Thursday, September 25, 2008

Financial Crisis: A Proposal

It’s been interesting listening to various perspectives on the cause of our current financial crisis. McCain blames the greedy people on Wall Street. Obama blames the system. Financial people in the heart of the crisis blame the irresponsibility of the home owners who borrowed money outside of their means.

Listening to these financial people who were almost all in their 70s and 80s reminded me of the banker scene in Mary Poppins.

President Bush gave a very detailed logical explanation of the sequence of events leading to the crisis. He did not address the cause.

The truth is that our financial system is a complex system. This statement is not a truism. I mean complex in the mathematical sense. Complex systems have a very curious property – history matters, but effect is not linked to cause. Complex systems are in disequilibrium. A classic example of a complex system is the unstable system of dirt, rocks, and boulders on the side of a mountain. A large bolder can fall at the top and nothing may happen. Conversely, a small rock can trigger an avalanche.

President Bush described the chain of events after the fact. So, you can see that history matters.

Continuing the metaphor, we’re considering throwing another bolder on top of an unstable system. The question is, will that boulder stop the avalanche or start another one. No one really knows. The future in unstable, complex systems is impossible to predict. The only thing that you can do is talk about probabilities if you have a lot of statistical history on the system. We have that kind of data on earthquakes. We don’t on our present economy.

I would like to see this crisis evaluated by at least considering several scenarios with the economic and social consequences estimated. The rush to judgment prevents this approach unless we can slow the process down, and convince the economic culture to suspend all actions. It’s a matter of days, not weeks or months in order to think this through.

If we assume that there 100 million tax paying families in the US, the $700 billion means $7,000 in taxes for each family. If the tax rate is 15%, that means that each family will have to earn an extra $47,000 in taxable income to generate that much tax. Or, the economy is going to have to generate $4,700 billion in new economic growth.

As for the cause of or unstable economy, in my opinion, we have to look at the three systems of the U.S. as described by Novak:

“…three systems in one: a predominately market economy; a polity respectful of the rights of the individual to life, liberty and the pursuit of happiness; and a system of cultural institutions moved by the ideals of liberty and justice for all. In short, three dynamic and converging systems functioning as one: a democratic polity, and economy based on markets and incentives, and a moral-cultural system which is pluralistic and, in the largest sense, liberal”

The political, capitalistic and morale-cultural systems make up an integrated system. That integrated system has been compromised by a steady erosion of the boundaries between the systems, rendering it unstable. Balancing the three systems should be our prime goal.

The boundaries between the political system and the capitalistic and moral-cultural systems are being blurred. The encroachment of the moral-cultural system into the political system, and vice versa, should be obvious, but other than causing distractions from their individual missions, is not the cause of this crisis. Through enmeshment, our economic system has co-opted the other two.

Our capitalistic system has been the success story for our generation. As a result we have adopted the business paradigm in both the political and moral-cultural systems.

There are three elements of the business paradigm, when applied without the equal emphasis of the political and moral-cultural systems, are important to the instability - markets, disintermediation, and economic value added.

Markets –“ …the concept of a market is any structure that allows buyers and sellers to exchange any type of goods, services and information. The exchange of goods or services for money is a transaction. Market participants consist of all the buyers and sellers of a good who influences its price. This influence is a major study of economics and has given rise to several theories and models concerning the basic market forces of supply and demand. There are two roles in markets, buyers and sellers. The market facilitates trade and enables the distribution and allocation of resources in a society. Markets allow any tradable item to be evaluated and priced. A market emerges more or less spontaneously or is constructed deliberately by human interaction in order to enable the exchange of rights (cf. ownership) of services and goods.”: Wikipedia. The problem arises when we try to apply the concepts of a market indiscriminately. Not all elements in the political and moral-cultural systems can be treated as markets. Moreover, a market without the guidance of the political and moral-cultural systems will be corrupted.

DisintermediationCoase won the Noble prize in economics for his understanding the impact of transaction cost on the size of organizations. When traction cost was high, vertically integrated corporations were advantageous. Now, with transaction costs (material, information or capital) essentially zero, any task is theoretically more efficient if it is done by an expert no matter where the expert resides. As a result, the lowest cost expert is sought. This gives rise to outsourcing, off shoring and even the transfer of costs and risks to customers or consumers. The problems arise when this is not tempered by the political and moral-economic systems, or applied indiscriminately to the other tow systems.

Economic Value Added - is touted as a measure of the true economic performance of a company and a strategy for creating shareholder wealth. EVA measures the residual wealth of a company when its cost of capital is deducted from its operating profit. Al Ehrbar, author of EVA: The Real Key to Creating Wealth, writes "EVA is the framework for complete financial management and incentive compensation system that can guide every decision a company makes ... that can transform corporate culture, that can improve the working lives of everyone in an organization by making them more successful, and can help them produce greater wealth for shareholders, customers, and themselves." The complete rationalization of this concept throughout a business without the guiding forces of the political and moral-cultural systems can result in the ruthless actions of some corporations and their leaders. And, the application of modified versions of these principles to entities within the political and moral-cultural systems is evil.

In summary, there are three things that we have to do for the future:

* Separate the three systems – capitalistic, political and moral-cultural
* Balance the three systems in our perceptions, decisions and actions
* Innovate

Innovation is a process, the way resources are used to affect the common weal (a sound, healthy, or prosperous state), or to create a new resource. An innovation is the result of that process.

Innovation is the way that we can avoid a crisis in the future. All three systems – economic, political and moral-cultural – are in desperate need of innovation. And, we need to understand and evaluate proposed innovations by their impact on all three systems. Innovation can create new markets. Innovation can eliminate the need for disintermediation. And, innovation is the only true rationalization system for corporations.


  1. Top Theorists Examine Rippling Economic Turbulence

    As the financial sector shifts, so does the reach of the jolt to economic structures around the world. Economist Nassim Nicholas Taleb and his mentor, mathematician Benoit Mandelbrot, speak with Paul Solman about chain reactions and predicting the financial crisis.

    This interview links complexity to the market and our economic system.

  2. he credit crunch and the crisis of meaning

    A really interesting article!

    A quote: "But why worry about a tiny economy like Iceland’s? Because historical experience shows that a chain reaction can be unleashed from the most unexpected places. Back in 1931, it was the failure of Austria’s largest bank, the Creditanstalt, that precipitated a panic that would eventually envelop the European banking system."

  3. From Anthony Bucci:

    Thanks for forwarding these links -- I have only had a chance to skim the first, but my experience with complexity theory (and my odd job title of "Complexity Scientist") certainly had me thinking in those terms about the present situation.

    I came across this Op-Ed in the NYT that also dicusses the present financial crisis in terms of complexity theory, pointing to some research that has been/is being done:

    The article is talking about the idea of a phase transition (or something called a percolation threshold). You see these in traffic jams quite a lot: a road can handle a certain number of cars without noticeable problems, but once the traffic density hits a certain threshold, traffic jams because almost certain. There's a very sharp change such that a seemingly small increase in traffic density leads to a massive increase in the probability
    of a jam. Traffic jams then appear unpredictable, but in fact, since they are an emergent property of the system as a whole, getting your head around how the traffic system works gives a lot of insight into when and where jams will occur. This NYT article refers to work aiming to get a simulated handle on financial markets, which minimally ought to lead to better prediction of events like the current crisis.

    Naturally I can't resist plugging my own blogging efforts, as they are tangentially relevant. Here is the blog of an Artificial Life group in which I participate in Boston; haven't blogged here yet, but will soon:

    There are occasionally articles about complexity theory posted there, though I don't see any right now.

    And my own blog:

    The posts about what the word "rational" means (as opposed to "rule of thumb") seem relevant; I have also posted a few thoughts I've had about what "innovation" means that I thought you might appreciate.

    Anyway, to put it in the above terms, the use of so-called equilibrium methods to model markets just doesn't fly anymore. These methods amount to rules of thumb that have been used for decades, but with relatively little self-scrutiny of the sort that Peirce would label rational. The "surprising" nature of crises like the current one is the result of using inappropriate (Peirce would say irrational!) methods to understand the system. An innovative look at how markets function, such as the agent-based ones pointed to by the above op-ed, would make situations like this much less perplexing I think. The $700 billion band-aid recently applied has as
    much chance of failing as succeeding, it seems to me, because it was likely not born of a deep rational scrutiny of the problem.