circular functions had become undetectable and unmeasurable.
• Responses of the system to external stimuli were becoming increasingly chaotic as a result.

Then it is not a case of individual companies being “too big to fail”. That is a political crock, reasoned to justify governmental intervention of a particular kind and for equally political purposes. At the political level, that kind of intervention can be justified provided that the rationale is honest – it is for political reasons that A is too big to fail. The cause of the failure might well be unforeseen circumstances arising from the global financial system. That is accepted. That is not the reason for the intervention; that is political, whoever does it.


T. F. Stern said...

On a related topic; mostly because I don't claim to be able to juggle financial theory on this level, I watched a show on the Discovery Channel some time back. It had to do with the making of a simple pencil and all the other industries which had to be considered in order to pull off such a simple task.

I would suppose that manipulation of the financial markets would be similar if not more involved.

The probligo said...

That's a pretty good start, TF.

This thing is difficult to explain in simple language - as you have probably gathered from the convolutions in my piece.

It is a bit like the cruise control on a car, coupled with auto-navigation and anti-crash devices, and also working along with the closest 500 cars around you, and influenced by cars driving up Fleet St in London.