by Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB
There is a long list of culprits when it comes to assigning blame for the financial crisis. A number of recent papers such as, Andrew Haldane “What have economists ever done for us” (VOXEU, Oct. 1st) argues economists are among the guilty, falling to an intellectual virus of theory-induced blindness. Haldane calls for an intellectual reinvestment in models of heterogeneous, interacting agents, which may require an examination of other disciplines.
Concurrently, Robert May wrote a recent column in the Financial Times “In finance too, complex ecosystems can be vulnerable” (FT, Oct. 21st). He notes there are some parallels between complexity in financial systems and eco-systems in zoology. The greater the complexity in an eco-system (more species and greater interactions among them) the more vulnerable it may become to environmental shocks (May-Wigner theorem). A general statement can be said, it is that stressful environments tend to be associated with simple not complex ecosystems. The introduction of an alien species into a complex ecosystem can result in a complete disruption. Financial systems continue to increase in complexity through greater interconnections and expansion with computer power.
There are several lessons that can be drawn from ecology and complex systems: (1.) the regulatory focus is primarily on individual entities, but now the focus from recent events is shifting to systems. In particular, the failure on one bank, through interconnections, can propagate throughout the whole system (super spreaders of infections). Large, complex banks need to hold large capital reserves. (2.) The prevention of contagion is laudable, but it is better to avoid failure in the first place. For example, do we fully understand the pricing of derivatives that are largely based on simplistic, perfect market conditions? This may actually increase system vulnerability through faulty assumptions. (3.) There are concerns that that we do not fully understand the dynamics of banking systems. Banks are a larger part of the economy, but the foundation for regulations is coming from Basel I & II. The risk is that by only addressing some fundamental issues, the new regulations are making the system more complex.
The main lesson is that in a complex, species-rich ecosystems can persist in relatively predictable environment. However, the introduction of an alien species can produce pressures that may cause wide environmental fluctuations (financial systems & complexity).
Haldane notes that economists have tended to ignore cycles in money and bank credit. The interplay of bank money and credit and the wider economy has been pivotal to the mandate of central banks for centuries. Two developments – one academic, one policy-related – appear to have been responsible. The first was the emergence of micro-founded dynamic stochastic general equilibrium (DGSE) models in economics which downplayed the role of financial factors. The second was an accompanying neglect for aggregate money and credit conditions in the construction of public policy frameworks and neglect of bank balance sheets.
The lessons of financial history have been painfully re-taught and it underscores the importance of sub-disciplines such as economic and financial history. Second, it underlines the importance of reinstating money, credit and banking, as well as refocusing on models of the interplay between economic and financial systems. Third, the crisis showed that institutions really matter, be it commercial banks or central banks, when making sense of crises, their genesis and aftermath.
There is increased integration of markets of all types, economic, but especially financial and social. The dynamics in socioeconomic systems are becoming increasingly familiar, but with a fragile property: swan-like serenity one minute, riot-like calamity the next. These dynamics do not emerge from most mainstream models of the financial system or real economy. The majority of these models use the framework of a single representative agent (or a small number of them). That effectively neuters the possibility of complex actions and interactions between agents shaping system dynamics.
The financial system is an archetypical complex, adaptive socioeconomic system – and has become more so over time. In the early years of this century, financial chains lengthened dramatically, system-wide maturity mismatches widened alarmingly and intrafinancial system claims ballooned exponentially. The system became, in consequence, a hostage to its weakest link. When that broke, so too did the system as a whole. Communications networks and social media then propagated fear globally.
Conventional models, based on the representative agent and with expectations mimicking fundamentals, cannot capture the system dynamics. They are fundamentally ill-suited to capturing today’s networked world, in which social media shape expectations, shape behavior and thus shape outcomes. Can economists learn to understand the dynamics of systemic risk?
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