Markets, indeed economies as a whole, are complex adaptive systems. Like biological ecosystems, they continuously and spontaneously order themselves in response to unfolding influences, large and small, internal and external.
When it comes to nature, we’re both part of it and a profound external influence. We shape the world around us for ill and sometimes for good, not only through deliberate actions but also, of course, merely by being here. Some of our activities and their consequences in the natural world, were we only willing to listen, could teach us much about how to better manage man-made systems such as the markets and the economy.
Forestry management provides a striking example. Our natural inclination is to put fires out wherever we can, not only to safeguard valuable property but also to protect the forests themselves and their many wild occupants.
In pursuing this practice, however, subtle changes take place over time. Dead trees and fallen branches accumulate and the undergrowth becomes thicker and much more widespread. Finally a fire occurs that we’re unable to stop, one that feeds on all the detritus to produce firestorms so powerful they can at times fundamentally change a whole ecosystem.[1]
The analogy to our economic management in recent decades is obvious, particularly when it comes to the financial system. There too, fires were continuously put out, all with the laudable goal of sidestepping the pain and distress of downturns.
As with the forests, for a long time it seemed to work wonderfully well, ushering in an exceptionally long period of largely uninterrupted growth fondly termed by some as “the great moderation”. Many even believed the business cycle had finally been consigned to the rubbish bin, a relic defeated by modern understanding and newly contrived management tools.
It was, of course, an illusion, a period of apparent grace during which imbalances of all kinds were allowed (indeed encouraged) to flourish and accumulate. As with the forests, this long period of suppression finally so distorted matters that the next blaze to break out was very nearly unmanageable.
Almost all system resilience had been lost.
How and why we let this unhappy illusion proceed isn’t such a great mystery. Where politicians have the power to alleviate apparent ills, the incentives to do so are overwhelmingly powerful. To expect them to not act, to deliberately allow events to take an apparently unnecessary and painful course, is almost certainly to expect too much. The incentives are all wrong.
In any event, the result of all this well-meaning (and, it must be said, self-interested) activity was a progressive deterioration in the many feedback mechanisms that actually enable markets to work. Positive ones were given every assistance, indeed new ones were regularly invented, but negative feedback? Thank you but no, we don’t need any of that here.
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The catalyst for these thoughts is an intriguing website called Macroeconomic Resilience. The concept of resilience is used there to gain a better understanding of social systems such as markets. The author (who prefers to remain anonymous) provides the following definition for resilience: “[T]he capacity of a system to absorb disturbance and reorganize while undergoing change so as to still retain essentially the same function, structure, identity, and feedbacks.”
In order to be resilient, any system must have an effective complex of countervailing feedback mechanisms. Without these, it wouldn’t have the capacity to absorb shocks, whether positive or negative, while retaining its essential character. Take our individual immune systems: if they’re too weak, external organisms will invade and wreak havoc; if, on the other hand, they themselves aren’t properly kept under control they can turn on us in the kind of self-immolation that characterises auto-immune diseases. And so on and so on. All systems, even the most apparently simple, generally have a multitude of intricately interlocked influences that feed off, oppose, or sustain each other.
Our anonymous author (let’s call him MR) applies this concept very nicely to markets:
“However, in a dynamic conception of markets, a resilient market is characterised not by the absence of positive feedback processes but by the presence of a balanced and diverse mix of positive and negative feedback processes.
Policy measures that aim to stabilise the system by countering the impact of positive feedback processes select against and weed out negative feedback processes – Stabilisation reduces system resilience.”
Exactly right, I think, and nicely put. This principle (that the desire to avoid destabilisation and short-term pain merely ensures more of both is likely in the long-term) lies at the heart of almost everything that’s wrong with our economic and financial systems.
MR takes as an example the minor meltdown on May 6th this year, rightly questioning one of the more common explanations, namely that it was the result of a kind of perfect storm: “When the WSJ provides us with the least plausible explanation of the “Crash of 2:45 p.m.”, it is only fitting that Jon Stewart provides us with the most succinct and accurate diagnosis of the crash.” Here’s Stewart’s take:
“Why is it that whenever something happens to the people that should’ve seen it coming [but] didn’t see [it] coming, it’s blamed on one of these rare, once in a century, perfect storms that for some reason take place every f–king two weeks. I’m beginning to think these are not perfect storms. I’m beginning to think these are regular storms and we have a sh–ty boat.”
Indeed. MR again: “So what is the true underlying cause of the crash? In my opinion, the crash was the inevitable consequence of a progressive loss of system resilience. Why and how has the system become fragile? A static view of markets frequently attributes loss of resilience to the presence of positive feedback processes such as margin calls on levered bets, stop-loss orders, dynamic hedging of short-gamma positions and even just plain vanilla momentum trading strategies . . . . “
The real problem, though, as noted earlier, is that through a desire to protect against positive feedback processes, negative feedback is progressively weeded out. Back to MR.
“The decision to cancel errant trades is an example of such a measure. It is critical that all market participants who implement positive feedback strategies (such as stop-loss market orders) suffer losses and those who step in to buy in times of chaos i.e. the negative-feedback providers are not denied of the profits that would accrue to them if markets recover. This is the real damage done by policy paradigms such as the “Greenspan/Bernanke Put” that implicitly protect asset markets. They leave us with a fragile market prone to collapse even with a “normal storm”, unless there is further intervention as we saw from the EU/ECB. Of course, every subsequent intervention that aims to stabilise the system only further reduces its resilience.”
The end result is a system subject to catastrophic phase shifts, where even normal storms can bring on an almost complete collapse as one-sided feedback processes snowball. In other words pretty much exactly what happened with the whole global financial crisis.
There’s plenty more meat at the site, including consideration of how poorly conceived regulation can undermine resilience and system diversity, the degree to which individual behaviour is shaped by institutional structures, and how Minsky’s notion that stability breeds instability has parallels in the field of ecology.
I’ll almost certainly come back to some of these in future posts but in the meantime recommend you go and have a look for yourself.
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1 Like most things, forestry management seems to become more complex the more one delves into it (until, perhaps, some blessed day when knowledge and experience fuse to reveal deeper truths). That day obviously hasn’t, and never will, arrive for me but from what little I do know views such as these about the dangers of fire suppression are now widely held.
Money, Credit & Financial Systems 