…an example of tight coupling with weak cohesion, which is how you create an unstable system.

then a couple lines down, you stated the following:

Tight coupling plus weak cohesion = avoidable problems

How then does an unstable system equal avoidable problems? I don’t understand this relationship.

I also think there are some very strong parallels that can be drawn between the current state of finance on physics a half century or so ago. Finance theory is currently dominated by large, comprehensive theories that appear to work well “on average”, under the “right assumptions”, and in the “long run” (read the U Chicago School of Thought). These ideas are somewhat similar to Einstein’s Theory of Relativity. The concepts of quantum physics proved that this grand theory did not work on the micro level. Likewise, we seem to continually rediscover that these grand financial theories do not in any specific instance. It would seem that finance would benefit from the introduction of the equivalent of quantum physics, or any theory inherently based on uncertainty, to explain individuals’ behavior in aggregate.

The social sciences seem more loath then the biological ones to accept this understanding. I am not knowledgeable enough in Economics to know if it respects emergent properties.
But it seems to me likely that the complex economic models we have seen fail recently in fact are victims of a Reductionist fallacy. They cannot be fixed by “tweaking” the curent model. The current economic crisis can be seen as easily the most expensive scientific experiment ever performed.
plschwartz

Jennifer,

This is a good way of putting it. I don’t want to go too far overboard in advocating for an overdamped system. It seems obvious to me that one can go too far in either direction, and engineering a system (financial or otherwise) for stability alone without regard to efficiency is a bad idea. There are tradeoffs to be made between the two in search of a useful balance and therein lies the real art of it.

I think the most difficult part of this problem is that in seeking to balance the two we often are judging the merits of things that play out on significantly different time scales. Efficiency arguments tend to address shorter term concerns, whereas systemic stability arguments are really addressing the impact of low frequency-high amplitude events (or black swans), and having enough expertise and wisdom to judge well in both domains can be a stretch in terms of background and outlook. I would say this is something of an intellectual (rather than moral) hazard problem.

I expect that the relative importance which each generation assigns to stability vs. efficiency arguments is colored by their personal and collective experience, which is where trans-generational memory comes into play. As a consequence it seem reasonable to me to expect a sort of rough-and-ready periodicity to the historical patterns we see in how these factors are weighed and tradeoffs made.

It makes sense to me that the current credit crisis is causing some people to rethink the relative value of financial stability vs. efficiency, perhaps to a degree we haven’t seen since the 1950s. If we can construct a more stabilizing regulatory environment for our economic system without descending into something as painful as the Great Depression of the 1930s that would be a very good outcome IMHO – an example (to paraphrase Bismarck) of benefiting by learning from other people’s mistakes. I hope our current situation plays out this way. When reading about the current crisis on this blog (and others), I keep thinking of the question that Niels Bohr posed to Oppenheimer upon his arrival at Los Alamos in 1943 (as quoted by Richard Rhodes, in TMotAB epilog p.778): “Is it really big enough?” (i.e. to change our way of thinking).

It occurs to me than when you couple more closely as Anonymous describes in a system rife with feedback paths, you also get a de facto increase in leverage which can serve as a multiplier.

Scary stuff.

Perhaps damping is akin to regulation, and dropping Glass-Steagall was the last little bit of feedback that led to a big squealing feedback event.

As you point out, thinking about the financial system (and indeed the broader economy) in this fashion helps us to realise that risks and difficulties can’t be done away with and that attempts to do so will eventually bring far greater catastrophes.

Complex, self organising systems tend, I think, to be highly stable and creative. To endure, adapt and prosper, however, they must have constant real world feedback. In the case of our financial architecture, that loop has for decades been clogged and distorted. Implicit or explicit central bank guarantees and various government support schemes have over time fundamentally altered the perception of risk. This, in turn, together of course with central bank accommodation, has enabled credit growth to far exceed all historical parameters.

Put simply, it seems to me that if the financial system is to be deregulated, then participants must not be saved from their own errors or foolishness. If the political decision is made that all manner of protection is to be provided, then fairly stringent regulation is essential. What we have seems to me the worst of both worlds.

As for “liquidity”, I wonder if it isn’t a bit of a red herring in this discussion. The word can mean so many things to different people and in different contexts that it may confuse rather than illuminate. If it is to be of any use at all, I suspect each of us who trots it out as either a prop or a target should first define the sense in which we’re using it.

Speaking as the commenter quoted by Yves, I’m not an econ/finance person (my background is in the earth sciences and software engineering), so I probably have it wrong, please correct me. My thinking was that the problem was with how the liquidity was used, to make fungible things which previously were not (like houses and MBS), which was part of what I read into Yves’ top level post yesterday.

IMHO making thing fungible creates a stronger dependency between them, which is where systems theory enters into the picture (see below for more clarification of terms). I would say that excess liquidity was an enabling factor in the breakdown of structural barriers (e.g. securitization of mortgages) which previously provided a compartmentalized character (and hence systemic stability) to our economy. In this sense liquidity acted like a solvent. This break down of barriers might have occurred anyway, but the high levels of liquidity we recently enjoyed eased and accelerated the process.

Please deconstruct this argument as I’m speculating well outside my areas of expertise here.

Yves,
Wow – I’m humbled and honored to be quoted like this (the anon comment from the Liquidity thread was mine and I suppose I should have used a handle).

Anon at 9:27 raises a good point with: “all novelty and progress, come precisely from those complex systems where information is not tightly controlled“.

I didn’t use very precise terminology in my original comment because I didn’t want to weigh it down with a bunch of object oriented programming jargon, so let me clarify something here:

Tight control over information isn’t really the goal when designing a stable system, instead it is controlling unwarranted and counterproductive proliferation of dependencies between different parts of the system that you aim for. This is because when one part of a system depends on another a part, and then that one in turn depends on yet another part (and so on through the system) then this set of dependencies (or “tight coupling”) creates a path for a failure which starts in only one part to cascade across the system causing greater harm than it would if it had been more compartmentalized.

It is possible to pass information between different part of a system in a way that minimizes their dependencies – in the programming literature this is called using “loose coupling”, and when combined with cohesion (all the stuff which is associated together in the same part of the system is strongly related) this is a good thing and still allows for a free flow of information, but in a more stable manner. The architecture of the internet is a good example of this principle at work.

An example of tight coupling from our current credit crisis would be the move by the monoline insurers into the mortgage backed securities business. They created a dependency between two somewhat unrelated financial sectors (muni bonds and residential mortgages) which were weakly coupled to each other before, such that now a city in one part of the country may have problems issuing bonds on account of declining home values in a geographically remote and economically unrelated part of the country, when from a systems standpoint there was little reason why these things needed to be connected. This is an example of tight coupling with weak cohesion, which is how you create an unstable system.

Another example would be our globalized system of agriculture, which is now putting people in 3rd world countries on the brink of starvation in part because Iowa corn farmers are paying more for oil based inputs.

Tight coupling plus weak cohesion = avoidable problems.

The problem that I see with the very high levels of liquidity and reduction of arbitrage we’ve enjoyed recently (and really globalization more generally) is that it was used to create all sorts of new dependencies between different sectors of our economy which were weakly coupled before and are now tightly coupled. Much of the slack (i.e., arbitrage) which existed before has been taken out of our system, and now shocks can propagate freely from one part of the system to the others with few barriers to stop or attenuate them. A perhaps bad analogy would be that it is as if somebody made money removing all of the shock absorbers from our cars because “they weren’t adding any value”, something which appears to be true right up to the point where you hit a big pothole in the road, at which point it would be nice to have them back. Too late.

CrocodileChuck said:
The study of natural systems would seem to be essential

I can’t echo this strongly enough. Natural systems have much longer timeframes than economists are used to looking at, so they provide an intellectual framework for thinking about grey swan and black swan events (which in some natural systems are the norm, and perform most of the “work” of the system) that is sorely missing right now.

For example, anyone familiar with the dilemma that the US Forest Service is currently grappling with regarding their legacy of excessively zealous fire suppression in the US since 1910 (in the absence of the frequent small ground fires which would normally have occurred the net fuel load in our forests has built up to unnatural and dangerous levels, making very large and destructive crown fires much more likely) could have told you that the various recession and credit crisis suppression efforts conducted by the Fed under Greenspan were going to add up to a much larger crisis down the road.

IMHO small recessions and small credit crises function in our economy much like small frequent ground fires function in a forest ecology – by clearing out things that need to be removed periodically (like bad business practices) they act to maintain the health (i.e. long term stability) of the system, as long as they occur frequently and have small amplitudes. Greenspan tried to suppress their frequency (much like the US Forest Service spent the middle part of the 20th cen. putting out every fire they could get to), and the net effect is that we’ve converted a larger number of small amplitude events into a single large amplitude event doing the same amount of work. IMHO this was not a good trade, and might have been avoided if someone whose intellectual background included thinking about longer time horizons (and the low frequency-high amplitude events that they imply) had been in charge.