The Financial System is Unstable !!!

Triple-Dip-Recession

In 2005 the then newly appointed at Tilburg University professor Hans Blommestein [(OECD) asked me “are very large and complex interconnected financial systems stable or not ?”. The banking world had always ASSUMED that more interconnections between their (several types of) banks and with insurance companies would make the total ‘network’ of organizations more stable, since the them current thought was that small disturbances would even out and risks could be shared when misfortune did happen in one of their investments. But from the signals from the field Blommestein was not so sure anymore if that assumption was right, so he asked me as experienced computer network architect if this was true or not. He expressed worries about the SYSTEM INSTABILITY of the banking system [1]. 

1. Sure the financial system does fluctuate and can do so suddenly and violently. As do stock markets. “Volatility” can be staggering as up as well as down, as even German and Chinese civilian-investor have learned the hard way. Many fancy instruments called “derivatives” even make money when things go down and gamble on how fast the slope of change is. Benoit Mandelbrot wrote a lot of clear (for mathematicians) explanations [2, 3] why these curves can behave “more than random” ( with many times the standard deviation ) because fractal clusters are at their core (‘scale free’ = on many scales). 

2. No I am not referring in this blog to the wild swings but to real “recessions /depressions”. 

US Fin system

The world of financials centered in Wall Street(NY) and The City(London)  but also in Chicago, Frankfurt and Shanghai, etc. is very very interconnected. The graph above only shows part of the US financial “network” some years ago. You can see that the network is not homogenous in topology (size of nodes and central very connective positions), number of links (relations with others) and strenghts of links. 

3. In 2014 prof. Carlo Jäger, of Potsdam University (to be Googled with Carlo Jaeger) gave a stunning lecture [4] at the Netherlands Royal Institute of Sciences (KNAW & NWO) conference on complexity in Amsterdam, where he explained that tightly coupled and growing complex systems above a certain level of connectivity suddenly start to behave unstable. And that any measure to stabilize it is doomed to be fighting the symptoms of that instability. In other words the instability is systematic. This lecture surely worked as an alarm bell and warning for me as an active connectivist and network architect. I have since then tried and succeeded in finding ways (architectural guidelines, 4 up to now) to construct large networks that can be stable and can scale up. As Carlo declared himself Nature has learned to do so long ago, although life exhibits sudden transitions and unstable phases too. So here again we can learn from biology. The above graph is simple compared to the structure of a cell or bacteria culture.

4. So, now at last I have found the answer to Blommesteins question, in the form a very important paper published in Science, February 2016 [5], I will show here the summary:  http://science.sciencemag.org/content/351/6275/818

======================
Complexity theory and financial regulation
Corresponding author. E-mail: C.H.Hommes@uva.nl
Science  19 Feb 2016:
Vol. 351, Issue 6275, pp. 818-819
Summary

Traditional economic theory could not explain, much less predict, the near collapse of the financial system and its long-lasting effects on the global economy. Since the 2008 crisis, there has been increasing interest in using ideas from complexity theory to make sense of economic and financial markets. Concepts, such as tipping points, networks, contagion, feedback, and resilience have entered the financial and regulatory lexicon, but actual use of complexity models and results remains at an early stage. Recent insights and techniques offer potential for better monitoring and management of highly interconnected economic and financial systems and, thus, may help anticipate and manage future crises. (for the full paper see below [5])

========================

My comment: They did show that Topology (structure) and Strenght of interactions are important, and that  with certain parameters in a heterogenous model could have shown a pre-crisis phase starting in 2005, before the actual sudden crisis did strike in 2008.

So the answer to Blommestein is: Yes, tightly coupled and growing financial NETWORKED SYSTEMS will become unstable beyond a certain strong link connectivity. 5. and 6. below concluded the same.

5. The journalist Joris Luyendijk did interview under anonymity a number of volunteers from The City who quite frankly told him about the narrow escape the world went through, when total collapse of the financial system was avoided by government interference in USA, UK and China. And he was shocked how the banksters did operate without any shame or guilt [6], while robbing investors and pension funds; without offering any serious added value.   And he wondered why real structural-systemic changes had not been made to avoid a such a near-disaster in the future. Just more oversight seems not to be enough.

6. The former guardian of the Bank of England Lord King made a statement in the Guardian (Feb 2016) : “The crisis was a failure of a system, and the ideas that underpinned it” Mervyn King warns of impending crisis. see his full statement [7] below. The Guardian writes about Lord King’s book, in which he blames the crisis and possible new (triple) dip on “imbalances” in the world economy. Which shows IMHO that he still has no clue about STRUCTURAL system instabilities, although he stated “The crisis was a failure of a system, and the ideas that underpinned it” Mervyn King warns of impending crisis.

It is rather embarrassing to see that the many very esteemed and mutual praizing economics academics of even the most prestigious universities  have FAILED to forecast or notice the arrival of the Crash of 2008. And even now have dared to admit their failure. They still 10 years after they could have noticed the real cause talk about “unexpected imbalances” and cheerfully indicate to their respective governments and governors that the economy is recuperating (NL: HERSTEL ) from the double dip. NOT. And yes the banksters, saved by the population in bad times again tell eachother the False Fairytale “that you can make money with money its self”. NOT.

It is at least encouraging that students, in my country at least,  have started to notice that the economics lectures they get are outdated and no longer valid& rooted in reality. Stable and simple “market equilibria”and well informed rational choices in static lineair models are not realistic anymore. Reality is Complex, Dynamic and Non-Linear herd-like behaviour including chain reactions.

7. We are now 10 years after the right indicators could have shown in 2005 that a structural systems failure was about to happen. So now the billion dollar question for the national bank regulators (including those in China who have reacted rather puzzled recently to the slowing down of their economy) all over the world is:

A. What do the RIGHT indicators show right now? Do we have a more relevant DASHBOARD in place to track economies in real time? Is a Triple Dip ahead or not?

B. What structural system measures and architectural guidelines must be taken to stabilize upcoming sudden jumps resulting from tight coupled growth and complexity?

8. Somebody else who DID forcast the 2008 Crash long before it actually happened (in 2002)  and who did give advice for a number of clear structural measures, which are  pre-conditions to get out of the deep dips, is Prof. Carlota Perez, which I have mentioned before in my blogs. She can be reached at the London School of Economics (LSE). In 2002 (!) she published a remarkable study in a book “Technological Revolutions and Financial Capital” in which she showed that the subsequent “golden ages” and their core breakthrough technologies all behave with 4 phases with halfway….. a crisis:

Perez LSE

In order to get out of the mid-curve ‘hole’ a number of serious changes have to be made. I do have the sheets in which she shows what these changes are. Yes financing of rollout of the needed infrastructures must be done by governments in a very different way. The good news, by the way, is that if we succeed together to climb out of the 2, or 3 dips with the right tools we can look forward to a ‘golden age’ ahead of us.

The “unstable complexity issue” shown in this blog demands serious attention, study and serious budgets to answer one of the Big Questions of our times as Carlo Jaeger has called it. The networks and systems & organizations involved are so vital for economy and society that they can no longer be just turned off, without inflicting serious damage in vital parts of society.

schakelaar

9. Not only the Financial network of organizations exhibit the instabilities as described. Other “sectors and infrastructures” are also Tightly Coupled, Complex and Growing.

9.1 For instance the Ethernet and TCP/ IP Netwoking industry has been amazingly successful and growing in for instance the Inter-nets with many orders of magnitude, but looked the last couple of years to become stuck in its own success and complexity of machinery and operations, from the 1980’s or ’70’s ?. See [9]. At the same time telecom and CableTv operators counter the erosion of their margins, caused by internet tech price/perf improvements and dis-intermediation of their services, by consolidation: taking over tha small ISP’s and eachother. The other counter-strategy they employ is increased vertical integration : not only “triple play” (fixed teleph/TV channels/ Internet video streaming) is offered as one-stop-shop offeres but also mobile smartphone use is added. This is accompanied by implementation of SDN and NFV encapsulation and of complexity and virtualsation of the control intelligence to central server farms. Wonderful, and understandable since software and computer processing and storage evolved in a similar way (horizontal bifurcation to more decenrral: smartphones && more central: cloud computers and virtual routing networks). But my question is: can this new complex SDN & NFV”network land”  be constructed and upscaled in a STABLE and resilient way ?? Or will the learning curves, emplying optics no doubt, exhibit crashes and sudden bursts too ?? This is a serious question which network architects (like I was) must pose and answer (!!!) to those responsible for digital infrastructures.

9.2 The upcoming “internet of things” (IoT) installing webs of thightly connected sensors and tiny computers in homes, offices, vehicles and industries beg the same question: “Will IoT suddenly become unstable because of structural complexity boundaries are exceeded??“. Reassuring statements of suppliers about tight control and menagement do not convince me. We are building new lifeforms in our ecology we have to share with swarms of machines and ever more clever bacteria!

9.3 Another example are the power grids for generating and transport of electrical power. These infrastructures are now also rapidly made more clever with “smart grid ” technology which will allow not only delivery to but also contribution by small businesses and home owners who want to feed back energy (stored in their cars maybe) into the grid at a price. This poses huge and complex control problems !! Power companies assume that they will be able to sense and control such grids from a central point. I doubt if that assumption can be upheld in the face of large and small changes in suppy of wind- and solar power plus congestion in transport grids. Already some power grids have shown domino-chain outages here power plants where shut off automaticly to prevent overload, which in its turn started to overload other plants. A network architectural design error never foreseen on a local scale. So my question is here too: “ can complex, very much interconnected and open smart power grids be designed so that they behave in a stable way ?

10. False solutions.

The obvious but false solution to instability of complex networks is to simplify them, by isolation & purification and disconnection with the outside world. IS, Trump, UK Boris, Putin, Wilders, et. al. give really confortable isolationalist fairytales to the many middleclass people who live in uncertaintu and fear. And Ashby’s Law of bureaucratic control seems to dictate such simplification approach, too.  This is destructive and silly.

You can build walls around you and your tribe but cut off from the ecology you are in you will die. It is like holding your breath if you have the flue. You will stop coughing but you will not survive this. Nevertheless many quite popular politicians propose this enclosure idea to shield the nation state from external disturbances and by enforcing their internal dictatorial power. The result will be smaller and smaller safe area’s for “us” to keep “them” out and the quiteness and order of prisons, where those who are different will be locked up. And..an unbelievable scale of mutual assured destruction.

The right way to proceed IMHO is to accept that the world Is Complex, [10, 11]. And there are many much more clever ways to cope with complexity and even synthesize value and wealth by diversity. We have to learn from their complex behaviour of these above mentioned  “dynamic ecologies” and constructively design and  improve them all the time in every possible ways.

walls&&bridges

And, …..it makes much more sense to build bridges than to build walls !!

Jaap van Till, TheConnectivist

PS (March 2, 2016) Barclays Bank announced that they will split themselves into two separate banks: a classical retail bank where savings can be aggregated for loans and an investment bank which does high risk, high yield gambles.  The two should never have been allowed to be combined.

 

[ 1 ] H. J.Blommestein “Visions about the Future of Banking” 2006, based on his oratio at Tilburg 2005.  https://www.suerf.org/docx/s_dabd8d2ce74e782c65a973ef76fd540b_1179_suerf.pdf

[2] Benoit Mandelbrot, “The (mis) Behaviour of Markets”

[3] Benoit Mandelbrot, “Fractals and Scaling in Finance”

[4] Prof. Carlo Jaeger https://www.youtube.com/watch?v=xvVTyhgaxpI  , January 2014

[5] Battiston, Farmer, Flache, Garlaschelli, Haldane, Heesterbeek, Hommes, Jaeger, May, Scheffer ; “Complexity Theory and Financial Regulation”; Science 19 Feb 2016;  http://science.sciencemag.org/content/351/6275/818.full

[6]  Joris Luyendijk; “Swimming with Sharks: My Journey into the World of the Bankers”; 17 Sep 2015.

[7]  Mervyn King: new financial crisis is ‘certain’ without reform of banks. Guardian about Lord King’s book, in which he blames the crisis and possible new (triple) dip on “imbalances” in the world economy. Which shows IMHO that he still has no clue about STRUCTURAL system instabilities, although he stated “The crisis was a failure of a system, and the ideas that underpinned it” Mervyn King warns of impending crisis.

[8] Carlota Perez, “Technological Revolutions and Financial Capital – The Dynamics of Bubbles and Golden Ages – January 2002 http://www.e-elgar.com/shop/technological-revolutions-and-financial-capital

[9] Joe Howard;  https://www.linkedin.com/pulse/why-network-industry-has-been-stuck-1980s-ciscos-embrace-joe-howard

[10] W. Brian Arthur; “The Economy Isn’t A Machine. Its Organic and Constantly Changing” – The origins of complexity economics – Feb 24, 2016.  http://evonomics.com/the-economy-isnt-a-machine-its-organic/

[11] Jean G. Boulton, Peter M. Allen, and Cliff Bowman “Embracing Complexity – Strategic Perspectives for an Age of Turbulence -” ; September 2015

  • Provides an authorative and accessible explanation of a difficult subject
  • Tackles the subject from a variety of angles – modeling, history, personal experience, empirical, theoretical and practical

 

Advertisements

About broodjejaap

See ABOUT on TheConnectivist.wordpress.com
This entry was posted in Complexity, Uncategorized and tagged , , . Bookmark the permalink.

8 Responses to The Financial System is Unstable !!!

  1. broodjejaap says:

    Brian P. Hanley gave me explicit permission to post his comment on my blog here.
    It shows HOW the banksters constructed the moneymaking machine that collapsed later dragging the whole world down. While this blog shows The Propagation Structure in which such bubbles could be cooked up and propagated to let other predators in to the kill. – Jaap van Till –
    ==================================
    Complexity/size and connectivity is the cause of propagation. But systemic fraud of an unusual kind was the cause. 2008 was more analogous to a deliberate crash of the internet’s backbone nodes from intentional mismanagement.

    The core of the problem was fraud magnified by the invention of a new banking multiplier. I believe the fraud was deliberate, but the banking multiplier invention was an accident. Here is the peer reviewed economics paper I published on that.

    http://www.economics-ejournal.org/economics/journalarticles/2012-3 – ‘Release of the Kraken: A Novel Money Multiplier Equation’s Debut in 21st Century Banking’

    In a nutshell I discovered that bankers created a new banking multiplier around the turn of the 21st century. Many people are aware that 1/r (where r is the reserve ratio) is the asymptotic limit of banking’s ability to create money. (e.g. in a 5% reserve system, the banking multiplier limit is 20.) The invention of the banking multiplier underpins the explosion of European civilization across the globe by making money available. Banking started as a scam, and over a few generations became a foundation to our civilization.

    How did this new multiplier work? It is based on the fact that a bank can use insured assets as reserves. So, with AIG offering low-cost credit default swap loan insurance, banks could: A. Write a real-estate loan. This loan is now an asset of the bank. B. Insure the loan to face value from an external entity. Usually they could do this for less than the points charged for the loan. C. Move that insured loan asset back into capital reserves. D. Make another loan. For most practical purposes, banks could write real-estate loans endlessly. I showed that banking multipliers could be thousands or more instead of the historical range from 2 to 50.

    Since the only type of loan this was available for was real-estate, this created a huge incentive to force money into the real-estate loan market. The problem with that is that in real estate, except when a new building (that is needed) is built, or a significant renovation is done, there is no new utility value created. So, there is pressure to create a price bubble.

    This new multiplier was a something new under the sun, an honest-to-god innovation in banking. Its impact is, potentially bigger than the invention of banking was. This innovation could be a bigger disruptor than banking was when it was invented almost 1000 years ago. In itself there is nothing wrong with money creation. We must have it, and it’s a good thing as long as it is associated with utility value creation. Everyone on this list is involved with creating aspects of the new utility value that money creation is for. When money creation occurs in the context of making things or delivering services, that is fine. When money creation pumps up unchanging utility value – inflating price – that is pathological when it exceeds a low threshold.

    So this brings us to the most fundamental problem. Bankers added a step to that 4 described above. Step E – Sell off the insured loan, recover capital, and keep the insurance policy. Again, in itself, that was not a problem. However, it created a perverse incentive that they system wasn’t regulated to control.

    Selling off the loan and keeping the insurance policy made it profitable to make loans that would go bad. Remember extraordinary record banking profits just prior to the crash? It is unlikely that selling off the loan to recover capital after making a new loan started as a way to increase profits. But when loans went bad and the bank got paid yet again after selling? I think that lit up. Banking had never made money like that before. The result was essentially an arsonists real-estate fire-sale bonanza.

    Pumping bad loans through the system on purpose obviously will break it. But, with one bank doing it, the rest have to as well in order to stay abreast. This is the core fraud perpetrated by all the CEOs, and a number of officers, of all the big banks. Break it did. AIG couldn’t pay.

    So let’s look at what that failure did. When AIG, the insurer for almost everything failed, overnight, no insured loan assets were good as capital. Banks woke up one morning and instead of having loan ratios of 1:20, or 1:30, or even 1:40, they had ratios less than 1:1500 or 1:2000. And that meant there was not enough money to execute simple bank wires.

    The paper is written to be fully understandable by the intelligent layman. So section 1 lays out background before getting more detailed.
    The story you see in “The Big Short” is just the final act, the tip of the iceberg, not the foundation of the problem.

    Brian Hanley
    (415)518-8153
    http://orcid.org/0000-0003-1202-2795

  2. broodjejaap says:

    Brian Hanley asked me to post a second comment for him. JvT
    ================================================
    I would appreciate it if you could also post this comment. The reason is that most technical people are quite ignorant about the fundamentals of how our banking economy works, and what its advantages are. I have been trying to find ways to focus on how to improve things. In the final analysis, all money is an abstraction, a belief system. There is probably an instinctual aspect to it, as we humans have invented money all over the world, and assigned monetary purpose to all sorts of things, from feather belts and strings of shells, to huge stones. Bitcoin is an excellent case-study of technological mastery wrapped around serious conceptual errors. Monetary stability is dynamic, but most people think of it as a static thing. This weird expansion of finance of finance ((“making money with money”; JvT)) that has occurred is, as you have said, the most serious problem. But, if we can get engineers to grasp money properly, and give them this sort of tool to create money with to fund real-economy utility, we may have a shot at growing our way out of this era.

    ————-
    One of the things I didn’t say in my digest is that a mechanism like this could have tremendous value to real innovation if engineers and such understood it and got hold of it to do real things. Currently, venture capital functions as money-lending rather than banking. The stock market is the other place where money is created in private hands because we agree to value all shares at the price of the last trades. (In practice, shares are discounted as collateral until sold.) If ventures could be funded with cheaper money, and businesses could grow that way, not only would it make many things viable that aren’t in the current system (because VC money costs so much in the end) but it should stabilize support for ventures so that longer-term investment can be more viable. VC time horizons are short. (VC is also ripe for disruption.)

    I have been working out how to implement an investment system of this kind within current banking regulations “from scratch”. With a significant stake, it can be practical to create a variant mechanism to refocus investment on creation of utility value.

    • broodjejaap says:

      Brian summarized his comments as follows:

      This issue of how to deal with finance of finance parasitic transactions is a, if not the, key economic matter of our time.

  3. broodjejaap says:

    Susan Crawford has given a brilliant answer to my question posed in 9.1 (how to can we keep the worldwide Network for Networking stable?), it must be SPLIT in functionally independent layers, each with different timescales of funding, building and chnaging/updating. See her article in “backchannel” :
    https://backchannel.com/you-didn-t-notice-it-but-google-fiber-just-began-the-golden-age-of-high-speed-internet-access-67b3f775fb85?mc_cid=706358a3e0&mc_eid=abf984a980#.1w418fdpn

  4. Pingback: Doc Searls Weblog · Pile ‘o links #2

  5. kwalitisme says:

    Reblogged this on kwalitisme and commented:
    As usual very interesting

  6. Pingback: Conference on Complex Systems, Amsterdam Sept 19 -22 | The Connectivist

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s