The Connectivist

The Financial System is Unstable !!!

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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”. 

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

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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])

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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:

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.

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.

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

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Update June 2107: the Financial System crisis is not the only avalance like chain reaction we have experienced since 2008. There has been a cascade of such worldwide crises, each can be traced back from a political act of DEREGULATION [thanks to the stubborn ideologists  for Neo-Liberal thinking 😦    ], see:

https://theconnectivist.wordpress.com/2017/06/25/about-our-connected-future-3-patterns-of-complexity-of-world-society/

 

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